Introduction to Labor Search Models

Dr. Parag Waknis

Ambedkar University Delhi

Macro II Winter 2020

April 16, 2020

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 Why Labor Search

• Unemployment is the feature of any economy around the

world including India.
• Measured as number of people actively seeking work.
• No counterpart of this concept in the standard
representative agent neoclassical growth models
including the RBC model.
• Need a model which can model activities of job search,
leisure and employment and the time it takes to transit
between unemployment and employment.
• Search models have these characteristics where
unemployment arises as an equilibrium phenomenon
unlike in the Keynesian models where it is primarily a
disequilibrium outcome (rigid wages and prices).

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 Two types of Search Models

• One sided search partial equilibrium model- McCall

Model.
• Two sided search and matching models- Mortensen &
Pissarides Model.

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 McCall Model

Suppose a continuum of agents with unit mass, each having

preferences given by:
∞
∑
E0 β t ct
t=0

where,
• 0 < β < 1 and
• β = 1+r
1
, with r being the real interest rate.

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 McCall Model

• Assume that there is no disutility form job effort or search

effort.
• Many jobs in the economy offering different wage,w .
• Distribution of wage offers given by probability
distribution, F(w) , with probability density function, f(w).
• Assume that w ∈ [0, w̄] which is the support of the
distribution.
• δ is the probability of an employed worker being
unemployed also called the separation rate.
• b is the unemployment benefit with b < w̄.

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 McCall Model

Let Vu the value of being unemployed and it is given by the

following Bellman equation:

∫w̄
Vu = {b + β max [Ve (w), Vu ] f(w)dw} (1)
0

• An unemployed agent receives unemployment insurance

benefit, b, at the beginning of the period, consumes it,
and then receives a wage offer from the distribution F(w).
• Wage offer is accepted if Ve (w) ≥ Vu and declined
otherwise.
• Integral is the expected utility of sampling from the wage
distribution.

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 McCall Model

Let Ve (w) the value of being employed at wage w as of the

end of period. It is given by the following Bellman equation:

Ve (w) = {w + β(δVu + (1 − δ)Ve (w))} (2)

• An employed agent receives the wage, w and consumes
it.
• Then either suffers a separation or will continue to work
at the wage w next period.

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 McCall Model

To get some results from these value functions, let us do some

manipulations. First divide both sides of equation (1) by β,
1
substitute β = 1+r and subtract Vu from both sides to get:

∫w̄
rVu = b(1 + r) + max[Ve (w) − Vu , 0] f(w)dw (3)
0

On the right-hand side of (3) is the flow return when

unemployed plus the expected net increase in expected utility
from the unemployed state.

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 McCall Model

Using the same method, equation (2) can be simplified to:

rVe (w) = w(1 + r) + δ[Vu − Ve (w)] (4)

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 McCall Model

Question: What wage offers will an agent accept when

unemployed?
From (4) we get the following:

w(1 + r) + δVu
Ve (w) = (5)
r+δ
thus:
• Ve (w) is strictly increasing linear function of w.
• ⇒ there is some w∗ such that Ve (w) ≥ Vu for w ≥ w∗ and
Ve (w) ≤ Vu for w ≤ w∗ .

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 McCall Model

w∗ is called the reservation wage implying the unemployed

agent will accept any wage offer w∗ or more and decline
anything else.

Technically at w∗ the agent should be indifferent between

being employed or staying unemployed.

⇒ Ve (w∗ ) = Vu , which when used in (5) gives:

w∗ (1 + r)
Vu = (6)
r

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 McCall Model

Then, if we substitute for Vu in equation (3) using (6) and for

Ve (w) using (5) we get:

∫w̄ [ ]
∗ (w − w∗ )(1 + r)
w (1 + r) = b(1 + r) + max , 0 f(w)dw
r+δ
0

Dividing both sides by (1 + r):

∫w̄
∗ 1
⇒w =b+ { (w − w∗ )f(w)dw}
r+δ
w∗

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 McCall Model

∫w̄
1
⇒ w∗ − b = (w − w∗ )f(w)dw (7)
r+δ
w∗

• Equation (7) is often used to characterize the reservation

wage.
• LHS is the cost of searching one more time when an offer
w∗ is in hand.
• RHS is the expected benefit of searching one more time in
terms of the expected present value associated with
drawing w > w∗ .
• Equation (7) instructs the agent to set w∗ s.t. the cost of
searching one more time equals the benefit.

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Probability- a detour

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Probability- a detour

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Probability- a detour

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Probability- a detour

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 Probability- a detour

PDF and CDF of a uniformly distributed variable:

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Probability- a detour

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Probability- a detour

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 McCall Model

Following from (7), we have:

∫w̄
∗ 1
w =b+ { wf(w)dw − w∗ [1 − F(w∗ )]}
r+δ
w∗

Next use integrate by parts to obtain:

∫w̄
1
w∗ = b + {w̄ − w∗ F(w∗ ) − F(w)dw − w∗ [1 − F(w∗ )]}
r+δ
w∗

∫w̄
∗ 1
⇒w −b= [1 − F(w)]dw (8)
r+δ
w∗

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 McCall Model
Note that:
• LHS of (8) is a strictly increasing and continuous function
of w∗ .
• RHS of (8) is a decreasing function of w∗ .
• For w∗ = 0, the right-hand side of the equation exceeds
the left-hand side, and for w = w∗ the left-hand side
exceeds the right
• ⇒ a solution for w∗ exists, and it is unique.
Define the following:

∫w̄
∗ 1
A(w ) = [1 − F(w)]dw (9)
r+δ
w∗

We will use the above equation to draw a graph for McCall

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McCall Model

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 McCall Model-Comparative Statics

We can now use the model and the associated graph to

figure out effect of changes in the exogenous variables on the
endogenous variable w∗ .

Exogenous variables:
dw∗
db Changes in the unemployment benefits.
dw∗
dr Changes in the real interest rate.
dw∗
dδ Changes in the job separation rate.

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 McCall Model-Comparative Statics

Changes in the unemployment benefits.

Totally differentiating equation (7) and solving gives:

dw∗ r+δ
= >0 (10)
db r + δ + 1 − F(w∗ )

⇒ An increase in b increases the reservation wage w∗ . This

occurs because an increase in b reduces the cost of search
while unemployed. An unemployed worker therefore
becomes more picky concerning the jobs he or she will accept.

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McCall Model-Comparative Statics

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 McCall Model-References

1 Degroot M & M Schervish 2012, Probability & Statistics,

Fourth Edition
2 Ljungqvist, Lars & Sargent, Thomas J., 2012. “Recursive
Macroeconomic Theory, Third Edition,” MIT Press Books,
The MIT Press, edition 3.
3 Yashiv, Eran, 2007. “Labor search and matching in
macroeconomics,” European Economic Review, Elsevier,
vol. 51(8), pages 1859-1895, November.
4 Williamson Stephen, “Notes on Labor Search”

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