Quantity and Elasticity Spillovers onto the Labor Market: Theory and Evidence on Sluggishness

Firms' beliefs that they may be unable to sell as much as they would like at the market price leads not only to a quantity spillover (even when prices are flexible) but also to a spillover of product demand elasticity onto the elasticity of labor demand. Hence, optimal firm behavior can be expected to produce a negative correlation between the (absolute value of) the wage elasticity and the unemployment rate. This hypothesis is tested on three sets of data. 1) For low-skilled workers in the United States in 1969 there is weak support for this hypothesis; 2) In time-series data for the U.S. there is no evidence for the hypothesis (there is essentially no cyclical variability in the elasticity); and 3) In time-series data for the United Kingdom there is fairly strong evidence supporting it. We also find that, in both the U.S. and the U.K., the demand elasticity for labor decreased in the 1970s to an extent that does not appear to be explained by changes in other factor prices.