Monday, July 16, 2007

The substitution effect dominates the income effect 

Ezra Klein gets all Veblenesque in his critique of Americans working too much. It's all about positional competition, he says.
He argues that the U.S. economy has set its incentives up so as to systematically underemphasize leisure and overemphasize consumption. Much of what we purchase are called "positional goods" � goods whose value is measured in relation to the purchases of others. Take housing. Would you rather live in a land where you had a 4,000-square-foot house and everyone else had a 6,000-square-foot house, or one in which you had a 3,000-square-foot house and everyone else had a 2,000-square-foot house? Given this choice, studies show that most respondents pick the latter.
And on. The problem with working so much is that we do it for the wrong reasons; it's wasteful to try to get ahead of the Joneses.

Let me return you to a post Russ Roberts had last year regarding another article on declining real wages. Which, of course, is a lot of hooey, at least if you can read BLS data. What do we find? Real wages are rising.

My professor Craig Stubblebine read a story like this many years ago and remarked to me how stupid he thought the argument was. "So real wages go up and people are supposed to work less? Whatever happened to the substitution effect?" (That's a paraphrase; he said this to me at least twenty years ago.)

Now in the aggregate we think in the long run that labor supply is relatively unresponsive to changes in the real wage (though I still remember the Mincer effect of rising real wages on increased female labor force participation -- did this effect not survive years of econometric testing?) But that doesn't mean that you can't buy more in the short run, or that the short run is all that short. Increases in productivity have increased the demand for labor, and also have changed the nature of work and the tradeoff with leisure. But the income effect could certainly be something that takes hold more slowly and can easily explain that which Klein abhors.

Roberts concluded:
What keeps my wages high (and yours) is our alternatives. Is there any evidence that workers have fewer alternatives than they once had? If anything, workers are more mobile today than ever. What sets workers wages are the wages of those alternatives. That depends, generally, on our skills, our knowledge and our drive and discipline�human capital and how well we are able to apply it. Workers are better educated than ever. That is why I believe that compensation, properly measured, is higher than it was five or ten or twenty or thirty years ago.
We are able to do more with our leisure than ever before, so the value of income in supplementing that leisure is also higher. What motivates us to do that is, frankly, irrelevant to whether it creates the prosperity engine we now enjoy.

UPDATE: The Onion gets it.