Productivity Shocks, Dynamic Contracts and Income Uncertainty

This paper examines how employer and worker specific productivity shocks transmit to wage and employment in an economy with search frictions and firm commitment. I develop an equilibrium search model with worker and firm shocks and characterize the optimal contract offered by competing firms to attract and retain workers. In equilibrium risk-neutral firms offer risk-averse workers contingent contracts where payments are back-loaded in good times and front-loaded in bad ones: the combination of search frictions, productivity shocks and private worker actions results in partial insurance against firm and worker shocks. I estimate the model on matched employer-employee data from Sweden, using information about co-workers to separately identify firm specific and worker specific earnings shocks. Preliminary estimates suggest that firm level shocks are responsible for about 20% of permanent income fluctuations, the remaining being accounted for by individual level shocks (30% to 40%) and by job mobility (40% to 50%). The wage contract attenuates 80% of individual productivity shocks but passes through 30% of firm productivity fluctuations.