A Tale of Two Dispersions: Wage and Firm Size

Abstract

The traditional literature treat wage dispersion and firm dynamics, which are closely connected to each other, in isolation. This paper delivers a unified treatment to wage dispersion and firm-size distribution by developing a real-option-theoretic approach. The model is tractable with analytic solution, generating the following testable implications. Firstly, the distribution of firm size is a uni-modal, right-skewed with a Paretian tail, which is in line the empirical findings, in particular the Zipf Law. So is that of wage dispersion. Secondly, as in Mortensen and Pissarides (1994), the incumbents prefer to preserve the pattern of labor hoarding rather than exiting the market when hit by (not too severely) negative productivity shock. Thirdly, in addition to the effect in standard search and matching theory, the labor market tightness is also found to produce additional transition mechanisms to the unemployment rate. Fourthly, the model predicts that, the larger the firm is, the longer the firm will survive at the market.