IZA DP No. 950: Equilibrium Employment in a Model of Imperfect Labor Markets
This paper presents a simple model of imperfect labor markets with endogenous labor market participation and home production. We show that a two-sector economy (home and market) implies a three-state labor market when labor market imperfections take the form of an irreversible entry cost incurred by workers. This simple framework brings several results. First, it delivers an expression for the employment rate and as side-products, a measure of the unemployment rate and the size of the labor force. Second, it rationalizes several empirical works on the definition of unemployment in labor force surveys. Third, it derives endogenously all flows between three labor market states. Fourth, a calibration of the model rationalizes differences in employment rates: in the U.S., we find a market productivity premium of +30% and market frictions of -15% compared to France. Finally, the model is a very simple reduced form of search models with which it is fully consistent: the irreversible entry cost is the opportunity cost of search and depends on aggregate conditions.