Career choice and the risk premium in the labor market

We find a strong, robust, and positive correlation between average earnings and the standard deviation of both temporary and permanent idiosyncratic shocks to earnings across 19 US industries. Is this compensation for risk or for unobserved abilities? To answer this question we embed a Roy model into an incomplete markets equilibrium framework that features risk averse individuals who face industry-specific idiosyncratic shocks to their labor earnings. The interaction between earnings shocks and an individual's comparative advantage determines the optimal industry choice. Compensation for permanent shocks to labor earnings represents about two thirds of the observed correlation. There is no compensation for temporary risk. Compensation for risk explains about 40% of observed cross-industry differences in residual labor earnings. Additionally, workers accumulate different levels of wealth depending on their chosen industry.