ECON 2HH3:

Intermediate Macroeconomics II
Winter 2021

Bettina Brüggemann & Marc-André Letendre

1
Part II
Basic Macroeconomic Models: A One-Period Model

2
Chapter 4
Consumer and Firm Behaviour:
The Work-Leisure Decision and Profit Maximization

3
Overview
1. Motivation
2. The Representative Consumer
3. The Representative Firm

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Motivation
• Up to now: How do we measure variables of macroeconomic interest?
• Now: How do we construct a particular macroeconomic model to analyse
these variables?

• Static, one-period model of consumer and firm behaviour

• Simplification to understand basic microeconomic principles of consumer and
firm optimization

• Consumer: trade-off between work and leisure

• Firm: profit maximization
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The Representative Consumer
• Consumer’s preferences over consumption and leisure as represented
by indifference curves
• Consumer’s budget constraint
• What purchases are feasible given market prices?
• Consumer’s optimization problem:
• Making his or herself as well off as possible given his or her budget constraint
• How does the consumer respond to:
i. an increase in non-wage income?
ii. an increase in the market real wage rate?

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Consumer’s Preferences
•Consumer
  desires two goods:
1. Physical good (the “consumption good”)
• The aggregation of all consumer goods in the economy
• Quantity of consumption:

2. Leisure
• Any time not working in the market (hobbies, work at home, sleeping, …)
• Quantity of leisure:

• Preferences of a representative consumer over leisure and consumption can be

captured through a utility function:
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Consumer’s Preferences
• Consumption
  bundle:
• is strictly preferred to if

• is strictly preferred to if

• Consumer is indifferent if
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Consumer’s Preferences: Assumptions
1. More is always preferred to less.
2. The consumer likes diversity in his or her consumption bundle.
3. Consumption and leisure are normal goods.

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Consumer’s Preferences: Indifference curves
Definition:
An indifference curve connects a set of points, with these points
representing consumption bundles among which the consumer is
indifferent.

Key properties:
1. An indifference curve slopes downward (more is preferred to less)
2. An indifference curve is convex (preference for diversity)

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Figure 4.1
Indifference Curves

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Figure 4.2
Properties of Indifference Curves

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Consumer’s Preferences:
Marginal Rate of Substitution
•Definition:
 
The marginal rate of substitution of leisure for consumption, denoted
is the rate at which the consumer is just willing to substitute leisure for
consumption goods.

• Convex indifference curve implies that is diminishing

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Figure 4.2
Properties of Indifference Curves

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Consumer’s Budget Constraint
•  Consumer behaves competitively: price-taker
• Barter economy: All trade involves exchanges of goods for goods
• Two goods in our model: consumption and leisure
• No money

• What are the constraints under which the consumer is operating?

• Time constraint:

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Consumer’s Budget Constraint (cont’d)
•  Consumer’s real disposable income
• Real wage income = real wage * time spent working =
• real dividend income = profits earned by firms =
• taxes = lump-sum tax (in real terms) =

• Budget constraint: Total consumption equals real disposable income

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Consumer’s Budget Constraint (cont’d)
•  Substituting time constraint:

• Put differently:

→ Compares implicit expenditure to implicit real disposable income

• Or (convenient for graph):

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Figure 4.3
Representative Consumer’s Budget Constraint when T  

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Figure 4.4
Representative Consumer’s Budget Constraint T  

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Consumer Optimization
•  The consumer chooses the consumption bundle that is on their highest
indifference curve, while satisfying their budget constraint
→ Optimal consumption bundle

• The consumer is rational:

• Knows preferences and budget constraint
• Can make an informed optimization decision

• Optimization implies:

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Figure 4.5
Consumer Optimization

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Figure 4.6
The Representative Consumer Chooses Not to Work

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Experiment 1: Change in Dividends or Taxes
•  Change consumer’s real dividend minus taxes,
• Could be caused by changes in dividends taxes or both

• Pure income effect: Disposable income increases without change in

prices (i.e., real wage )

• Both consumption and leisure are normal goods:

• Higher non-wage disposable income should increase consumption and leisure

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Figure 4.7
An Increase in the Consumer’s Dividend Income

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Experiment 2: Change in the Real Wage
• Has both income and substitution effects

• Substitution effect of wage increase: the price of leisure rises, so the

consumer substitutes from leisure to consumption

• Income effect: the consumer is effectively more wealthy and, since

both goods are normal, consumption increases and leisure increases

• Conclusion: Consumption must rise, but leisure may rise or fall

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Figure 4.8
Increase in the Real Wage Rate–Income and Substitution Effects

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Figure 4.10
Labour Supply Curve  Labour supply curve:

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Figure 4.11
Effect of an Increase in Dividend Income or a Decrease in Taxes

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The Representative Firm
• Demand labour from consumers and supply consumption goods

• Choices for firms are determined by the available technology and by

profit maximization

• Available technology is described by the production function

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The Firm’s Production Function
• 

• = output of consumption good

• = total factor productivity (TFP)
• = capital input
• = labour input measured in total hours worked (flexible)
• is a function

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Properties of the Firm’s Production Function
• Constant returns to scale
• Output increases with increases in either the labour input or the capital
input
• The marginal product of labour decreases as the labour input increases
• The marginal product of capital decreases as the capital input increases
• The marginal product of labour increases as the quantity of the capital
input increases

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Figure 4.13
Production Function, Fixing the Quantity of Capital and Varying the Quantity of Labour

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Figure 4.14
Production Function, Fixing the Quantity of Labour and Varying the Quantity of Capital

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Figure 4.15
Marginal Product of Labour Schedule for the Representative Firm

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Figure 4.16
Adding Capital Increases the Marginal Product of Labour

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Figure 4.17
Total Factor Productivity Increases

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Figure 4.18
Effect of an Increase in Total Factor Productivity on the Marginal Product of Labour

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What Could Cause Changes in TFP?
• Improvements in management
• Better managers use production inputs more efficiently
• Technological innovation
• Assembly line in automobile manufacturing introduced by Henry Ford
• Weather
• Higher crop yields, quicker construction
• Government regulations
• Requirements on pollution abatement equipment

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Total Factor Productivity and the Canadian
Aggregate Production Function
• Common
  production function: Cobb-Douglas where

• Good approximation of the actual Canadian aggregate prod. function:

• TFP cannot be measured directly, but it can be measured as a residual:

→ called the Solow residual

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Figure 4.19
The Solow Residual for Canada, 1961–2017

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Profit Maximization
•  Firms goal is to maximize profits
• Profits are given by total revenue (=output) minus variable costs:

• Profits are maximized when the marginal product of labour equals the
real wage:

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Figure 4.20
Revenue, Variable Costs, and Profit Maximization

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Figure 4.21
The Marginal Product of Labour Curve Is the Labour Demand Curve of the Profit-
Maximizing Firm

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