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Robust Inference for the Frisch Labor Supply Elasticity

Institute Working Paper 81 | Published November 17, 2023

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Michael Keane Visiting Scholar, Institute
Timothy Neal University of New South Wales
Robust Inference for the Frisch Labor Supply Elasticity


The Frisch labor supply elasticity plays a key role in many economic policy debates, but its magnitude remains controversial. Many studies estimate the Frisch elasticity using 2SLS regressions of hours changes on wage changes. But a little appreciated power asymmetry property of 2SLS causes estimates to appear spuriously imprecise when they are shifted away from the OLS bias. This makes it difficult for a 2SLS t-test to detect a true positive Frisch elasticity. We illustrate this problem in an application to NLSY97 data. We obtain an estimate of 0.60 for young men, but the t-test indicates it is insignificant. In contrast, the Anderson-Rubin (AR) test – which avoids the power asymmetry problem – implies the estimate is highly significant. The same power asymmetry issue that afflicts the t-test here will arise in many IV applications. Thus, we argue the AR test should be widely adopted in lieu of the t-test.