This paper develops a search model with heterogeneous workers, rms, and on-the-job

search. Employed low-skilled workers are allowed to seek better paid jobs at high productivity

rms. Low productivity rms make take-it-or-leave-it wage oers, whereas high productivity

rms use Nash bargaining over wages. There are two important sources of ineciency in

the model besides the well-known classical search externality. First, low-skilled workers do

not have any bargaining power when they are employed at low productivity rms. Second,

the two types of workers are pooled in the same submarket. We demonstrate that lump-sum

transfers paid to workers can internalize these ineciencies. Moreover, both types of rms

may benet from the increase in the supply of low-skilled workers when the productivity

dierence in the two jobs for these workers is large, as a result the overall wage gap among

workers increase. On the contrary, when the productivity dierence is small, the eects

are reversed. Finally, both types of rms emerge in the equilibrium when rms are allowed

to open vacancies in both submarkets. On the one hand, it is attractive for rms to open

vacancies in the low productivity submarket since they pay low wages to workers. On the

other hand, it is also protable for rms to open vacancies in the high productivity submarket

because the probability of jobs being lled with low-skilled workers increase signicantly, even

though the bargained wages of high-skilled workers increase.