Labor Supply: Are the Income and Substitution Effects Both Large or - PowerPoint PPT Presentation

Labor Supply: Are the Income and Substitution Effects Both Large or Both Small? Miles S. Kimball and Matthew D. Shapiro

Why Study the Elasticity of Labor Supply? • Labor Economics: Labor supply elasticities are key parameters for labor economics. The existing literature is not definitive on its value. • Macroeconomics: The Frisch labor supply elasticity is a key parameter in business cycle models. Ideally, to avoid macroeconomic data- mining, it should be identified from microeconomic data. • Public Finance: The labor supply elasticity is a key parameter for public finance in determining the size of the distortions caused by labor taxation.

Areas of Agreement and Disagreement about Labor Supply • There is wide agreement that the income and substitution effects approximately cancel ( i.e., that the long-run elasticity of labor supply is close to zero). • Most labor economists believe the income and substitution effects are both small. • Most macroeconomists believe the income and substitution effects are both large.

Evidence that the Long-Run Elasticity of Labor Supply ≈ 0 • Cross-National Evidence: A 10-fold difference in wages from poor to rich countries may reduces the workweek from about 44 hours to about 39 hours. • The Time Trend: A 3-fold increase in real wages has accompanied a decline in male hours and an increase in female hours, but only a modest decline in overall hours. • Cross-Sectional Evidence: Large differences in the real wage are associated with modest differences in labor hours. This is true with or without individual fixed effects.

Strategy of this Research 1. Theory: Develop a theoretical framework that imposes a zero long-run elasticity of labor supply, while allowing for • Intertemporal optimization • Integration of spousal labor supply decisions • Nonseparability between consumption and labor • Fixed cost of going to work

Strategy of this Research (cont.) 2. Empirics: Experimental survey approach: • Collect survey data on how a household would respond to winning a sweepstakes • Compare the change in labor hours after winning the sweepstakes to the implied change in consumption after winning the sweepstakes • Adjust for the change in job-induced consumption J i to get the change in baseline consumption B = C – Σ J i • Frisch elasticity = - ∆ ln(N)/ ∆ ln(B)

Dealing with Quits • The implication of a quit for consumption needs no adjustment • The fixed cost is calibrated to match the fact that many people work 20 hours per week, but few people work between 1 and 19 hours per week. • If someone quits, we infer that, absent the fixed cost, they would have wanted to work less than 19 hours per week. • This gives a lower bound for the labor supply elasticity of someone who quits after winning the sweepstakes.

Theory: The Utility Function � ∞ e − ρt U ( C, N , ν ) dt E 0 0 � 1 − α � − α 1 1 − α [ ψ ( ν ) + αg ( N )] U ( C, N , ν ) = C 1 − α − α � g ( N ) = g i ( N i ) i

The Additively Separable Case U ( C, N ) = ψ ( ν ) ln( C ) − g ( N ) H = ψ ( ν ) ln( C ) − g ( N ) + λ [ W · N − C + rA + Π] W i N i − λ − 1 g i ( N i ) max N i

The Nonseparable Case � 1 − α � − α 1 1 − α [ ψ ( ν ) + αg ( N )] H = C 1 − α − α + λ [ W · N − C + rA + Π] � � � C = λ α − 1 ψ ( ν ) + α g i ( N i ) i

Baseline Consumption and Job-Induced Consumption B = λ α − 1 ψ ( ν ) J i = αλ α − 1 g i ( N i ) � C = B + J i i

Benefits and Costs of Work rA + Π − λ α − 1 ψ ( ν ) � max λ α N � W i N i − λ α − 1 g i ( N i ) � �� + i W i N i − λ α − 1 g i ( N i ) max N i 0 if N i = 0 � g i ( N i ) = M i [ F + v ( N i )] if N i > 0

Labor Supply N ∗ if N ∗  i > N # i     if N ∗ i < N # N i = 0   either N ∗ i or 0 if N ∗  i = N #  � λ 1 − α W i � N ∗ i = v ′− 1 M i

Overall Results: 56% Quit 21% No change 23% Reduce hours

Table 1 Labor Supply Responses to Winning the Sweepstakes (Percent of Responses) Single- Dual- Change in earner, earner, labor Total Single married married No change 21.3 31.4 27.4 14.5 Reduce hours 22.5 32.4 18.8 22.0 Quit 56.3 36.2 53.8 63.5 Number 1388 207 457 724

Table 2 Labor Supply Responses to Winning the Sweepstakes, by Flexibility in Labor Hours (Percent of Responses) Change in Desired versus actual labor Flexible Inflexible Missing hours Actual Actual Desired exceeds equals exceeds desired desired actual No change 23.2 19.7 28.1 16.5 22.1 27.5 Reduce hours 21.5 21.7 35.4 26.4 20.9 24.2 Quit 55.3 58.5 36.6 57.1 57.0 48.3 Number 414 892 82 333 935 120

Table 4 Labor Supply Responses to Winning the Sweepstakes, by Sex (Percent of Responses) Single- Dual-earner, earner, married Total Single married Change in labor male female male female male female male female No change 22.7 19.8 34.8 30.4 29.4 24.5 16.3 12.7 Reduce hours 25.3 19.8 32.6 32.3 23.0 12.8 26.0 18.0 Quit 52.0 60.3 32.6 37.3 47.6 62.8 57.7 69.3 Number 677 711 46 161 269 188 362 362

Table 7 Individual-Specific Elasticity of Labor Supply η (Median) η N Change in labor α = 0.3 α = 0.5 α = 0.1 No change 0.0 0.0 0.0 295 Reduce hours 0.59 0.56 0.64 312 By less than 10 percent 0.09 0.09 0.09 5 10-25 percent 0.28 0.27 0.29 74 26-49 percent 0.58 0.54 0.62 129 50 percent 0.81 0.75 0.88 84 more than 50 percent 1.00 0.93 1.08 20 Quit * 0.88 0.80 0.97 781

Table 8: Abbreviated Average Labor Supply Elasticity: Censored Regression Estimates (1) (2) Constant 1.004 0.763 (0.034)** (0.059)** Dual-earner, married 0.379 (0.067)** Single-earner, married 0.140 (0.069)* σ 0.765 0.752 (0.020)** (0.020)** Observations 1388 1388

Review of Elasticity Concepts in the Frictionless Case: 1. Raw Marginal Propensity to Earn MPE: (Absolute value of) W ∆ N / ∆ Y 2. Marginal Expenditure Share of Leisure ℓ : Fraction of an extra dollar spent on leisure = |local MPE| 3. Utility Constant Elasticity η U : Theoretical Substitution Effect 4. Consumption Constant Elasticity η C : Elasticity of N s (W/C) 5. Frisch Elasticity η λ : Intertemporal Elasticity of Substitution for Labor 6. Uncompensated Elasticity η x : Labor supply elasticity when all extra labor income goes to consumption

Table 11: Abbreviated Marginal Propensity to Earn and Alternate Labor Supply Elasticities: Average Censored Regression Estimates Raw Marginal Marginal Expenditure Utility- Consumption- Uncompen- Propensity Share of constant constant Frisch sated to Earn Leisure Elasticity Elasticity Elasticity Elasticity ( η U ) ( η C ) ( η λ ) ( η X ) (|MPE|) ( ℓ ) All 0.373 0.581 0.793 1.499 1.004 0.327 Single, Male 0.340 0.564 0.545 1.360 0.731 -0.004 Single,Female 0.363 0.594 0.566 1.228 0.745 -0.009 Single Earner, Male 0.407 0.605 0.667 1.199 0.837 0.089 Single Earner, Female 0.393 0.638 0.881 1.374 1.052 0.309 Dual, Male 0.366 0.562 0.856 1.656 1.106 0.412 Dual Female 0.285 0.438 0.969 1.705 1.210 0.706

Experimental and Quasi- Experimental Elasticity Estimates • Oettinger (1999): Baseball park vendors respond quite elastically to changes in effective wages from level of attendance • Farber (2003): Taxicab driver’s supply responds strongly to high-frequency variation in the implicit wage (critical of Camerer, Babcock, Loewenstein and Thaler (1997) • Fehr and Gotte (2002): Elastic behavior of bicycle messengers.

Imbens, Ruben and Sacerdote (2001) • Survey of state lottery winners • Individual data (decision not to collect data on spouse behavior) • Quadratic term to deal with floor of zero on labor hours • Raw MPE of .291 for the 55—65 age group, compared to .373 in our data • Lower raw MPE for younger winners, but with a substantial standard error

Why Does Experimental Evidence Give a Different Answer? • Institutional frictions often inhibit individual labor supply responses to small variations in the real wage or in wealth. • Experimental, quasi-experimental and experimental survey evidence involves large variations in the real wage or in wealth, or circumstances with few institutional frictions. • Exception: In negative-income tax experiments, medium-sized changes in the real wage met substantial institutional frictions that inhibited labor supply responses.

Econometric versus Experimental Survey Methodology 1. Strength of signal: • The signal for identifying the long-run elasticity of labor supply is very strong. • By contrast, the variation for identifying the income and substitution effects separately yields only a weak signal in standard data. • By construction, the experimental survey methodology involves a large amount of relevant variation and so a strong signal.

Econometric versus Experimental Survey Methodology (cont.) 2. Other problems with standard econometric methodology: • A small signal may get further attenuated by institutional frictions • Measurement error in wages and hours (reporting error, systematic rounding error, division biases, allocational/observed, temporary/permanent) • Endogeneity