Sunday, May 20, 2012

The Labor Wedge

The labor wedge is a difference between the marginal rate of substitution (MRS) between consumption and leisure, and the marginal product of labor (MPL).  That is, how willing you are to trade off leisure for consumption, and the degree to which you are able to do it.  If an individual may do so perfectly, then the labor wedge is zero.  It is given its name because all real taxes have distortionary effects, and most, if not all, have effects on labor.  If we look at measures of MRS and MPL, we can say "what tax rate explains this gap?"  This is what the labor wedge is:  essentially a structural "this is what taxes seem to be, given distortions in the economy."

Below, Corrections offers the labor wedge as offered in Rob Shimer's book, with data from Cociuba, Prescott, and Ueberfeldt (Simona Cociuba's website).  We graph two possible labor wedges:  one with a low Frisch elasticity of 0.5, and one with a Frisch elasticity of 4 (used for most macro settings).   The Labor Wedge is depicted graphically below (click to enlarge).

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