Efficiency of Investment in Human and Physical Capital in a Model of Bilateral Search and Bargaining

Abstract

A matching model is used to analyze the effect of search frictions on incentives to invest in human and physical capital. Equilibrium involves inefficient (low) levels of investment. The source of the inefficiency cannot be attributed solely to either search or bargaining. Schemes that assist matching are Pareto-improving. While the ratio of workers to firms remains fixed, intermediaries that pay owners according to the amount of capital carried into the market are able to generate efficient outcomes. Such intervention may not eliminate inefficiencies when the ratio is endogenized. Policy implications include encouragement of investment (even while abstracting from growth). This paper examines investment in human and physical capital in an environment with explicit frictions. In particular, I analyze a random matching model, where workers must search for employers and vice versa, but one that is generalized beyond the previous literature to include ex ante investments on both sides of the market.2 The model generates equilibria with inefficiently low levels of investment. To identify the source of the inefficiency, its robustness to variations in the environment is considered. I also analyze a generalized version of the model, in which individuals can choose whether to invest in physical or human capital (i.e., whether to become employers or workers). The model predicts that the