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Frictional Wage Dispersion in Search Models: A Quantitative Assessment

  • Andreas Hornstein
  • Per Krusell
  • Giovanni L. Violante

Standard search and matching models of equilibrium unemployment, once properly calibrated, can generate only a small amount of frictional wage dispersion, i.e., wage differentials among ex-ante similar workers induced purely by search frictions. We derive this result for a specific measure of wage dispersion -- the ratio between the average wage and the lowest (reservation) wage paid. We show that in a large class of search and matching models this statistic (the "mean-min ratio") can be obtained in closed form as a function of observable variables (i.e., the interest rate, the value of leisure, and statistics of labor market turnover). Various independent data sources suggest that actual residual wage dispersion (i.e., inequality among observationally similar workers) exceeds the model's prediction by a factor of 20. We discuss three extensions of the model (risk aversion, volatile wages during employment, and on-the-job search) and find that, in their simplest versions, they can improve its performance, but only modestly. We conclude that either frictions account for a tiny fraction of residual wage dispersion, or the standard model needs to be augmented to confront the data. In particular, the last generation of models with on-the-job search appears promising.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13674.

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Date of creation: Nov 2007
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Publication status: published as Andreas Hornstein & Per Krusell & Giovanni L. Violante, 2011. "Frictional Wage Dispersion in Search Models: A Quantitative Assessment," American Economic Review, American Economic Association, vol. 101(7), pages 2873-98, December.
Handle: RePEc:nbr:nberwo:13674
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