Bounds on Elasticities with Optimization Frictions: A Synthesis of Micro and Macro Evidence on Labor Supply

65 Pages Posted: 18 Jan 2010 Last revised: 11 Nov 2013

See all articles by Raj Chetty

Raj Chetty

University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: December 2009

Abstract

How can price elasticities be identified when agents face optimization frictions such as adjustment costs or inattention? I derive bounds on structural price elasticities that are a function of the observed effect of a price change on demand, the size of the price change, and the degree of frictions. The degree of frictions is measured by the utility losses agents tolerate to deviate from the frictionless optimum. The bounds imply that frictions affect intensive margin elasticities much more than extensive margin elasticities. I apply these bounds to the literature on labor supply. The utility costs of ignoring the tax changes used to identify intensive margin labor supply elasticities are typically less than 1% of earnings. As a result, small frictions can explain the differences between micro and macro elasticities, extensive and intensive margin elasticities, and other disparate findings. Pooling estimates from existing studies, I estimate a Hicksian labor supply elasticity of 0.33 on the intensive margin and 0.25 on the extensive margin after accounting for frictions.

Suggested Citation

Chetty, Nadarajan (Raj), Bounds on Elasticities with Optimization Frictions: A Synthesis of Micro and Macro Evidence on Labor Supply (December 2009). NBER Working Paper No. w15616. Available at SSRN: https://ssrn.com/abstract=1537519

Nadarajan (Raj) Chetty (Contact Author)

University of California, Berkeley - Department of Economics ( email )

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