Integrating Labor Demand Frictions in a Random Utility Random Opportunity Labor Supply Model

This paper studies labor market responses to tax policy using a structural labor supply model estimated within a Random Utility - Random Opportunity framework. The RURO model represents labor supply as a choice among a finite set of work options, where individuals compare the utility of different employment and hours combinations given the opportunities available to them. Preferences are modeled in a random utility framework, while heterogeneity in job availability and constraints is captured through the opportunity structure. This allows the model to account for both choice behavior and limitations in feasible options. We combine this structural labor supply framework with a detailed microsimulation model based on Belgian administrative data, allowing for an accurate mapping from labor supply choices to disposable income and fiscal outcomes.

The main contribution of the paper is to extend the RURO labor supply model by incorporating labor demand elasticities. Standard applications of structural labor supply models implicitly assume perfectly elastic labor demand, omitting wage adjustments and firm side responses. This assumption can limit the ability of these models to capture key labor market frictions. By supplementing the RURO framework with labor demand elasticities, we allow employment and wages to adjust to policy induced changes in labor supply, providing a more realistic representation of labor market equilibrium.

This integrated approach improves the interpretation of labor supply estimates and strengthens the link between individual choice behavior and aggregate labor market outcomes. More broadly, the paper contributes to the structural labor supply literature by showing how demand side adjustments can be incorporated in a tractable way, addressing an important limitation of existing models.