Using a model with constant relative risk-aversion preferences, endogenous labor supply and partial insurance against idiosyncratic wage risk, this paper provides an analytical characterization of three welfare effects: (a) the welfare effect of a rise in wage dispersion, (b) the welfare gain from completing markets, and (c) the welfare effect from eliminating risk. The analysis reveals an important trade-off for these welfare calculations. On the one hand, higher wage uncertainty increases the cost associated with missing insurance markets. On the other hand, greater wage dispersion presents opportunities to raise aggregate productivity by concentrating market work among more productive workers. Welfare effects can be expressed in terms of the underlying parameters defining preferences and wage risk or, alternatively, in terms of changes in observable second moments of the joint distribution over individual wages, consumption and hours.
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A predecessor of this paper circulated as “Insurance and opportunities: The welfare implications of rising wage dispersion.” We would particularly like to thank Randall Wright. Several ideas in this paper originated from a conversation we had with him. We also thank Orazio Attanasio, Marco Bassetto, Jeremy Greenwood, Guido Lorenzoni, Victor Ríos-Rull, one anonymous referee, and participants at many seminars and conferences for comments. Heathcote and Violante thank the Economics Program of the National Science Foundation (Grant SES 0418029) for financial support. Storesletten—a fellow of the CEPR—thanks the Norwegian Research Council for financial support. The opinions expressed here are those of the authors and not necessarily those of the Board of Governors of the Federal Reserve System or its staff.
- Labor supply
- Wage dispersion