Instructor's Manual

Stephen D. Williamson
Washington University in St. Louis
Hafiz Akhand
Queen's University

Macroeconomics
Fourth Canadian Edition
Stephen D. Williamson
Washington University in St. Louis

Toronto

Copyright 2013 Pearson Canada Inc., Toronto, Ontario.

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Instructors Manual for Macroeconomics, Fourth Canadian Edition

b) Total Factor Productivity
c) Henry Ford and Total Factor Productivity (Macroeconomics in Action 4.1)
d) Total Factor Productivity and the Canadian Aggregate Production Function
(Theory Confronts the Data 4.2)
e) The Profit Maximization Problem of the Representative Firm
i) Profits = Total Revenue Total Variable Costs
ii) Marginal Product of Labour = Real Wage
iii) Labour Demand

TEXTBOOK QUESTION SOLUTIONS

Problems
1.

Consider the two hypothetical indifference curves in Figure 4.1. Point A is on both
indifference curves, I1 and I2. By construction, the consumer is indifferent between A
and B, as both points are on I2. In like fashion, the consumer is indifferent between A
and C, as both points are on I1. But at point C, the consumer has more consumption
and more leisure than at point B. As long as the consumer prefers more to less, he or
she must strictly prefer C to A. We therefore contradict the hypothesis that two
indifference curves can cross.

Figure 4.1

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Chapter 4: Consumer and Firm Behaviour: The WorkLeisure Decision and Profit Maximization
2.

u = al + bC

a) To specify an indifference curve, we hold utility constant at u . Next rearrange in

the form:
C=

u a
l
b b

Indifference curves are therefore linear with slope, a/b, which represents the
marginal rate of substitution. There are two main cases, according to whether
a
a
a
> w or < w . Panel a of Figure 4.2 shows the case of < w . In this case the
b
b
b

indifference curves are flatter than the budget line and the consumer picks point
A, at which l = 0 and C = wh + T . Panel b of Figure 4.2 shows the case of
a
> w . In this case the indifference curves are steeper than the budget line, and
b
the consumer picks point B, at which l = h and C = T . In the coincidental
a
case in which = w , the highest attainable indifference curve coincides with the
b

indifference curve, and the consumer is indifferent among all possible amounts
of leisure and hours worked.

Panel a

Panel b
Figure 4.2

b) The utility function in this problem does not obey the property that the consumer
prefers diversity, and is therefore not a likely possibility.
c) This utility function does have the property that more is preferred to less.
However, the marginal rate of substitution is constant, and therefore this utility
function does not satisfy the property of diminishing marginal rate of substitution.
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Instructors Manual for Macroeconomics, Fourth Canadian Edition

3. Suppose that h = 16. Then, the budget constraint for the consumer is

C = .75(16 l ) + 8 6,
and since perfect complements with a =1 implies that the consumer wishes to
equalize leisure and consumption, this gives C = l. Then, substituting in the above
equation and solving for C, we get C = l = 3.9. In part (b), if the wage doubles for the
consumer to 1.5, then going through the same procedure, we solve for consumption
and leisure to get C = l = 7.5. Thus, consumption and leisure both increase. Given
perfect complements, there is no substitution effect, only an income effect. When the
wage increases there is a positive income effect on both consumption and leisure, and
so both quantities increase. It is straightforward to draw a diagram as in Figure 4.11 in
the text with the budget constraint shifting out and the quantities of consumption and
leisure increasing when the budget constraint shifts.
4. When the government imposes a proportional tax on wage income, the consumers
budget constraint is now given by:
C = w(1 t )(h l ) + T ,

where t is the tax rate on wage income. In Figure 4.3, the budget constraint for t = 0 is
FGH. When t > 0, the budget constraint is EGH. The slope of the original budget line
is w, while the slope of the new budget line is (1 t)w. Initially the consumer picks
point A on the original budget line. After the tax has been imposed, the consumer
picks point B. The substitution effect of the imposition of the tax is to move the
consumer from point A to point D on the original indifference curve. Point D is at the
tangent point of indifference curve, I1, with a line segment that is parallel to EG. The
pure substitution effect induces the consumer to reduce consumption and increase
leisure (work less).
The tax also makes the consumer worse off, in that he or she can no longer be on
indifference curve I1, but must move to the less preferred indifference curve, I2. This
pure income effect moves the consumer to point B, which has less consumption and
less leisure than point D, because both consumption and leisure are normal goods.
The net effect of the tax is to reduce consumption, but the direction of the net effect
on leisure is ambiguous. Figure 4.3 shows the case in which the substitution effect on
leisure dominates the income effect. In this case, leisure increases and hours worked
fall. Although consumption must fall, hours worked may rise, fall, or remain the
same.

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Chapter 4: Consumer and Firm Behaviour: The WorkLeisure Decision and Profit Maximization

Figure 4.3

5. In Figure 4.4, the income tax deduction implies an extra kink in the budget constraint
of the consumer, so the initial budget constraint is ABDF. A reduction in the tax
deduction implies a shift in the budget constraint to GHDF. A consumer who chose a
point such as J before the change, may still choose J if (in contrast to what is shown in
the figure) the reduction in x is sufficiently small. However, in the figure, x is large
enough that consuming at J is no longer feasible. The consumer will choose point H,
where total wage income is just equal to the tax deduction. Thus, the consumer
increases l, reduces labour supply, and reduces consumption. This consumer does not
pay the tax, but the change in the deduction has changed his or her behaviour.

Figure 4.4

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Instructors Manual for Macroeconomics, Fourth Canadian Edition

Now, suppose, as in Figure 4.5, that the consumer initially chooses point J, where the
consumer initially pays the tax. Then, a reduction in the tax deduction has a pure
income effect for the consumer, shifting his or her budget constraint in a parallel
fashion. Therefore, given normal goods, consumption and leisure both decrease.
Thus, the effects are quite different, depending on whether or not the consumer was
initially paying the tax.

Figure 4.5
6. Lump-Sum Tax versus Proportional Tax: Suppose that we start with a
proportional tax. Under the proportional tax the consumers budget line is EFH in
Figure 4.6. The consumer chooses consumption C* and leisure l * , at point A on
indifference curve I1. A shift to a lump-sum tax makes the budget line steeper.
The absolute value of the slope of the budget line is (1 t )w and t has fallen to zero.
The imposition of the lump-sum tax shifts the budget line downward in a parallel
fashion. By construction, the lump-sum tax must raise the same amount of
revenue as the proportional tax. The consumer must therefore be able to continue
to consume C* of the consumption good and l * of leisure after the change in tax
collection. Therefore, the new budget line must also pass through point A. The
new budget line is labeled LGH in Figure 4.6. With the lump-sum tax, the
consumer can do better by choosing point B on the higher indifference curve I2.
Therefore, the consumer is clearly better off. We are also assured that
consumption will be greater at point B than at point A, and that leisure will be
smaller at point B than at point A. The proportional tax distorts economic

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Chapter 4: Consumer and Firm Behaviour: The WorkLeisure Decision and Profit Maximization

decisions and is therefore less efficient in extracting the same revenue that a
lump-sum tax can generate.

Figure 4.6

7. The increase in dividend income shifts the budget line upward. The reduction in the
wage rate flattens the budget line. One possibility is depicted in Figure 4.7. The
original budget constraint HGL shifts to HFE. There are two income effects in this
case. The increase in dividend income is a positive income effect. The reduction in
the wage rate is a negative income effect. Panel a of Figure 4.7 shows the case where
these two income effects exactly cancel out. In this case we are left with a pure
substitution effect that moves the consumer from point A to point B. Therefore,
consumption falls and leisure increases. As leisure increases, hours of work must fall.
Panel b of Figure 4.7 shows a case in which the increase in dividend income, the
distance GF, is larger and so the income effect is positive. The consumer winds up on
a higher indifference curve, leisure unambiguously increases, and consumption may
either increase or decrease. Finally, panel c of Figure 4.7 shows a case in which the
increase in dividend income, the distance GF, is smaller and so the income effect is
negative. The consumer winds up on a lower indifference curve, consumption
unambiguously decreases, and leisure may either increase or decrease.

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Instructors Manual for Macroeconomics, Fourth Canadian Edition

Panel a

Panel b

Panel c
Figure 4.7
8. This problem introduces a higher overtime wage for hours worked above a threshold,
q. This problem also abstracts from any dividend income and taxes.
a) The budget constraint is now EJG in Figure 4.8. The budget constraint is steeper
for levels of leisure less than h q, because of the higher overtime wage. Figure
4.8 depicts possible choices for two different consumers. Consumer 1 picks point
A on her indifference curve, I1. Consumer 2 picks point B on his indifference
curve, I2. Consumer 1 chooses to work overtime; Consumer 2 does not.

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Chapter 4: Consumer and Firm Behaviour: The WorkLeisure Decision and Profit Maximization

Figure 4.8

b) The geometry of Figure 4.8 makes it clear that it would be very difficult to have
an indifference curve tangent to EJH at a point near J. In order for this to happen,
the indifference curve would need to be close to right angled as in the case of pure
complement. It is unlikely that consumers wish to consume goods and leisure in
fixed proportions, and so points like A and B are more typical. For any other
allowable shape for the indifference curve, it is impossible for point J to be
chosen.
c) An increase in the overtime wage makes the EJ segment of the budget constraint
steeper, but has no effect on the segment JG. For an individual like Consumer 2,
the increase in the overtime wage has no effect up until the point at which the
increase is large enough to shift the individual to a point like point A. Consumer
#2 receives no income effect because the income effect arises out of a higher
wage rate on inframarginal units of work. An individual like Consumer 1 has the
traditional income and substitution effects of a wage increase. Consumer 1
increases her consumption, but may either increase or reduce hours of work
according to whether the income effect outweighs the substitution effect.
9. If h represents time not working in the market, then the provision of free day care
essentially increases h, as it reduces the amount of time spent in home production. In
Figure 4.9, this causes a parallel shift in the budget constraint of the consumer. The
effect on consumption and leisure works just as for an increase in non-wage income,
in that, under the assumption of normal goods, consumption and leisure must both
increase. However, note that leisure increases by less than the increase in h, so that
hours of work must also increase. That is, the consumer has time freed up due to the
provision of day-care services, and uses some of this free time in leisure and some in
the market. Note that we have not taken account of how the day-care services are
financed by the government. The implicit assumption is that someone else other than
the consumer in question is taxed to supply these services.
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Instructors Manual for Macroeconomics, Fourth Canadian Edition

Provision of Day Care Services

Figure 4.9

10. Supposing that the only options open to the consumer are working q hours and paying
a tax T, or working zero hours and receiving an unemployment insurance benefit b,
consumption will be w(h-q)-T if the consumer works, and b if the consumer decides
not to work. Then, either the consumer prefers not to work, as in the Figure 4.10,
where the highest indifference curve is achieved at point A rather than at point B, or
the consumer prefers to work, as in Figure 4.11. There is also another case where the
consumer is just indifferent between working and not working, but that case is not
important.
a) Think of the economy as consisting of many consumers, some of whom are in a
situation as in the Figure 4.10 and some as in Figure 4.11. Some consumers do not
work, and some choose to work. If the wage goes up, then that will make working
preferable for some consumers who formerly did not choose to work. An increase
in the wage will not discourage anyone from working, but those who were
working already will not choose to vary hours of work (they cannot). But total
employment in the economy will increase, as now more people are working. With
the constraint on hours of work, there are no issues related to income and
substitution effects. A higher wage always increases the total quantity of labor
supplied.

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Chapter 4: Consumer and Firm Behaviour: The WorkLeisure Decision and Profit Maximization

Figure 4.10

Figure 4.11

b) Similar to part (a), if the unemployment insurance benefit increases, this will
make not working preferable to some consumers who were formerly working, and
employment will fall. An increase in the unemployment insurance benefit
unequivocally reduces the quantity of labor supplied.
11. The firm chooses its labour input, Nd, so as to maximize profits. When there is no tax,
profits for the firm are given by:
= zF (K , N d ) wN d .

That is, profits are the difference between revenue and costs. In the top panel in
Figure 4.12 the revenue function is zF (K , N d ) and the cost function is the straight line

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Instructors Manual for Macroeconomics, Fourth Canadian Edition

wNd. The firm maximizes profits by choosing the quantity of labour where the slope
of the revenue function equals the slope of the cost function:
MPN = w .

The firms demand for labour curve is the marginal product of labour schedule in the
bottom panel of Figure 4.12.
With a tax that is proportional to the firms output, the firms profits are given by:
= zF(K,Nd) wNd tzF(K,Nd)
= (1 t)zF(K,Nd) wNd.
Here, the term (1 t )zF (K , N d ) is the after-tax revenue function and, as before, wNd is
the cost function. In the top panel of Figure 4.12, the tax acts to shift down the
revenue function for the firm and reduces the slope of the revenue function. As
before, the firm will maximize profits by choosing the quantity of labour input where
the slope of the revenue function is equal to the slope of the cost function, but the
slope of the revenue function is (1 t ) MPN , so the firm chooses the quantity of labour
where
(1 t ) MPN = w .
In the bottom panel of Figure 4.12, the labour demand curve is now (1 t ) MPN and the
labour demand curve has shifted down. The tax acts to reduce the after-tax marginal
product of labour, and the firm will hire less labour at any given real wage.

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Chapter 4: Consumer and Firm Behaviour: The WorkLeisure Decision and Profit Maximization

Figure 4.12

12. The firm chooses its labour input Nd so as to maximize profits. When there is no
subsidy, profits for the firm are given by
= zF (K , N d ) wN d .

That is, profits are the difference between revenue and costs. In the top panel in
Figure 4.13 the revenue function is zF (K , N d ) and the cost function is the straight line
wNd. The firm maximizes profits by choosing the quantity of labour where the slope
of the revenue function equals the slope of the cost function:
MPN = w .

The firms demand for labour curve is the marginal product of labour schedule in the
bottom panel of Figure 4.13.
With an employment subsidy, the firms profits are given by
= zF (K , N d ) (w s) N d

where, the term zF (K , N d ) is the unchanged revenue function and (w s)Nd is the cost
function. The subsidy acts to reduce the cost of each unit of labour by the amount of
the subsidy, s. In the top panel of Figure 4.13, the subsidy acts to shift down the cost
function for the firm by reducing its slope. As before, the firm will maximize profits
by choosing the quantity of labour input where the slope of the revenue function is
equal to the slope of the cost function, (t s), so the firm chooses the quantity of
labour where
MPN = w s .
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Instructors Manual for Macroeconomics, Fourth Canadian Edition

In the bottom panel of Figure 4.13, the labour demand curve is now MPN + s and the
labour demand curve has shifted up. The subsidy acts to reduce the marginal cost of
labour, and the firm will hire more labour at any given real wage.

Figure 4.13

12. Minimum Employment Requirement: In Figure 4.14, given the minimum quantity
of employment that the firm requires to operate, the production function (indentical to
the total revenue function) follows ABD, and then continues along the same
production function we would have without the minimum quantity of employment.
The firm maximizes profits, which implies that, if the market wage rate is greater than
w* the firm will earn negative profits for any quantity of labor input greater than or
equal to N*. Therefore, if w > w* then N d = 0. If the real wage rate is less than or
equal to w* (so that the firm can earn positive profits for at least some positive
quantities of labor input), but larger than MPN* (the marginal product of labor when

N d = N * ), then the firm will choose N d = N * to maximize profits, as is the case in

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Chapter 4: Consumer and Firm Behaviour: The WorkLeisure Decision and Profit Maximization

Figure 4.14 when w = w1 . That is, choosing N d = N * is better than choosing N d = 0

in this case, because the firm will earn positive profits rather than zero profits.
However, if the firm increases the labor input above N*, this will just reduce profits,
as w > MPN when N d N * . Now, if w MPN* , then the minimum quantity of
employment does not make any difference for what the firm chooses to do. The firm
sets N d so that w = MPN , and the firm will choose N d = N * , as in Figure 4.14 when
the firm faces a market wage w2 and chooses N d = N 2 . Therefore, the labor demand
curve is as depicted in Figure 4.15. The interesting feature of the firm's behavior is
that labor demand does not change smoothly in response to the real wage. There is a
critical wage rate w* at which the firm is willing to start up, and at that wage it will
actually hire more labor than would an identical firm that did not face a minimum
employment constraint. In reality, firms may face constraints like this, for example a
restaurant needs at least one cook, one waiter, and one cashier to operate, and this
may cause employment to increase and decrease by larger amounts in response to
changes in market wages than would otherwise be the case.

Figure 4.14

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Instructors Manual for Macroeconomics, Fourth Canadian Edition

Figure 4.15

14. The level of output produced by one worker who works h l hours is given by:
Y = zF ( K , h l ) .

This equation is plotted in Figure 4.16. The slope of this production possibilities
frontier is equal to MPN .

Figure 4.16

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Chapter 4: Consumer and Firm Behaviour: The WorkLeisure Decision and Profit Maximization

15. The pollution regulation alters the firms profits according to

= Y w(1 + x) N
Therefore, the pollution regulation (x > 0) has the same effect as an increase in the
wage for the firm. The firm now maximizes profits by hiring labour to the point
where the marginal product of labour is equal to w(1 + x). This has the effect of
shifting the labour demand curve to the left, and the firm will hire less labour, and
produce less, given the market real wage w.
16. Y = zK 0.3n 0.7
a) Y = n 0.7 . See the top panel in Figure 4.17. The marginal product of labour is
positive and diminishing.
b) Y = 2n 0.7 . See Figure 4.17.
c) Y = 20.3 n 0.7 1.23n 0.7 . See Figure 4.17.
d) See the bottom panel of Figure 4.17.
z = 1, K = 1 MPN = 0.7n 0.3
z = 2, K = 1 MPN = 1.4n 0.3
z = 1, K = 2 MPN = 20.3 0.7n 0.3 0.86n 0.3

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Instructors Manual for Macroeconomics, Fourth Canadian Edition

Figure 4.17

17. a) The production function, for fixed K, is shown in Figure 4.18. For any wage w,
profits for the firm will increase with N, and there is no limit on how much labor the
firm wants to hire. The firm maximizes profits by hiring an infinite amount of labor.
b) This presents problems for competitive equilibrium because supply could never
equal demand in equilibrium, as the quantity of labor supplied could not be
infinite. Essentially, competitive equilibrium is the wrong modeling approach if
there are increasing returns to scale. A more appropriate approach would be to
assume a monopoly producer, or at least an oligopoly where firms behave
strategically instead of as price takers.

Figure 4.18

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