/DERXU 0DUNHW
Only a very small segment of the labour market corresponds to the Walrasian notion of a
spot market, where market participants meet to negotiate a new labour contract with a
market clearing price every day. Also, labour services offered and demanded in each
segment of this market are certainly not homogeneous. Many highly differentiated skills and
abilities are traded in the labour market. Neither for firms nor for workers is the type of
work that is required or the quality of work that is offered completely transparent. Also, and
in contrast to the spot market notion in the equilibrium model, both workers and firms seem
to have an interest in longer term employment contracts due, for example, to training costs
or mobility costs or as insurance against unemployment. All these different aspects taken
together renders the services traded in labour markets rather complex. Given the
information sets of both firms and workers it seems very difficult to achieve an optimal
match in very short periods of time. This is also the central idea of search theoretic models:
trade in the labour market must be regarded as highly uncoordinated, time-consuming and
costly for both workers and firms. The following specification of a theoretical search model
for the labour market, which is based on previous work by Howitt (1988) and Pissarides
(1990), tries to capture these different aspects.
The basic incentive for search activities in the labour market by both workers and firms are
the profit opportunities in present value terms which are associated with a successful job
match for both parties. Let us therefore first state the income of workers in both states and
the value of an occupied and a vacant position for a firm. Denote the permanent income of
an employed and unemployed worker by +WH and +WX respectively. The process
generating permanent income can be described by the following arbitrage conditions:
u,+,‘ = : (i - wo)+*(+,“ - +)+ (δн'+,
(21a)
and
u + = %E1 + /EIS + sure(.)( + - + )+ E ∆+
(2,b)
+ + + + 1 \ + + + t f+1
The left hand side of equation (2,a) is the return from the human capital of an employed
person and is composed of the wage rate, the risk of losing the job * and any changes in +WH
which result from expected future changes in the wage rate and job security. Similarly, the
left hand side of equation (2,b) is the return of the human capital of an unemployed person
which consists of unemployment benefits %E1W and an imputed value for leisure /EI6W 2, an
expected capital gain from switching into employment (with probability surE), which
depends on labour market tightness proxied by the unemployment rate) and a change in the
value of +WX associated with any future changes in the former components.
The real pure profit of a firm per employee can be defined as revenue minus total wage
costs per worker ( GOSt∕1t). The average cost of a vacant position is simply given by 9&t.
Let )RW and )YW be the present discounted values of an occupied and a vacant position for
the firm, then the arbitrage conditions for both an occupied and a vacant position can now
be stated as follows
2 See Box ,
13