Firms’ Expectation Biases and Labor Market Dynamics

• Applicants: Professor Georg Dürnecker, Ph.D.; Professor Dr. Leo Kaas
• Subject Area: Economic Theory ; Economic Policy, Applied Economics
• Term: since 2022
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 501107822

The standard approach in labor market research is to make use of the rational expectations paradigm by imposing that workers and firms have all relevant knowledge about the stochastic processes governing individual and aggregate risks. This approach is analytically convenient but it neglects the effects of potential expectation biases on individual and aggregate labor market outcomes. While ongoing research analyzes the role of worker expectations in the labor market, the role of firms’ expectations has received much less attention. Our project fills this gap in the literature by analyzing the role of firms’ expectation biases regarding future employment for labor market dynamics, using empirical methods and quantitative analysis of labor market models with heterogeneous firms. The project comprises three work packages (WP). WP 1 provides the empirical foundation by analyzing survey data for German firms to measure firms' expectations biases, and how they vary with firm characteristics, over time, and across regions. In addition to studying existing datasets, we further collect new data on firms’ expected and realized worker flows. In WP 2, we use a general equilibrium model of firm dynamics to investigate how biased employment expectations impact the entry, exit and growth of firms, the allocation of labor among heterogeneous firms, and thereby affect macroeconomic outcomes such as aggregate productivity, factor misallocation, and welfare.  In WP 3, we study theoretically and quantitatively the implications of biased expectations on individual and aggregate labor market outcomes such as unemployment, worker flows and wage dynamics. As a key innovation with respect to the literature, we introduce a two-sided expectation bias by allowing both, firms and workers to have biased expectations. We use a calibrated version of the model to study (1) the role of regional differences in expectation biases for explaining the sluggish convergence of East-German states since reunification, and (2) how the labor market reforms implemented in the mid-2000s have shaped the performance of the German labor market via their effect on firms’ and workers’ expectations.

• DFG Programme: Research Grants