Matching, Heterogeneity, and the Evolution of Income Distribution

This paper analyzes a model in which firms and workers have to engage in costly search to find a production partner, and endogenizes the skill, job, and wage distributions in this context. The presence of search frictions implies that there are two redistributive forces in the labor market. The first is mismatch relative to the Walrasian economy; skilled workers tend to work with lower physical to human capital ratios, and this compresses the earnings differentials. The second is the opportunity cost effect; because the opportunity cost of accepting an unskilled worker, which is to forgo the opportunity to employ a skilled worker, is high, unskilled wages are pushed down. The interaction between these two forces leads to a non-ergodic equilibrium process for wage and income inequality. Further, the presence of mismatch reduces the rate of return to physical capital and thus depresses growth. A key prediction of the analysis is that increasing wage inequality is more likely to arise in economies with less frictional labor markets, which is in line with the diverse cross-country patterns observed over the past two decades. Finally, the paper predicts that, as is largely the case with U.S. data, between group and within group wage inequality should move in the same direction.