The transformation of macroeconomic policy and research prize Lecture, December 8, 2004 by

387

11 

See Prescott (2004).

12

The preference ordering used has a constant elasticity of substitution between consumption and

leisure, not between consumption and labor supplied to the market. The elasticity of labor supply

for our stand-in household is (1 – 

h

)/

h

, where 

h

is the fraction of productive time allocated to the

market. Given that 

h

in Europe is smaller than one-fourth of the U.S. number, the elasticity of 

labor supply there is even greater than 3 in Europe.

obtained in this island version of the Hornstein–Prescott world. Many ran this

regression for full-time male workers and obtained a small coefficient as 

predicted by theory, independent of whether the micro or Frischian labor

supply elasticity is big or small.

Thus, a low value of this regression coefficient does not imply low elasticity

of aggregate labor supply elasticity, which is what matters for the study of 

business cycles and the evaluation of tax policies. A low value does not even

indicate a low micro labor supply elasticity, which is a statement about prefer-

ences only. I emphasize that aggregate labor supply elasticity is a statement about

both preferences and technology. Only for empirically uninteresting cases are the

micro and macro elasticities equal.

Evidence from Consequence of Tax Rates across Countries and across Time

Good statistics are available on labor supply and tax rates across the major ad-

vanced industrial countries. My measure of aggregate labor supply is aggregate

hours worked in the market sector divided by the number of working-age 

people.

Given that the effect of the marginal effective tax rate on labor supply 

depends on this elasticity, and given that tax rates vary considerably, these 

observations provide an almost ideal test of whether the aggregate labor

supply elasticity is 3. The set of countries that Prescott (2004) studied are the

G-7 countries, which are the large advanced industrial countries. The differ-

ences in marginal tax rates and labor supply are large; Canada, Japan, and

the United States have rates near 0.40, and France, Germany, and Italy near

0.60.

11

The prediction, based on an aggregate labor supply elasticity of 3, that

Western Europeans will work one-third less than North Americans and

Japanese is confirmed.

12

Added evidence for an aggregate elasticity of 3 is

that it explains why labor supply in France and Germany was nearly 50 

percent greater during the 1970–1974 period than it is today.

Observations on aggregate labor supply across countries and across time

imply a labor supply elasticity near 3.

Recent Evidence from Major Contractions and Expansions

Additional evidence is provided by the study of recent major contractions.

The finding is that the elasticity of labor supply must be near 3 to account for

the behavior of the labor supply in each case. Three advanced industrial

countries with good economic statistics suffered a 20 percent or more loss in

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output per capita relative to a 2 percent trend in the last quarter to the 20th

century. The countries are Japan in the 1990s and New Zealand and

Switzerland in the 1970s and 1980s. The behavior of labor supply during these

extended periods of nonbalanced growth implies the same labor supply

elasticity as do business cycle fluctuations.

13

Life Cycle Labor Supply Evidence

Recently, Imai and Keene (2004) examined the life cycle pattern of male labor

supply. Real payments per hour are hump-shaped, as are hours worked over

the working lifetime. The percentage size of the hump is greater for real 

payment per hour than for hours worked. This led some to conclude that male

labor supply is inelastic; that is, the elasticity is less than 1. Imai and Keene take

into consideration the value of the skills that younger workers acquire on the

job – that is, the human capital they receive. This is part of total compensa-

tion and should be included in the wage. When it is, the lifetime wage schedule

is much flatter than life cycle labor supply. Imai and Keene’s estimate is 3.7. If

this estimate rather than 3 is used, it would not change business cycle findings

significantly. Further, the real interest rate implied by their analysis is close to

the average real return on capital obtained using the neoclassical growth model

and the national accounts.

An important difference between what labor economists estimate and what

macroeconomists estimate is that labor economists use a constant elasticity 

of substitution utility function on consumption and labor supply, whereas 

macroeconomists use a constant elasticity of substitution on consumption

and leisure.

A problem with many labor economists’ estimates is that they maintain the

hypothesis that people are not in organizational settings that have a fixed

workweek length. Fitzgerald (1998) introduces team production with both

supervisors and workers. Equilibrium is characterized by a fixed workweek

length. The hours worked is not a choice variable of individuals. The individual

choice variable is whether or not to work for this organization or for some other

organization. In this world when people are promoted from worker to super-

visor, their wages increase, but no change in hours worked occurs. Under the

incorrect maintained hypothesis, these observations would lead to the concl-

usion that labor supply is perfectly inelastic, even if it is in fact large.

To summarize, aggregate observations imply that the aggregate labor supply

elasticity is large. Aggregation theory implies that whenever the principal

margin of adjustment is the fraction employed and not hours per person 

employed, the aggregate labor supply elasticity is large. This finding is 

consistent with all the micro observations, so no conflict arises between micro

and macro observations.

388

13 

See the Kehoe and Prescott (2002) volume for a number of economic depression studies.

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