Global COE Hi-Stat Discussion Paper Series 285

Research Unit for Statisticaland Empirical Analysis in Social Sciences (Hi-Stat)

Compensating Wage Differentials in
Stable Job Matching Equilibrium

Hi-Stat Discussion Paper

Seungjin Han
Shintaro Yamaguchi

March 2013

Hi-Stat
Institute of Economic Research
Hitotsubashi University
2-1 Naka, Kunitatchi Tokyo, 186-8601 Japan
http://gcoe.ier.hit-u.ac.jp

Compensating Wage Differentials in
Stable Job Matching Equilibrium
Seungjin Han∗

Shintaro Yamaguchi†

27th February 2013

Abstract
This paper studies implicit pricing of non-wage job characteristics in thelabour market using a two-sided matching model. It departs from the previous
literature by allowing worker heterogeneity in productivity, which gives rise
to a double transaction problem in a hedonic model. Deriving sufficient conditions under which assortative matching is the unique stable job-worker matching, we show that observed wage differentials between jobs reflect not only
compensating wage differentials, but also worker productivity gaps between
the jobs. We find that the job-worker matching pattern determines the extent
to which compensating wage differentials are confounded with the worker
productivity gap effect.

Keywords: hedonic model, heterogeneity, two-sided matching, matching pattern,
wage differential, equalizing difference, worker productivity
JEL Codes: C78, J31∗ Address: Department of Economics, McMaster University, Hamilton, Ontario Canada; Email:hansj@mcmaster.ca† Address: Department of Economics, McMaster University, Hamilton, Ontario Canada; Email:yamtaro@mcmaster.ca11Introduction

The theory of equalising differences has remained one of the most fundamental
value theories in economics since Adam Smith’s classic discussion in “The Wealthof Nations.” Rosen (1974) develops a theory of equalising differences for a commodity market and shows that implicit markets arise for differentiated products inwhich hedonic prices adjust so that all markets clear: The observed price differentials reflect the buyer’s willingness to pay for a better product.1 The key idea of
equalising differences also holds in the labour market. Rosen (1986) applies the theory to the labour market and finds that equilibrium wage differentials reflect workers’ willingness to pay for job characteristics. His theoretical finding demonstrates
how non-wage characteristics of a job are valued and how workers are matched tosuch jobs.
Although the theory is a rich description of the labour market for heterogeneous
jobs, it assumes homogeneous worker productivity. Rosen (1986) notes the importance of workers’ productivity heterogeneity, pointing out“...On the theoretical side of these questions, much more attention mustbe paid to the value of workers’ productivity characteristics and thenature of sorting and selection in those dimensions....”The objective of this paper is to develop a theory of the labour market in which
both job characteristics and worker productivity are heterogeneous. Our main question is how labour productivity and job characteristic are valued in the labour market. The difficulty in examining this problem arises from double transactions: workers sell their productivity characteristics to the firms, while the firms implicitly sell
job characteristics to the workers. Double transactions are inherent in labour markets and absent in commodity markets. On the one hand, in the commodity market,
consumers do not sell their characteristics to firms, and hence their characteristics
do not directly affect firms’ profits. On the other hand, in the labour market, not
1 The theory of equalising differences has been applied to various types of commodity mar-kets. For example, Scotchmer (1985) develops a hedonic price model in the housing market, andKanemoto (1988) applies the theory to study the benefits of public projects. The theory is further developed by Ekeland (2010) and Chiappori et al. (2010) who undertake hedonic equilibrium analysis
in a more general matching model.

2only does the wage affect the employer’s profit, but so do workers’ characteristics.
This implies that the wage difference between jobs reflects not only the compensating wage differentials, but also the difference in the productivity of the workers
occupying the jobs. The presence of double transactions complicates our problem
and prevents us from applying the known results for commodity markets.
Another question that arises is how heterogeneous jobs and workers are matchedin the labour market. The double transaction issue also complicates the matchingmechanism, since not only do worker’s productivity characteristics affect a firm’s
profit, but the job characteristic in a firm affects worker’s utility as well. A match
is formed only when a firm and a worker agree on the wage that reflects the net
value of the characteristics on both sides. The analysis is even harder when utility
is not transferable, because the marginal utility of the job characteristic depends on
the wage. The established results (Teulings 1995, Shimer 2005) in the optimal assignment literature for heterogeneous jobs and workers do not answer this question,
because job characteristics do not affect the utility of a worker 2 , and hence, doubletransactions do not exist in those models.
In our model workers are heterogeneous in their productivity and jobs differ intheir characteristics. Workers derive utility not only from wages, but also from thecharacteristics of the job they hold. The labour market is frictionless so that all
workers can freely choose any job and all firms can freely hire any worker. We findthat positive assortative matching is the unique stable matching between jobs andworkers, if (i) a good job characteristic increases the marginal utility of consumption or the marginal productivity of a worker and (ii) the worker’s utility function isconcave in consumption. This result holds even when utility is not transferable.
We then show that the wage difference between two jobs reflects a compensating wage differential and the difference in productivity between workers occupying
those two jobs. On the one hand, the former lowers the wage of a better job, because
a worker is willing to accept a lower wage in exchange for better job characteristics.
On the other hand, the latter raises the wage of a better job in assortative matching,because the worker occupying the better job is more productive. When the worker
2 Sattinger (1975) also considers the matching problem, but the worker’s utility function is notmodelled.

3productivity effect dominates the compensating wage differentials, the observed
wage gaps across jobs seem contradictory to the theory of equalising differences,because the observed wage increases, rather than decreases, with job characteristics. We clearly characterise how this worker productivity effect masks compensating wage differentials in the data, and find that the job-worker matching patterndetermines the extent to which the worker productivity effect appears in the wage.
We further show that the distributions of jobs and workers pin down the job-worker
matching pattern.
Empirical research often fails to find the evidence for compensating wage differentials. Various econometric reasons have been posited for the difficulty in estimating equalising differences in the labour market. Among them, unobserved
heterogeneity (Hwang et al. 1992), omitted variables (Brown 1980, Lucas 1977),
measurement errors (Duncan and Holmlund 1983) and an unappealing linear approximation (Ekeland et al. 2004), have all been considered as sources of thecounter-intuitive results. All of these papers improve on the econometric methods, but are based on the model by Rosen (1986) in which worker productivity ishomogeneous.
An explanation based on economic theory, rather than econometric theory, isprovided by Hwang et al. (1998) and Lang and Majumdar (2004). They show thatlabour market frictions make it less likely to observe compensating wage differentials, using a search model with homogeneous worker productivity. Our model
differs in that we allow for heterogeneous worker productivity and consider a frictionless economy. Our explanation is alternative to theirs and emphasises the jobworker matching pattern as the main cause preventing us from interpreting the wage
differences between jobs as compensating wage differentials.
The rest of the paper is structured as follows. We begin by reviewing the theoryof equalising differences in a labour market composed of homogeneous workers
in Section 2. Then, we introduce heterogeneous worker productivity in Section 3.
We derive sufficient conditions for assortative matching and characterise a stableequilibrium by the wage and matching functions. Section 4 discusses empiricalimplications of the main theoretical result. Section 5 concludes the paper. Proofs
and technical discussions are collected in the Appendix.
42

Equalising Differences

To provide the intuition for equalising differences, we begin with the analysis of
the relationship between wage and job characteristics when labour productivity ishomogeneous. Throughout the paper, consider a market with a continuum of firms
and workers, each with the total measure of one. Firms differ in the characteristicsof their jobs: firm x has a job with characteristic x ≥ x, where x ∈ R is the lowest
job characteristic. Let H(x) be the measure of firms whose job characteristics are
no more than x.
For now, assume that workers are homogeneous in their productivity characteristic. Let the utility function u(c, x) represent worker’s preferences over the consumption good c and the characteristic x of her job. Worker’s preferences are monotone, so that the marginal utilities uc (c, x) and ux (c, x) of the consumption good andthe job characteristic respectively, are both positive for all (c, x) ∈ R+ × R. Let
workers’ exogenous unearned income be normalised to zero. Then, if a worker’s
wage is w, she purchases w units of the consumption good (c = w).
The production function is given by f (x, y), where y is a worker’s productivity
characteristic. Because workers are homogeneous in their productivity, it can be
rewritten as f (x, ȳ) where ȳ is the same productivity for all workers. Let w(x)be the equilibrium wage paid to the worker who takes the job with characteristic
x. Because workers are homogeneous in their productivity, all of them must havethe same equilibrium utility, u(w(x), x) = ū. Worker utility is increasing in job
characteristic, so the less preferred job must be compensated by a higher wage inequilibrium in order to equalise the workers’ utilities, i.e., w(x) > w(x0 ) if x < x0 .
Therefore, the observed wage should be negatively related to the job characteristic. This is recognised as an equalising difference in the labour market or a compensating wage differential (see Rosen (1986).) This relationship is solely driven
by the workers’ monotonic preferences. It does not depend on the nature of the job
characteristic in the production technology or on other properties of the workers’
preferences.

5

3

Stable Matching Equilibrium

3.1

Environment

We turn to the analysis of the labour market in which workers’ productivity characteristics are heterogeneous. Heterogeneity in labour productivity gives rise to the
double transaction problem as the worker sells her productivity characteristic to thefirm, and the firm sells the job’s characteristic to the worker. Therefore, the equilibrium wage reflects two prices: one for the worker’s productivity characteristic andthe other for the job characteristic. We show how these two prices determine theequilibrium wages by constructing a stable matching equilibrium where no alternative pairs of firms and workers can be strictly better off by matching and transferring
wage.
Let y ≥ y denote a worker’s productivity characteristic, where y ∈ R is the lowest
productivity characteristic. Let G(y) be the measure of workers whose productivity
characteristics are no more than y. Recall that firm x has a job with characteristicx ≥ x, and analogously H(x) is the measure of firms whose job characteristics are no
more than x. Denote by h and g the density functions for the distributions of the job
characteristic and the worker’s productivity, H and G, respectively. For technicalpurposes, the values of densities are finite positive real numbers: 0 < h(x) < ∞for all x and 0 < g(y) < ∞ for all y. Let f (x, y) denote a firm’s production function.
The production function is increasing in y: fy (x, y) > 0 for all values of (x, y), which
naturally follows from what productivity means. We do not impose a restriction on
the sign of fx (x, y): it can be either negative, zero, or positive. If necessary, we
assume that utility and production functions are twice differentiable.

3.2

Definition of Equilibrium

A stable matching can be characterised by a matching function and a wage function.
Let m(x) be a matching function that specifies the productivity characteristic of theworker who works for firm x in equilibrium. Let w(x) be a wage function that6

specifies the wage firm x pays to its worker.3
A worker’s objective is to maximise her utility by deciding who to work for andat what wage level. In doing so, she must allow her employer to earn the profit
at least as high as the potential profit the employer would earn given the matching
and wage functions; in other words, f (x, y) − w ≥ f (x, m(x)) − w(x). The worker’s
problem is formulated as (W1) below:
max u(w, x)
(x,w)

(W1)

subject to f (x, y) − w ≥ f (x, m(x)) − w(x).
If the constraint slacks, the worker can increase her utility by raising the wage w
without violating the constraint. Therefore, the constraint is binding at a solution to(W1).
A firm’s objective is to maximise its profit by deciding whom to hire and at
what wage level. In doing so, the firm must secure its employee the level of utility
at least as high as the potential utility level that the employee would enjoy given
the matching and wage functions. Let n(y) be the job characteristic that worker yis matched under m(·), i.e., m(n(y)) = y. The firm’s problem is formulated as (F1)
below:
max { f (x, y) − w}
(F1)

(y,w)

subject to u(w, x) ≥ u(w(n(y)), n(y)).
Similar to the worker’s problem, the constraint in the firm’s problem is also binding
at a solution.
In a stable matching equilibrium, the solutions to problems (W1) and (F1) coincide with the matching function y = m(x) and the wage function w(x), and nopairs of firms and workers can make themselves strictly better off by matching andtransferring wage.
Definition 3.1 For the given distributions of the job characteristics and workers’
productivity characteristics, a stable matching equilibrium is given by a set of
3 Note that the wage does not depend on y given x and the matching function, because w(x, y) =w(x, m(x)) = w(x).

7matching and wage functions {m(·), w(·)}, if (i) (x, w(x)) is a solution to the problem (W1) for every worker y; (ii) (y, w(x)) is a solution to the problem (F1) for every
firm x; (iii) y = m(x); and (iv) the payoffs determined by {m(·), w(·)} are equal toor greater than their reservation payoffs to remain unmatched for every worker yand firm x.

3.3

Assortative Matching

In this subsection, we derive a sufficient condition for the matching function m(·)
to exhibit a positive assortative matching in which high productivity workers arematched to firms with better jobs. We begin by showing that the worker’s equilibrium utility is increasing in her productivity. This lemma holds in any stablematching equilibrium.
Lemma 3.1 In a stable matching equilibrium characterised by {m(·), w(·)}, theworker’s equilibrium utility is increasing in her productivity characteristic y.
Proof. See Appendix 6.1.
This result comes from the monotonicity of worker preferences and the monotonicity of the production function in the worker’s productivity characteristic.
When workers are homogeneous, a less preferred job characteristic must becompensated by a higher wage in order to equalise the equilibrium utility acrossworkers as shown in Section 2. However, when workers’ productivity is heterogeneous, the relationship between the equilibrium wage and the job characteristic is
not that obvious, because various combinations of wages and job characteristics canincrease worker’s utility. This is how the double transaction problem complicatesthe analysis of the equilibrium wage. The increasing property of the equilibrium
utility leads to the following lemma.
Lemma 3.2 Let w(x, u) be the lowest wage for firm x to maintain the worker’s
utility level at u. If the utility function is concave in consumption (i.e., ucc (c, x) ≤ 0)
and supermodular (i.e., ucx (w, x) ≥ 0), the following inequality holds:
w(xL , uH ) − w(xL , uL ) ≥ w(xH , uH ) − w(xH , uL ),
8

(3.1)

where the strict inequality holds if the utility function is strictly supermodular (i.e.,ucx (w, x) > 0).
Proof. See Appendix 6.2.
Consider two firms xH and xL (xH > xL ) that attempt to hire one of the twoworkers yH and yL (yH > yL ). Each firm must offer a higher wage to the yH worker, because the yH worker receives a higher utility than the yL worker in equilibrium(see Lemma 3.1). Equation (3.1) shows that the difference in the firm xL ’s wage
offers between the two workers is at least as large as the difference in the firm xH ’s.
This result is used to prove the following theorem. Note that many commonly usedproduction and utility functions satisfy supermodularity.4
Theorem 3.1 The matching function m(·) is increasing if the utility function is concave in consumption (i.e., ucc (c, x) ≤ 0 at each (c, x)) and Condition 1 or 2 is satisfied:
1. u(·, ·) is supermodular and f (·, ·) is strictly supermodular
2. u(·, ·) is strictly supermodular and f (·, ·) is supermodular
Proof. See Appendix 6.3.
Assortative matching under transferable utility with a strict supermodular production function is well-known.5 Suppose that the worker’s utility function is quasilinear in wage so that it is given by u(w, x) = v(x) + w, where v(·) is an increasing
and concave function. This assumption implies transferable utility, because one unitof the profit f (x, y) − w can be transferred to the worker as one unit of utility. In
4 In our context, the supermodular utility functions include, among many others, (a) substi-

tutable consumption and job characteristic: u(c, x) = αca + β xb with α ≥ 0 and β ≥ 0 (b) perfectcomplements: u(c, x) = min{αc, β x} with α ≥ 0 and β ≥ 0. (c) Cobb-Douglas utility function:u(c, x) = β ct xs with β ≥ 0, t ≥ 0, s ≥ 0, and (d) constant elasticity of substitution utility function:u(c, x) = (αcρ + β xρ )1/ρ with α ≥ 0, β ≥ 0, ρ ≤ 1 . The classes of utility functions, (c) and (d),are strictly supermodular if the parameter restrictions hold with strict inequality. The examples of
the common supermodular production functions are similar.
5 The first contribution is Becker (1973). Also see Topkis (1998) for more details.

9this case, a strict supermodular production function ensures assortative matching.
Condition 1 of theorem 3.1 includes this case.
Theorem 3.1 generalises the well-known result to the case of non-transferable
utility as well. Suppose that the worker’s utility function is not separable so that it
is given by u(w, x). This generalisation allows us to consider the case in which thejob characteristic affects the marginal utility of consumption (i.e. wage). Under thispreference, one unit of wage is not transferable to the worker as one unit of utility.
Condition 2 of theorem 3.1 includes this case. Theorem 3.1 shows that assortative
matching arises even if utility is not transferable and the production function is notstrictly supermodular as long as Condition 2 is met.
Legros and Newman (2007) also derive a sufficient condition for assortative
matching when utility is not transferable. One difference in our paper is that we
consider the case in which continuum of agents exist, while Legros and Newman(2007) consider the model in which finite number of agents exist. Thanks to thecontinuity, we can clearly characterise the relationship between wage differentials
and the matching pattern in term of a differential equation, as seen in the next
subsection.
Another difference is that we present the sufficient condition in terms of properties of the primitive payoff functions themselves, while Legros and Newman (2007)
provide it in terms of properties of the function that specifies the agent’s maximum
payoff conditional on the payoff for its matching partner. Our result allows one toreadily examine not only whether the condition is satisfied or not, but also whether
the condition is economically plausible or not. For example, similar to Theorem
3.1, we can establish the sufficient condition for negatively assortative matching by
replacing the concavity assumption of the worker’s utility function with the convexity and the supermodular assumption with the submodular one. However, theconvexity assumption seems less intuitive, which is why we focus on positive assortative matching in this paper.

10

3.4

Equilibrium Characterisation

In this subsection, we show the necessary and sufficient condition for the wage andmatching functions to characterise a stable matching equilibrium.
Proposition 1 Suppose that the utility function is concave in consumption and Condition 1 or 2 in Theorem 3.1 is satisfied. Then, the matching and wage functions{m(·), w(·)} characterise a stable matching equilibrium if and only if:
1. For all workers and firms, the matching and wage functions {m(·), w(·)} provide payoffs equal to or higher than their reservation payoffs to remain unmatched.
2. ∀x ≥ x,
H(x) = G(m(x))(3.2)

3. ∀x ≥ x,
w0 (x) +ux (w(x), x)= fy (x, m(x))m0 (x)uc (w(x), x)(3.3)

Proof. See Appendix 6.4.
Equation (3.2) characterises the assortative matching function m(·) as the uniquestable matching function. Equation (3.3) is the first-order necessary condition for
the wage function that characterises solutions for both firm’s problem (F1) andworker’s problem (W1). If Conditions 2 and 3 are satisfied, no pairs of a firm
and a worker can make themselves strictly better off by matching and transferring
wage.
Equation (3.3) clearly shows the relationship between job characteristics, worker
productivity, and wages in a stable matching equilibrium. The right-hand side ofEquation (3.3) shows that, as the job characteristic increases at the margin, theproductivity of the worker occupying the job also increases by m0 (x), which consequently results in a change in the total output by fy (x, m(x))m0 (x). In a competitive
labour market, this change in the total output is fully passed onto the worker. On theleft-hand side of Equation (3.3), the first term is the marginal change of wage, andthe second term is the marginal change in the worker’s utility due to the change in11

job characteristics normalised by the marginal utility of wage. Hence, this second
term is the dollar value of the marginal utility of the job characteristics, which isprecisely the compensating wage differential.

3.5

Existence and Uniqueness of Equilibrium

Note that Equation (3.3) is a first-order differential equation for the wage functionw(·) given the assortative matching function characterised in Condition 2 in Proposition 1:
w0 (x) = φ (x, w(x)),(3.4)
where the function φ (·, ·) is defined as
φ (x, w(x)) := −ux (w(x), x)+ fy (x, m(x))m0 (x).
uc (w(x), x)(3.5)

Hence, the wage function can be derived by solving this first-order differential equation with an initial condition of the wage w(x) in the bottom match. The exact levelof the wage in the bottom match will be ultimately determined by bargaining powereach side has, which may depend on various factors, such as legal and culturalenvironment as well as which side of the market has more potential entrants. The
existence and uniqueness of an equilibrium come down to the existence and uniqueness of a solution to the first-order differential equation (3.4). For the existence anduniqueness, consider the following conditions.
Condition 1. fy (x, m(x))m0 (x) is continuous in x.
(w,x)
is (i) continuous in x and (ii) Lipschitz continuous in w,
Condition 2. uuxc (w,x)
that is, there exists a scalar 0 ≤ k < ∞ such that, for each x and all w, w0 ,ux (w, x) ux (w0 , x)−
≤ k w − w0 .
uc (w, x) uc (w0 , x)

(3.6)

If Conditions 1 and 2 are satisfied, then the function φ (·, ·) is Lipschitz continuous
in w and continuous in x. This ensures a unique solution w(x) given an initialcondition w(x) by the Picard-Lindelof Theorem (See Teschl (2012)).
12

The slope of the matching function is given by m0 (x) = h(x)/g(m(x)) by taking
a derivative of both sides of Equation (3.2). Because the values of the densities hand g are assumed to be positive finite numbers, the value of m0 (x) is a positive
finite number. If we further assume that the densities are continuous, then m0 (·) is
continuous as well. Condition 1 is then satisfied if fy (·, m(·)) is continuous in x,
which is satisfied if fy (·, ·) is continuous in both x and y because m(·) is continuous.
(w,x)
is the marginal rate of substitution of the
As for Condition 2, note that uuxc (w,x)
job characteristic for consumption. This is continuous in x if each marginal utility
function is continuous in x. The Lipschitz continuity with respect to w specified
in Equation (3.6) essentially requires that the marginal rate of substitution be notblown to infinity at any possible wage level given a job characteristic. Therefore,
the ratio of the difference between the two marginal rates of substitution to thedifference between the two corresponding wages is always bounded by some scalark.

3.6

Heterogeneous Worker Preferences

The model can easily incorporate heterogeneity in worker preferences. Suppose thatN groups of workers exist. For example, a group of males and a group of females
exist, with N = 2 if males and females have different preferences over consumption
and job characteristics. Let the preferences for workers in group i be represented by
the utility function ui (c, x). Denoting the wage and matching functions group i bywi (x) and mi (x), respectively, the first-order condition (3.3) for group i is given by
w0i (x) +uix (w(x), x)= fy (x, mi (x))m0i (x) for i = 1, . . . , N.
uic (w(x), x)

Finally, in equilibrium, firm x is indifferent to the group from which it hires aworker. This condition implies that for all x,
f (x, mi (x)) − wi (x) = f (x, m j (x)) − w j (x) for all i, j.

13

4

Empirical Implications

In this subsection we discuss the empirical implications of Proposition 1. To see
how the equilibrium wage varies with job characteristics, we rearrange Equation(3.3) asw0 (x) = −ux (w(x), x)+ fy (x, m(x))m0 (x).
uc (w(x), x)(4.1)

The first term on the right-hand side is the (negative) marginal rate of substitution of
the job characteristic for consumption, and thus, compensating wage differentials.
When workers are homogeneous in productivity, i.e., m0 (x) = 0, wage differentials across jobs reflect only the compensating wage differentials, which confirms
the theoretical prediction of equalising differences. However, when workers areheterogeneous in productivity and they are assortatively matched with jobs, i.e.,m0 (x) > 0, the observed wage differentials across jobs w0 (x) include the compensating wage differentials and the difference in worker productivity across jobs.
The key insight is that the slope of the matching function m0 (x) determines theextent to which the difference in worker productivity affects the observed wage differentials across jobs w0 (x). On the one hand, wages decrease with job characteristic
x for compensating wage differentials. On the other hand, wages increase with job
characteristic for a higher worker productivity, when matching is positively assortative (i.e. m0 (x) > 0).The observed wage differentials across jobs show the net effectof the two. Depending on the size of the slope of the matching function m0 (x), compensating wage differentials may be completely offset by the worker productivity
effect.
The shape of the matching function m(x) is determined by the distributions ofjobs x and workers y. Recall that we denoted by h and g the density functions forthe distributions of the job characteristic and the worker’s productivity, H and G,
respectively. The assortative matching function m(·) is derived by Equation (3.2).
Taking the derivatives of both sides of this equation yields
m0 (x) =h(x).
g(m(x))

14(4.2)

The slope of the matching function m(x) at x is the ratio of the density of the job
characteristic h(·) to the density of the worker’s productivity g(·). This ratio can beinterpreted as a local measure of dispersion of worker productivity relative to that ofjob characteristics at x, since a lower density can be interpreted as more dispersion.
This point is clearer under a certain class of parametric distribution functions.
When the distributions, H and G, are in the class of Weibull, Pareto, Fréchet, Gumbel, or log-normal distribution, the logarithm of the matching function is given byln y = ln m(x) = ln k + q ln x,(4.3)

where the parameter q is the elasticity. In particular, when the distributions are lognormal, the elasticity is given by the ratio of the standard deviations q = σy /σx ,where σx and σy are the standard deviations of worker productivity and job characteristics, respectively. This example clearly shows that the slope of the matching
function is determined by the relative dispersion of worker productivity to job characteristics.
Our analysis here shows that the observed wage differentials across jobs do
not necessarily reflect only compensating wage differentials. Moreover, we findthat in economies where the relative dispersion of worker productivity is higher,
we observe less of evidence for compensating wage differentials; we may evenobserve wages increasing with job characteristic. The driving factor of our result isthe matching pattern of jobs and workers that is determined by their distributions.
Hwang et al. (1998) and Lang and Majumdar (2004) also find that the observed
wage differentials across jobs are not necessarily reflected solely by compensating
wage differentials. However, their findings are significantly different from oursin that worker productivity is homogeneous and labour market friction plays thecentral role in their model.

5Conclusion

Rosen (1986) emphasises that much more attention must be paid to the value ofworkers’ productivity and the nature of sorting and selection along that dimension15

in order to facilitate a thorough understanding of compensating wage differentials;
an important point given that productivity is arguably the most important worker
characteristic. The main analytical challenge this presents is the existence of the
double transaction in the labour market. The presence of the double transaction
prevents us from applying known results that are suitable to markets lacking a double transaction, such as commodity markets.
There are two main results in our paper. First, we show the condition under which an assortative matching of jobs and workers arises as the unique stable matching in a two-sided matching model with continuum of jobs and workers.
Second, using the differential equation for the equilibrium wage and matching, we
explicitly show how compensating wage differentials and worker productivity differences affect the wage structure across jobs. The key insight of the theory is thatthe job-worker matching pattern drives the extent to which the worker productivity
effect appears in the wage.
We note two important directions for future research. The first one is to allow
for more than one dimension in job and worker characteristics. While showing theexistence of stable matching under this environment may not be too complicated,characterising a stable matching pattern seems particularly difficult. Such characterisation would uncover the intuition behind how each characteristic component
is valued and how the valuation of each characteristic affects compensating wage
differentials. The second direction for future research is to introduce labour market
frictions. We conjecture that, even in the presence of search frictions, equilibrium
wage differentials across jobs reflect the net effect of compensating wage differentials and worker productivity gap. However, search frictions may weaken the effectof worker productivity gap as well as the effect of compensating wage differentials,
because workers and jobs are not matched in a fully assortative way under the presence of labour market frictions. We leave those problems for our future research.

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6

Proofs

6.1

Proof of Lemma 3.1

Consider any two workers, worker yH and worker yL such that yH > yL . Remember that n(y) is the job characteristic that worker y is matched under m(·), i.e.,m(n(y)) = y. The equilibrium utility for worker y is u(w(n(y)), n(y)). The highest
wage that the firm n(yL ) is willing to offer to the worker yH is
ŵL,H = f (n(yL ), yH ) − f (n(yL ), yL ) + w(n(yL )),(6.1)

because firm n(yL ) must earn the profit as high as it can earn by hiring the worker
yL . Because the firm n(y) hires a worker y in a stable matching equilibrium, we
have a no-deviation condition,u(w(n(yH )), n(yH )) ≥ u(ŵL,H , n(yL )),(6.2)

where the left-hand side is the equilibrium of utility of worker yH , and the righthand side is the highest utility that the firm n(yL ) can give to the worker yH .
Firm n(yL ) produces more when it is matched with worker yH than worker yL ,implying that f (n(yL ), yH )− f (n(yL ), yL ) > 0. This means that the highest possible
wage ŵL,H that firm n(yL ) offers worker yH is strictly higher than the equilibrium
wage w(n(yL )) that the same firm offers worker yL (see Equation 6.1), implying thatŵL,H > w(n(yL )). Hence, we have the following inequality,u(ŵL,H , n(yL )) > u(w(n(yL )), n(yL )).
Combining inequalities (6.2) and (6.3), we haveu(w(n(yH )), n(yH )) > u(w(n(yL )), n(yL )),

19

(6.3)

where the left-hand side is the equilibrium utility of worker yH and the right-handside is the equilibrium utility of worker yL . This proves that a worker’s equilibrium
utility is increasing in her characteristic. 

6.2

Proof of Lemma 3.2

The lowest wage function w(x, u) can implicitly be defined by the equation u(w(x, u), x)−u = 0. Taking the cross partial derivative of u(w(x, u), x) − u = 0 with respect to x
and u yields
wxu (x, u) = −

ucc (w, x)
ucx (w, x)
wx (x, u)wu (x, u) −w (x, u).
uc (w, x)
uc (w, x) u

(6.4)

Given the utility level u, if the job characteristic increases, the wage must decrease:wx (x, u) < 0 . If the utility level u increases given the job characteristic, the wage
must increase: wu (x, u) > 0. Because the worker’s utility function is increasing in
consumption, we have uc (w, x) > 0. Given the signs of the above derivatives andthe concavity (ucc (c, x) ≤ 0) and supermodularity (ucx (w, x) ≥ 0) assumptions, wehave wxu (x, u) ≤ 0 at each (x, u).
Consider a pair of utility levels (uH , uL ) where uH > uL and a pair of job characteristics (xH , xL ) where xH > xL . The non-positive sign of wxu (x, u) is equivalent
to(6.5)
w(xL , uH ) − w(xL , uL ) ≥ w(xH , uH ) − w(xH , uL ).
If the worker’s utility function is strictly supermodular (i.e., ucx (w, x) > 0), wxu (x, u)
is strictly negative, and hence, Equation (6.5) holds with strict inequality. 

6.3

Proof of Theorem 3.1.

Suppose instead that the matching function m(·) is decreasing. Then, a firm witha better job characteristic xH hires a worker with lower productivity yL , and a firmwith a worse job characteristic xL (< xH ) hires a worker with higher productivity
yH (> yL ). Because a worker’s equilibrium utility is increasing in her productivity(see Lemma 3.1), we have uH = u(w(xL ), xL ) > uL = u(w(xH ), xH ), where the left-

20

hand side is the equilibrium utility for worker yH and the right-hand side is theequilibrium utility for worker yL . The wages w(xL ) and w(xH ) are the lowest wages
that firms xL and xH must offer to induce the worker’s utility levels that are at leastas high as uH and uL , respectively, implying
w(xL ) = w(xL , uH )(6.6)

w(xH ) = w(xH , uL ),(6.7)

where w(x, u) is the lowest wage for firm x to maintain the worker’s utility level atu.
In a stable matching equilibrium, firm xL cannot be better off by hiring worker
yL (instead of worker yH ), we havef (xL , yH ) − w(xL ) ≥ f (xL , yL ) − w(xL , uL ),(6.8)

where w(xL , uL ) is the lowest wage that firm xL must offer to hire worker yL . Using
Equation (6.6), we can rearrange this inequality as
f (xL , yH ) − f (xL , yL ) ≥ w(xL , uH ) − w(xL , uL ).

(6.9)

When the worker’s utility function is supermodular, and thus, Equation (3.1) holds,
Equation (6.9) implies thatf (xL , yH ) − f (xL , yL ) ≥ w(xH , uH ) − w(xH , uL ),(6.10)

where strict inequality holds if the worker’s utility function is strictly supermodular.
If the production function is supermodular, we havef (xH , yH ) − f (xH , yL ) ≥ f (xL , yH ) − f (xL , yL ),(6.11)

with strict inequality if the production function is strictly supermodular.
If either Condition 1 or 2 in Theorem 3.1 hold, one of the two conditions (6.10)

21

and (6.11) hold with strict inequality, implying thatf (xH , yH ) − f (xH , yL ) > w(xH , uH ) − w(xH , uL ).

(6.12)

Using Equation (6.7), we can rearrange this inequality as
f (xH , yH ) − w(xH , uH ) > f (xH , yL ) − w(xH ).

(6.13)

Note that the left-hand side of this inequality is the profit for the firm xH fromhiring worker yH at wage w(xH , uH ) and the right-hand side is the profit from hiring
worker yL . Hence, this inequality implies that there is a wage that is mutually
beneficial to firm xH and worker yH , which contradicts the stability of the matching
function. Therefore, if the utility function is concave in consumption and either
Condition 1 or 2 is satisfied, the matching function m(·) is an increasing function.


6.4

Proof of Proposition 1

Condition 1 is one of equilibrium properties that the matching and wage functions {m(·), w(·)} satisfy because every firm and worker can choose to remain unmatched.
We turn to Condition 2. If the conditions stated in Theorem 3.1 are satisfied, any
stable matching pattern is assortative. In other words, any non-assortative matching
is not a stable matching pattern. Therefore, the assortative matching is the uniquestable matching pattern given the conditions stated in Theorem 3.1 and it is characterised in Condition 2 of Proposition 1.
We prove necessity of Condition 3. Consider the firm’s problem (F1). The
constraint is always binding regardless of the worker whom the firm hires, because
the firm’s profit is decreasing in wage. Let w∗ (x, y) be the wage that makes theconstraint hold with equality for all x and y:u(w∗ (x, y), x) = u(w(n(y)), n(y)).

22(6.14)Given that the binding constraint is embedded in w∗ (x, y), this expression of wage
w∗ allows us to rewrite the firm’s problem as
max f (x, y) − w∗ (x, y).
y

The first-order necessary condition must be satisfied for all x ≥ x:
fy (x, y) − w∗y (x, y) = 0.

(6.15)

To proceed, we derive a useful expression for w∗y . Taking derivatives of bothsides of Equation (6.14) with respect to y yields
uc (w∗ (x, y), x))w∗y (x, y)= uc (w(n(y)), n(y))w0 (n(y))n0 (y) + ux (w(n(y)), n(y))n0 (y).

(6.16)

Using the fact that w∗ (x, y) = w(n(y)) and n(y) = x in equilibrium, we can rewrite
the equation above asw∗y (x, y) = w0 (n(y))n0 (y) +ux (w(n(y)), n(y)) 0n (y).
uc (w(n(y)), n(y))(6.17)

Substituting Equation (6.17) for w∗y in Equation (6.15), we havefy (x, y) − w0 (n(y))n0 (y) −ux (w(n(y)), n(y)) 0n (y) = 0.
uc (w(n(y)), n(y))(6.18)

Given the fact that n0 (y) = 1/m0 (n(y)), Equation (6.18) is equivalent to Equation(3.3) in Proposition 1. Similarly, we can prove that Equation (3.3) is the first-ordernecessary condition for the worker.
We next prove sufficiency of Condition 3. Consider two firms x and xL (x >xL ≥ x) and two workers y and yL (y > yL ). Because the sufficient conditions forassortative matching is satisfied (see Theorem 3.1), firm x is matched with worker
y, and firm xL is matched with worker yL . To see if firm x wants to deviate by hiring
worker yL instead of worker y, we can examine the marginal changes in firm x’s
profit around the worker’s productivity yL . As proved in the following, they are23

given byfy (x, yL ) − w∗y (x, yL ) > fy (xL , yL ) − w∗y (xL , yL )(6.19)= 0,(6.20)

which implies that if firm x currently hires a worker yL < y, it can increase its profit
by hiring someone whose productivity is slightly higher than yL . Equality (6.20)
holds because the first-order necessary condition (6.18) must be satisfied for all
firms.
We begin the proof of Inequality (6.19) by showing that w∗y (x, yL ) ≤ w∗y (xL , yL ).
Suppose that firm x hires worker yL . Then, the derivative of the binding constraint(6.14) with respect to y yields
uc (w∗ (x, yL ), x))w∗y (x, yL )= uc (w(n(yL )), n(yL ))w0 (n(yL ))n0 (yL ) + ux (w(n(yL )), n(yL ))n0 (yL ).(6.21)
Note that Equation (6.16) at (xL , yL ) implies that the right-hand side of Equation(6.21) is equal to uc (w∗ (xL , yL ), x))w∗y (xL , yL ). Hence, we haveuc (w∗ (x, yL ), x))w∗y (x, yL ) = uc (w∗ (xL , yL ), xL ))w∗y (xL , yL ).

(6.22)

Observe that firm x’s wage offer w∗ (x, yL ) that induces the utility level u(w(n(y)), n(y))
is lower than w∗ (xL , yL ), i.e., w∗ (x, yL ) < w∗ (xL , yL ), because the utility monotonically increases with job characteristic and x > xL . Because the utility function isconcave in consumption and supermodular, the fact that w∗ (x, yL ) < w∗ (xL , yL ) andx > xL implies
uc (w∗ (x, yL ), x)) ≥ uc (w∗ (xL , yL ), xL )).

(6.23)

Given this inequality, for Equation (6.22) to hold, it must be true thatw∗y (x, yL ) ≤ w∗y (xL , yL ).

24(6.24)

If the utility function is supermodular and the production function is strictlysupermodular (i.e., Condition 1 of Theorem 3.1 holds), we have Equation (6.24)
and fy (x, yL ) > fy (xL , yL ), implying Inequality (6.19) holds. If, instead, the utility
function is strictly supermodular and the production function is supermodular (i.e.,
Condition 3 of Theorem 3.1 holds), Equation (6.24) holds with strict inequality andwe have fy (x, yL ) ≥ fy (xL , yL ), implying Inequality (6.19) holds.
In the discussion above, we prove that hiring a worker yL < y is less profitable
for the firm x than hiring the worker y. Next, consider if it is profitable for firm x
to hire worker yH > y. By the argument similar to the one above, we can also showthatfy (x, yH ) − w∗y (x, yH ) < 0(6.25)

for all yH > y. This shows that if firm x currently hires worker yH > y, it canincrease its profit by hiring someone whose productivity is slightly lower than yH .
Therefore, firm x can maximise its profit by hiring the worker whose productivity is
y = m(x) under the assortative matching function m(·). We can similarly prove that
Equation (3.3) is also the sufficient condition for the worker’s problem (W1). 

25