Firm Dynamics and Residual Inequality in Open Economies

Increasing wage inequality between similar workers plays an important role for overall inequality trends in industrialized societies. To analyze this pattern, we incorporate directed labor market search into a dynamic model of international trade with heterogeneous ï¬rms and homogeneous workers. Wage inequality across and within ï¬rms results from their different hiring needs along their life cycles and the convexity of their adjustment costs. The interaction between wage posting and ï¬rms’ growth process allows us to explain some recent empirical regularities on ï¬rm and labor market dynamics. Fitting the model to capture key features obtained from German linked employer-employee data, we investigate how falling trade costs and institutional reforms interact in shaping ï¬rm dynamics and aggregate labor market outcomes. Focusing on the period 1996-2007, we ï¬nd that neither trade nor key features of the Hartz labor market reforms account for the sharp increase in residual inequality observed in the data. By contrast, inequality is highly responsive to the increase in product market competition triggered by domestic deregulation reforms.