Labor Market Friction, Firm Heterogeneity, and Aggregate Employment and Productivity

Abstract The paper is based on a synthesis of a "product variety" version of the firm life cycle model developed by Klette and Kortum (2004) and an equilibrium search model of the labor market with job to job flows introduced by Mortensen (2003). In the construction, a continuum of intermediate product and service varieties are produced with labor that serve as inputs in the production of a final good. Intermediate goods producers generally differ with respect to their productivity. New firms enter and continuing firms grow by developing new product varieties. The time required to match workers and jobs in the model depends on the total number of vacancies and possibly on the fraction of employed to unemployed worker. Workers receive job offers both while employed and unemployed. Wages are set through bargaining over marginal match surplus where the worker's bargaining position may improve with the arrival of outside job opportunities as in Dey and Flinn (2005) and Cahuc et al. (2006). A job separation occurs if either a worker quits or a job is destroyed. We show that a general equilibrium solution to the model exists and that the equilibrium is broadly consistent with observed dispersion in firm productivity, wages, and the relationship between them as well as patterns of worker flows. The model implies that frictions, both in the labor market and in the firm growth process, can be important determinants of aggregate productivity as well as aggregate employment.