Precautionary Demand for Labor and Firm Size

Abstract

This paper studies firms' job creation decisions in a labor market with search frictions. A simple labor market search model is developed in which a firm can search for a second employee while producing with a first worker, and this creates the equilibrium size distribution of firms. A firm expands employment even if the instantaneous payoff to a large firm is less than that of staying small - a firm has a precautionary motive to expand its size. In addition, this motive is enhanced by a greater market tightness. Because of this effect, firms' decisions become interdependent - a firm creates a vacancy if it expects other firms to do the same, creating strategic complementarity among firms and thereby self-fulfilling multiple equilibria. An increase in productivity can cause a qualitative change in labor market tightness and the rate of unemployment.

Keywords: labor demand, firm size, search frictions

JEL Classification: E24, J23, L25