Heterogeneities and the Fragility of Labor Markets

Abstract

Workers' labor market participation decisions and firms' vacancy creation decisions are studied in a model where different matches generate different surpluses. An immediate consequence of these heterogeneities is that better matches are possible in thicker markets. This creates a thick market externality: when additional workers and firms enter the market, they confer net benefits on the other workers and firms by improving the expected quality of their matches. As a consequence, there is always too little entry by both workers and firms. The thick market externality has further implications. Quite generally labor markets will be fragile: Considering shocks to average match productivities, there will be a critical threshold at which the market suddenly transitions from supporting multiple workers and multiple firms in equilibrium to supporting no workers or firms in any equilibrium. Workers and firms suffer discontinuous losses as this threshold is passed and the market collapses.