Labor market composition effects of productivity shocks

We develop a labor demand model that incorporates an important feature of the labor market, the heterogeneity of workers with respect to their productivity levels and the inability of firms to observe these in the hiring process. An additional contrast between our model and prototypical labor demand models is that in our model firms use an "employment criterion" in terms of a threshold level of productivity to make hiring decisions. A consequence of setting such a threshold is that each firm, in the process of employing workers generates externalities for other firms in the labor market by changing the productivity-mix of the unemployment pool. This yields interesting implications for the response of unemployment and average productivity to exogenous productivity shocks. In particular, we examine conditions under which a small productivity shock could lead to substantial variations in employment, and only a slight observed response of average productivity. This is because firms respond to productivity shocks by changing the employment criterion in such a way that the mix of high and low productivity workers among the employed changes to favor low productivity workers. We find that for sufficiently low rates of unemployment and levels of the employment criterion, the effects of productivity shocks on average productivity could be much moderated. In addition to the contributions at the theoretical model, our model yields interesting implications for the alternative effects of monetary disturbances and productivity shocks on the level of average productivity at the empirical level. This suggests the possibility of an empirical analysis exploring the components of variations in average productivity associated with productivity shocks on the one hand, and monetary disturbances on the other.