A Dynamic Model of Labor Supply Under Uncertainty

Abstract

This paper develops an multi-state optimizing model of individual labor supply that concentrates on all-or-nothing employment decisions. This model views individual behavior in the labor market as a process of moving between labor force activities (employed, unemployed, and not-in-the-labor-force). Agents are in a stochastic environment and make decisions whether they want to work or not. When an agent decides they want to work, however, they must search for a job. Jobs at the going wage cannot be found immediately, and an agent must spend time and (possibly) money looking for a firm with an available job. The probability of finding an available job in the next instant, if less than unity, acts as a constraint on labor supply; a worker would work at the current wage but is unable to do so because jobs are not instantaneously available. This is a formal model of frictional unemployment, although one could also label such unemployment involuntary. This model is closely related to the analysis of the duration of unemployment. (See, e.g. Kaitz, 1970; Salant, 1977; Nickell, 1979; Heckman and Singer, 1984a, 1984b.) Other models that deal with employment versus non-employment decisions are Lippman and McCall (1976); Toikka (1976); Burdett and Mortensen (1978a, 1978b).

Keywords: Three-state model, Labor supply, Unemployment, Aggregation

JEL Classification: C61, J21, J22