Heterogeneity and Learning in Labor Markets

I develop an equilibrium matching model where heterogeneous workers and firms learn about match quality and bargain over wages. The model generalizes Jovanovic (1979) to the case of heterogeneous workers and firms. Equilibrium wage dispersion arises due to productivity differences between workers, technological differences between firms, and heterogeneity in beliefs about match quality. Under a simple CRS technology, the equilibrium wage is additively separable in worker- and firm-specific components as well as in the posterior mean of beliefs about match quality. This parallels the “person and firm effects” empirical specification of Abowd et al (1999) and others. The model predicts a negative correlation between estimated person and firm effects, which is consistent with most previous empirical evidence. I estimate the equilibrium wage function and test the model's empirical predictions using linked employer-employee data from the U.S. Census Bureau. I find empirical support for many of the model's predictions and estimate that dispersion in beliefs about match quality explains over 20 percent of observed earnings variation.