Labor force participation, worker flows and labor market policies

We construct a model that explicitly considers nonparticipation as well as employment and unemployment in order to (i) generate gross worker flows as observed in the U.S. data, and (ii) re-examine the effects of labor market policies frequently evaluated in two state models. The distinction between unemployment and nonparticipation is workers' active/passive job search behavior. A key feature of the model is that we introduce heterogeneity in workers' productivity into the Mortensen and Pissarides (1994) matching model in order to incorporate worker's endogenous search intensity choice. The model is calibrated to replicate, in a steady state equilibrium, the key statistics of employment, unemployment and nonparticipation as well as the gross worker flows and job flows observed in the U.S. labor market data. Taking the model as a benchmark, we introduce five labor market policies into the model and re-examine their effects on labor market variables: unemployment insurance policy, firing taxes and severance payments, minimum wage regulation, labor unions and welfare system. Our findings from these policy experiments are generally consistent with empirical evidence and those from other papers that consider similar policies. One noticeable additional feature from our experiments is that all policies produce sizable changes in the labor force participation rate and worker transition rates in and out of the labor force. A distinguishing result among these policy experiments arises in the unemployment insurance policy. More generous UI benefits can increase both the fraction of population that is employed and unemployed, which cannot be obtained in the conventional two state models. This result is consistent with Canadian experience after UI reform in 1972.