On Flexibity and Productivity

We introduce a joint model of labor market search and firm size dynamics to explain the differential in labor market and productivity outcomes between the U.S. and the European Union. At the core, our model is a hybrid of the labor market search model by Mortensen and Pissarides (1994) and the model of the size distribution firms by Lucas (1978). Around this core, however, we add several layers that we use to add rigidities that affect the `flexibility' with which resources are allocated in our model economy. The first layer that we add is creative destruction. That is, we relate the need for job reallocations to the growth rate of the economy. In each period better firms enter while inferior firms exit, in the spirit of Jovanovic (1982). Hence, contrary to Mortensen and Pissarides (1994), exit of firms, and the destruction of the jobs that they offer, is thus endogenous in our model. The second layer that we add is the occupational choice of workers that are without a job. That is, in equilibrium workers endogenously decide whether to look for a job or to become an entrepreneur based on the quality of a business idea that they have. The third layer is the dynamic hiring and firing decisions of firms. Similar to Hopenhayn and Rogerson (1993), the firm dynamics in our model economy are in large part driven by the dynamic hiring and firing decisions made by the existing firms. We use this model to identify which types of rigidities have the biggest distortionary effect on the allocation of resources both in terms of labor as well as in terms of productivity