On the Composition Effects on the Labor Market Outcomes

It is well documented that hazard rates and entry wages decline with unemployment duration and are procyclical. These outcomes may be explained on the basis of workers' invariant characteristics and composition variation with unemployment duration and over the business cycle. To explore it theoretically and quantitatively, we build a labor market model in which firms lack information on the qualifications of the candidates and react to the asymmetry of information by designing self-selection schemes. As pointed out by the personnel economics literature, performance-contingent compensation plans are central in such sorting schemes. The other key ingredient of our self-selection mechanism is capital-skill complementarity, which allows firms to target one type of applicants by playing with the capital margin. As a result, workers of different types direct their search towards distinct submarkets and high-skilled workers experience higher job-finding rates and entry wages. We calibrate the model to replicate some salient facts of the US economy. In line with the empirical literature, the sorting mechanism explains almost one third of the 48 percent decline of the monthly hazard rate after three months of unemployment relative to the first week.