Productivity Shocks , Dynamic Contracts and Income Uncertainty ∗

This paper examines how employer and worker specific productivity shocks transmit to wage and employment in an economy with search frictions and firm commitment. I develop an equilibrium search model with worker and firm shocks and characterize the optimal contract offered by competing firms to attract and retain workers. In equilibrium risk-neutral firms offer risk-averse workers contingent contracts where payments are back-loaded in good times and front-loaded in bad ones: the combination of search frictions, productivity shocks and private worker actions results in partial insurance against firm and worker shocks. I estimate the model on matched employer-employee data from Sweden, using information about co-workers to separately identify firm specific and worker specific earnings shocks. Preliminary estimates suggest that firm level shocks are responsible for about 20% of permanent income fluctuations, the remaining being accounted for by individual level shocks (30% to 40%) and by job mobility (40% to 50%). The wage contract attenuates 80% of individual productivity shocks but passes through 30% of firm productivity fluctuations. ∗I am thankful to Jan Eeckhout, Jeremy Lise, Costas Meghir and Jean-Marc Robin for their invaluable advice and to Joseph Altonji, Hector Chade, Lisa Laun, Giuseppe Moscarini, Nicola Pavoni, Fabien PostelVinay and Shouyong Shi for their helpful comments and suggestions. I also thank seminar and conference participants at UCL, IFS, Yale University, the Cowles Macroeconomics conference, the Science-Po Search and Matching conference and the Essex Search and Matching conference. I gratefully acknowledge financial support from the cemmap, ESRC, the IFS and the Cowles Foundation. I am thankful to the IFAU for outstanding help with the Swedish administrative data. †Department of Economics, University College London, Gower Street, London WC1E 6BT, UK. [email protected] and Institute for Fiscal Studies.