DP5200 Insurance and Opportunities: The Welfare Implications of Rising Wage Dispersion

Author(s): Jonathan Heathcote , Kjetil Storesletten , Giovanni L Violante

Publication Date: August 2005

Keyword(s): insurance , labour supply , productivity , wage dispersion , welfare

JEL(s): D31 , D58 , D91 , E21 , J22 , J31

Programme Areas: International Macroeconomics , Labour Economics

Link to this Page: www.cepr.org/pubs/dps/DP5200.asp

This paper analyses the welfare effects of changes in cross-sectional wage dispersion, using a class of tractable heterogeneous-agent economies. We emphasize a trade-off in the welfare calculation that arises when labour supply is endogenous. On the one hand, as wage uncertainty rises, so does the cost associated with missing insurance markets. On the other hand, greater wage inequality presents opportunities to increase aggregate productivity by concentrating market work among more productive workers. We find that the observed rise in wage dispersion in the United States over the past three decades implies a welfare loss roughly equivalent to a 2.5% decline in lifetime consumption. Assuming Cobb-Douglas preferences, this number is the result of a welfare gain of around 5% from the endogenous increase in productivity coupled with a loss of around 7.5% associated with greater volatility in consumption and leisure.