Edward C. Prescott - Senior Monetary Advisor
Published January 1, 2011
There have been tremendous advances in macroeconomics, following the introduction of labor supply into the field. Today it is widely acknowledged that labor supply matters for many key economic issues, particularly for business cycles and tax policy analysis. However, the extent to which labor supply matters for such questions depends on the aggregate labor supply elasticity—that is, the sensitivity of the time allocation between market and non-market activities to changes in the effective wage. The magnitude of the aggregate labor supply elasticity has been the subject of much debate for several decades. In this paper we review this debate and conclude that the elasticity of labor supply of the aggregate household is much higher than the elasticity of the identical households being aggregated. The aggregate household utility function differs from individuals’ utility functions for the same reason the aggregate production function differs from individual firms’ production functions being aggregated. The differences in individual and aggregate supply elasticities are what aggregation theory predicts.
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