FIRMS PRODUCTION FUNCTION

[ ]
σ
σ −1 σ −1
σ −1
Y = ( A L EL ) σ
+( A H E H ) σ

WORKER’S UTILITY FUNCTION

1 2
u L=w L E L + γ L EL − E L
2

1 2
u H =w H E H + γ H E H − E H
2

NOTATION:
u L is the low-skill worker’s utility
u H is the high-skill worker’s utility
w L is the low-skill worker’s wage
w H is the high-skill worker’s wage
E L is the low-skill worker’s employment hours
E H is the high-skill worker’s employment hours
γ L is the low-skill worker’s non-monetary benefit of working
γ H is the high-skill worker’s non-monetary benefit of working
A L is the low-skill worker’s technology
A H is the high-skill worker’s technology
σ is a parameter that measures the elasticity of substitution between the two skill types

NOTE: σ is exogenous, γ L is exogenous, γ H is exogenous, A L is exogenous, A H is exogenous

Assumptions on Parameters: A L < A H , γ L < γ H , σ ϵ [1 , 2]

SOLVING
STEP 1: Firms set their wages at marginal product of labor

[ ]
σ −1 1 −1
σ−1 σ −1
∂Y σ −1
=A L σ ( A L E L ) σ
+( A H E H ) σ σ
E =w L
L
∂ EL

[ ]
σ−1 1 −1
σ −1 σ −1
∂Y σ −1
= A Hσ ( A L E L ) σ
+( A H E H ) σ
E Hσ =w H
∂ EH

STEP 2: Workers choose employment to maximize their utility:

∂ uL
=¿ w L + γ L −E L=0=¿ w L =E L −γ L
∂ EL
 ∂ uH
=¿ w H + γ H −E H =0=¿ w H =E H −γ H
∂ EH

STEP 3: To solve for labor market equilibrium levels of employment, equate the wages from
firm-problem and worker-problem?

[ ]
σ −1 1 −1
σ −1 σ−1
σ −1
σ
A L ( AL EL ) σ
+( A H E H ) σ
E Lσ =E L−γ L

[( A E ) ]
σ −1 1 −1
σ −1 σ−1
σ −1
σ σ
A H L L
σ
+( A H E H ) σ
E =E H −γ H
H

¿ ¿
…. complicated equations, but if I solve this, it would give me E H , E L?