Lecture 2: Frictional unemployment III. Endogeneizing job destruction

Where are we? So far, exogenous job destruction rate s Makes it difficult to talk about institutions such as firing costs Can’t use the model to explain the cyclical behaviour of job destruction Can we extend it to make job destruction endogenous?

The Mortensen-Pissarides model 1 firm = 1 job Each jobs produces p+σε ε = idiosyncratic shock ε changes according to a Poisson process Arrival rate λ Drawn from distribution F(), ε < ε u New firms start at ε = ε u

The firm’s life cycle: t ε εuεu εdεd

The role of turnover costs: In the absence of turnover costs, free entry at the highest productivity level would drive down all firms such that ε < ε u out of the market Here, profitable to go on rather than repaying the hiring cost next time

Firms:

Workers

Solving the model The model can be reduced to two conditions A job creation condition given by –J(ε u ) = c/q(θ) A job destruction condition given by –J(ε d ) = 0

Computing the solution

Graphically: PJC PJD θ εdεd

Explaining the slopes: Tighter labor markets  Higher recruiting costs  Higher value of a job  Less incentives to destroy jobs  lower destruction margin –PJC downward sloping Tighter labor markets  Higher opportunity cost of not searching  Lower surplus  Higher destruction margin –PJD upward sloping

Comparative statics PJDPJC b  β  c  λ 