J Econ (2010) 100:69–83

DOI 10.1007/s00712-010-0119-2

The effects of stochastic wages and non-labor income

on labor supply: update and extensions

W. Henry Chiu · Louis Eeckhoudt

Received: 14 September 2009 / Accepted: 23 January 2010 / Published online: 16 February 2010
© Springer-Verlag 2010

Abstract The analysis of labor supply under risk has a long history dating back to
Hicks (The theory of wages, St. Martin’s Press, New York, 2003) and Knight (Risk,
uncertainty and profit, Kelly, New York, 1964). In the 1980s more technical papers
investigated the impact of stochastic non-labor income and/or wage rate upon labor
supply. In this paper, we show that the effect of a mean-preserving increase in risk in
wage rate or non-labor income on labor supply is best understood as a special case
of an N th degree risk increase (as defined by Ekern (Econ Lett 6:329–333, 1980))
and the conditions for signing the effect of a higher-order risk increase in wage rate
or non-labor income on labor supply are analogous to those for signing the effect of
a simple non-stochastic decrease in wage rate or non-labor income. We thus extend,
and provide new and more intuitive interpretations for, related earlier results.

Keywords Labor supply · Risk aversion · Stochastic dominance · Prudence

JEL Classification D81

1 Introduction

Do individuals increase or decrease their labor supply in the face of greater uncer-
tainty in their wage rate or non-labor income? Prominent early authors offer differing

W. H. Chiu (B)
Economics, School of Social Sciences, University of Manchester, Manchester M13 9PL, UK
e-mail: henry.chiu@manchester.ac.uk

L. Eeckhoudt
IESEG School of Management, LEM, Lille, France

L. Eeckhoudt
CORE, 34 Voie du Roman Pays, 1348 Louvain-la-Neuve, Belgium

123
70 W. H. Chiu, L. Eechkhoudt

views on the issue, which has clear policy implications as well as theoretical interest.1
Hicks (1963) contends that wage rate uncertainty has deterrent effects on the supply
of labor. Knight (1964, p. 367) on the other hand, argues that individuals may have a
greater incentive to work for an uncertain than for a fixed compensation. These issues
are first rigorously analyzed in the expected utility framework by Block and Heineke
(1973). In the case of a risk increase in non-labor income, they find that under a set
of assumptions on preferences2 individuals will increase their labor supply as they
“use the labor market as a hedge against uncertainty”. In the case of uncertain wage
rate, however, they find that under the same assumptions on preferences, the effect of
an increase in wage rate uncertainty is ambiguous because an increase in wage rate
uncertainty has a negative “uncertainty substitution effect” on labor supply (given risk
aversion) as well as a positive “income uncertainty effect”, which is analogous to the
effect of an increase in non-labor income uncertainty.
Subsequent authors have sought to provide conditions for increased wage uncer-
tainty3 to have an unambiguous effect on labor supply. Tressler and Menezes (1980)
offer necessary and sufficient conditions for increased wage uncertainty to decrease
labor supply. Their conditions are, however, in terms of the “marginal rate of substitu-
tion between leisure forgone and income” and of “the disutility of a risk increase along
an indifference curve” and it is unclear how they relate to more primitive assumptions
on the preferences. Dionne and Eeckhoudt (1987) and Dardanoni (1988) show that
increased wage uncertainty decreases labor supply if the labor supply curve is pos-
itively sloped and “proportional risk aversion”4 is “non-decreasing along a budget
line”. While these sufficient conditions relate better to established measures of risk
aversion, they remain difficult to interpret5 and it is not obvious how their results

1 As explained by Tressler and Menezes (1980), uncertain nominal wage rate is common in markets where
earnings include commissions or when present work yields an unknown future income as in the case of
self-employed workers. And even if nominal wage rates are not uncertain, workers will be uncertain about
their real wage rate when they cannot accurately forecast inflation. Thus, how the practice of indexing nom-
inal wage rates to price changes affects labor supply, for example, depends on how changes in wage rate
uncertainty affect individual labor supply. Furthermore, since the variability of anticipated inflation tends
to increase as the inflation rate rises as empirical evidence suggests, the effect of real wage uncertainty on
labor supply may also be important in the analysis of the relationship between inflation and employment.
2 Specifically, they assume absolute risk aversion is decreasing in income but is constant with respect to
labor and labor is an inferior good.
3 The authors cited in what follows consider a mean-preserving increase in risk as defined by Rothschild and
Stiglitz (1970) in wage rate while Block and Heineke (1973) consider a special case of a mean-preserving
increase in risk in the form of an increase in γ with γ being such that the wage rate w̃ = E w̃ + γ (w̃ − E w̃).
4 For a utility function U (c, l) defined on consumption c and leisure l, the measure of proportional risk
aversion is defined to be
Ucc (x + w, l)
x
Uc (x + w, l)

where w denotes the initial wealth and Ucc and Uc are respectively the first and second partial derivatives
with respect to consumption. It is thus is a two-dimensional extension of the concept introduced by Menezes
and Hanson (1970) and Zeckhauser and Keeler (1970).
5 To explain intuitively the role of a positively sloped labor supply curve, both Dionne and Eeckhoudt (1987)
and Dardanoni (1988) rely on the assertion that individuals perceive an increase in wage rate uncertainty
as equivalent to a decrease in wage rate, which has no conceptual or analytical foundation.

123
The effects of stochastic wages and non-labor income on labor supply 71

can be extended to the case where the wage rate undergoes a stochastic change of a
different order.
Available empirical evidence appears to indicate that increased wage rate uncer-
tainty has a positive effect on labor supply. For example, Parker et al. (2005) find evi-
dence that self-employed American workers work longer hours in response to greater
wage uncertainty, which can help explain why self-employed Americans work longer
average hours for lower average wages than their employee counterparts.6
In this paper, we show that the conditions for signing the effects on labor supply of
increased uncertainty both in wage rate and in non-labor income can be more primi-
tive and easier to interpret. Moreover, the reasoning for obtaining these conditions can
be readily extended to sign the effects on labor supply of a stochastic deterioration
of any degree in either the wage rate or the non-labor income. That is, we find that
the effect on labor supply of a mean-preserving increase in risk in wage rate or non-
labor income is best understood as a special case of an N th degree risk increase (as
defined by Ekern (1980)) and the conditions for signing the effect of a higher-order
risk increase in wage rate or non-labor income are completely analogous to those for
signing a simple non-stochastic decrease in wage rate or non-labor income. Thus, we
are able not only to have a better understanding of what is involved in the assumption
of a positively-sloped labor supply curve but also to obtain, and have an insightful
interpretation of, the conditions under which labor supply increases when the wage
rate undergoes an increase in downside risk or outer risk whose importance has been
increasingly recognized. A downside risk increase, which is equivalent to a 3rd-degree
risk increase, is defined by Menezes et al. (1980) to be a change in distribution that
transfers dispersion from higher to lower levels of wealth and thus reduces the skew-
ness (as measured by the third central moment) while keeping the mean and variance
the same. An outer risk increase, which is equivalent to a 4th degree risk increase, on
the other hand, is defined by Menezes and Wang (2005a) to be a change in distribution
that transfers dispersion from the center to the tails and thus reduces the “peakedness”
in a way that keeps the mean, variance, and skewness the same.7
The rest of the paper is organized as follows. Section 2 sets out the basic model and
concepts and results related to N th degree stochastic changes. Section 3 analyzes the

6 Self-employed workers being an obvious example of workers facing uncertain wage rate, Parker et al.
(2005) offers perhaps the most relevant empirical evidence to date of the effects of wage uncertainty on
labor supply in the neo-classical labor supply model studied by the authors cited above since Block and
Heineke (1973). Using US time-series data covering 1950–1985 in the estimation of an intertemporal model,
Grossberg (1989) finds that increased anticipated wage rate uncertainty has a significantly positive effect
on labor supply as measured by the labor force participation rate. In a calibrated model, on the other hand,
Low (2005) shows that younger worker with much unresolved wage uncertainty work longer hours than
older worker with little remaining wage uncertainty.
7 In empirical studies, such as Parker et al. (2005), the variance (or standard deviation) of wages is typi-
cally used to measure wage uncertainty. They can thus be seen as focusing on second-degree risk changes
(although as shown by Rothschild and Stiglitz (1970) a second-degree risk increase implies but is not implied
by an increase in variance). But how higher-degree risk changes affect labor supply seems an area ripe for
empirical investigation. For example, Davies and Hoy (2002) show a change from a progressive income
tax to a flat tax may decrease the level of third-degree risk within the distribution of after-tax labor income.
Thus, understanding the effects of third-order risk changes or skewness is important in understanding the
effects of tax structure changes.

123
72 W. H. Chiu, L. Eechkhoudt

effects of stochastic changes in non-labor income on labor supply. Section 4 does the
same for stochastic changes in wage rate. Section 5 illustrates the main results with
two most commonly-used utility functions. Section 6 concludes with brief remarks.

2 The model

Consider an individual whose preferences are defined over consumption c and leisure
l and are represented by the utility function U (c, l), which is assumed to be increasing
and concave in both c and l. Given his total endowment of time T , his labor supply
L is given by T − l. Implicitly normalizing the price of the consumption good to one
(as in previous contributions since Block and Heineke (1973) and denoting the (real)
wage rate by w̃ and (real) non-labor income by ỹ, the individual chooses c and L to
maximize his utility subject to the budget constraint c = w̃L + ỹ. Equivalently the
individual chooses L to maximize

EU (w̃L + ỹ, T − L). (1)

Given the need to characterize the results in what follows in terms of higher-order par-
tial derivatives of the utility function, for n, m = 1, 2, . . ., we denote by U(n)(m) (c, l)
the nth partial derivative with respect to c of the mth partial derivative of U (c, l) with
respect to l, and by U(n)(0) (c, l) and U(0)(n) (c, l) the nth partial derivatives of U (c, l)
with respect to c and l respectively. Then assuming that the function is strictly concave
in L, i.e.,8

E w̃ 2 U(2)(0) (w̃L + ỹ, T − L) − 2E w̃U(1)(1) (w̃L + ỹ, T − L)

+ EU(0)(2) (w̃L + ỹ, T − L) < 0 (2)

the optimal labor supply L ∗ satisfies the first-order condition

E w̃U(1)(0) (w̃L ∗ + ỹ, T − L ∗ ) − EU(0)(1) (w̃L ∗ + ỹ, T − L ∗ ) = 0. (3)

Random variables such as the wage rate w̃ and the non-labor income ỹ are assumed to
be positive and bounded above with probability one and their (cumulative) distribution
functions are denoted by Fw̃ and Fỹ , respectively. For a distribution function Fỹ (x),
define Fỹ(1) (x) = Fỹ (x) and

x
(n+1) (n)
Fỹ (x) = Fỹ (y)dy for all x > 0 and all n ∈ {1, 2, . . .}.
0

The standard notions of N th-degree stochastic dominance and N th degree risk

increases (Ekern 1980) are defined as follows.

8 The conditions U
(2)(0) < 0, U(0)(2) < 0, and U(1)(1) > 0 are thus sufficient.

123
The effects of stochastic wages and non-labor income on labor supply 73

Definition 1 (i) ỹ1 dominates ỹ2 by N th-degree stochastic dominance (NSD) if

(N ) (N )
Fỹ1 (x) ≤ Fỹ2 (x) for all x > 0 where the inequality is strict for some x and
(n) (n)
Fỹ1 (∞) ≤ Fỹ2 (∞) for n = 2, . . . , N − 1.
(N ) (N )
(ii) ỹ2 is an N th degree risk increase of ỹ1 if Fỹ1 (x) ≤ Fỹ2 (x) for all x > 0 where
(n) (n)
the inequality is strict for some x and Fỹ1 (∞) = Fỹ2 (∞) for n = 2, . . . , N .

As pointed out by Ekern (1980), the condition Fỹ(n)

1
(∞) = Fỹ(n)
2
(∞) for n = 2, . . . , N
means the first (N − 1) moments of ỹ1 and ỹ2 are equal. Thus ỹ2 being a first degree
risk increase of ỹ1 is clearly the same as ỹ1 dominating ỹ2 by first-degree stochastic
dominance (FSD), and a second-degree risk increase is equivalent to a mean-pre-
serving increase in risk as defined by Rothschild and Stiglitz (1970). A third-degree
risk increase, on the other hand, is equivalent to a downside risk increase as defined
by Menezes et al. (1980), which corresponds to a dispersion transfer from higher to
lower wealth levels and implies a decrease in skewness as measured by the third cen-
tral moment. A fourth-degree risk increase is further equivalent to what Menezes and
Wang (2005a) define to be an increase in outer risk which corresponds to a disper-
sion transfer from the center of a distribution to its tails while maintaining its mean,
variance and skewness (i.e., third central moment). The well-known characterizing
properties of these concepts in the Expected Utility (EU) framework are summarized
as follows.9
Lemma 1 (i) For ỹ2 being an N th degree risk increase over ỹ1 , Eu( ỹ2 ) ≤ (≥)
Eu( ỹ1 ) if and only if (−1) N u (N ) ≤ (≥) 0.
(ii) For ỹ1 dominating ỹ2 via NSD, Eu( ỹ2 ) ≤ (≥) Eu( ỹ1 ) if and only if (−1)n u (n) ≤
(≥) 0 for all n = 1, 2, . . . , N .

3 Non-labor income risk and precautionary labor supply

In this section we consider the effects of stochastic changes in the non-labor income
ỹ and the wage rate is assumed fixed at w̃ = w̄. The individual thus chooses L to
maximize EU (w̄L + ỹ, T − L). Consider first the simplest case where ỹ decreases
from a non-random y1 to a non-random y2 . If L ∗1 and L ∗2 are the optimal choices given
y1 and y2 respectively, then we have

w̄U(1)(0) (w̄L ∗1 + y1 , T − L ∗1 ) − U(0)(1) (w̄L ∗1 + y1 , T − L ∗1 ) = 0 (4)

and

w̄U(1)(0) (w̄L ∗2 + y2 , T − L ∗2 ) − U(0)(1) (w̄L ∗2 + y2 , T − L ∗2 ) = 0. (5)

Given the second-order condition, we have L ∗2 ≥ L ∗1 if and only if

w̄U(1)(0) (w̄L ∗1 + y2 , T − L ∗1 ) − U(0)(1) (w̄L ∗1 + y2 , T − L ∗1 ) ≥ 0 (6)

9 A proof of the result can be found in Ingersoll (1987).

123
74 W. H. Chiu, L. Eechkhoudt

which is clearly true if U(2)(0) ≤ 0 and U(1)(1) ≥ 0. That is, a decrease in non-labor
income increases labor supply or equivalently leisure is normal if we assume the
marginal utility of consumption is decreasing and consumption and leisure are com-
plements. This is so because under these assumptions a decrease in non-labor income
increases the marginal utility of consumption, which makes an increase in labor supply
desirable, and at the same time reduces the marginal utility of leisure, which makes
labor supply less costly in utility terms. In other words, there are two constituent parts
to the often-invoked income effect and, as shown in what follows, the effects of a
more general stochastic change in the non-labor income can be better understood in a
similar fashion.
Proposition 1 For i = 1, 2, let L i∗ maximizes EU (w̄L + ỹi , T − L).
(i) For ỹ2 being an N th degree risk increase of ỹ1 , L ∗2 ≥ L ∗1 if

(−1) N U(N +1)(0) (c, l) ≥ 0 and (−1) N U(N )(1) (c, l) ≤ 0

for all c > 0 and l > 0. (7)

(ii) For ỹ1 dominating ỹ2 via NSD, L ∗2 ≥ L ∗1 if

(−1)n U(n+1)(0) (c, l) ≥ 0 and (−1)n U(n)(1) (c, l) ≤ 0 for all c > 0, l > 0,
and n = 1, 2, . . . , N . (8)

Proof The optimal choice L ∗1 satisfies the first-order condition

E w̄U(1)(0) (w̄L ∗1 + ỹ1 , T − L ∗1 ) − EU(0)(1) (w̄L ∗1 + ỹ1 , T − L ∗1 ) = 0. (9)

Given the second-order condition, L ∗2 ≥ L ∗1 if and only if

E w̄U(1)(0) (w̄L ∗1 + ỹ2 , T − L ∗1 ) − EU(0)(1) (w̄L ∗1 + ỹ2 , T − L ∗1 ) ≥ 0. (10)

Defining θ (y) = w̄U(1)(0) (w̄L ∗1 + y, T − L ∗1 ) and η(y) = U(0)(1) (w̄L ∗1 + y, T − L ∗1 ),

we have L ∗2 ≥ L ∗1 if Eθ ( ỹ2 ) ≥ Eθ ( ỹ1 ) and Eη( ỹ2 ) ≤ Eη( ỹ1 ). But by Lemma 1,
Eθ ( ỹ2 ) ≥ Eθ ( ỹ1 ) for ỹ2 being an N th degree risk increase of ỹ1 if and only if
(−1) N θ (N ) (y) ≥ 0 for all y ≥ 0, which is implied by

(−1) N U(N +1)(0) (c, l) ≥ 0 for all c ≥ 0 and l ≥ 0. (11)

And Eη( ỹ2 ) ≤ Eη( ỹ1 ) for ỹ2 being an N th degree increase in risk of ỹ1 if and only
if (−1) N η(N ) (y) ≤ 0 for all y > 0, which is implied by

(−1) N U(N )(1) (c, l) ≤ 0 for all c > 0 and l > 0. (12)

Also by Lemma 1, Eθ ( ỹ2 ) ≥ Eθ ( ỹ1 ) for ỹ1 dominating ỹ2 via NSD if and only if
(−1)n θ (n) (y) ≥ 0 for all y > 0 and n = 1, 2, . . . , N , which is implied by

(−1)n U(n+1)(0) (c, l) ≥ 0 for all c > 0, l > 0, and n = 1, 2, . . . , N . (13)

123
The effects of stochastic wages and non-labor income on labor supply 75

And Eη( ỹ2 ) ≤ Eη( ỹ1 ) for ỹ1 dominating ỹ2 via NSD if and only if (−1)n η(n) (y) ≤ 0
for all y > 0 and n = 1, 2, . . . , N , which is implied by

(−1)n U(n)(1) (c, l) ≤ 0 for all c > 0, l > 0, and n = 1, 2, . . . , N . (14)




The result immediately implies the following, which is concerned with the special
cases where N = 1 and 2.
Corollary 1 For i = 1, 2, let L i∗ maximizes EU (w̄L + ỹi , T − L).
(i) For ỹ1 dominating ỹ2 via FSD, L ∗2 ≥ L ∗1 if

U(2)(0) (c, l) ≤ 0 and U(1)(1) (c, l) ≥ 0 for all c ≥ 0, l ≥ 0. (15)

(ii) For ỹ2 being a mean-preserving increase in risk of ỹ1 , L ∗2 ≥ L ∗1 if

U(3)(0) (c, l) ≥ 0 and U(2)(1) (c, l) ≤ 0 for all c ≥ 0, l ≥ 0. (16)

To interpret the results, we start for the sake of concreteness with the case where there is
an N th-degree risk increase in the non-labor income and N = 2 (Corollary 1(ii)). The
result says that, assuming U(3)(0) ≥ 0 and U(2)(1) ≤ 0, a more risky non-labor income
increases labor supply. Intuitively, this is so because a more risky non-labor income
makes additional consumption, which can be gained by additional labor supply, more
valuable in utility terms under U(3)(0) ≥ 0, and reduces the marginal utility of leisure,
which is the utility cost of labor supply, under U(2)(1) ≤ 0.10 The first effect can be
termed “precautionary effect” or “apportionment effect” since, under U(3)(0) ≥ 0, it
is driven by the individual’s preference to bear a greater risk when the consumption
or wealth is higher, or equivalently, to disaggregate the harm of a greater risk and that
of lower consumption. This is thus conceptually and analytically not different from a
positive third derivative of a univariate von Neumann-Morgenstern utility indicating
a positive precautionary saving motive. The second effect can be termed stochastic
complementarity effect as it is concerned with whether the individual desires more or
less leisure when there is a stochastic deterioration in consumption. The assumption
U(2)(1) ≤ 0 can be seen as a generalized form of consumption and leisure being com-
plements as it means a reduction in the desirability of leisure when there is a stochastic
deterioration in consumption in the form of a 2nd-degree risk increase.11 Eeckhoudt
et al. (2007) on the other hand argue that individuals may be “cross-prudent”, meaning

10 EU
(1)(0) ( X̃ , l) ≤ EU(1)(0) (Ỹ , l) for Ỹ being an MPS of X̃ if and only if U(3)(0) ≥ 0 and
EU(0)(1) ( X̃ , l) ≥ U(0)(1) (Ỹ , l) for Ỹ being an MPS of X̃ if and only if U(2)(1) ≤ 0.
11 The results thus compare interestingly with those of Menegatti (2009). Considering precautionary saving
in the presence of a non-financial risk as well as a financial risk, Menegatti (2009) finds that whether there
is a positive precautionary saving motive also depends on the signs of the precautionary effect and the
stochastic complementarity effect. Specifically, in the case where the risks are small, there is a positive pre-
cautionary saving motive if the precautionary effect is positive and the stochastic complementarity effect
is positive (negative) assuming the two risks are positively (negatively) correlated.

123
76 W. H. Chiu, L. Eechkhoudt

in our context that they prefer to bear the greater risk in consumption with more leisure
not less and thus U(2)(1) ≥ 0. Notice that the two effects work in the same direction
to boost labor supply when the non-labor income becomes more risky if in addition
to U(3)(0) ≥ 0, we have U(2)(1) ≤ 0 not U(2)(1) ≥ 0.
In view of the fact that an increase in N th degree risk raises the marginal utility of
consumption under (−1) N U(N +1)(0) ≥ 0 and reduces the marginal utility of leisure
under (−1) N U(N )(1) ≤ 0,12 the case where there is an N th degree risk increase in
the non-labor income and N is any positive integer (Proposition 1(i)) can be inter-
preted completely analogously. In particular, the condition (−1) N U(N +1)(0) ≥ 0 can
be understood as indicating “prudence with respect to an N th degree risk increase” or
“N th degree prudence”. The condition (−1) N U(N )(1) ≤ 0, on the other hand, can be
interpreted as leisure being a “N th degree stochastic complement” of consumption.
Part (ii) of the proposition can then be understood by recognizing that ỹ1 dominates
ỹ2 via NSD if ỹ2 can be obtained from ỹ1 via any sequence of increases in nth degree
risk, for all positive integers n ≤ N .

4 Wage rate risk and labor supply

We now consider the effects of stochastic changes in the wage rate w̃ while the non-
labor income ỹ is assumed fixed at ȳ. By choosing L, the individual’s objective is to
maximize

EU (w̃L + ȳ, T − L). (17)

We again begin by considering a deterministic reduction in w̃ from a non-random

w1 to a non-random w2 . Letting L ∗1 and L ∗2 be the optimal choices given w1 and w2
respectively, we have

w1 U(1)(0) (w1 L ∗1 + ȳ, T − L ∗1 ) − U(0)(1) (w1 L ∗1 + ȳ, T − L ∗1 ) = 0 (18)

and

w2 U(1)(0) (w2 L ∗2 + ȳ, T − L ∗2 ) − U(0)(1) (w2 L ∗2 + ȳ, T − L ∗2 ) = 0. (19)

Given the second-order condition, we have L ∗2 ≥ L ∗1 if and only if

w2 U(1)(0) (w2 L ∗1 + ȳ, T − L ∗1 ) − U(0)(1) (w2 L ∗1 + ȳ, T − L ∗1 ) ≥ 0 (20)

which holds if a wage rate decrease makes higher labor supply desirable through both
its effects on consumption and on leisure. When there is a decrease in the wage rate, an

12 That is, EU
(1)(0) ( X̃ , l) ≤ EU(1)(0) (Ỹ , l) for Ỹ being an increase in N th degree risk of X̃ if and only if
(−1) N U(N +1)(0) ≥ 0, and EU(0)(1) ( X̃ , l) ≥ U(0)(1) (Ỹ , l) for Ỹ being an increase in N th degree risk of
X̃ if and only if (−1) N U(N )(1) ≤ 0.

123
The effects of stochastic wages and non-labor income on labor supply 77

increase in labor supply would both magnify the decrease in wage rate, which is unde-
sirable given U(1)(0) ≥ 0, and effectively shift consumption upwards (since wage rates
are positive), which, given diminishing marginal utility or U(2)(0) ≤ 0, is desirable
because marginal utility of additional consumption is raised by the wage rate reduc-
tion. The effect of a wage rate increase from w1 to w2 on the desirability of higher labor
supply through its effect on consumption can be explicitly decomposed as follows.

w2 U(1)(0) (w2 L + ȳ, T − L) − w1 U(1)(0) (w1 L + ȳ, T − L)

= w2 U(1)(0) (w2 L + ȳ, T − L) − w1 U(1)(0) (w2 L + ȳ, T − L)
+ w1 U(1)(0) (w2 L + ȳ, T − L) − w1 U(1)(0) (w1 L + ȳ, T − L)
= (w2 − w1 )U(1)(0) (w2 L + ȳ, T − L) + w1 [U(1)(0) (w2 L + ȳ, T − L)
− U(1)(0) (w1 L + ȳ, T − L)]

where the first term is negative given U(1)(0) ≥ 0 and the second term is positive
if U(2)(0) ≤ 0. Whether the second effect dominates the first depends on whether
U (x+ ȳ,l)
−x U(2)(0)
(1)(0) (x+ ȳ,l)
≥ 1 for all x > 0 since the condition is necessary and sufficient for
wU(1)(0) (wL + ȳ, T − L) to be increasing in w.13 If the second effect does dominate
the first, then under the assumption that consumption and leisure are complements,
i.e., U(1)(1) ≥ 0, which implies a lower marginal utility of leisure given a lower wage
rate, a wage rate reduction increases labor supply. On the other hand, if the first effect
U (x+ ȳ,L)
dominates the second, i.e., −x U(2)(0)(1)(0) (x+ ȳ,L)
≤ 1 for all x > 0, and preferences over
consumption and leisure are additively separable or they are not strong complements,
i.e., U(1)(1) is small or zero, then a lower wage rate leads to a lower level of labor sup-
ply. We thus have an alternative to the conventional Hicks–Slutsky decomposition for
understanding the effect of a change in wage rate. The first effect can clearly be thought
of as a kind of substitution effect although it is not conceptually identical to one in
the Hicksian sense since the utility is not held constant. The second and third effects
together constitute a kind of income effect as they both work through changes in con-
sumption or wealth. In contrast to the Hicks–Slutsky decomposition, this approach to
understanding the effect of changes in the wage rate can be easily extended to stochastic
deteriorations of any degree in the wage rate.14 The general result is given as follows.

13 That is, defining ψ(w) = wU 

(1)(0) (wL + ȳ, T − L), ψ (w) ≥ 0 for all w > 0 if and only if

U(2)(0) (wL + ȳ, l)

−wL ≥1 for all w > 0
U(1)(0) (wL + ȳ, l)

which is equivalent to

U(2)(0) (x + ȳ, l)
−x ≥1 for all x > 0.
U(1)(0) (x + ȳ, l)

14 Menezes and Wang (2005b) illustrate the difficulty in obtaining a Slutsky decomposition for an increase
in wage rate uncertainty.

123
78 W. H. Chiu, L. Eechkhoudt

Proposition 2 For i = 1, 2, let L i∗ maximizes EU (w̃i L + ȳ, T − L).

(i) Assuming (−1) N U(N )(0) ≤ 0, for w̃2 being an N th degree risk increase of w̃1 ,
L ∗2 ≥ (≤) L ∗1 if

U(N +1)(0) (x + ȳ, l)

−x ≥ (≤) N and (−1) N U(N )(1) (c, l) ≤ (≥) 0
U(N )(0) (x + ȳ, l)
for all x > 0, c > 0 and l > 0. (21)

(ii) Assuming (−1)n U(n)(0) ≤ 0 for n = 1, 2, . . . , N , for w̃1 dominating w̃2 via
NSD, L ∗2 ≥ (≤) L ∗1 if

U(n+1)(0) (x + ȳ, l)
−x ≥ (≤) n and (−1)n U(n)(1) (c, l) ≤ (≥) 0
U(n)(0) (x + ȳ, l)
for all x > 0, c > 0, l > 0, and n = 1, 2, . . . , N . (22)

Proof The optimal choice L ∗1 satisfies the first-order condition

E w̃1 U(1)(0) (w̃1 L ∗1 + ȳ, T − L ∗1 ) − EU(0)(1) (w̃1 L ∗1 + ȳ, T − L ∗1 ) = 0. (23)

Given the second-order condition, L ∗2 ≥ L ∗1 if and only if

E w̃2 U(1)(0) (w̃2 L ∗1 + ȳ, T − L ∗1 ) − EU(0)(1) (w̃2 L ∗1 + ȳ, T − L ∗1 ) ≥ 0. (24)

Defining ψ(w) = wU(1)(0) (wL ∗1 + ȳ, T − L ∗1 ) and φ(w) = U(0)(1) (wL ∗1 + ȳ, T − L ∗1 ),
we have L ∗2 ≥ L ∗1 if Eψ(w̃2 ) ≥ Eψ(w̃1 ) and Eφ(w̃2 ) ≤ Eφ(w̃1 ). But by Lemma 1,
Eψ(w̃2 ) ≥ Eψ(w̃1 ) for w̃2 being an N th degree risk increase of w̃1 if and only if
(−1) N ψ (N ) (w) ≥ 0 for all w > 0, which, given (−1) N U(N )(0) ≤ 0, is implied by

U(N +1)(0) (x + ȳ, l)

−x ≥N for all x > 0 and l > 0. (25)
U(N )(0) (x + ȳ, l)

And Eφ(w̃2 ) ≤ Eφ(w̃1 ) for w̃2 being an N th degree risk increase of w̃1 if and only
if (−1) N φ (N ) (w) ≤ 0 for all w > 0, which is implied by (−1) N U(N )(1) (c, l) ≤ 0 for
all c > 0 and l > 0.
Also by Lemma 1, Eψ(w̃2 ) ≥ Eψ(w̃1 ) for w̃1 dominating w̃2 via NSD if and only if
(−1)n ψ (n) (w) ≥ 0 for all w > 0 and n = 1, 2, . . . N , which, given (−1)n U(n)(0) ≤ 0
for n = 1, 2, . . . , N , is implied by

U(n+1)(0) (x + ȳ, l)
−x ≥n for all x > 0, l > 0, and n = 1, 2, . . . , N . (26)
U(n)(0) (x + ȳ, l)

And Eφ(w̃2 ) ≤ Eφ(w̃1 ) for w̃1 dominating w̃2 via NSD if and only if (−1)n φ (n) (w) ≤
0 for all w > 0 and n = 1, 2, . . . , N , which is implied by (−1) N U(N )(1) (c, l) ≤ 0 for
all c > 0, l > 0 and n = 1, 2, . . . , N . 


123
The effects of stochastic wages and non-labor income on labor supply 79

As can be seen in the proof, a sufficient condition for an N th degree risk increase in
wage rate to imply an increase (decrease) in labor supply is that (−1) N U(N )(1) ≥ (≤) 0
and

U(N +1)(0) (wL ∗1 + ȳ, l)

−wL ∗1 ≥ (≤) N
U(N )(0) (wL ∗1 + ȳ, l)
for all w in the supports of the wage distributions. (27)

Under the assumption that the random variables w̃1 and w̃2 can take any positive
value, the condition is equivalent to the simpler form of (21). When considering wage
distribuions whose supports have a strictly positive lower bound, however, condition
(27) clearly holds if for some x > 0 (determined by the lower bound and L ∗1 ),

U(N +1)(0) (x + ȳ, l)

−x ≥ (≤) N for all x ≥ x. (28)
U(N )(0) (x + ȳ, l)

For exploring the intuitive meaning of the general result, two immediate corollaries
are useful. First, the special cases where N = 1 and 2 offer more concreteness.

Corollary 2 For i = 1, 2, let L i∗ maximizes EU (w̃i L + ȳ, T − L).

(i) For w̃1 dominating w̃2 via FSD, L ∗2 ≥ L ∗1 if

U(2)(0) (x + ȳ, l)
−x ≥ 1 and U(1)(1) (c, l) ≥ 0
U(1)(0) (x + ȳ, l)
for all x > 0, c > 0 and l > 0. (29)

(ii) For w̃2 being a mean-preserving increase in risk of w̃1 , L ∗2 ≥ L ∗1 if

U(3)(0) (x + ȳ, l)
−x ≥ 2 and U(2)(1) (c, l) ≤ 0
U(2)(0) (c, l)
for all x > 0, c > 0 and l > 0. (30)

Second, in the special case where preferences over consumption and leisure are addi-
tively separable, the conditions can be simplified as stated in what follows.

Corollary 3 Suppose preferences over consumption and leisure are additively sepa-
rable. For i = 1, 2, let L i∗ maximizes EU (w̃i L + ȳ, T − L).

(i) Assuming (−1) N U(N )(0) ≤ 0, for w̃2 being an N th degree risk increase of w̃1 ,
L ∗2 ≥ (≤) L ∗1 if

U(N +1)(0) (x + ȳ, l)

−x ≥ (≤) N for all x > 0, c > 0 and l > 0. (31)
U(N )(0) (x + ȳ, l)

123
80 W. H. Chiu, L. Eechkhoudt

(ii) Assuming (−1)n U(n)(0) ≤ 0 for n = 1, 2, . . . , N , for w̃1 dominating w̃2 via
NSD, L ∗2 ≥ (≤) L ∗1 if

U(n+1)(0) (x + ȳ, l)
−x ≥ (≤) n for all x > 0, c > 0, l > 0,
U(n)(0) (x + ȳ, l)
and n = 1, 2, . . . , N . (32)

We now consider part (i) of Proposition 2 for N being any positive integer. One can
for concreteness refer to Corollary 2, which corresponds to the cases where N = 1
and 2 or there is a first-degree and second degree risk increase in the wage rate. When
the wage rate becomes more N th degree risky, there are three separate effects on labor
supply. First, an increase in labor supply would magnify the risk increase and hence is
undesirable assuming N -degree risk increases are undesirable or (−1) N U(N )(0) ≤ 0.
Second, since w̃ is non-negative, an increase in labor supply would shift the prospec-
tive wealth distribution upwards, which is desirable assuming (−1) N U(N +1)(0) ≥ 015
because marginal utility of additional consumption is raised by the risk increase. Third,
assuming (−1) N U(N )(1) ≤ 0, the risk increase reduces the marginal utility of leisure,
which makes labor supply less costly in utility terms. That is, under the assumption
that (−1) N U(N )(0) ≤ 0, (−1) N U(N +1)(0) ≥ 0 and (−1) N U(N )(1) ≤ 0, the first effect,
which can still be thought of as a kind of “substitution effect”, works to reduce labor
supply while the second and third effects, which can still respectively be termed “pre-
cautionary effect” and “stochastic complementarity effect”, work to increase labor
supply. The relative strengths of the first two effects are encapsulated in the mea-
U (x+ ȳ,l) U (x+ ȳ,l)
sure −x U(N(N+1)(0)
)(0) (x+ ȳ,l)
. If −x U(N(N+1)(0)
)(0) (x+ ȳ,l)
≥ N , the second effect dominates the
first16 and hence, given (−1) N U(N )(1) ≤ 0 in addition, a risk increase implies an
increase in labor supply. If, on the other hand, the first effect dominates the second or
U (x+ ȳ,l)
−x U(N(N+1)(0)
)(0) (x+ ȳ,l)
≤ N and leisure is not a strong N th degree stochastic complement
of consumption or even the individual exhibits N th degree cross prudence in leisure,
i.e., |(−1) N U(N )(1) | is small or (−1) N U(N )(1) ≥ 0, then an N th degree risk increase
in the wage rate leads to a reduction in labor supply. In the special case where the
preferences over consumption and leisure are additively separable (Corollary 3), the
third effect is absent and thus the effect of a risk increase in the wage rate on labor
supply is determined solely by the relative strengths of first two effects.

15 In the case where (−1) N U U(N +1)(0) (x+ ȳ,l)

(N +1)(0) ≤ 0, we always have −x U(N )(0) (x+ ȳ,l) ≤ N . The interpretation
for such a case can be analogously given.
16 As can be seen in the proof of the Proposition, the marginal expected utility of a labor supply increase
through its effect on consumption E w̃U1 (w̃L + ȳ, T − L) is raised by a more N th degree risky wage
rate, i.e., a more N th degree risky wage rate makes higher labor supply more desirable through its effect
U(N +1)(0) (x+ ȳ,l)
on consumption, if and only if −x U(N )(0) (x+ ȳ,l) ≥ N . In the case where U is additively separable in
U(N +1)(0) (x,l)
its two arguments and ȳ = 0, −x U is what (Eeckhoudt and Schlesinger 2008) refer to as a
(N )(0) (x,l)
“measure of relative N th degree risk aversion”. Chiu et al. (2009) present a context-free interpretation of
the measure in terms of an individual’s preferences over lotteries.

123
The effects of stochastic wages and non-labor income on labor supply 81

The interpretation of Proposition 2(ii) follows naturally from the fact that ỹ1 dom-
inates ỹ2 via NSD if ỹ2 can be obtained from ỹ1 via any sequence of increases in nth
degree risk, for all positive integers n ≤ N .

5 Examples of specific utility functions

In this section, we illustrate the workings of our main results with two of the most
commonly used utility functions. We start with a bi-variate Hyperbolic Absolute Risk
Aversion (HARA) utility function

1
U (c, l) = (c − ŷ)1−α l β (33)
1−α

where ŷ is usually interpreted as the subsistence level of consumption. Since

1
U(1)(0) = (c − ŷ)−α l β and U(0)(1) = β (c − ŷ)1−α l β−1 , (34)
1−α

it can be easily verified that if 0 < α < 1, β > 0, then (−1) N U(N +1)(0) (c, l) ≥ 0
and (−1) N U(N )(1) (c, l) ≤ 0 for all c > ŷ and l > 0 and thus by Proposition 1, an
N th degree risk increase in non-labor income leads to a higher level of labor supply.
Furthermore, since

U(N +1)(0) (x + ȳ, l) x

−x = (α − 1 + N ) , (35)
U(N )(0) (x + ȳ, l) x + ȳ − ŷ

if 0 < α < 1, β > 0, and ȳ ≥ ŷ, we have (−1) N U(N )(0) (c, l) ≤ 0,
U (x+ ȳ,l)
(−1) N U(N )(1) (c, l) ≤ 0 and −x U(N(N+1)(0)
)(0) (x+ ȳ,l)
≤ N for all x > 0, c > ŷ and
l > 0 and thus Proposition 2 indicates that an N th degree risk increase in wage rate
implies a decrease in labor supply. On the other hand, if α > 1, β < 0, and ȳ is equal
or close to ŷ, then (−1) N U(N )(0) (c, l) ≤ 0 and (−1) N U(N )(1) (c, l) ≥ 0 for c > ŷ
U (x+ ȳ,l)
and l > 0 and there exists x > 0 such that −x U(N(N+1)(0) )(0) (x+ ȳ,l)
≥ N for x ≥ x.17 and
therefore an N th degree risk increase in wage rate implies an increase in labor supply
(provided that the supports of the wage distributions have a sufficiently large lower
bound).18
Now consider a bivariate Constant Absolute Risk Aversion (CARA) utility funtion

U (c, l) = −e−k(c+l) , k > 0. (36)

17 That is, for  > 0 such that α = 1 + , there exists δ > 0 and x > 0 such that ȳ = ŷ + δ and

x
(α − 1 + N ) ≥N for x ≥ x.
x + ȳ − ŷ

18 See the discussion following the proof of Proposition 2.

123
82 W. H. Chiu, L. Eechkhoudt

Since

U(N +1)(0) (x + ȳ, l)

U(1)(0) = ke−k(c+l) , U(0)(1) = ke−k(c+l) , and −x = kx,
U(N )(0) (x + ȳ, l)
(37)

it can be easily verified that (−1) N U(N )(0) (c, l) ≤ 0 and (−1) N U(N )(1) (c, l) ≥ 0 for
U (x+ ȳ,l)
all c > 0 and l > 0 and −x U(N(N+1)(0))(0) (x+ ȳ,l)
≥ N for x ≥ N /k. Thus, for N and
the wage distributions being such that these conditions are satisfied, Proposition 2
indicates that an N th degree risk increase in wage rate implies an increase in labor
supply.

6 Concluding remarks

In this paper, we obtain conditions for signing the effects on labor supply when the
non-labor income or the wage rate undergoes a stochastic deterioration of any degree.
As pointed out by Dardanoni (1988), the neo-classical labor supply model is but one
example of a class of models based on a two-argument utility function. Other examples
in this class includes Sandmo’s (1970) model of optimal savings and Dardanoni and
Wagstaff (1990) model of the demand for heath care. While all the results in this paper
are presented and interpreted in terms of the optimal choice of labor supply for expo-
sitional simplicity, they can clearly all be applied and analogously interpreted in the
settings of optimal savings and demand for health, among others. In particular, inter-
preted in the setting of optimal saving, Propositions 1 and 2 in this paper can be seen
as generalizations of the main results in Eeckhoudt and Schlesinger (2008) that deal
with the effects of changes in labor income risk and interest rate risk on precautionary
saving in a two-period model where a consumer’s preferences over consumption in
the two periods are additively separable.

References

Block MK, Heineke JM (1973) The allocation of effort under uncertainty: the case of risk-averse behavior.
J Political Econ 81:376–385
Chiu WH, Eeckhoudt L, Rey B (2009) On relative and partial risk attitudes: theory and implications. mimeo
Dardanoni V (1988) Optimal choices under uncertainty: the case of two-argument utility functions. Econ J
98:429–450
Dardanoni V, Wagstaff A (1990) Uncertainty and the demand for medical care. J Health Econ 9:23–38
Davies JB, Hoy M (2002) Flat rate taxes and inequality measurement. J Public Econ 84:33–46
Diamond PA, Stiglitz JE (1974) Increases in risk and in risk aversion. J Econ Theory 8:337–360
Dionne G, Eeckhoudt L (1987) Proportional risk aversion, taxation and labor supply under uncertainty.
J Econ 47(4):353–366
Eeckhoudt L, Rey B, Schlesinger H (2007) A good sign for multivariate risk taking. Manag Sci 53(1):
117–124
Eeckhoudt L, Schlesinger H (2008) Changes in risk and the demand for saving. J Monet Econ 55(7):
1329–1336
Ekern S (1980) Increasing Nth degree risk. Econ Lett 6:329–333
Grossberg AJ (1989) Labor supply under real wage uncertainty: a new look at the intertemporal substitution
hypothesis. South Econ J 55(4):974–986

123
The effects of stochastic wages and non-labor income on labor supply 83

Hicks JR (1963) The theory of wages. St. Martin’s Press, New York
Ingersoll JE (1987) Theory of financial decision making. Rowman & Littlefield, New Jersey
Knight F (1964) Risk, uncertainty and profit. Kelly, New York
Low HW (2005) Self-insurance in a life-cycle model of labour supply and savings. Rev Econ Dyn 8(4):
945–975
Menegatti M (2009) Optimal saving in the presence of two risks. J Econ 96(3):277–288
Menezes C, Geiss C, Tressler J (1980) Increasing Downside Risk. American Economic Review 70: 921-932
Menezes C, Hanson DL (1970) On the theory of risk aversion. Int Econ Rev 11(3):481–487
Menezes C, Wang XH (2005a) Increasing outer risk. J Math Econ 41(7):875–886
Menezes C, Wang XH (2005b) Duality and the slutsky income and substitution effects of increases in wage
rate uncertainty. Oxf Econ Pap 57(3):545–557
Parker SC, Belghitar Y, Barmby T (2005) Wage uncertainty and the labour supply of self-employed workers.
Econ J 115:C190–C207
Ross SA (1981) Some stronger measures of risk aversion in the small and the large with applications.
Econometrica 49(3):621–638
Rothschild M, Stiglitz J (1970) Increasing risk I: a definition. J Econ Theory 2:225–243
Tressler JH, Menezes CF (1980) Labor supply and wage rate uncertainty. J Econ Theory 23:425–436
Zeckhauser R, Keeler E (1970) Another type of risk aversion. Econometrica 38(5):661–665

123