Matching, Heterogeneity, and the Evolution of Income Distribution

This paper analyzes a model in which firms and workershave to engage in costly search to find a production partner,and endogenizes the skill, job, and wage distributions in thiscontext. The presence of search frictions implies that thereare two redistributive forces in the labor market. The firstis mismatch relative to the Walrasian economy; skilled workerstend to work with lower physical to human capital ratios, andthis compresses the earnings differentials. The second is theopportunity cost effect; because the opportunity cost of acceptingan unskilled worker, which is to forgo the opportunity to employa skilled worker, is high, unskilled wages are pushed down. Theinteraction between these two forces leads to a non-ergodic equilibriumprocess for wage and income inequality. Further, the presenceof mismatch reduces the rate of return to physical capital andthus depresses growth. A key prediction of the analysis is thatincreasing wage inequality is more likely to arise in economieswith less frictional labor markets, which is in line with thediverse cross-country patterns observed over the past two decades.Finally, the paper predicts that, as is largely the case withU.S. data, between group and within group wage inequality shouldmove in the same direction.