A New Method of Estimating Risk Aversion

This paper develops a new method of estimating risk aversion using data on labor supply behavior. In particular, I show that existing evidence on labor supply behavior places a tight upper bound on risk aversion in the expected utility model. I derive a formula for the coe¢ cient of relative risk aversion ( ) in terms of (1) the ratio of the income elasticity of labor supply to the wage elasticity and (2) the degree of complementarity between consumption and labor. I bound the degree of complementarity using data on consumption choices when labor supply varies randomly across states. Using labor supply elasticity estimates from thirty-three studies, I …nd a mean estimate of 1: I then show that generating > 2 would require that wage increases cause sharper reductions in labor supply than estimated in any of the studies. (JEL D80, J20, J60) Department of Economics, University of California, Berkeley and NBER, 549 Evans Hall #3880, Berkeley CA 94709 USA (email: [email protected]). This paper is based on the second chapter of my Ph.D. thesis at Harvard. I thank George Akerlof, John Campbell, David Card, Gary Chamberlain, David Cutler, Martin Feldstein, John Friedman, Ed Glaeser, Caroline Hoxby, Louis Kaplow, Larry Katz, Miles Kimball, Greg Mankiw, Richard Rogerson, anonymous referees, and numerous seminar participants for very helpful comments and discussions. Financial support from the National Science Foundation Graduate Fellowship, the National Bureau of Economic Research, and Harvard University is gratefully acknowledged.