S EARCH & M ATCHING IN THE L ABOUR

M ARKET

Costanza Naguib
(University of Geneva)
S EARCH AND M ATCHING : INTUITION

I There are two key features of the labour market that the
models we have seen so far do not capture:
1. in the real world, vacant jobs and unemployed workers
coexist all the time;
2. there always are large flows into and out of employment
and unemployment even when the level of unemployment is
constant.

I Search and Matching models are meant to provide a much

more realistic description of the dynamic functioning of the
labour market

I These models are based on the intuition that information

asymmetries prevent all vacant jobs to be matched with
unemployed workers and this is the essential friction
generating unemployment in equilibrium.
T HE MATCHING PROCESS

I Mortensen and Pissarides - Nobel prize winners 2010.

I Unemployed workers search for jobs and employers with

vacant jobs search for workers.

I Searching is costly and inefficient, i.e. even when

searching there is a certain probability of not finding a
partner.

I Random search: all workers are identical and all firms are
identical
I meeting probabilities depend on how many workers are
searching and how many vacant jobs are open.
T HE MATCHING FUNCTION

I We summarize the features of this search and matching

process with a matching function:

M = m(U, V )

where M is the number of matches/meetings, U is the

number of unemployed and V is the number of vacant jobs

I We assume m(·) to be increasing and concave in both U

and V.

I We assume m(·) to have constant returns to scale:

I if one doubles the number of both U and V the number of
matches doubles;
I small and large labour markets are equally efficient
T HE MATCHING FUNCTION (2)

I Constant returns to scale means that, for any constant a:

m(aU, aV ) = am(U, V )

I Then, consider a = 1/F , where F is the labour force

(constant):
M
= m(u, v )
F
where u = U/F is the unemployment rate, v = V /F is the
ratio of vacant jobs over the labour force and m = M/F is
the ratio of matches over the labour force.
M EETING PROBABILITIES

I What is the probability that a vacant job meets an

unemployed worker?
   
M m(U, V ) U 1
= =m ,1 = m , 1 = q(θ)
V V V θ

where θ = VU is called labour market tightness and q(θ)

decreases with θ.

I What is the probability that an unemployed worker meets a

vacant job?
M MV
= = q(θ)θ
U V U
which is increasing in θ.
DYNAMIC EQUILIBRIUM

I This matching process takes place in every period (every

second, every instant...)

I How do we define the equilibrium in such a dynamic

economy?
I we define the steady state equilibrium as the situation such
that the endogenous variables of the model are constant
over time.

I Steady state unemployment:

I inflows into unemployment equal outflows from
unemployment.
S TEADY STATE UNEMPLOYMENT

I Inflows equal outflows:

θ∗ q(θ∗ )u ∗ = x(1 − u ∗ )
| {z } | {z }
outflow inflow

where x is the exogenous rate at which existing job

matches dissolve (separation rate).

I Rearranging terms:
x
u∗ =
θ∗ q(θ∗ ) +x

I this equation describes a relationship between market

tightness and unemployment known as the Beveridge
Curve (BC).
T HE FIRM PROBLEM

I Simplifying assumptions:
I each firm has only one job that can produce a given output
y if filled with a worker;
I the marginal product of labour is constant;
I the firm expects to be operating for an infinite period of time
and has a discount rate of r .

I Searching is costly:
I the firm needs to pay a fixed cost µ for every period in
which the job is vacant;
I the firm can always decide not to open the vacant job and
stop paying µ.
T HE FIRM VALUE FUNCTIONS

I The value of a vacant job to the firm:

q(θ)J f + (1 − q(θ))J v
J v = −µ +
1+r

where J f is the value of the filled job.

I The value of a filled job to the firm:

(1 − x)J f + xJ v
J f = (y − w) +
1+r

I Similarity with financial activities and their expected

returns.
T HE FREE - ENTRY CONDITION

I If there are no impediments to new entrants in the market,

firms will keep opening vacancies as long as their value is
positive.
I In equilibrium J v = 0 (free-entry condition).

I Given free-entry, J f > 0.

I Contrary to perfect competition, now firms make real
positive profits!
I These profits are the result of a dominant position in the
labour market, a rent that cannot be taken away by market
forces;
I any competitor wanting to challenge the rent of an existing
firm first needs to pay the search cost to enter the market.
J OB CREATION

I Combining the value functions of the firm and the

free-entry conditions yields the Job Creation condition
(JC):
µ
w = y − (r + x)
q(θ)

I the wage is lower than the marginal product because the

firm needs to recover the search cost;
I the JC is a negative relationship between the wage that the
firm is willing to pay and the degree of market tightness
(more tightness means higher recruitment costs and thus
lower wages);
I the JC plays here a role that is analog to the role of labour
demand in a perfectly competitive market as it defines the
firm policy for any given market condition.
T HE WORKER PROBLEM

I Simplifying assumptions:
I the worker expects to be active in the labour market for an
infinite period of time and has a discount rate of r ;
I when unemployed the worker has access to a certain
income b < y (unemployment benefit, value of home
production, et.)

I The workers’ value functions:

θq(θ)W e + (1 − θq(θ))W u
Unemployment: W u = b +
1+r
(1 − x)W e + xW u
Employment: W e = w+
1+r
T HE SURPLUS OF THE MATCH

I Given the above assumptions, it is clear that workers prefer

employment over unemployment (W e > W u ) and a firm
prefers a filled job to a vacancy (J f > J v = 0).

I Hence, when a worker and an employer meet they are in a

very privileged position and they are willing to negotiate a
wage that would allow both of them to enjoy a share of the
benefits of the meeting:
I define the surplus of the worker as S w = W e − W u . The
worker is willing to accept any wage as long as her surplus
remains positive;
I define the surplus of the firm as S f = J f − J v . The firm is
willing to pay any wage as long as its surplus remains
positive.
T HE SURPLUS OF THE MATCH (2)

I Since both the surplus of the worker and the surplus of the
firm are positive there are many wages that satisfy both
conditions. Which one is chosen?
I It depends on the relative bargaining powers of the parties
(Nash bargaining).

I We assume that the worker gets a share γ of the total

surplus S = S w + S f and the firm gets the remaining 1 − γ:

W e = W u + γS
Jf = J v + (1 − γ)S = (1 − γ)S

I γ can be interpreted as the bargaining power of the worker

WAGE SETTING

Now a bit of algebra to close the model...

I Rearrange the expression for the value of employment W e
as follows:
(1 + r )w + xW u
We =
r +x

I Now replace this and the expression for J f (with the

free-entry condition J v = 0) into the following equation:
γ
W e − W u = Jf
1−γ

obtained from the outcome of the wage negotiation

process.
WAGE SETTING (2)

I The result is the following Wage Setting (WS) condition:

w = b + γ(y + θµ − b)

I which is a positive relationship between the wage and

labour market conditions.

I The wage setting condition shows that the worker can

negotiate a higher wage in tighter labour markets, where
workers are hard to find.
E QUILIBRIUM

I The three key endogenous variables of the model are the

wage w, the market tightness θ and unemployment U.

I They are defined by three equilibrium conditions that we

have derived earlier on:
µ
Job Creation (JC) w = y − (r + x)
q(θ)
Wage Setting (WS) w = b + γ(y + θµ − b)
x
Beveridge Curve (BC) U =
θq(θ) + x
E QUILIBRIUM
E QUILIBRIUM FLUCTUATIONS

I A productivity increase shifts both the JC and the WS

curves upwards
I firms are willing to pay higher wages for the same
recruitment cost (JC ↑)
I workers can command a higher wage for the same
tightness because there is more total surplus to be shared
(WS ↑).

I As a result equilibrium wages increase and market

tightness also increase.

I Then, unemployment declines along the Beveridge curve.

C ONCLUSIONS

I The search and matching model provides a very realistic

description of the labour market.

I Unemployment is a key equilibrium feature of the model

and arises because of matching frictions

I Vacant jobs and unemployed workers always coexist

I There always are flows across labour market states

I unemployed workers find jobs and loose jobs
I vacant jobs are filled and active jobs are destroyed

I Changes in unemployment occur when the relative

magnitudes of inflows and outflows change.