On-the-Job Search and Sorting

We characterize the equilibrium of a search model with a continuum of job and worker types, wage bargaining, free entry of vacancies and on-the-job search. Although on-the-job search reduces the output loss due to frictions, it increases the wage differentials. The decentralized economy with monopsonistic wage setting yields too many vacancies and hence too low unemployment compared to first best, due to a business-stealing externality. Raising workers' bargaining power resolves this inefficiency. Unemployment benefits are a second best alternative to this policy