Insurance and Opportunities: The Welfare Implications of Rising Wage Dispersion

Jonathan H. Heathcote, Georgetown University
Kjetil Storesletten, University of Oslo
Giovanni L. Violante, New York University

Abstract

This paper provides an analytical characterization of the welfare effects of changes in cross-sectional wage dispersion, using a class of tractable heterogeneous-agent economies. We express welfare effects both in terms of changes in the observable joint distribution over individual wages, consumption and hours, and in terms of the underlying parameters defining preferences and wage risk. Our analysis reveals an important trade-off for welfare calculations. On the one hand, as wage uncertainty rises, so does the cost associated with missing insurance markets. On the other hand, greater wage dispersion presents opportunities to increase aggregate productivity by concentrating market work among more productive workers. In a calibration exercise, we find that the observed rise in wage dispersion in the United States over the past three decades implies a welfare loss roughly equivalent to a 2.5% decline in lifetime consumption. This number is the net effect of a welfare gain of around 5% from an endogenous increase in labor productivity, coupled with a loss of around 7.5% associated with greater dispersion in consumption and leisure. We also calculate the welfare gains from completing insurance markets. We find that they stem primarily not from reduced consumption dispersion, but from a more efficient allocation of labor effort. This labor productivity improvement means that expanding insurance against wage risk offers larger welfare gains than redistributive policies that reduce dispersion in after-tax wages.