Econometrica, Vol. 71, No.

5 (September, 2003), 1377–1404

EQUILIBRIUM WAGE-TENURE CONTRACTS

BY KEN BURDETT AND MELVYN COLES1

In this study we consider a labor market matching model where firms post wage-
tenure contracts and workers, both employed and unemployed, search for new job op-
portunities. Given workers are risk averse, we establish there is a unique equilibrium
in the environment considered. Although firms in the market make different offers
in equilibrium, all post a wage-tenure contract that implies a worker’s wage increases
smoothly with tenure at the firm. As firms make different offers, there is job turnover,
as employed workers move jobs as the opportunity arises. This implies the increase in
a worker’s wage can be due to job-to-job movements as well as wage-tenure effects.
Further, there is a nondegenerate equilibrium distribution of initial wage offers that is
differentiable on its support except for a mass point at the lowest initial wage. We also
show that relevant characteristics of the equilibrium can be written as explicit functions
of preferences and the other market parameters.

KEYWORDS: Search, contracts, turnover, wage-tenure, wage dispersion.

1. INTRODUCTION
THE OBJECTIVE OF THIS STUDY is to analyze equilibrium in a labor mar-
ket where firms post wage/tenure contracts and workers—both employed and
unemployed—search for better paid job opportunities. Given the environment
faced, we show that in equilibrium the contract offered by any firm implies
the worker’s wage increases with tenure at that firm. Further, although firms
in equilibrium do not offer the same contract, they are all related to a single
wage/tenure contract with different firms offering different starting points on
that contract. This implies that employed workers change jobs over time, and
do so whenever they contact a firm offering better wages than those currently
earned. Hence, a worker’s wage increases over time due to both wage/tenure
effects and to quitting to better paid employment. As we can explicitly solve
for the major characteristics of the model in equilibrium, the results lead to
several predictions about the labor market histories of workers and the nature
of labor market equilibria that have not been exploited to date.
During the last ten years or so a literature has developed based on the equi-
librium analysis of labor markets where employed workers continue search for
better job opportunities. Much of this work has been based on the framework
developed by Burdett and Mortensen (1989, 1998) (hereafter termed B/M).2
A critical feature of the B/M framework is that each firm posts a single price—
a wage that it pays all of its employees at each point in time. In the context of a

1
We would like to acknowledge the financial support given by the Leverhulme Trust in sup-
porting the project ‘Labor Market Dynamics in a Changing Environment.’ We would also like to
thank two anonymous referees and the Editor for helpful comments. We are, of course, respon-
sible for any errors.
2
Albrecht and Axell (1984), Eckstein and Wolpin (1990), and Acemoglu and Shimer (1999)
provide interesting alternative approaches.

1377
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1378 K. BURDETT AND M. COLES

relatively standard matching framework with identical firms and workers, equi-
librium with on-the-job search implies a nondegenerate distribution of wage
offers.3 The logic is relatively simple. Firms offering a high wage make less
profit per employee than those firms offering a lower wage. On-the-job search,
however, implies those firms offering higher wages attract more workers and
so enjoy a larger steady-state labor force. In equilibrium, all firms obtain the
same steady-state profit flow, even though they offer different wages.
This framework has proved to be empirically useful as it can be used to ex-
plain why observationally equivalent workers earn different wages (see van den
Berg (1999) for a recent survey).4 An important theoretical shortcoming of the
B/M framework, however, is that more efficient wage contracts potentially ex-
ist.5 For example with complete financial markets, Stevens (2002) shows the
first best contract specifies a hiring fee that workers pay on being hired. The
worker is then paid marginal product while employed, which ensures any sub-
sequent quit decision is jointly efficient.
This paper extends the B/M framework to equilibria where firms do not
post a single wage, but post contracts where the wage paid depends on an em-
ployee’s tenure at the firm. Two central restrictions play a large part in estab-
lishing our results. First, we assume imperfect capital markets. Being liquid-
ity constrained, workers cannot pay an up-front fee for their job and so firms
can only extract rents from employees by paying wages below marginal prod-
uct. Employees then recover part of those rents through on-the-job search for
better paid employment opportunities. Second, we assume that workers are
strictly risk averse. These two restrictions imply there are two basic forces at
work. As employees obtain job offers from other firms, there is an incentive
for firms to backload wages in any wage/tenure profile. By offering a worker a
smaller wage today but a greater wage at some future date, a firm reduces its
current wage bill and also increases an employee’s expected return to staying
with the firm. This, in turn, reduces an employee’s quit probability. Strictly risk
averse employees, however, prefer, ceteris paribus, a constant wage paid per
period. An optimal contract trades off these two competing effects. As we shall
see, it leads to an optimal contract where wages increase smoothly with tenure.
In related work, Stevens (1999, 2002) establishes that when workers are
risk neutral and there are no financial markets, a step wage/tenure contract
is optimal—a firm pays a zero wage for short tenures, and pays marginal prod-
uct once the worker’s tenure exceeds some threshold. She also establishes that
equilibrium is always degenerate, where all firms offer the same step contract

3
As B/M show, it is also straightforward to generalize this framework to consider heteroge-
neous firms without disturbing the basic results.
4
Bontemps, Robin, and van den Berg (1999, 2000), Postel-Vinay and Robin (2002b), and van
den Berg and Ridder (1998) provide even more recent contributions to the empirical literature.
A recent insightful review of the theoretical literature is provided by Mortensen (2002).
5
Shimer (1996) was perhaps the first to make this point.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1379

and there is no quit turnover. Furthermore in this degenerate equilibrium,

there is a continuum of alternative contracts that are payoff equivalent to the
equilibrium step contracts.
Our paper finds that when workers are strictly risk averse, the distribution
of contract offers is necessarily nondegenerate. When we consider the special
case where workers have a constant relative risk averse utility function, then as
risk aversion goes to zero, we find that the limiting equilibrium implies all firms
offer the same wage/tenure contract and there is no quit turnover. The limit-
ing wage tenure contract, however, is unique and is a smooth, strictly increas-
ing function of tenure. Even so, it is payoff equivalent to those characterized
by Stevens, which are in turn payoff equivalent to the Diamond paradox (Di-
amond (1971)). In this limiting case, a degenerate contract offer distribution
implies workers obtain no surplus through search.
In contrast, we also show that as the coefficient of risk aversion becomes in-
finite, the market equilibrium converges to the B/M equilibrium. Infinitely risk
averse workers imply a flat wage/tenure contract is optimal. As in B/M, all indi-
vidual worker wage growth arises through quitting to better paid employment,
and greater wage competition by firms for employed workers leads to wages
paid being more generous than in the pure monopsony case.
An important element of our results is that the equilibrium is character-
ized by a baseline salary scale. The baseline salary scale is the equilibrium
wage/tenure profile of a firm offering the lowest starting wage for new hires
in the market. It is shown that any other firm’s wage tenure profile can be de-
scribed by this baseline salary scale with a different starting point. For example,
suppose a firm offers a starting wage that is the same as the baseline salary at
(say) 7 months tenure. An optimal contract implies employees at this firm are
paid a wage after 3 months equal to the wage paid at 10 months according to
the baseline salary scale. And so on. This, of course, leads to a strong testable
restriction on possible wage/tenure profiles offered by firms.
The resulting market equilibrium implies different firms offer different start-
ing points on the underlying baseline salary scale. As in the original B/M frame-
work, all firms obtain the same steady state profit, even though they offer dif-
ferent wage contracts. Here, however, wages rise with tenure at a firm. The
underlying empirical implications are that within a firm, workers with shorter
tenures earn lower wages and are more likely to quit, while across firms, those
firms that offer more generous wage-tenure contracts have lower average quit
rates and attract more workers.
An important assumption made in the paper is that a firm does not respond
to outside offers received by any of its employees. Clearly this restriction is
not satisfied in some labor markets such as the academic labor market in the
U.S. Nevertheless, there are reasons to suspect our restriction holds in other
labor markets, especially those markets where workers are homogenous. First,
outside offers may not be observable by firms. Indeed, why should a firm ver-
ify to another firm that it has made a particular offer to a worker? Of course,
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1380 K. BURDETT AND M. COLES

given offers from other firms are not observed, they will be ignored. Second, as
we assume throughout that all workers are equally productive, some employ-
ees may well become disgruntled should a no more talented and more junior
employee receive a higher wage on the basis of some random outside offer.
In contrast, suppose firms do respond to outside offers. In an insightful study,
Postel-Vinay and Robin (2002a) assume that the two firms—the worker’s cur-
rent employer and the firm that made the outside offer—enter into a Bertrand
bidding game. Although Postel-Vinay/Robin consider heterogeneous firms, the
homogeneous firm and worker case is insightful. In this case, if any employee of
a firm contacts another firm, then both firms make the same bid—the worker’s
marginal product. The worker then stays at his or her current employer but
yields no further profit to it. Unemployed workers are hired at a starting wage
below the flow value of being unemployed, where a new hire anticipates a
higher future wage through continuing search for an outside offer. We ob-
tain a similar result here though not because workers expect higher wages
through generating outside offers, but because wages increase automatically
with tenure. This creates a foot-in-the-door effect where unemployed workers
will accept a low starting wage as an investment in higher future wages.
In the next section we specify the basic elements of the model. As the deriva-
tion of the results is not trivial, things are kept reasonably simple. After briefly
describing the optimal quit behavior of workers, we first derive the optimal
contract a firm offers within a particular matching environment (Theorem 1).
We then construct a market equilibrium and derive closed form solutions for
the distribution of starting wages, the distribution of wages paid, and the un-
derlying baseline salary scale (Theorem 2). The final section discusses the im-
plications of our results and various extensions.

2. BASIC FRAMEWORK
Time is continuous and only steady states are considered. Suppose there is
a unit mass of workers and of firms who participate in a labor market. Work-
ers and firms are homogeneous in that any firm generates revenue p for each
worker it employs per unit of time. Both unemployed and employed workers
obtain new job offers from time to time. Let λ denote the Poisson arrival rate
of new job offers faced by any worker (employed or unemployed). Any job
offer is fully described by the wage contract offered by the firm. Such a con-
tract specifies the wage the worker receives as a function of his or her tenure
at that firm, i.e., an offer is a function w() ≥ 0 defined for all tenures t ≥ 0. As
employees are equally productive, assume a firm offers all new hires the same
contract.6 Also assume there is no recall should a worker quit or reject a job
offer.7
6
For example, anti-discrimination legislation might require equal treatment of all new hires.
7
The no recall assumption is used for tractability. In equilibrium, a worker would never wish
to return to a previously contacted employer who is paying relatively low wages.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1381

An important simplification is that firms and workers have a zero rate of

time preference. The objective of any firm is to maximize steady state flow
profit. Workers are strictly risk averse and are finitely lived, where any worker’s
life is described by an exponential random variable with parameter δ > 0. The
objective of any worker is to maximize total expected lifetime utility. To main-
tain a steady state, δ also describes the inflow of new unemployed workers into
the market. Assume unemployed workers obtain b per unit of time and that
p > b > 0.

2.1. Worker Payoffs and Job Search Strategies

Each worker takes as given the firm’s posted wage contract w(), which spec-
ifies the wage it pays any employee at any tenure t. There are no financial mar-
kets so that a worker who obtains income w ≥ 0 at any instant of time obtains
flow utility u(w) by immediately consuming it.8 We now impose the following
restriction on this utility function.
A1: Assume u is strictly increasing, strictly concave, and twice differentiable
such that limw→0+ u(w) = −∞.
Although restrictive, A1 much simplifies the analysis by ensuring that the
corner constraint w ≥ 0 is never binding. Later, alternatives to this restriction
are discussed in detail.
Given a job offer w(), a worker calculates his/her expected lifetime utility
conditional on accepting it and using an optimal quit strategy in the future.
Let V0 denote this return. Further, let F(V0 ) denote the proportion of firms
whose contract offer, if accepted, yields an expected lifetime utility no greater
than V0 . As search is random, F(V0 ) also describes the probability that any
offer received yields an expected lifetime utility no greater than V0 . Let V (V )
denote the infimum (supremum) of the support of F .
Suppose a worker with tenure t is employed by a firm offering contract w().
Let V (t|w()) denote this worker’s expected lifetime payoff when using an
optimal quit strategy in the future. Similarly, let Vu denote an unemployed
worker’s expected lifetime payoff.
Given any contract w() and any tenure t where V (t|w()) > Vu , the no recall
assumption implies the worker will quit if and only if he/she receives a job offer
that has starting value V0 > V (t|w()). Standard arguments imply V () satisfies
dV (t|w())
(1) δV (t|w()) −
dt

V
= u(w(t)) + λ [V0 − V (t|w())]dF(V0 )
V (t|w())

8
As equilibrium implies that each worker’s wage is strictly increasing over time, an employed
worker has no incentive to save for future consumption.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1382 K. BURDETT AND M. COLES

If V (t|w()) < Vu for some tenure t, the worker’s optimal strategy is to

quit into unemployment. Although this event never occurs in equilibrium, at
this stage we need to allow for this possibility and so define T = inf{t ≥ 0 :
V (t|w()) < Vu }. Hence, T denotes the tenure at which a worker optimally
quits into unemployment. If V (t|w()) ≥ Vu for all t, then define T = ∞.
Optimal job search therefore implies the following worker strategies:
(i) if unemployed, the worker accepts a job offer if it has starting value
V 0 ≥ Vu ;
(ii) if employed with contract w() and tenure t < T , the worker quits if and
only if a job offer is received with starting value V0 > V (t|w());
(iii) if employed with contract w() and tenure t = T < ∞, the worker quits
into unemployment.
Given wage contract w() and tenure s < T , a worker leaves a firm’s employ-
ment at rate δ + λ(1 − F(V (s|w()))). For tenures t < T , the survival proba-
bility
t
(2) ψ(t|w()) = e− 0 [δ+λ(1−F(V (s|w())))]ds

describes the probability a newly employed worker does not leave the firm
before tenure t. Of course if T < ∞, then ψ = 0 for all t ≥ T .

2.2. Firm Payoffs

Let G(V ) denote the steady state number of workers who are either unem-
ployed or employed currently enjoying an expected lifetime utility less than V .
Now consider a firm that posts contract w() and let V0 denote a worker’s ex-
pected lifetime payoff by accepting this contract. If V0 < Vu the firm attracts no
workers and so obtains zero profit. Suppose instead V0 ≥ Vu . The definition of
G implies G(V0 ) describes the number of workers who are willing to accept the
firm’s job offer; it includes those who are unemployed with payoff Vu ≤ V0 and
those employed with payoff V < V0 . Hence, λG(V0 ) describes this firm’s hiring
rate and its steady state flow profit is given by

∞
Ω= λG(V0 )ψ(t|w())[p − w(t)]dt
0

Note, λG(V0 )ψ(t|w())dt describes the number of employees with tenures

[t t + dt), and [p − w(t)] is the profit flow generated by each of those workers.
This expression can be rearranged as

∞ 
Ω = [λG(V0 )] ψ(t|w())[p − w(t)]dt 
0

and note that the firm’s steady state flow profit equals its hiring rate λG(V0 )
times its expected profit per new hire.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1383

In what follows, we decompose the firm’s optimization problem into two

components. First, conditional on offering a new hire lifetime payoff V0 ≥ Vu ,
we define an optimal contract w() as one that maximizes the firm’s expected
profit assuming the worker accepts the offer; i.e., conditional on V0 , an optimal
wage contract solves the programming problem

∞
max ψ(t|w())[p − w(t)]dt
w()≥0 0

subject to V (0|w()) = V0 , where ψ(t|w()) is determined by the worker’s opti-

mal job search strategy described earlier. This optimal contracting problem is
considered in Section 3 below.
Assuming an optimum exists, let w∗ (|V0 ) denote the optimal wage tenure
contract and let Π ∗ (0|V0 ) denote the firm’s maximized payoff per new hire.
Optimized steady state flow profits then reduce to Ω∗ (V0 ) = λG(V0 )Π ∗ (0|V0 ).

2.3. Definition of Equilibrium

To simplify the exposition, we impose the following restriction.

A2: For all V0 ∈ (V  V ), F is continuously differentiable and satisfies

F  (V0 ) > 0.

This restriction is difficult to justify at this stage. We discuss how it may be

relaxed later. Notice it requires that the support of F is connected and contains
no mass points in its interior. We now define a market equilibrium.

DEFINITION: A market equilibrium is:

(ME1) a distribution of starting payoffs F satisfying A2;
(ME2) a set of optimal wage tenure contracts w∗ (|V0 ) indexed by V0 ≥ Vu ;
(ME3) optimal job search by unemployed workers, where optimality implies
Vu satisfies

V
δVu = u(b) + λ [x − Vu ]dF(x);
Vu

(ME4) optimal quit behavior by employees, where V (t|w∗ ) describe the

worker’s expected lifetime payoff at tenure t given wage contract w∗ ();
(ME5) a distribution of expected lifetime payoffs G consistent with steady
state turnover; and
(ME6) a steady state profit condition

Ω∗ (V0 ) = Ω ≥ 0 for all V0 ∈ [ V  V ]

(3)
Ω∗ (V0 ) ≤ Ω otherwise,
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1384 K. BURDETT AND M. COLES

so that any offered contract (i.e., an optimal contract w∗ with starting value V0 ,
which lies in the support of F), maximizes steady state flow profit.

The following fully characterizes a market equilibrium given preferences sat-

isfy A1 and shows that one always exists. The next section characterizes w∗ , the
set of optimal wage contracts. Given those results, the equilibrium structure
then becomes transparent and Section 4 will fully characterize the equilibrium
(and prove existence). Section 5 then discusses the results.

3. OPTIMAL WAGE-TENURE CONTRACTS

The objective in this section is to derive the contract that maximizes a firm’s
expected profit per new employee, given it yields an expected lifetime utility of
V0 to a worker who accepts it and uses an optimal quit strategy. Such a contract
is termed an optimal contract. As previously stated, there are two forces that
determine the nature of this contract. First, as capital markets are imperfect,
there is an insurance problem where, ceteris paribus, risk averse workers prefer
a constant wage stream. Second, there is a moral hazard problem where an
employee quits if a better outside offer is received.
When designing an optimal contract, each firm takes as given (a) F , the dis-
tribution of contracts offered by other firms in the market, (b) Vu , the expected
lifetime utility of an unemployed worker, and (c) the optimal quit strategy of
an employed worker given the contract offered. The firm’s formal optimal con-
tracting problem is defined as

∞
(4) max ψ(t|w())[p − w(t)]dt
w() 0

subject to

(5) w() ≥ 0
(6) V (0|w()) = V0 

and ψ is defined by (2) consistent with the worker’s optimal quit strategy.
We begin by making some preliminary points. First, note the arrival rate of
further job offers, λ, is independent of a worker’s employment status, and so
any unemployed worker accepts a contract that offers w(t) = b for all t. As
b < p by assumption, a firm can always obtain strictly positive profit by offer-
ing this contract. Equilibrium therefore implies (a) firms make strictly positive
profit, Ω > 0; (b) V ≥ Vu (as a firm that offers V0 < Vu makes zero profit);
and (c) V < u(p)/δ (no firm pays a worker more than the worker’s expected
value). Hence, in the above optimization problem, we assume that F not only
satisfies A2, but also Vu ≤ V and V < u(p)/δ.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1385

Optimality also implies T (w∗ ) = ∞—an employed worker never quits into
unemployment. In particular if T < ∞ existed, the firm could strictly increase
profit by instead setting w(t) = b for all t ≥ T . In that case, the worker obtains
the same payoff V (t|w(t) = b) = Vu at all t ≥ T , and therefore the worker does
not quit to unemployment and b < p implies the firm makes strictly greater
profit with this alternative contract.
Claim 1 describes the optimal wage contract of a firm that offers V0 ≥ V .

CLAIM 1: Fix an F satisfying A2 and a Vu ≤ V . If V0 ≥ V , the optimal wage

contract implies w(t) = w0 for all t where u(w0 ) = δV0 , and an employee never
quits to another firm.

PROOF: Fix V0 ≥ V . Now consider the wage contract w() = w0 where w0 is

defined in the Claim. The Bellman equation (1) implies V (t|w()) = V0 for all t,
where V0 ≥ V ≥ Vu implies the worker never quits. As this contract is jointly
efficient (it offers full insurance and the worker never quits) and also extracts
maximal employee rents (given V0 ), it maximizes the firm’s profit. Q.E.D.

As it plays a most important role in what follows, for a given F we define

w by u(w) = δV . Claim 1 establishes that a firm that offers the contract that
yields the greatest lifetime utility to new hires (i.e., sets V0 = V ), provides per-
fect income insurance—it offers a constant wage w(t) = w for all t. As an em-
ployee never quits at such a firm, the firm’s expected profit Π per hire is Π =
[p − w ]/δ, and note that strictly positive profit requires w < p.
We now turn to a firm that offers a contract that yields V0 , where V ≤ V0
< V . Such a firm faces a positive risk that its employees quit to competing
firms. What follows establishes that in the optimal contract, a firm will gradu-
ally increase wage payments with tenure.
Let w∗ (|V0 ) denote a firm’s optimal contract, given V0 . Further, let V ∗ (τ|V0 )
denote an employee’s expected lifetime utility when employed with tenure τ
at a firm that offers contract w∗ and let Π ∗ (τ|V0 ) denote the firm’s expected
profit given this employee.9

THEOREM 1: Fix an F satisfying A2 and assume Vu ≤ V . For any V0 ∈ [ V  V ),

the optimal contract w∗ and corresponding worker and firm payoffs {V ∗  Π ∗ } are
solutions to the differential equation system {w V  Π}:
−u (w) dw
(7) = λF  (V )Π
u (w)2 dt

V
dV
(8) δV − = u(w) + λ [x − V ]F  (x)dx
dt V

9
Note, V ∗ (|V0 ) is equivalent to V (|w∗ ).
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1386 K. BURDETT AND M. COLES

dΠ
(9) [δ + λ(1 − F(V ))]Π − = [p − w]
dt
subject to the boundary conditions:
(a) limt→∞ {w(t) V (t) Π(t)} = (w V  Π), and
(b) the initial condition V (0) = V0 .

PROOF: See Appendix.

Equations (8) and (9) are standard flow equations describing the continua-
tion payoffs V ∗ and Π ∗ . For example, (8) is implied by the worker’s Bellman
equation (1), while integration of (9) and boundary condition (a) (which im-
plies boundedness) gives

∞
ψ(τ|w∗ )
(10) Π ∗ (t|) = ∗)
[p − w∗ (τ|)]dτ
t ψ(t|w
which is the firm’s expected future profit given an employee with current
tenure t.
The central economic insight is provided by (7), which describes how wages
change optimally with tenure. As Π > 0 and F  > 0 by assumption, (7) implies
wages are strictly increasing with tenure while V ∈ (V  V ). Note, given an em-
ployee with current expected payoff V = V ∗ (τ|), the density function F  (V )
measures the number of firms whose outside offer will marginally attract this
worker. If there are no such firms, i.e., if F  (V ) = 0, then marginally raising
the worker’s wage w∗ (τ|) at tenure τ has no marginal effect on the worker’s
quit rate at τ. Optimal insurance then implies the firm pays a (locally) constant
wage (cf. Claim 1 for V ≥ V ). Given F  (V ) > 0, however a slightly higher wage
then results in a marginally lower quit rate and (7) then describes the optimal
trade-off. More intuitively, integrating (7) over [0 τ] implies that the optimal
wage contract satisfies

τ
u (w∗ (0|))  ∗
(11) = 1 + u (w (0|)) λF  (V ∗ (t|))Π ∗ (t|)dt
u (w∗ (τ|)) 0

By marginally increasing the wage paid at tenure τ, the firm reduces marginally
the worker’s quit rate over [0 τ]. The integral term in (11) measures the firm’s
overall return to that decreased quit rate, which then distorts the optimal wage
contract away from full insurance.
As is standard with moral hazard, the optimal contract rewards those who
do not quit—in this case the principal increases payments for those with higher
tenure. Being liquidity constrained, new employees are potentially made worse
off (as they cannot borrow against future earnings) but the promise of higher
earnings in the future lowers their quit rate and increases joint surplus (where
a quit is jointly inefficient).
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1387

Given wages increase with tenure, so does the value of employment, V ∗ (t|).
Further, as wages keep rising while V ∗ < V , there comes a point where V ∗
equals (or is at least very close to) V . Claim 1 describes the optimal contract for
V = V , and boundary condition (a) ensures that the limiting contract is opti-
mal. The optimal wage contract is then identified by using backward induction:
start at the terminal point (w V  Π), iterate the system {w V  Π} backwards
over time using (7)–(9), then stop when V = V0 and define t = 0 at that point.
Assumption A2 and standard backward induction arguments establish that the
implied optimal contract w∗ (τ|V0 ) and V ∗ (τ|V0 ) are both continuous and in-
creasing with τ, converging to w and V respectively.
Note, (w V  Π) is a stationary point of the differential equation system
(7)–(9). If limV →V F  (V ) > 0, the conditions of Theorem 1 imply that w∗ con-
verges to w in finite time. Claim 2 in the next section, however, establishes that
this cannot occur in a market equilibrium; i.e., a market equilibrium will imply
F  (V ) tends to zero in this limit. In that case the optimal wage contract has the
saddle path property.
Given the set of optimal contracts as described in Theorem 1, we now focus
on the contract offered by the least generous firm—the one that offers V0 = V .

DEFINITION: Given an F satisfying A2, the baseline salary scale, denoted

{ws (t), Vs (t), Πs (t)}, is the solution to the differential equations and bound-
ary conditions defined in Theorem 1 with V0 = V .

The baseline salary scale is important as it can be used to describe the op-
timal wage contract of any firm offering a starting payoff V0 ∈ [ V  V ). In par-
ticular, Assumption A2 and the equations of Theorem 1 imply that ws () and
Vs () are both continuous and increasing functions that converge to w and V
respectively. Hence, given any other starting payoff V0 ∈ (V  V ), a salary point
t0 > 0 exists where Vs (t0 ) = V0 . Further, optimality of ws implies that the op-
timal wage contract given starting payoff V0 = Vs (t0 ) corresponds to the wage
tenure payments ws () described for tenures t ≥ t0 . This yields the convenient
result that w∗ (t|V0 ) ≡ ws (t + t0 ); i.e., given any starting salary point t0 ≥ 0, an
optimal wage contract pays a worker with tenure t a wage commensurate with
point (t0 + t) on the baseline salary scale. Note, this also implies the firm’s
continuation payoff Π ∗ (t|V0 ) ≡ Πs (t + t0 ).
The next section now characterizes a market equilibrium where firms not
only choose an optimal wage tenure contract given V0 , but also choose V0 to
maximize steady state profit Ω∗ (V0 ). A market equilibrium requires that the
choices of V0 and w∗ (|V0 ) are optimal given distributions F and G, and that F
and G are, in turn, consistent with those choices and the optimal quit strate-
gies of workers. Not surprisingly, it can be shown that offering a higher V0
(or equivalently a higher starting point t0 ) implies a firm obtains less profit
per hire. On-the-job search, however, implies that offering a higher V0 attracts
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1388 K. BURDETT AND M. COLES

more employees. As we show below, a market equilibrium implies disperse

wage contract offers.

4. MARKET EQUILIBRIUM
The next Claim implies that in a market equilibrium, ws only converges to w
asymptotically.

CLAIM 2: At a market equilibrium the functions F and 1 − G do not have mass

points at V .

PROOF: Note, 1 − G(V ) describes the steady state number of work-

ers employed whose current lifetime utility is at least V . The proof is by
contradiction—suppose in equilibrium that 1 − G has a mass µ > 0 at V .
Claim 1 implies that a firm offering starting payoff V enjoys profit Ω∗ (V ) =
λ(1 − µ)[(p − w)/δ]. Consider instead a firm offering starting payoff V ε > V .
Claim 1 implies the optimal contract is a constant wage w = w + ε for some
ε > 0 and Ω∗ (V ε ) = λ[(p − w − ε)/δ]. As equilibrium implies w < p then
µ > 0 implies Ω∗ (V ε ) > Ω∗ (V ) for ε small enough, which contradicts the de-
finition of a market equilibrium. As 1 − G cannot have a mass point at V ,
Claim 1 now implies that F cannot have a mass point at V . Q.E.D.

Claim 2 establishes that ws (t) < w for all t and so the baseline salary scale
only converges to w asymptotically. As this also implies Vs (t) < V for all t < ∞,
Theorem 1 and A2 imply ws and Vs are strictly increasing for all t in a market
equilibrium. Given a market equilibrium must exhibit a baseline salary scale,
then rather than consider firms as offering starting payoffs V0 ∈ [ V  V ], it is
more convenient to consider firms as offering starting points t0 ∈ [0 ∞) along
the endogenously determined baseline salary scale.
Given the definition of the baseline salary scale, define Fs (t) as the dis-
tribution of starting points offered by firms on the baseline salary scale,
and note that F(V ) is determined by F(Vs (t)) = Fs (t). Differentiating yields
F  (Vs )dVs /dt = dF s /dt, and A2 implies Fs is strictly increasing for all t; i.e.,
Fs has connected support [0 ∞). Claim 2 also implies limt→∞ Fs (t) = 1. Simi-
larly, we can define [1 − Gs (t)] as the number of currently employed workers
with salary point at least as great as t ≥ 0 on the baseline salary scale, and note
that G(Vs (t)) ≡ Gs (t). No mass point in G at V implies limt→∞ Gs (t) = 1. Let
w = ws (0) w = ws (∞) so that [ w w ] denotes the support of wages paid in a
market equilibrium.

CLAIM 3: A market equilibrium implies the baseline salary scale {ws  Vs  Πs }

satisfies the differential equations
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1389

−u (ws ) dws dFs /dt

(12)  2
= λΠs 
u (ws ) dt dVs /dt

∞
dVs
(13) δVs − = u(ws ) + λ [Vs (τ) − Vs (t)]dFs (τ)
dt t

dΠs
(14) {δ + λ[1 − Fs ]}Πs − = [p − ws ]
dt
and the boundary conditions
(a) limt→∞ (ws (t) Vs (t) Πs (t)) = (w V  Π) where V = u(w)/δ, Π =
[p − w ]/δ;
(b) Vs (0) = V .

PROOF: The proof follows from the definition of the baseline salary scale
and Theorem 1, using F(Vs ) = Fs , F  (Vs ) = [dFs /dt]/[dVs /dt]. Q.E.D.

Next we compute steady state Gs .

CLAIM 4: A market equilibrium implies

Gs (0) = δ/(λ + δ)

dGs
(15) [δ + λ[1 − Fs ]]Gs + = δ for t > 0
dt

PROOF: As V ≥ Vu in equilibrium, each worker accepts the first job offer re-
ceived. Further, optimality implies a worker never quits to unemployment and
so steady state unemployment equals δ/(λ + δ). The definition of Gs now im-
plies Gs (0) = δ/(λ + δ). Pick any point t > 0 on the baseline salary scale. Opti-
mal quit turnover implies that an employed worker on salary point t quits only
if the outside offer is a higher starting point t0 > t on the baseline salary scale.
Given 1 − Gs (t) describes the number of employed workers with salary point
no lower than t, then over any arbitrarily small time interval dt > 0, steady
state turnover implies

δdt(1 − Gs (t)) = (1 − δdt)[Gs (t) − Gs (t − dt)

+ Gs (t − dt)λdt(1 − Fs (t))] + o(dt 2 )

Letting dt → 0 and rearranging yields (15). Q.E.D.

As Fs has connected support [0 ∞), the constant profit condition [ME6]
requires λGs (t)Πs (t) = Ω for all t ≥ 0, where λGs (t) is the hiring rate of a
firm that offers any starting point t ≥ 0 and Πs (t) is the firm’s expected profit
per new hire at point t on the baseline salary scale. Letting t → ∞, a market
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1390 K. BURDETT AND M. COLES

equilibrium implies Gs → 1 and Πs → Π = (p − w)/δ, which yields Ω = λ(p −

w)/δ. The constant profit condition now reduces to

(16) Gs (t)Πs (t) = [p − w ]/δ for all t ≥ 0

Proposition 1 establishes that firms offering the least generous wage contract
in the market extract all the surplus from unemployed workers, i.e., Vs (0) = Vu .
This leads to the following characterization of a market equilibrium.

PROPOSITION 1: Necessary and sufficient conditions for a market equilibrium

are:
(a) a vector of functions {ws  Vs  Πs  Fs  Gs } satisfying the four differential
equations (12)–(15) and the constant profit condition (16), subject to
   
lim ws (t) Vs (t) Πs (t) Gs (t) Fs (t) = w V  Π 1 1
t→∞

where w < p V = u(w)/δ Π = [p − w ]/δ;

(b) Gs (0) = δ/(λ + δ);
(c) Vu = Vs (0) where

∞
δVu = u(b) + λ [Vs (t) − Vu ]dFs (t);
0

and Fs  Gs must have the properties of distribution functions, and imply F(V ) has
properties A2.

PROOF: We prove these conditions are both necessary and sufficient in turn.
Necessary. Strictly positive profit implies Vu ≤ Vs (0). Suppose for the moment
Vu < Vs (0) ≡ V . Now consider the conditions of Theorem 1, but with starting
payoff V0 ∈ [Vu  Vs (0)). The optimal contract implies an early tenure phase for
some τ > 0, where the firm pays a fixed wage w0 ∈ (0 w ] for tenures t < τ,
and wages w = ws (t − τ) for tenures t ≥ τ. It is straightforward to argue that
this contract generates strictly greater profit per hire.10 As the hiring rate is the
same as for a firm offering V = V , this implies Ω∗ (V0 ) > Ω∗ (V ), which contra-
dicts the definition of a market equilibrium. Hence, Vu = Vs (0) is a necessary
condition of equilibrium.
Note that the equation for Vu given in Proposition 1(c) follows from the
definition of Vu in a market equilibrium and that Vu = Vs (0) ≤ Vs (t) for all
t ≥ 0. Claims 2–4 now imply Proposition 1 describes necessary conditions for a
market equilibrium.
Sufficient. By construction of the baseline salary scale, any starting point
t ≥ 0 implies the firm is offering an optimal wage contract, and the constant

10
See (17), and note that dV /dt > 0 implies dΠ/dt < 0.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1391

profit condition (16) guarantees that each optimal contract offered generates
the same steady state profit Ω > 0. Further, any other contract that offers
V < Vs (0) is rejected by workers and so generates zero profit, whereas any op-
timal contract that offers V > Vs (∞) = V attracts no more workers than one
that offers V = V and pays a strictly higher wage. This implies that a solution
to the conditions of Proposition 1 also guarantees conditions (ME1)–(ME6)
are satisfied and so describes a market equilibrium. Q.E.D.

4.1. Existence and Characterization

We now solve the conditions described in Proposition 1 and so fully charac-
terize a market equilibrium.11 A critical step is to note that as the firm’s control
problem is autonomous and as the firm has a zero rate of time preference, the
Hamiltonian used to solve the firm’s optimal contract problem is identically
zero (Leonard and Long (1992, p. 298)). It follows from (29) in the Appendix
that

0 = [p − w] − Π[δ + λ(1 − F(V ))]


V 
− [1/u (w)] δV − u(w) − λ [x − V ]dF(x) 
V

Using (8) and (9) from Theorem 1, the above implies

dVs dΠs
(17) = −u (ws (t))
dt dt
along the baseline salary scale. Note, this is an efficiency condition that states
that as the worker’s wage increases with tenure, the increase in the worker’s
expected lifetime utility equals the loss in the firm’s continuation profit (mea-
sured in current worker utils). This much simplifies the analysis as it re-
places (13) in Claim 3, which also describes dVs /dt along the baseline salary
scale.
The proof of Theorem 2 below identifies closed form solutions to the con-
ditions of Proposition 1. It does this indirectly by first solving for the equi-
librium functions in terms of the wages offered by firms. In particular, define
Fw (w0 ) as the proportion of firms whose starting wage is no greater than w0 ,
and note that a market equilibrium implies Fw (ws (t)) = Fs (t). Similarly, define
1−Gw (w) as the number of employed workers with current wage no lower than
w, and so Gw (ws (t)) = Gs (t). Finally, define Πw (w) where Πw (ws (t)) = Πs (t).
Of course, Fw  Gw also have significant empirical interest.

11
We are grateful to an anonymous referee for pointing out the following line of argument.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1392 K. BURDETT AND M. COLES

THEOREM 2: There exists a unique market equilibrium. At this equilibrium, the

baseline salary scale ws satisfies


dw δ p − w w u (x)dx
(18) = √
dt p − w u (w) w p−x

subject to w = w at t = 0. Further,

p−w
(19) Gw = 
p−w
1
(20) Πw = (p − w)(p − w)
δ
and for w > w, Fw is continuous, strictly increasing, and is given by

w
δ p−w 1 u (x)dx
(21) 1 − Fw = −1−   
λ p−w 2u (w) w (p − w)(p − x)

and has a mass point at w where

λ + δ u(b) − u(w)
Fw (w) = 
λ(p − w) u(w)
The support of wages paid [ w w ] is nondegenerate and implies w < b, w < p
satisfying
 2
δ p−w
(22) = 
λ+δ p−w
√

p − w w u (x)dx
(23) u(w) = u(b) − √ 
2 w p−x

PROOF: The proof solves explicitly the conditions of Proposition 1. We do

this in four steps, where the first step is to solve for the equilibrium functions
Fw  Gw  Πw .
Step 1. To solve for Gw  Πw note that the constant profit condition (16) im-
plies
dGs dΠs
Πs + Gs = 0
dt dt
Substituting out dGs /dt and dΠs /dt using (15) and (14) implies Πs = Gs (p −
ws )/δ. This condition and the constant profit condition (16) now imply (19)
and (20).
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1393

We next solve for Fw . As Fw (ws (t)) = Fs (t) by definition, then

dFs /dt
fw (ws (t)) =
dws /dt

where Fw (w) = fw (w). Using (12) to substitute out dws /dt, and using (17)
yields
  
u (ws ) dΠs /dt
fw (ws ) = 
u (ws ) λΠs

Substituting out dΠs /dt using (14), and using (20) implies
 1/2
u (ws ) δ δ p − ws
− f w (w s ) + 1 − F w (w s ) + = 
u (ws ) λ λ p−w

which is a first order differential equation for Fw with w = ws . Multiplying

throughout by u (w), and integrating yields
 w
1/2
δ δ w  p−x
u (w)[1 − Fw (w)] + u (w) = u (x) dx
λ w0 λ w0 p −w

Integrating the right-hand side by parts and simplifying yields (21).

Step 2. We now solve Proposition 1(a) for {ws  Fs  Gs  Πs  Vs }. First, ws is
characterized. As (20) implies Πs (t) = (1/δ)[(p − w)(p − ws (t))]1/2 , differen-
tiation yields
 1/2
dΠs 1 p−w dws
=− 
dt 2δ p − ws dt

Substituting out dΠs /dt using (14), the solution for Πs now implies (18) with
w = ws . Further for w ∈ [ w w ] with w > 0 and w < p, the Fundamental
Theorem of Differential Equations implies a solution to (18) exists for all
w ∈ [ w w ], and so (18) with initial value ws (0) = w implies ws exists, is strictly
increasing, and asymptotes to w.
Given the above solutions for Fw  Gw  Πw and the baseline salary scale ws ,
the definitions of Fw  Gw  Πw now imply solutions for Fs  Gs  Πs . Although not
specified in the Theorem, note that dVs /dt is determined by (17) with dΠs /dt
and ws given above. Vs is then the solution to that linear first order differential
equation, subject to the boundary condition limt→∞ Vs (t) = [p − w ]/δ. Note,
t = 0 and ws = w implies


dVs (0) 1  w
u (x)
= p−w √ dx
dt 2 w p−x
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1394 K. BURDETT AND M. COLES

As (18) implies ws → w as t → ∞, the above solutions imply

   
lim ws (t) Vs (t) Πs (t) Gs (t) Fs (t) = w V  Π 1 1 
t→∞

Hence, for arbitrary values of w > 0 and w < p we have constructed functions
{ws  Fs  Gs  Πs  Vs } that satisfy Proposition 1a.
Step 3. Here, we solve Proposition 1(b) and 1(c). As Gs (0) = Gw (w), then
Proposition 1(b) is satisfied if and only if Gw (w) = δ/(λ + δ). As Gw is given
by (19), Proposition 1(b) is satisfied if and only if (22) holds.
Proposition 1(c) is satisfied if and only if

∞
δVs (0) = u(b) + λ [Vs (t) − Vu ]dFs (t)
0

and Vu = Vs (0). Now Vs (0) is given by (13) with t = 0. Given dVs (0)/dt de-
scribed above, Proposition 1(c) is satisfied if and only if (23) is satisfied and
Vu = Vs (0).
Step 4. We now prove existence and uniqueness of equilibrium. Note, as long
as w > 0 and w < p, the implied wage offer density
 
w
δ −u (w) u (x)dx
fw = 
λ u (w)2 w (p − w)(p − x)

is continuous and strictly positive over [ w w). Also note that Fw (w) ≥ 0 if
and only if w ≤ b. It now follows that as long as w ∈ (0 b] and w < p, then
the implied Fs  Gs have the properties of distribution functions (i.e., they are
(strictly) increasing over their supports and take values in the interval [0,1]),
and that F(V ) has properties A2 (i.e., it has connected support and is differ-
entiable over the interior of its support).
Hence, establishing existence and uniqueness of a solution to the conditions
of Proposition 1, and therefore a market equilibrium, reduces to finding a pair
(w w) satisfying (22) and (23) with w ∈ (0 b] and w ∈ [ w p). Note, (22) de-
scribes a straight line and is labelled XY in Figure 1. It is simple to show XY
has a positive slope that is strictly less than one and passes through the point
(p p). (23) is labelled RV in Figure 1. Concavity of u implies that RV is down-
ward sloping for all w ∈ (0 b]. Note, RV passes through (b b).
We complete the proof of Theorem 2 by showing that RV passes through a
point (wL  p) where wL ∈ (0 b) as drawn in Figure 1. To do this, define φ(w)
where

p
1 u(p) − u(x)
φ(w) = u(p) − u(w) − (p − w)1/2 dx
2 w (p − x)3/2
− 2[u(p) − u(b)]
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1395

FIGURE 1.

Putting w = p and integrating (23) by parts implies w = wL where φ(wL ) = 0.

Inspection establishes that φ is finite for all w > 0, is strictly decreasing and is
strictly negative at w = b. As concavity implies u(p) − u(x) ≤ (p − x)u (x), we
also have

p
1 u (x)
φ(w) ≥ u(p) − u(w) − (p − w)1/2 dx
w (p − x)
2 1/2

− 2[u(p) − u(b)]

p  1/2 
 1 p−w
= u (x) 1 − dx − 2[u(p) − u(b)]
w 2 p−x

But 1 − (p − w)1/2 /(2(p − x)1/2 ) = 1/2 at x = w and is strictly positive in a

neighborhood of x = w. Hence, A1 implies φ(w) → +∞ as w → 0+ and so a
wL > 0 exists satisfying φ(wL ) = 0.
As A1 implies wL > 0 exists, RV is as depicted in Figure 1. Hence, there
exists a unique (w w) satisfying (22) and (23) and also w ∈ (0 b] and w ∈
[b p). Q.E.D.

Before discussing these results in detail, we quickly consider comparative

statics. Suppose there is an increase in b. This does not affect the XY locus,
but shifts up the RV locus. The RV locus corresponds to (23) and reflects the
reservation value Vu of an unemployed worker, given that the distribution of
job offers is consistent with wage competition by firms. An increase in b implies
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1396 K. BURDETT AND M. COLES

that the equilibrium w and w increase. The distribution of wages paid, denoted
by K, is given by
  
λ+δ δ δ p−w
K(w) = Gw (w) − = −1 
λ λ+δ λ p−w

As a higher w implies first order stochastic dominance in the distribution of

wages paid, an increase in b leads unambiguously to higher wages paid.
Suppose now there is a decrease in search frictions; i.e., λ increases. The
RV locus does not move, while XY rotates upwards as it always passes though
(p p). The XY locus corresponds to (22), and describes equilibrium wage
competition between firms. A reduction in search frictions (i.e., an increase
in λ), implies w increases and w decreases. Equation (19) implies that for any
wage w, the number employed with at least that wage strictly increases as λ
increases. We do not, however, have first order stochastic dominance in wages
paid as there is a fall in unemployment, and the unemployed are willing to
accept lower starting wages (i.e., w decreases). As λ → ∞ (i.e., frictions dis-
appear), XY becomes flat and we converge to the competitive outcome where
the distribution of wages paid converges to a mass point at p; i.e., K(w) → 0
for all w < p and w → p.

5. FURTHER DISCUSSION
5.1. Alternatives To Assumption A1
Restriction A1, that limw→0+ u(w) = −∞, is convenient as it guarantees the
corner constraint w ≥ 0 never binds. It can be shown that assuming u(0) = 0
and limw→0+ u (w) = ∞ is not sufficient to ensure w > 0 in an optimal contract
(see the proof of Theorem 1). If this alternative assumption is made, the base-
line salary scale may have an initial phase where firms pay w = 0. The analysis
above remains valid for the nonbinding phase (which always exists; otherwise
job seekers reject a job offer w = 0 for all tenures) and the wage distributions
are as implied by Theorem 2, except possibly with a mass point at w = 0. The
same argument also applies if the government imposes a minimum wage pol-
icy, that w ≥ wmin , which may or may not bind in equilibrium.
Suppose that we drop A1 and instead only assume that u is increasing and
strictly concave. The above analysis remains valid as long as the corner con-
straint w ≥ 0 is never binding in an optimal contract. If w > 0, where w is
determined as the intersection of RV and XY as depicted in Figure 1, then
the corner constraint w ≥ 0 never binds in a market equilibrium. Given u is
strictly concave, a sufficient restriction that guarantees w > 0, and therefore a
market equilibrium exists, is that b ∈ [w1  p) where
 2
δ
w1 = 1 − p
δ+λ
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1397

FIGURE 2.

Strict concavity of u implies the RV locus is strictly decreasing and passes

though (b b). XY is a straight line with intercept w1 < p and passes through
(p p). As shown in Figure 2, if b > X, the restriction b ∈ [w1  p) guarantees a
market equilibrium exists with w > 0.

5.2. Constant Relative Risk Aversion

Given b large enough and u is strictly concave, we now consider what hap-
pens in equilibrium as worker risk aversion changes. To do this, we restrict
attention to CRRA utility functions, u(x) = x1−σ /(1 − σ) with σ > 0.
Setting p = 5 and δ/λ = 01, then b = 46 is large enough to guarantee w > 0
in what follows. Table I describes the equilibrium w, w and the mass point
Fw (w) for various σ.

TABLE I

σ w w Fw (w)
0.0 0.600 4.964 1.000
0.1 1.333 4.970 0.911
0.2 1.751 4.973 0.864
0.4 2.223 4.977 0.803
0.8 2.728 4.981 0.727
1.4 3.126 4.985 0.657
∞ 4.600 4.997 0.000
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1398 K. BURDETT AND M. COLES

As σ → 0 (risk neutral workers), the market equilibrium converges to a

well defined limit. Even with σ = 0, a solution to the conditions of Theo-
rem 2 exists (with b large enough) and implies a baseline salary scale that is a
smooth, strictly increasing concave function. The solution for w, however, im-
plies Fw (w) = 1; the distribution of contract offers is degenerate, even though,
by construction, firms are indifferent to offering any contract with starting
wage w0 ∈ [ w w ]. Such an outcome fails the formal definition of a market
equilibrium—the implied distribution of offers F() does not satisfy A2. Nev-
ertheless, given such an F , the baseline salary scale satisfies the equations of
Theorem 1 and so describes an optimal contract. The equilibrium outcome is
that all workers receive the same starting payoff and none ever quit. Indeed, as
all firms offer Vs (0) = Vu , workers obtain no surplus through finding employ-
ment and so Vu = u(b)/δ. Equilibrium implies the pure monopsony outcome
where employers extract all match rents (analogous to the Diamond paradox;
see Diamond (1971)).
Stevens (1999, 2002) was the first paper to establish this degeneracy result.
She also shows there is a continuum of payoff equivalent optimal contracts.
Theorem 1 confirms this as
−u (w) dw
= λF  (V )Π
u (w)2 dt
describes how wages change optimally with tenure, and dw/dt is ill-determined
given u = 0 (risk neutral workers) and F  (V ) = 0 (degenerate offers). When
workers are risk neutral, the baseline salary scale implied by Theorem 2 de-
scribes only one of many equilibrium wage tenure contracts. The baseline
salary scale, however, describes the unique limiting equilibrium contract as
σ → 0.
As described above, the equilibrium distribution of wages paid is

δ p−w
K(w; σ) = −1
λ p−w

where w = w(σ). Note, σ changes this distribution only through its impact
on w. As shown in Table I, an increase in σ leads to an increase w, and there-
fore an increase in worker risk aversion leads to first order stochastic domi-
nance in the distribution of wages paid.
To explain this outcome, note that backloading wages using an increasing
wage-tenure contract increases the expected lifetime payoff of those employ-
ees who have significant tenures. From the other firms’ standpoint, attracting
such workers requires offering a high starting payoff, which is relatively unprof-
itable. Stevens (2002) finds that when firms compete in step contracts, firms can
backload wages sufficiently that, in equilibrium, poaching employed workers by
offering a high starting payoff is strictly dominated by offering a low starting
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1399

payoff to extract full search rents from unemployed job seekers. The under-
lying insight is that firms use wage/tenure contracts to reduce employee quit
incentives, which then affects the incentives of other firms to post high value
contracts.
The comparative static on σ can be explained as follows. First, note that an
increase in worker risk aversion implies that the insurance value of a smoother
wage stream is greater, and so firms have less incentive to backload wages.
Table I demonstrates that an increase in σ leads to a fall in the range of wages
paid [w − w ] along the baseline salary scale.
Reduced backloading of worker wages then implies that employees with sig-
nificant tenures have relatively low expected lifetime payoffs. In contrast to
Stevens (2002), firms then have a greater incentive to raise their starting wage
and so poach employed workers using on-the-job search. Table I demonstrates
that as σ increases, the mass point in Fw at w decreases; more firms offer higher
starting wages.
As more firms offer starting wages above w, the value of continued search by
unemployed workers increases, which raises Vu . This then leads to an increase
in w and an increase in wages paid as described in Table I.
As σ → ∞, it can be shown analytically that the market equilibrium con-
verges to the equilibrium characterized in B/M. In this limit, the insurance
effect dominates so that wage tenure effects become arbitrarily small and
the baseline salary scale becomes flat. Given firms compete in flat wage con-
tracts, equilibrium search and wage competition then implies the B/M outcome
where, given that the offer arrival rate λ is the same for employed and unem-
ployed workers, equilibrium implies w = b.
Note that although the functional form describing the distribution of wages
paid, K, is the same across all equilibria, the composition of worker wage
growth, via quit turnover and wage/tenure effects, varies across the equilibria.
For example, in the limiting B/M case (where σ → ∞), all worker wage growth
arises through on-the-job search and quit turnover—there are no wage-tenure
effects. It should also be noted that this high quit outcome yields the highest
wages paid in equilibrium. In contrast, in the limiting Stevens case (σ → 0),
all worker wage growth arises through wage tenure effects—there is no quit
turnover. This zero quit outcome yields the pure monopsony outcome.

5.3. Dropping Assumption A2

Finally, we reconsider Assumption A2. Theorem 1 establishes that an opti-
mal contract implies


u (w∗ (0|)) τ
= 1 + u (w∗ (0|)) λF  (V ∗ (t|))Π ∗ (t|)dt
u (w∗ (τ|)) 0
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1400 K. BURDETT AND M. COLES

i.e., the optimal wage paid at each tenure depends on the density of outside
wage offers. If F is not differentiable in the interior of its support, then an
optimal wage contract may not exist and a market equilibrium is ill-defined.
It can also be argued that a connected support is a necessary property of
equilibrium. In particular, given an arbitrary value for w ∈ [w1  p) and end-
point

(ws  Vs  Πs  Gs  Fs ) = (w V  Π 1 1)

a backward induction argument along the saddle path implied by Proposi-

tion 1(a) establishes that F  (Vs ) > 0 while ws > 0. The intuition is that if there
were a hole, say over [V −  V + ], then offering a starting payoff V0 equal to V −
plus a cent would strictly dominate offering V + (i.e., a hole in F is inconsistent
with equal (steady state flow) profit).

6. CONCLUSION
In this study a reasonably standard labor market with frictions has been con-
sidered: workers and firms are homogeneous, there is no capital market, firms
make take it or leave it offers, and workers also search while employed. Within
such an environment we have shown that when workers are risk averse, the
equilibrium can be characterized by two major features. First, each firm offers
a wage-tenure contract that implies any employee’s wage smoothly increases
with tenure. Second, there is a nondegenerate distribution of initial wage of-
fers made by the firms in the market with a positive mass offering the lowest
initial wage. In such an equilibrium there is worker turnover as an employed
worker may contact a firm making a more desirable offer than his or her cur-
rent employer. This implies that firms offering more generous offers have a
greater steady state number of employees and suffer fewer quits than firms
offering less generous offers. Further, in equilibrium any worker’s increase in
wage through time will be due to both wage-tenure effects and job-turnover
effects. As we can explicitly solve for the baseline salary scale and know the
quit rate of the worker from the firm, it is possible to calculate the expected
proportion of a worker’s wage growth through time due to wage-tenure effects
as a function of the parameters of the model. Indeed, as we can explicitly solve
for the equilibrium characteristics of the model, empirical investigation may
not be that difficult.
Several extensions of the basic framework should yield new important av-
enues of research. The most important of these is to extend the framework
to allow for heterogeneous firms and workers. Although such extensions may
not be easy to achieve, the results should be of great interest to empirical re-
searchers. If it is assumed that firms are heterogeneous in an otherwise identi-
cal model to that used above, the baseline salary scale property of equilibrium
is lost. This much complicates the analysis. If, for example, there are two types
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1401

of firms, it is reasonable to conjecture that in equilibrium there will be two

baseline salary scales. It is the relationship between these two salary scales that
will determine the nature of equilibrium. An equilibrium analysis when firms
are homogenous but workers are heterogenous, although not trivial to achieve,
should also lead to new insights.
Dept. of Economics, University of Essex, Wivenhoe Park, Colchester, CO4 3SQ,
U.K., and Dept. of Economics, University of Pennsylvania, 3718 Locust Walk,
Philadelphia, PA 19104, U.S.; [email protected]
and
Dept. of Economics, University of Essex, Wivenhoe Park, Colchester, CO4 3SQ,
U.K., and Institut d’Analisi Economica (CSIC), Barcelona, Spain; mcole@essex.
ac.uk.

Manuscript received October, 2001; final revision received September, 2002.

APPENDIX

PROOF OF THEOREM 1: Fix an F satisfying A1 and a Vu ≤ V . Choose any V0 ∈ [ V  V ). We first

establish some preliminary results implied by optimality (Claim S1). Step 1 then uses optimal
control theory to characterize how wages change optimally with tenure. Step 2 then identifies
the appropriate transversality condition. Let Π(t|w()) denote the firm’s expected profit given a
worker with tenure t and wage contract w().

CLAIM S1: Given V0 ∈ [ V  V ) optimality implies:

(a) Vu ≤ V (τ|w∗ ) ≤ V for all τ ≥ 0, and so V satisfies the Bellman equation (1) subject to the
boundary condition that V is uniformly bounded.
(b) 0 < Π(t|w∗ ) ≤ p/δ for all t.

PROOF: Contradiction arguments are used to establish the claims.

(a) Suppose a τ ≥ 0 exists where V (τ|w∗ ) < Vu . In this case the worker quits and obtains payoff
Vu while the firm obtains a zero payoff. Consider instead wage payments w(t) = b for all t ≥ τ.
In that case the worker’s continuation payoff at τ is still Vu but the worker does not quit into
unemployment, while b < p implies the firm makes strictly positive profit, which contradicts the
optimality of the original wage contract. Hence, V (τ|w∗ ) ≥ Vu for all τ.
Now suppose a τ ≥ 0 exists where V (τ|w∗ ) > V . As V (0|w∗ ) = V0 < V and V is continuous
over t (it is differentiable), there exists tenure τ > 0 where V (τ |w∗ ) = V . Claim 1, however,
implies the optimal contract specifies w = w for all τ ≥ τ and therefore V = V for all τ ≥ τ ,
which is the required contradiction.
(b) Suppose a τ ≥ 0 exists where Π(τ|w∗ ) ≤ 0. Part (a) implies V (τ|w∗ ) ∈ [Vu  V ]. Consider
the alternative contract wT that for tenures t ≥ τ specifies w(t) = b for t ≤ τ + T , and w(t) = w
for t > τ + T , for some T ≥ 0. Note, this describes a step contract where after additional tenure
T , the firm raises the worker’s wage from b to w. If T = 0, Claim 1 implies this contract implies
continuation payoff V (τ|wT ) = V , while if T = ∞ it offers continuation payoff V (τ|wT ) = Vu .
As this continuation payoff is continuous and strictly decreasing in T , a T  ≥ 0 exists so that this
contract offers continuation payoff V (τ|wT  ) = V (τ|w∗ ) ∈ [Vu  V ]. As w < p, this contract makes
strictly positive profit, which contradicts the optimality of w∗ . As w ≥ 0 by assumption, and a
worker leaves at a rate no lower than δ Π ≤ p/δ is immediate. Q.E.D.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1402 K. BURDETT AND M. COLES

Step 1. Optimal control theory. Claim S1 establishes that the firm’s optimal wage contract w∗
solves the programming problem

∞
(24) max ψ(t)[p − w(t)]dt
w≥0 0

where

(25) ψ̇ = −[δ + λ(1 − F(V ))]ψ

V
(26) V̇ = δV − u(w) − λ [x − V ]dF(x)
V

with starting values

(27) ψ(0) = 1 V (0) = V0 

and V is uniformly bounded, satisfying

(28) Vu ≤ V (t) ≤ V for all t

The following maximizes (24) but only subject to (25)–(27); i.e., it ignores the constraint (28).
It shall be shown that (28) is automatically satisfied at the optimum and so is never a binding
constraint.
Define the Hamiltonian

V 
(29) H = ψ[p − w] − xψ [δ + λ(1 − F(V ))]ψ + xV δV − u(w) − λ [x − V ]dF(x) 
V

where xψ and xV denote the costate variables associated with the state variables ψ and V . Then
the Maximum Principle implies the necessary conditions for a maximum at any tenure t are:

(30) either w = 0 and ∂H/∂w ≤ 0 ⇔ xV /ψ ≥ 0

or w>0 and ψ + xV u (w) = 0 ⇔ xV /ψ < 0 and 1/u (w) = −xV /ψ

where

(31) ẋV = −xV [δ + λ(1 − F(V ))] − xψ λF  (V )ψ

(32) ẋψ = −[p − w] + xψ [δ + λ(1 − F(V ))]

and ψ V satisfy the differential equations and initial values described above. Note this is an
autonomous problem and as there is no discounting, H = 0 at the optimum (Leonard and Long
(1992, p. 298)).
As (32) is linear in xψ , using ψ as the integrating factor yields

∞
xψ (t)ψ(t) = ψ(s)[p − w(s)]ds + A2
t

where A2 is the constant of integration. As the firm’s continuation payoff is given by

∞
ψ(s)
Π(t|w) = [p − w(s)]ds
t ψ(t)

we obtain xψ (t) = Π(t|) + A2 /ψ(t).

 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
WAGE-TENURE CONTRACTS 1403

A1 and V ≥ Vu > −∞ require w > 0 almost everywhere. Hence, (30) implies xV /ψ < 0 al-
most everywhere where 1/u (w) = −xV /ψ. Substituting out xV and xψ in the definition of the
Hamiltonian, (29), and noting H = 0 at the optimum, implies
0 = [p − w] − [Π + A2 /ψ][δ + λ(1 − F(V ))]

V 
− [1/u (w)] δV − u(w) − λ [x − V ]dF(x)
V

almost everywhere. As δ > 0 implies ψ → 0 as t → ∞, A2 = 0 implies the second term becomes

unboundedly large in absolute value. As Claim S1 implies V  Π are uniformly bounded, then
A2 = 0 implies w > 0 becomes unboundedly large almost everywhere as t → ∞ and so Π < 0 for
t large enough. Therefore A2 = 0 contradicts Π > 0 for all t. Note that A2 = 0 implies xψ ≡ Π
and (32) implies the differential equation for Π, (9), as stated in the Theorem.
As (31) is linear in xV ,using 1/ψ as the integrating factor yields

t
xV (t)
=− λF  (V (s))Π(s)ds + A1
ψ(t) 0

where A1 is the constant of integration. Note, Π > 0 implies xV /ψ is decreasing over time. For
those t where xV /ψ < 0, (30) implies w > 0 and satisfies

t
1
= λF  (V (s))Π(s)ds − A1 
u (w(t)) 0

Differentiating with respect to t implies

−u (w) dw
(33) = λF  (V )Π
u (w)2 dt
for such t. If A1 > 0, then xV /ψ ≥ 0 for t small enough and (30) then implies w = 0; i.e., the corner
constraint can bind for small enough t. But as w > 0 almost everywhere, the corner constraint
can only bind at t = 0. Hence, w evolves according to (33) for all t > 0, and so w V  Π evolve
according to the differential equation system as described in the Theorem.
Step 2. The Transversality Condition. Claim S1 implies Π is strictly positive and so (33) implies
w is increasing in tenure. Hence, V is also increasing in tenure. As V is bounded, monotonicity
implies V must converge to some limit value V ∞ . Further, as V (0) = V0 ∈ [ V  V ), (33) and V ≤ V
imply V ∞ = V . Further, (8) implies w must converge to w and (9) implies limt→∞ Π(t) = Π.
Finally, note that V increasing implies V ∈ [V0  V ] for all t, and so this solution also satis-
fies (28) (and so does not bind). Q.E.D.

REFERENCES
ACEMOGLU, D., AND R. SHIMER (1999): “Wage and Technology Dispersion,” Review of Economic
Studies, 68, 585–608.
ALBRECHT, J., AND B. AXELL (1984): “An Equilibrium Model of Search Unemployment,” Journal
of Political Economy, 92, 824–840.
BONTEMPS, C., J.-M. ROBIN, AND G. J. VAN DEN BERG (1999): “An Empirical Equilibrium Job
Search Model with Search on the Job and Heterogenous Workers,” International Economic
Review, 40, 1039–1075.
(2000): “Equilibrium Search with Continuous Productivity Dispersion: Theory and Non-
Parametric Estimation,” International Economic Review, 41, 305–358.
BURDETT, K., AND D. T. MORTENSEN (1989): “Equilibrium Wage Distributions: Compensating
and Otherwise,” MEDS Working Paper, Northwestern University.
 14680262, 2003, 5, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/1468-0262.00453 by Edinburgh University Library, Wiley Online Library on [09/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
1404 K. BURDETT AND M. COLES

(1998): “Wage Differentials, Employer Size, and Unemployment,” International Eco-

nomic Review, 39, 257–273.
DIAMOND, P. A. (1971): “A Model of Price Adjustment,” Journal of Economic Theory, 3, 156–168.
ECKSTEIN, Z., AND K. I. WOLPIN (1990): “Estimating a Market Equilibrium Search Model from
Panel Data on Individuals,” Econometrica, 58, 783–808.
LEONARD, D., AND N. V. LONG (1992): Optimal Control Theory and Static Optimization in Eco-
nomics. Cambridge: Cambridge University Press.
MORTENSEN, D. T. (2002): “Wage Dispersion: Why are Similar Workers Paid Differently,”
Mimeo, Northwestern University.
POSTEL -VINAY, F., AND J.-M. ROBIN (2002a): “The Distribution of Earnings in an Equilibrium
Search Model with State-Dependent Offers and Counter-Offers,” International Economic Re-
view, 41, 989–1017.
(2002b): “Equilibrium Wage Dispersion with Worker and Employer Heterogeneity,”
Econometrica, 70, 2295–2350.
SHIMER, R. (1996): “Contracts in a Frictional Labor Market,” Mimeo, MIT.
STEVENS, M. (1999): “Wage-Tenure Contraction in a Frictional Labour Market: Firms’ Strategies
for Recruitment and Retention,” Mimeo, Oxford University.
(2002): “Wage-Tenure Contraction in a Frictional Labour Market: Firms’ Strategies for
Recruitment and Retention,” Mimeo, Oxford University.
VAN DEN BERG, G. J. (1999): “Empirical Inference with Equilibrium Search Models of the Labor
Market,” Economic Journal, 109, F283–F307.
VAN DEN BERG, G. J., AND G. RIDDER (1998): “An Empirical Equilibrium Search Model of the
Labor Market,” Econometrica, 66, 1183–1221.