Lecture 4

• Recall that we are interested in learning about

models

• In this chapter, we will learn about

– behavior of the representative consumer

– behavior of the representative firm

4-1

4-2

Representative Consumer

• Consumer’s preferences over consumption and leisure as represented by indifference curves.

• Consumer’s budget constraint.

• 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?

Let’s first look at the consumer preferences

4-4

Representative Consumer’s

Indifference Curves

• An indifference curve connects a set

of points, representing consumption

bundles among which the consumer

is indifferent

• An indifference curve slopes

downward (more is preferred to

less).

• An indifference curve is convex (the

consumer has a preference for

diversity in his or her consumption

bundle).

4-5

Properties of Indifference

Curves

• Marginal rate of substitution

of leisure for consumption:

the rate at which the

consumer is willing to

substitute consumption goods

for leisure

• For example, if MRS = 2, the

consumer is willing to give up

2 units of consumption to

obtain one unit of leisure

Now let’s look at the constraints that the consumer

faces

4-7

The consumer’s time constraint

Leisure and hours worked (labor supply) is equal to

available time.

4-8

The consumer’s budget

constraint

Consumption is equal to total wage income, plus

dividend income, minus taxes (lump-sum).

LHS: Total expenditure

RHS: Real disposable income

4-9

Budget constraint rewritten

4-10

Budget constraint rewritten

slope intercept

4-11

Representative Consumer’s Budget

Constraint (T > π)

• Consumer’s BC when taxes

are greater than consumer’s

dividend income.

• Slope of BC = -w

• Constraint shifts with nonwage

real disposable income: π -T

4-12

Representative Consumer’s Budget

Constraint (T < π)

• Consumer’s BC when taxes

are less than consumer’s

dividend income.

• Slope of BC = -w in upper

portion, vertical in lower portion

• Because consumer cannot

consume more than h hours of

leisure

4-13

Consumer Optimization

The consumer chooses the

Optimal consumption bundle

that is on his or her highest

indifference curve, while

satisfying his or her budget

constraint.

4-14

Consumer Optimization

• The marginal rate of

substitution of leisure for

consumption equals the

real wage.

• What if MRS > w?

4-15

Consumer Optimization

• The marginal rate of

substitution of leisure for

consumption equals the

real wage.

• What if MRS > w?

– Consumer values leisure

more than the opportunity

cost more leisure

4-16

Consumer Optimization

• The marginal rate of

substitution of leisure for

consumption equals the

real wage.

• What if MRS < w?

4-17

Consumer Optimization

• The marginal rate of

substitution of leisure for

consumption equals the

real wage.

• What if MRS < w?

– Consumer values leisure

less than the opportunity

cost less leisure

4-18

The Representative Consumer

Chooses Not to Work

If the representative

consumer chooses not

to work, then the firm

cannot meet their labor

demand

Not consistent

Comparative Statics

• What if real dividends increase or taxes

decrease?

• What if real wages increase?

4-19

4-20

An Increase in π − T for the

Consumer

• consumption and leisure are both

normal goods.

(A good is normal if the quantity of

goods that s/he purchases

increases when income increases)

• An increase in dividends or a

decrease in taxes then causes the

consumer to increase consumption

and leisure (reduce the quantity of

labor supplied).

4-21

An increase in the market real

wage rate

• This has income and substitution effects.

• Substitution effect: 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.

4-22

Increase in the Real Wage Rate—

Income and Substitution Effects

F 0: substitution effect

F and O are on same

indifference curve. Captures

substitution from leisure to

consumption

4-23

Increase in the Real Wage Rate—

Income and Substitution Effects

O H: income effect

EB and JK have the same

slope. Captures increase in

consumption and leisure in

response to pure income

effect

4-24

Increase in the Real Wage Rate—

Income and Substitution Effects

F 0: substitution effect

O H: income effect

Consumption increases, leisure

may rise or fall

4-25

Increase in the Real Wage Rate—

Income and Substitution Effects

What happens when the

substitution effect is

larger than the income

effect?

- Then working hours are

increasing in real wages

4-26

Labor Supply Curve

Labor supply curve here is

upward sloping, implying the

assumption that the

substitution effect of the real

wage is larger than the

income effect

4-27

Effect of an Increase in Dividend

Income or a Decrease in Taxes

Income effect!

For every wage level, an

increase in non-labor

income reduces

employment

4-28

Any questions?

We are now ready to look at handout 1!