The Role of Firm Heterogeneity in the Earnings Inequality

Over the past three decades, individual earnings inequality has seen rising alongside increases in the concentration of firm employment and revenue in the U.S. This paper studies the factors underlying these trends and their macroeconomic impacts. I extend a canonical uninsurable earnings risks model with heterogeneous firms and labor market search friction as in Lucas and Prescott (1974). There are a large number of spatially distinct labor markets - islands or firms - and workers’ earnings becomes a product of their own labor productivity and a function of employers’ productivity. Workers may leave an island by paying search cost or can be exogenously separated. Once leave, they move to a nearby island following a transition process. Through searching, better workers move to better firms. Better workers can afford search cost since they tend to be wealthy. Also once they move to a better firm, their wage increase is larger than the increase of low productivity workers. Thus productive workers engage searching, have higher chance to move up while low productive workers tend to stay where they are. The model replicates earnings distribution, firm size distribution and wealth distribution successfully. With the quantitatively disciplined model, transitional dynamics exercise is designed to measure individual and firm component in rising inequality. It shows that the individual component in wages explains the most of the rise in earnings concentration. The majority of the firm concentration is driven by the changes in firm productivity distribution. The model suggests that shifts in the productivity distributions and changes in the worker-firm matching pattern which are driving rising inequality, have important implications: They explain 22% of output growth, 15% of capital growth and a quarter of the decline in the interest rate since the 1990’s.