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Lecture3

The document discusses the DMP model in macroeconomics, focusing on search externalities and policy implications. It explores the efficiency of resource allocation by a planner in the presence of search frictions and introduces the concept of constrained efficiency. The analysis also examines the effects of labor taxes and the impact of heterogeneity in job types on job creation and unemployment rates.

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Runsheng Wang
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0% found this document useful (0 votes)
3 views

Lecture3

The document discusses the DMP model in macroeconomics, focusing on search externalities and policy implications. It explores the efficiency of resource allocation by a planner in the presence of search frictions and introduces the concept of constrained efficiency. The analysis also examines the effects of labor taxes and the impact of heterogeneity in job types on job creation and unemployment rates.

Uploaded by

Runsheng Wang
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Econ 2010d: Heterogeneity in Macroeconomics

Lecture 3: Search Externalities and Policy in DMP

Adrien Bilal
Spring 2024
Harvard
Introduction
Recap: The DMP Model

• Built a model that speaks to unemployment volatility, inflows and outflows

• Today study its efficiency and normative properties

• When study a policy, need to specify what the market failure is!
I Unless about pure redistribution
I Without market failure, welfare theorems hold
I No need for any intervention (except redistribtuion)

1 / 28
Setup
Constrained Efficiency

• Same setup as in Lecture 2 (linear costs and Nash bargaining)

• We want to study how a benevolent planner would allocate resources

• If the planner could get rid of search frictions, would do so


I But if search frictions are part of technology, planner should internalize them

• Use concept of constrained efficiency


I Study planner’s problem taking search frictions as given

2 / 28
Planning Problem
Planner’s Problem (1/2)


X
max E0 β t Ct
{Ct ,vt }t ,
t=0
s.t. Ct = zt (1 − ut ) + ut b − cvt
ut+1 − ut = s(1 − ut ) − f (vt /ut )ut , u0 given

• Here specify b as home production


• With linear preferences, maximizing consumption ≡ maximizing output
I Transfers immaterial: everyone has same marginal utility of consumption

• Stock-flow equation and matching function as constraints


I Constrained efficiency

3 / 28
Planner’s Problem (2/2)

• Planner problem simplifies to standard dynamic optimization problem



X
β t zt (1 − ut ) + ut b − cvt
 
max E0
{vt }t ,
t=0
s.t. ut+1 − ut = s(1 − ut ) − M(ut , vt ) , u0 given

• Can solve with


I Lagrangian method
I Dynamic programming (define planner’s value Ω(u))

4 / 28
Planner’s Optimality Conditions (1/2)
• Use value function of planner:

Ω(u, z) = max z(1 − u) + ub − cv + βEu,z Ω(u 0 , z 0 )


v
s.t. u 0 = u + s(1 − u) − M(u, v )

• Obtain
 
∂M ∂Ω 0 0
c = −β (ut , vt )Ez (u , z )
∂v ∂u
   
∂Ω ∂M ∂Ω 0 0
(u, z) = b − z + β 1 − s − (ut , vt ) Ez (u , z )
∂u ∂u ∂u

• Using Cobb-Douglas formula for matching function, obtain

c = βq(1 − α)Ez [−∂u Ω0 ]


−∂u Ω = z − b + β (1 − s − αf ) Ez [−∂u Ω0 ]

5 / 28
Planner’s Optimality Conditions (2/2)
• Define the planner’s surplus from a job as S(u, z) = −∂u Ω(u, z)

• The planner’s surplus satisfies the Bellman equation

St = zt − b + β(1 − s − αft )Et St+1

• Vacancy creation becomes

c = (1 − α)βqt Et St+1

• Recall similar equations in decentralized equilibrium

St = zt − b + β(1 − s − γft )Et St+1


c = (1 − γ)βqt Et St+1

• Planner and equilibrium share same stock-flow equation

• Find the difference?

6 / 28
Efficiency
(In)Efficient Vacancy Creation
• Differences between planner and equilibrium are:
I The vacancy creation condition

c = (1 − α)βqt Et St+1 vs. c = (1 − γ)βqt Et St+1

I The surplus equation because of the option value of search

St = zt − b + β(1 − s − αft )Et St+1 vs. St = zt − b + β(1 − s − γft )Et St+1

• If α = γ, the decentralized equilibrium is efficient: Hosios condition (1990)

• If α 6= γ, the decentralized equilibrium is inefficient

• Intuition
I Both firms (and workers) congest the matching function for other searchers
v ∂M
I For firms: M ∂v
=1−α
I How much firms internalize congestion depends on surplus share 1 − γ
I Efficient when firms’s surplus share equals their technological congestion effect

7 / 28
When is Unemployment Too Low or Too High? (1/2)
• Focus again on steady-state zt ≡ z and approximation s, r  f :
1−γ z −b 1−αz −b
θDE ≈ vs. θSP ≈
γ c α c
s
and recall u ≈ mθ 1−α

• Ratio between equilibrium and efficient unemployment rates:


1−α
u DE

γ 1−α

u SP 1−γ α
I Increasing in γ

• Unemployment is too high iff γ > α


I Worker bargaining power is high, firm bargaining power is low
I Firms receive too little surplus and so create too few vacancies

• To leading order, unemployment volatility unaffected by (in)efficiency


du DE du SP

u DE u SP
8 / 28
When is Unemployment Too Low or Too High? (2/2)

• Many estimates find α ∼ 0.5, γ ∼ 0.2

• Imply that steady-state unemployment rate is too low (by half)!


I Somewhat surprising
I But recall that planner can redistribute between risk-neutral agents
I So planner just maximizes output, all about vacancy creation here

• Recall that we consider constrained efficiency

9 / 28
Optimal Policy
Labor Taxes
• Now return to the decentralized equilibrium

• Introduce a lump-sum labor tax τt paid by the firm

• Values of workers and vacant firm unchanged

• Value of filled firm in decentralized equilibrium now

Jt = zt − τt − wt + β(1 − s)Et Jt+1


• Solve for wages and values using bargaining solution as before
I Previous equations hold after replacing zt by zt − τt

• Seek tax τt such that in all states of the world

(1 − γ)St (τt ) = (1 − α)St , θtDE = θtSP


where now we use the alternative expression for the surplus (see Lecture 2)
St = zt − τt − b + θtDE c + β(1 − s − ftDE )Et St+1
St = zt − b + θtSP c + β(1 − s − ftSP )Et St+1
10 / 28
Optimal Labor Tax

• Optimal tax
α−γ 
τt = zt − b + θtDE c
1−γ

I When γ > α and unemployment too high, subsidize labor


I When γ < α and unemployment is too low, tax labor

• In practice need to
I Know α, γ
I Know zt , b, c
I Measure θt

• Can also use proportional wage tax, similar information requirements

11 / 28
Taking Stock

• We have seen the efficiency criteron of the DMP model


I Each side be compensated by how much it congests the matching function
I Hosios condition: γ ≶ α. Unemployment too high iff γ > α
I Can be corrected with labor or wage tax/subsidy

• So far considered a model with homogeneous workers and firms

• Now introduce heterogeneity and study how it affects efficiency

12 / 28
Composition Externalities
Setup

• Suppose now there are many types of jobs/firms i ∈ {1, 2, ..., I }


I zi+1,t > zi,t a.s.
I Measure Mi of each type

• Keep workers homogeneous


I Could have worker heterogeneous too, same logic

• Suppose that all firm types face random matching


I If firm i posts vi vacancies, it meets qvi workers, q = P M
i Mi vi

I All firm types bundled into same matching function

• Revert to convex cost formulation from lecture 2


I Important to ensure that all firm types are active in equilibrium
I cit = Ci0 (vit ) ≡ ci (vit ) = c0 viν

13 / 28
Values
• Value of unemployment now
 
X
Ut = b + βEt ft ωj (vv t )Ej,t+1 + (1 − ft )Ut 
j

where
M i vi
ωi (vv ) = P
j M j vj

is firm i’s vacancy share

• Other Bellman equations remain unchanged (except adding an i subscript)

• Firm type-specific surplus


 
X
Si,t = zit − b + β(1 − s − γft )Et Si,t+1 + βγft Et Sit+1 − ωj (vv t )Sjt+1 
| {z } j
as in homogeneous case | {z }
heterogeneity correction: worker’s outside option

14 / 28
Job Creation

• Job creation for each type

cit = (1 − γ)βqt Et Si,t+1

• In steady-state
X
Si = zi − b + β(1 − s)Si − βγf ωj Sj
j
ci = βq(1 − γ)Si

• Heterogeneity in wages across firms i !


 
X
wi = (1 − γ) b + βγf ωj Sj  + γzi .
j

15 / 28
Planner’s Problem
• Planner’s state variable is now employment at each type
I In homogeneous model could equivalently use unemployment
I Denote vectors with bold font: (n1 , ..., nI ) ≡ n and (v1 , ..., vI ) ≡ v

• Use value function of planner:


!
X  X
Ω(nn , z ) = max zi ni − Mi Ci (vi ) + 1− ni b + βEz Ω(nn 0 , z 0 )
v
i i
P !
j Mj vj
s.t. ni0 = (1 − s)ni + Mi vi q P for all i
1− j nj

• Obtain
X Mj vj 0
n0 , z 0 ) + β n0 , z 0 )
   
ci (vi ) = βq(θ)Ez ∂ni Ω(n q (θ)Ez ∂nj Ω(n
j
u
 0 0 
n, z )
∂ni Ω(n = zi − b + β (1 − s) Ez ∂ni Ω(n n ,z )
X Mj vj 0
n0 , z 0 )
 
+ q (θ)θEz ∂nj Ω(n
j
u

16 / 28
Planner’s Solution

• Define the planner’s suplus of a job at firm i as

Sit ≡ ∂ni Ω(nn t , z t )

• In steady-state:
X
Si = zi − b + β (1 − s) Si − βαf ωj Sj
j
n X o
ci = βq Si − α ωj Sj
j

17 / 28
Surpluses and Job Creation
• Compare steady-state match surplus in eq. Si vs. in planner’s solution Si
X
Si = zi − b + β(1 − s)Si − βγf ωj Sj
j
X
Si = zi − b + β (1 − s) Si − βαf ωj Sj
j

I Under Hosios condition α = γ, both coincide given f

• Compare vacancy creation conditions

c(vi ) = βq(1 − γ)Si


X
c(υi ) = βq(1 − α)S i + α ωj (S i − S j )
j

• Even w/ Hosios condition α = γ, heterogeneity ⇒ composition externality


I Planner internalizes that creation of job i congests matching fct for job j

18 / 28
Direction of Composition Externality
• Compare job creation conditions under Hosios condition

c(vi ) = βq(1 − α)Si


X
c(υi ) = βq(1 − α)S i + α ωj (S i − S j )
j
I Planner internalizes that creation of job i congests matching fct for job j

• Consider only two firm types i ∈ {1, 2}

• Then z2 > z1 and so S2 > S1 , S2 > S1

• Can show with some algebra that

ω2SP > ω2DE , ω1SP < ω1DE

I If f , q, ωi the same in SP vs. DE, SP increases vacancies at productive firm


I Too many bad jobs in equilibrium! (Acemoglu 2001)

19 / 28
Taking Stock: Composition Externalities

• With heterogeneous prod., search frictions lead to composition externalities

• Workers randomly meet firms ⇒ low-prod. firms “free-ride” labor market


I Planner diverts job creation away from low-prod. firms
I Happens despite endogenous job creation
I Always leads to excess job creation at unproductive firms
I If heterogeneous workers instead: too much search effort by low-prod. workers

• High-prod. firms would like to operate in a separate labor market


I Bonus slides: segmented markets
I Back to Hosios condition, no composition externalities

• Solution: Endogenous markets!


I Moen (1997): competitive/directed search
I Will see that it removes both the Hosios and the composition externalities

20 / 28
Competitive Search
Endogenous Labor Market Segmentation

• For now return to homogeneous firms and no aggregate shocks zt ≡ z

• Relax exogenous markets

• Markets now segmented by wage offer w


I Firms now have commitment power
I They post a wage offer w
I One labor market per wage offer
I Let firms open their own labor market/join an existing market

• Matching function applies market by market

• Workers observe wage offers and decide in which market to search

• Firms internalize that posting a higher wage may attract more applicants

21 / 28
Endogenous Labor Market Segmentation
• Value of unemployment if search in market with wage w

U(w ) = b + β [f (w )E (w ) + (1 − f (w ))U(w )]

• E (w ) as before

• Ex-ante worker arbitrage between (active) markets

U(w ) ≡ U ≡ max
0
U(w 0 ) =⇒ f (w ) [E (w ) − U] ≡ Λ
w

I When w increases, E (w ) rises


I Worker indifference implies that f (w ) must fall
I From matching function, q(w ) rises: firms attract more workers
I Trade-off between wage and recruiting speed across markets

• Surplus still independent from wage

S = z − b + β(1 − s)S − βΛ
22 / 28
Firm’s Problem (1/2)

• Vacant firms now choose which wage to offer

max q(w )J(w ) s.t. f (w )[S − J(w )] = Λ


w

• Trade off
I Higher wage/lower profits (J(w ) ↓)
I Hiring workers faster (q(w ) ↑)

• Can re-write as choosing J directly


1 α
max (mΛ−α ) 1−α J (S − J) 1−α
J

I Used matching function to relate q and f


I No need to express J(w ) = z − w ...

23 / 28
Firm’s Problem (2/2)

1 α
max (mΛ−α ) 1−α J (S − J) 1−α
J

• Solution

J = (1 − α)S , c = β(1 − α)qS

• “As if” bargaining solution with bargaining power γ = α!


I All firms identical here, so all choose same wage and split of value

• Commitment =⇒ firms internalize their congestion through wages


I Just as the planner does
I In equilibrium, only one wage is posted
I But firms internalize off-equilibrium changes in their market’s tightness

24 / 28
Bringing Back Heterogeneity

• Now introduce again firm types zi , i = 1...I as before

• Workers now indifferent between


I Different wages within firm types
I Different firm types

• Calculations in homogeneous case hold conditional on Λ ≡ fi (w )[Ei (w ) − U]

• Solution

Ji = (1 − α)Si , ci = β(1 − α)qi Si

I Coincides with planning solution when markets are segmented


I As in homogeneous case, surplus is shared efficiently

• Where did composition externalities go?

25 / 28
Composition Externalities

• With competitive search, opening a new labor market is part of technology

• So the planner can also open new markets


I Never optimal to mix firm types inside same market if can avoid it
I Otherwise bad firm crowds out applications to good firm

• Thus, we are back to the planner’s solution for segmented markets

c(υi ) = β(1 − α)qi Si

• The decentralized equilibrium is efficient

• No composition externalities

26 / 28
Taking Stock
• Competitive search makes search economy efficient
I Irrespectively of homogeneity or heterogeneity
I Also called directed search

• Key ingredients for efficiency to obtain


I Commitment to wage offers
I Workers perfectly observe all wage offers
I Possibility of opening new markets
I Undoes “Hosios” externality: firms internalize wage-congestion trade-off
I Undoes composition externalities: firms optimally segment across markets

• Competitive search sometimes very useful


I For writing models with frictions...
I ...But where the goal is to emphasize different market failure

• But interpretation harder than with random search


I If workers know everything about the labor market, what are search frictions?
I Search frictions usually a short-hand for incomplete information, screening, etc.
27 / 28
Conclusion
Conclusion: Unemployment and the DMP Model
• Unemployment facts
I St.dev. of unemployment rate ≈ 1.5 p.p. over the cycle
I Job finding rate accounts for ≈ 60 − 90% of that variation
I Vacancy creation strongly procyclical

• The DMP model: positive analysis


I Captures the basic forces that determine unemployment
I Generates income risk at worker level
I Need tweaking to match empirical u-rate volatility (high b, rigid wages)

• The DMP model: normative analysis


I Hosios condition: efficiency and direction of policy in plain vanilla model
I With heterogeneity also get composition externalities
I Competitive search (vs. random search) brings back efficiency

• Next: Implication of income risk for consumption patterns

28 / 28
Bonus: Segmented Markets
Segmented Markets

• Suppose now that labor markets are also segmented by firm type i
I Now can use either linear or convex job creation costs

• There is an identical matching function for every market i


I i-specific tightness θi , unemployment rate ui

• Unemployed workers choose in which market to search


I Can only search in one market at a time
I Value of unemployment equalized across markets i

29 / 28
Equilibrium Values with Segmented Markets
• Value of unemployment if search in market i

Uit = b + βEt [fit Ei,t+1 + (1 − fit )Uit ]

• Worker arbitrage between markets

Uit ≡ Ut =⇒ fit Et [(Ei,t+1 − Ut )] ≡ Λt

• Surplus satisfies for all markets i

γfit Et Si,t+1 = Λt

I High productivity, high surplus markets have low job-finding rate


I Workers enter market i, lowers job-finding rate, until indifferent with market j

• Surplus Bellman equation

Si,t = zi,t − b + β(1 − s − γfit )Et Si,t+1

30 / 28
Planning Problem

• Similar planning problem as without segmented markets

• Key difference: law of motion of employment


 
0 Vi
ni = (1 − s)ni + vi q
1 − ni

I Tightness is specific to market i


 P V 
j j
I Before had q 1−P nj
j

I No possibility of cross-type congestion ⇒ removes composition externalities

• Derive planning solution as before

31 / 28
Efficiency With Segmented Markets

• Surplus equations in steady-state

Si = zi − b + β(1 − s − γfi )Si , fi Si = constant


Si = zi − b + β(1 − s − αfi )Si , fi Si = constant

• Free entry/job creation conditions

c(vi ) = βq(1 − γ)Si


c(υi ) = βq(1 − α)Si

• Efficiency: back to Hosios condition α = γ

32 / 28
Taking Stock

• With segmented markets composition externalities vanish

• But imposes strong assumption

• Why can’t firm j operate in market i?

• If firm j less productive than i, incentive to enter market i

33 / 28

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