Endogenous TFP, Labor Market Policies and Loss of Skills

This paper builds a model of endogenous TFP with search and matching frictions in the labor market with two features: production units are subject to idiosynchratic shocks and workers suffer skill loss during unemployment. I show that aggregating firms' micro-production decision leads to an aggregate production that is Cobb-Douglas in labor and capital. The endogenous TFP depends on two equilibrium characteristics of the labor market: the productivity of matches formed and active, and the aggregate skill distribution. In particular, the job destruction decision and the job finding rate are sufficient statistics that uniquely determine TFP. The labor market affects TFP through two channels. First, an increase in the reservation productivity raises the average match productivity and TFP. Second, the job finding rate and the job destruction decision shape the skill distribution, as it determines how long workers remain unemployed and the amount of skill loss. The paper then studies the effect of labor market policies on TFP. In contrast with previous studies, the effect of unemployment insurance on TFP depends on the relative size of the two channels. More generous unemployment insurance programs improve TFP only if the effect on the average productivity is larger than the compositional effect through to the skill channel.