Labor Earnings Inequality and Learning about Individual Ability: Theory and Evidence from Japan and the United States

Abstract

This paper examines the evolution of labor earnings inequality in an environment where individuals learn about their own ability (productivity) from wage realizations and decide their effort levels. It is shown that innate ability heterogeneity and idiosyncratic income shock variance have distinct effects on emergence patterns of earnings inequality. Structural parameters are estimated using data from Japan and the United States. It is found that wage is more directly linked with individual ability in the United States than Japan. The weak linkage of wage to individual ability in Japan slows down the speed by which agents learn about ability, and makes the evolution of both cross-agent effort and earnings variability later in lifetime in the country.