We study a model of individual wage bargaining between heterogeneous worker
s and firms, with instantaneous matching, free firm entry, workers' individ
ual productivities are discovered by firms only after being hired, and it i
s expensive for firms to hire and fin workers. We show that inefficiencies
due to bargaining and externalities in the matching process lead firms to e
mploy too few worker types. Employment among employed worker types is also
inefficiently low when workers have high bargaining power, but may be too h
igh when workers' bargaining power is low. The government can correct these
inefficiencies by reducing or increasing firms' hiring and firing costs. T
his implies that the costs of firing tenured workers 'almost always' should
be reduced. We argue that the model gives a good description of recent lab
or market phenomena in advanced economies. (C) 2000 Elsevier Science B.V. A
ll rights reserved.