Wealth Effects and Labor Supply: An Experimental Study

The preferences introduced by Greenwood et al. [1988] (GHH preferences) are being used in the macroeconomics literature to resolve puzzles regarding the comovement of labor and consumption in response to exogenous shocks which do not change the current schedule for marginal product of labor. The GHH preferences imply that labor/leisure decision is independent of consumption decision and wealth effects on labor supply is zero. Despite its widespread usage, there is little and mixed empirical evidence regarding the wealth elasticity of labor supply. This study is an attempt to experimentally test the behavioral foundations of the GHH preferences. Employing the BDM mechanism proposed by Becker et al. [1964], we try to elicit the subjects� innate preferences for leisure in a real effort experiment, and then observe whether these preferences change in response to an unexpected increase in non-labor income. Our results show that approximately 19% of the subjects react to the positive income shock by increasing their reservation wages. This finding on the existence of wealth effect on labor supply in the short run and even in the lab environment puts the predictions of the macroeconomic models that employ GHH preferences under scrutiny and calls for further experimental/empirical research on the topic.