Search in the Labour Market, Incomplete Contracts and Growth

This paper shows that search in the labour market has important effects on accumulation decisions. In a labour market characterized by search, employment contracts are naturally incomplete and this creates a wedge between the rates of return and marginal products of both human and physical capital. As a result, when workers invest more in their human capital, they increase the rate of return on physical capital. Provided that these factors are complements in the production function, this will increase the desired level of investment for firms. Then, because physical capital is not being paid its marginal product, the rate of return on all human capital goes up. In this model, therefore, there are pecuniary increasing returns to scale in human capital accumulation in the sense that the more human capital there is, the more profitable it is to accumulate human capital. Applying this argument conversely, the presence of pecuniary increasing returns in physical capital accumulation also follows. These pecuniary increasing returns lead to amplified inefficiencies and to the possibility of multiple equilibria. They also imply that factor distribution of income has an important impact on growth. Finally, the paper derives new links between unemployment and human capital accumulation and shows that when technology choice is endogenized, search introduces a negative wage formation externality which may lead to excessively fast diffusion of new technologies.