A Quantitative Rat Race Theory of Labor Market Dynamics

A fundamental puzzle for productivity driven business cycle theories is that labor productivity and hours are negatively correlated. I refine the empirical puzzle and provide a theory to account for it. I emphasize that hours per worker and individual hours relative to usual hours move counter to productivity. In the cross-section, I find that almost all workers increase their hours when productivity is low, except for low (residual) wage earners. Furthermore, low wage earners suffer larger wage losses when productivity falls. Based on these findings, I hypothesize that non-neutral movements in productivity exacerbate frictions due to adverse selection. I use recent advances in competitive search theory to imbed Akerlof’s Rat Race into a Neo-Classical growth model with search frictions. Firms bundle high earnings with long hours in order to separate more able and willing workers from the less productive. When low productivity workers fall (relatively) farther behind, the firm requires longer hours from everyone else; perversely, many workers work harder even as the market value of their time falls. A calibrated version of the model is used to measure the aggregate volatility generated by productivity shocks when labor markets are burdened by adverse selection. ∗I would like to thank Victor Rios Rull, Fabrizio Perri, Jonathan Heathcote, Kjetil Storesletten, Fatih Guvenen, Joe Ritter, Ali Shourideh, and seminar participants at the Federal Reserve Bank of Minneapolis, the University of Western Ontario, the University of Pennsylvania, UT-Austin, Southern Methodist University, Simon Fraser University, and the University of Rochester