Pairwise matching, worker heterogeneity and non-linear wages

The paper studies wage formation in a pairwise matching model with heterogeneous labor. Firms propose wage offers unilaterally but workers can opt to search for alternative contacts besides pairwise meetings. Due to this option, the Diamond Paradox does not emerge but workers earn a non-trivial share of the transferable rent. Since the search option is disproportionately valuable for high skilled workers, the equilibrium wage function is increasing and convex in worker's skills. A mean preserving spread in the skill distribution induces greater wage dispersion. In the short-run, an increase in the average skill level compresses wages and may drive some low skilled workers out of the market. In the long-run, however, higher skill levels stimulate labor demand, counterbalancing the negative short-run effects. The long-run demand effect and the non-linear wage function can help to explain the empirically observed increase in the both supply and price of skilled labor.