Labour Market Imperfrections and Thick Market Externalities from Innovation

In the presence of labor market imperfections, workers do not receive their full marginal product and the skill level of the workforce becomes a public good from which all firms benefit. As a result, the adoption of an innovation that increases the non-firm specific human capital of a worker creates a positive externality for his future employers who will also benefit from the increased productivity. This holds even when complete contracts can be written between worker and employer because the externality is between current and future employers of the worker. This externality can lead to a multiplicity of equilibria whereby in the Pareto dominated equilibrium innovation is not profitable because the workforce is untrained (unskilled). This mechanism also illustrates how labor market conditions influence investment and innovation activity and offers new links between unemployment and growth. These links imply that when entry decisions of firms are endogenized an additional thick market externality is created. Entry, by reducing unemployment, makes investment and further entry more profitable. Finally, when firms are allowed to choose the timing of their innovation, free-rider effects are introduced and the Pareto preferred equilibrium is destroyed.