An Empirical Model of Wage Dispersion with Sorting

This paper studies wage dispersion in an equilibrium on-the-job-search model with endogenous search intensity and wage setting through bargaining with employers competing for workers' services. Workers differ in permanent skills, firms differ in productivity. Workers can respond to mismatch by searching harder for better matches; they 'create their own luck'. This mechanism may generate labor market sorting. The model is estimated on Danish matched employer-employee data. We find that high-skilled workers tend to sort into high-productive firms. Log wage variation comprises worker heterogeneity, firm heterogeneity, imperfect labor market competition, and sorting in proportions 49%, 17%, 23% and 11%. Hence, labor market sorting is a separate and significant source of dispersion. In a counterfactual economy where workers are prevented from acting on mismatch, there is no sorting, and worker heterogeneity is found to be a much weaker contributor to wage variation, and imperfect labor market competition, effectively 'luck', a much stronger contributor. Ignoring worker's search choice may thus substantially impact our understanding wage inequality.