Unemployment, labor market transitions, and residual wage dispersion

It is commonplace in the debate on Germany's labor market problems to argue that low wage dispersion is a major reason for the high unemployment rate. This paper analyzes the relationship between unemployment and residual wage dispersion for individuals with comparable attributes. In the conventional neoclassical point of view, wages are determined by the marginal product of the workers. Accordingly, increases in union minimum wages result in a decline of residual wage dispersion and higher unemployment. A competing view regards wage dispersion as the outcome of search frictions and the associated monopsony power of the firms. Accordingly, an increase in search frictions causes both higher unemployment and higher wage dispersion. The empirical analysis attempts to discriminate between the two hypotheses for West Germany analyzing the relationship between wage dispersion and both the level of unemployment as well as the transition rates between different labor market states. The findings are not completely consistent with either theory. However, as predicted by search theory, one robust result is that unemployment by cells is not negatively correlated with the within-cell wage dispersion.