Risk and the Misallocation of Human Capital (with Pedro Silos & Vesa Soini)
With risk-averse workers and uninsurable earnings shocks, competitive markets allocate too few workers to jobs with high earnings uncertainty. Using an equilibrium Roy model with incomplete markets, we show that risky occupations are inefficiently small and hence talent is misallocated. We obtain analytical expressions for the compensation for risk in the labor market, and for the aggregate level of human capital and output. We also study the welfare properties by solving for the constrained-efficient allocation. ...Misallocation is positively related to the correlation between a worker’s abilities in different occupations. Quantitatively we find that market incompleteness can by itself generate permanent output and welfare losses of close to one percent of output. Around 35% of the loss is due to the presence of the pecuniary externality.
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