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Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization
Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization
CHAPTER 4
Consumer Optimization
▶ Once we have preferences and budget constraint, we next put them together to analyze
how the representative consumer behaves
▶ We assume that the consumer is rational i.e. the consumer knows his or her own
preferences and budget constraint and can evaluate which feasible consumption bundle is
best for him or her.
▶ The optimal consumption bundle is the point representing a consumption–leisure pair that
is on the highest possible indifference curve and is on or inside the consumer’s budget
constraint.
▶ Labor supply curve: Tells us how much labor the representative consumer wishes to
supply given any real wage.
▶ To construct the labor supply curve, one could imagine presenting the representative
consumer with different real wage rates and asking what quantity of labor the consumer
would choose to supply at each wage rate.
▶ Formally, suppose l(w) is a function that tells us how much leisure the consumer wishes
to consume, given the real wage w.
▶ Then the labor supply curve is given by:
N s (w) = h − l(w)
▶ Assuming that the substitution effect of an increase in the real wage dominates the
income effect (to be covered later), the labor supply curve is upward-sloping.
▶ The production function has the property that output increases when either the capital
input or the labor input increases.
▶ In other words, the marginal products of labor and capital are both positive: M PN > 0
and M PK > 0.
▶ The representative firm behaves competitively, in that it takes as given the real wage,
which is the price at which labor trades for consumption goods.
▶ The goal of the firm is to maximize its profits:
π = Y − wN d
π = zF (K, N d ) − wN d ,
▶ Profit is then the difference between total revenue and total variable cost.
▶ The maximized quantity of profits, π∗, is the distance AB.
▶ At the profit-maximizing quantity of labor, N, the slope of the total revenue function is
equal to the slope of the total variable cost function
▶ Hence we have M PN = w
▶ The contribution to the firm’s profits of having employees work an extra hour is the extra
output produced minus what the extra input costs i.e. M PN − w.
▶ Given a fixed quantity of capital, M PN is very large for Nd = 0, so that M PN − w > 0
for Nd = 0, and it is worthwhile for the firm to hire the first unit of labor, as this implies
positive profits.
▶ As the firm hires more labor, M PN falls, so that each additional unit of labor is
contributing less to revenue, but contributing the same amount, w, to costs.
▶ Eventually, at Nd = N , the firm has hired enough labor so that hiring an additional unit
implies M PN − w < 0, which in turn means that hiring an additional unit of labor only
causes profits to go down, and this cannot be optimal.
▶ If firm hires A, her marginal product is 5 clients per year, which exceeds the real wage of
2.5 clients, and so it would be worthwhile for the firm to hire A
▶ If the firm hires B, then B’s marginal product is 4 clients per year, which also exceeds the
market real wage, and so it would also be worthwhile to hire B
▶ If the firm hires C, then C’s marginal product is 2 clients per year, which is less than the
market real wage of 2.5 clients
▶ Therefore, it would be optimal in this case for the firm to hire two accountants, A and B.