Frictional Wage Dispersion: A Puzzle?∗

This paper demonstrates that the standard search and matching models of equilibrium unemployment, once properly calibrated, can generate only a tiny amount of frictional wage dispersion, i.e., wage differentials among ex-ante similar workers induced purely by search frictions. The analysis is centered around a specific measure of wage dispersion— the ratio between the average wage and the lowest (reservation) wage paid. We show that in the textbook search and matching models this statistic (the “mean-min ratio”) can be obtained in closed form as a function of observable variables, without any parametric assumption on the wage offer distribution. Looking at various independent data sources suggests that, empirically, frictional wage dispersion is larger by a factor of 20. We discuss the extent to which three extensions of the model (risk aversion, volatile wages during employment, and on the job search) can improve its performance. We are grateful for comments from Gadi Barlevy, Bjoern Bruegemann, Zvi Eckstein, Chris Flinn, Giuseppe Moscarini, and Philippe Weil, and from seminar participants at the Cleveland Fed, ESSIM 2004 (Cyprus), NYU Macro Lunch, Philadelphia Fed, Penn State, Princeton, USC, Yale, and York University. Greg Kaplan and Matthias Kredler provided excellent research assistance. The views expressed here are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System. Federal Reserve Bank of Richmond, and CEPR Princeton University, CEPR, and NBER New York University, and CEPR