Endogenous labour supply and negative economic shocks in a large scale spatial CGE model of the European Union

We introduce endogenous labour supply decisions with an extensive and intensive margin in a regional computational general equilibrium model. We show that endogenising labour supply generates an additional economic loss compared to a model with fixed labour supply. Both the intensive margin and the extensive margin contribute to the higher cumulative loss in employment, consumption and GDP. A first insight from the general equilibrium framework is that the response at the external margin of labour supply is larger than what could be expected from considering wage elasticities alone, due to discouraged individuals choosing to stay out of the labour market in face of higher unemployment and a lower probability of finding a job. More insights are provided by the unique extensive regional dimension of our model. We show that country-level results hide substantial heterogeneity at the regional level. The results carry important lessons for macro-economic models used for policy evaluation: economic effects may be underestimated by models with fixed labour supply or models considering only the intensive margin of labour supply. Aggregate country level estimates may hide large differences in effects observed at the regional level.