Insurance and Opportunities: The Welfare Implications of Rising Wage Dispersion

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 with various insurance market structures. 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 the changing nature of wage risk. Our analysis reveals an important tradeoff 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 inequality presents opportunities to increase aggregate productivity by concentrating market work among more productive workers. This productivity gain means that improving the degree of insurance against wage risk offers larger welfare gains than redistributive policies that reduce individual wage variability. 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. JEL Classification Codes: D31, D58, D91, E21, J22, J31.