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Insurance and Opportunities: A Welfare Analysis of Labor Market Risk

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  • Jonathan Heathcote
  • Kjetil Storesletten
  • Giovanni L. Violante

Abstract

Using a model with constant relative risk-aversion preferences, endogenous labor supply and partial insurance against idiosyncratic wage risk, we provide an analytical characterization of three welfare effects: (a) the welfare effect of a rise in wage dispersion, (b) the welfare gain from completing markets, and (c) the welfare effect from eliminating risk. Our analysis reveals an important trade-off for these welfare calculations. On the one hand, higher wage uncertainty increases the cost associated with missing insurance markets. On the other hand, greater wage dispersion presents opportunities to raise aggregate productivity by concentrating market work among more productive workers. Our welfare effects can be expressed in terms of the underlying parameters defining preferences and wage risk, or alternatively in terms of changes in observable second moments of the joint distribution over individual wages, consumption and hours.

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  • Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2007. "Insurance and Opportunities: A Welfare Analysis of Labor Market Risk," NBER Working Papers 13673, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:13673
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    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
    • J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials

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