Wage Inequality and Unemployment: United States versus Europe

Throughout the 1970s and 1980s, wage differentials widened in the US but not in Europe, where marginal labor-force groups experienced increasing and persistent unemployment instead. Both phenomena may be explained, for different labor-market institutions, by more pronounced volatility of labor-demand forcing processes in a simple model of labor allocation under idiosyncratic uncertainty. If workers bear the costs of labor reallocation, then a higher option value of work in currently depressed regions, occupations, or sectors is consistent with wider wage differentials in equilibrium. Under centralized wage setting and job-security legislation, conversely, higher likelihood of negative shocks in the near future decreases labor demand by hiring firms. These and other implications of our model are consistent with the phenomena motivating our work and with other pieces of evidence.