A Welfare Analysis of Labor Market Inequality: Inspecting the Mechanism∗

This paper develops a series of simple heterogeneous-agents economies in order to study the welfare implications of labor market inequality. We perform two types of welfare calculations. First we compute the welfare cost of a rise in labor market risk, given a particular asset market structure (complete markets, incomplete markets, autarky). Second, we compute the expected gain from completing markets (starting from autarky or incomplete markets) for a given level of wage inequality. We are able to derive intuitive closed-form expressions for these welfare effects, expressions which depend only on preference parameters and the size of (the change in) wage dispersion. We then exploit the positive implications of our incomplete-markets economy for the cross-sectional joint distribution over earnings, hours and consumption to estimate the preference parameters. Plugging these estimates into our welfare expressions allows us to quantify the welfare consequences of the rise in wage inequality observed in the United States over the past three decades as 2.5% of lifetime consumption. Moreover, we calculate that completing the asset markets, given the current level of inequality, would lead to a welfare improvement equivalent to 40% of lifetime consumption. ∗We would like to thank, without implicating, Randy Wright. Several ideas in this paper originated from a conversation we had with him. We also thank participants to the NYU Macro Reading Group, and to the Richmond Fed Conference on Labor Markets for comments.