Labor Supply Management in Search Equilibrium

Abstract:

We propose a framework for understanding why nonparticipation in the labor force accelerates during contractions and participation does not fully recover during expansions to the pre-recession levels. We interpret this phenomenon as the coordination failure among firms and workers as vacancies are posted arising from wage-contracting features; that is, random search and ex-ante wage commitments. Within this setup we show that the persistent changes in labor force participation will arise in response to transitory movements in the marginal product of labor: A negative shock to productivity may induce each firm to restrict wages unilaterally (solving its individual monopsony problem.) On the upside, however, raising wages beyond the going wage level has no impact on labor supply, since worker expectations are based on the aggregate wage level and each individual firm is massless and facing random search. These results are driven by an externality due to the search friction: an atomistic firm cannot unilaterally induce reentry of nonparticipants but a (universal) wage increase can increase the rate of participation.