A Labor Market Sorting Model of Hysteresis and Scarring

Abstract

Labor market sorting substantially changes across the business cycle, increasing inefficient mismatches. This paper proposes a new framework to analyze the interactions between labor market sorting and business cycle fluctuations. Using Italian administrative data, we estimate a tractable search equilibrium model that considers firm and worker heterogeneity, aggregate risk, and life-cycle dynamics. We jointly account for endogenous changes in match-dependent human capital accumulation and worker-firm assignment. We show that distortions in human capital accumulation and worker-firm sorting caused by aggregate fluctuations contribute significantly to the persistent effects of business cycles, resulting in economic hysteresis. Aggregate fluctuations have substantial welfare effects, with significant heterogeneity along the earnings, skill, and age distribution. We also find that features of the labor compensation distribution are key predictors of the severity of downturns. Finally, our model is able to account for the increased length of recessions in recent decades.

Keywords: Sorting, Labor Market, Search, Business Cycles

JEL Classification: E32, J20, E60