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Wage Volatility and Changing Patterns of Labor Supply

Over the past few decades, U.S. hours worked of skilled men relative to unskilled men have increased while the skill premium rose. This fact is in contrast with previous studies suggesting a wage elasticity of labor supply close to zero. This paper explores the possibility that wage volatility can resolve this discrepancy. As wages become more volatile, individuals not only accumulate more precautionary savings but also increase work hours. Using the Panel Study of Income Dynamics (PSID), we document that skilled men experienced a greater rise in wage volatility accompanied by an increasing share of persistent wage shocks compared to unskilled men. We build a general equilibrium incomplete markets model and feed in the estimated wage processes. The model can replicate the increasing trends in hours worked of skilled men relative to unskilled men in the data. However, the pattern is reversed in the long run, implying that hours adjustment is important for self-insurance in the short run, whereas precautionary savings play the dominant role in the long run. We also find that the variances of persistent wage shocks are important in explaining the evolution of hours worked, whereas the quantitative impact of a transitory component is fairly modest.


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