Truncated Hedonic Equilibrium

Workers and firms in a bilateral matching market offer wages and human capital investments then match assortatively. The hedonic or competitive solution for this model has the undesirable property that in order to support the equilibrium, the worst workers and firms must misunderstand the consequences of reducing their investments. This paper proposes an alternative to the competitive solution in which the worst workers' and firms' conjectures about the consequences of reducing their investments coincide with consequences they would face in a Nash equilibrium of a large finite matching game. The resulting equilibrium induces the worst types of workers and firms to pool their investments at a level that exceeds the competitive level. This pooling supports sorting among higher types at investments and wages that are at least as high as in the competitive solution. Under some conditions the worst types exert a strong spillover effect on the higher types. We show that entry of low quality firms can depress wages and investment levels of high quality firms and workers, a kind of Wal-Mart effect.