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

Macroeconomics, 6e (Williamson)
Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit
Maximization
4.1 Multiple-Choice Questions
1) A dynamic decision is one that

A) is made very quickly.
B) involves only the present.
C) involves only the future.
D) involves planning over more than one time period.
Answer: D
LO: 4.1: List the properties of the representative consumer's preferences, and explain why it is
useful to assume these properties.
Difficulty: moderate
Classification: concept
AACSB: application of knowledge
2) A static decision is one that

A) is made very slowly.
B) involves planning over one time period.
C) involves planning over exactly two time periods.
D) involves planning over more than one time period.
Answer: B
Difficulty: easy
3) It is useful to assume that there is a single representative consumer because

A) this is realistic.
B) this is a useful abstraction if we are interested in problems where distribution effects are not
important.
C) this is the only model we know how to work with.
D) a model with one consumer is the same as one with many consumers.
Answer: B
Classification: application
1
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4) The utility function captures
A) how consumers interact.
B) how an individual consumer ranks consumption bundles.
C) how output is produced from labor and capital inputs.
D) how happy a consumer is about a given consumption bundle.
Answer: B
5) Leisure includes all of the following except

A) sleep.
B) home yardwork.
C) market work.
D) recreational activities.
Answer: C
6) In macroeconomic analysis, the representative consumer

A) denotes the consumer with the average amount of income.
B) plays the role of a stand-in for all consumers in the economy.
C) is the consumer who bargains with firms for all workers in the economy.
D) is always a misleading fiction.
Answer: B
Difficulty: easy
7) A utility function
A) needs to measure the absolute level of happiness.
B) needs to measure relative amounts of happiness for a single individual.
C) helps compare the relative happiness of two separate consumers.
D) is most useful if it can be influenced by others.
Answer: B
Difficulty: difficult
2
8) We use indifference curves because
A) households on average do not care.
B) they help represent preferences.
C) households sometimes make mistakes.
D) they formalize the production process.
Answer: B
9) In the one-period model, what do we assume about household preferences?

A) Households prefer more to less.
B) Households like money.
C) Households dislike taxes.
D) Households care about others.
Answer: A
10) We assume that the representative consumer's preferences exhibit the properties that
A) they are convex and that more is always preferred to less.
B) more is always preferred to less and that each consumer has one strictly favorite good.
C) each consumer has one strictly preferred good and that consumption and leisure are both
normal goods.
D) consumption and leisure are both normal goods and that the consumer likes diversity in his or
her consumption bundle.
Answer: D
Difficulty: easy
3
11) A good is normal for a consumer if
A) it is always consumed in a consistent quantity.
B) its consumption rises when income rises.
C) its consumption falls when income rises.
D) some minimal level of the good must be consumed to assure the consumer's survival.
Answer: B
12) We assume leisure is a normal good. This implies that

A) an increase in taxes decreases the demand for leisure.
B) households maximize utility.
C) preferences over consumption are well defined.
D) an increase in the wage increases demand for leisure.
Answer: A
13) A consumption bundle

A) is a particular combination of consumption and leisure.
B) only measures a quantity of goods and services, but not the amount of leisure.
C) is a method of bringing home consumption goods.
D) measures the quality of a particular good.
Answer: A
14) The fact that indifference curves are downward sloping

A) is not true.
B) follows from the fact that more is preferred to less.
C) follows from the property that the consumer likes diversity in his or her consumption bundle.
D) follows from the property that consumption and leisure are normal goods.
Answer: B
AACSB: analytical thinking
4
15) The fact that indifference curves are bowed in toward the origin
A) is not true.
B) follows from the fact that more is preferred to less.
C) follows from the property that the consumer likes diversity in his or her consumption bundle.
D) follows from the property that consumption and leisure are normal goods.
Answer: C
Difficulty: easy
16) The property of diminishing marginal rate of substitution follows from the property that the
indifference curve is
A) downward sloping.
B) upward sloping.
C) bowed in toward the origin.
D) bowed out from the origin.
Answer: C
17) When consumers act as price-takers, we say that they behave

A) cooperatively.
B) competitively.
C) monopsonistically.
D) irrationally.
Answer: B
LO: 4.2: Construct the representative consumer's budget constraint.
18) A barter economy

A) cannot be a market economy.
B) is an economy without monetary exchange.
C) is an economy with no business firms.
D) is not a competitive economy.
Answer: B
5
19) A numeraire is
A) an average good.
B) a tax levied on each consumer.
C) a good used as a unit of account.
D) an optimal bundle of goods.
Answer: C
20) Which of the following is false?

A) A lump-sum tax does not depend on any action taken by a consumer.
B) In practice, no taxes are lump-sum.
C) Lump-sum taxes are realistic.
D) All taxes have distorting effects on the behavior of economic agents.
Answer: C
Difficulty: easy
21) The real wage denotes

A) the number of units of consumption goods that can be exchanged for one unit of labor time.
B) the number of units of labor time that can be exchanged for one unit of consumption goods.
C) the number of units of labor time that can be exchanged for one unit of leisure time.
D) the number of units of leisure time that can be exchanged for one unit of labor time.
Answer: A
22) A lump-sum tax is a tax that

A) can be avoided by strategic behavior.
B) does not depend on the actions of the economic agent being taxed.
C) does not depend on the actions of the government.
D) distorts economic decisions.
Answer: B
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23) A consumer's real disposable income equals
A) wage income plus consumption expenditures.
B) wage income plus profit income minus taxes.
C) total income minus profit income minus taxes.
D) total income minus wage income minus taxes.
Answer: B
24) With consumption on the vertical axis and leisure on the horizontal axis, the slope of the
budget line is equal to
A) w.
B) -w.
C) π.
D) -π.
Answer: B
25) If dividend income increases, the following does not happen:

A) the consumer chooses to consume more leisure.
B) the consumer chooses to consume more consumption goods.
C) the budget constraint shifts to the right.
D) the substitution effect exceeds the income effect.
Answer: D
Difficulty: easy
26) The household budget constraint may have a kink because

A) there is uncertainty.
B) households prefer diversity.
C) households may substitute consumption for leisure, or the reverse.
D) leisure is limited by the number of available hours.
Answer: D
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27) Saying the consumer is rational means
A) the consumer is a stand-in for all consumers.
B) the consumer is getting rationed.
C) the consumer makes reasonable choices.
D) the consumer makes the best choices.
Answer: D
LO: 4.3: Show how the consumer optimizes given his or her budget constraint to determine
labor supply and consumption.
28) A positive, pure income effect can be obtained by

A) increasing the real wage.
B) increasing the tax.
C) increasing the dividend.
D) decreasing leisure.
Answer: C
29) When consumption and leisure are both normal goods, after an increase in real dividend
income minus taxation, the rational consumer
A) increases consumption and increases labor supply.
B) increases consumption and reduces labor supply.
C) reduces consumption and increases labor supply.
D) reduces consumption and reduces labor supply.
Answer: B
LO: 4.4: Determine the effects of changes in the representative consumer's environment on his
or her choices.
8
30) If consumption and leisure are perfect complements for the consumer
A) an increase in the real wage causes the consumer to substitute consumption for leisure.
B) an increase in the real wage causes the consumer to substitute leisure for consumption.
C) an increase in dividend income has no effect on the ratio of consumption to leisure.
D) the effect of an increase in dividend income depends on whether consumption is normal.
Answer: C
or her choices.
Difficulty: easy
31) Theoretically, an increase in the real wage

A) increases leisure.
B) decreases leisure.
C) has an ambiguous effect on leisure.
D) has no effect on leisure.
Answer: C
or her choices.
32) The substitution effect measures

A) the responses of quantities to changes in the relative prices of goods.
B) the responses of relative prices to changes in the demand for goods.
C) how two goods can be used for the same purpose.
D) the responses of quantities to changes in the relative qualities of goods.
Answer: A
or her choices.
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33) The quantity of labor supplied
A) is similar to the supply for any other good or service, as quantity supplied increases with
price.
B) may decrease with the real wage, if the income effect is smaller than the substitution effect.
C) may increase with the real wage, if the substitution effect is larger than the income effect.
D) always decreases when the real wage increases.
Answer: C
or her choices.
34) A production function describes the

A) technological possibilities for converting factor inputs into outputs.
B) intellectual possibilities for converting factor inputs into outputs.
C) amount of resources available to the representative firm.
D) actual process of converting factor inputs into outputs.
Answer: A
LO: 4.5: List the properties of the production function, and explain why it is useful to assume
these properties.
35) The marginal product of a factor of production

A) is equal to the ratio of the amount of that factor of production to the amount of output
produced.
B) is equal to the amount of additional output that can be produced with one additional unit of
each factor input.
C) is equal to the amount of additional output that can be produced with one additional unit of
that factor input, holding constant the quantities of the other factor inputs.
D) always exceeds the average product of that factor input, holding constant the quantities of the
other factor inputs.
Answer: C
these properties.
Difficulty: easy
10
36) If there are increasing returns to scale in production
A) increasing capital with labor held constant reduces output.
B) increasing capital and labor in the same proportion reduces output.
C) increasing capital and labor in the same proportion increases output.
D) this is the same as constant returns to scale.
Answer: C
these properties.
37) As the quantity of labor increases, the marginal product of capital

A) is constant.
B) increases.
C) decreases.
D) may either increase or decrease.
Answer: B
these properties.
38) The assumption that the marginal product of labor decreases as the labor input increases
implies that
A) output decreases as the labor input increases.
B) the wage increases as the labor input increases.
C) the production function is concave.
D) the production function shifts upward.
Answer: C
these properties.
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39) The production function is concave in capital because
A) the contribution to production of each additional unit of capital decreases.
B) the marginal product of capital is increasing.
C) the marginal product of labor is decreasing.
D) the cost of loans increases with their quantity.
Answer: A
these properties.
40) An increase in total factor productivity could be the result of

A) adverse weather.
B) the addition of new machinery.
C) new hires.
D) the introduction of new manufacturing methods.
Answer: D
these properties.
Difficulty: easy
41) If the firm hires more labor, everything else held constant, then
A) the marginal product of labor falls.
B) output decreases.
C) there is an increase in the marginal product of labor.
D) total factor productivity falls.
Answer: A
these properties.
42) An increase in total factor productivity

A) changes neither the slope nor the position of the production function.
B) changes the slope but not the position of the production function.
C) changes the position but not the slope of the production function.
D) changes both the slope and the position of the production function.
Answer: D
these properties.
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43) The profit-maximizing quantity of labor equates the marginal product of labor with
A) total factor productivity.
B) the marginal product of capital.
C) the real wage.
D) the average product of labor.
Answer: C
LO: 4.6: Show how the representative firm optimizes given its production technology to
determine labor demand and output.
44) When the representative firm maximizes profits

A) production is at its maximum.
B) the slope of the production function is at its flattest.
C) labor costs are minimized.
D) the marginal product of labor equals the wage.
Answer: D
45) Labor demand is decreasing in the wage because

A) the substitution effect is larger than the income effect.
B) the income effect is larger than the substitution effect.
C) the marginal product of labor is decreasing in labor.
D) the marginal product of labor is increasing in labor.
Answer: C
LO: 4.7: Determine the effects of changes in the representative firm's environment on its labor
demand and output choices.
Difficulty: easy
13
4.2 True/False Questions
1) True or False: The consumer's indifference curves are concave.

Answer: FALSE
2) True or False: For a consumer, more is always preferred to less.

Answer: TRUE
Difficulty: easy
3) True or False: An indifference curve is downward sloping because of the consumer's

preference for diversity.
Answer: FALSE
4) True or False: The consumer's budget constraint is bowed in toward the origin.
Answer: FALSE
5) True or False: A lump sum tax is a tax that is independent of the consumer's actions.
Answer: TRUE
6) True or False: Dividend income depends on the consumer's behavior.

Answer: FALSE
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7) True or False: The consumer chooses a consumption bundle that is as close as possible to the
budget constraint, but not on it.
Answer: FALSE
Difficulty: easy
8) True or False: When the consumer optimizes, the marginal rate of substitution of leisure for
consumption equals the real wage rate.
Answer: TRUE
9) True or False: Given our assumptions about consumer preferences, the consumer could be
indifferent between two or more consumption bundles when he or she is optimizing.
Answer: FALSE
10) True or False: If taxes go down, then the consumer substitutes consumption for leisure.
Answer: FALSE
or her choices.
11) True or False: If dividend income declines, then consumption and leisure fall.
Answer: TRUE
or her choices.
15
12) True or False: If the real wage decreases, then consumption rises and leisure must fall.
Answer: FALSE
or her choices.
Difficulty: easy
13) True or False: Increasing returns to scale means that, if both factors of production double,
then output more than doubles.
Answer: TRUE
these properties.
14) True or False: If the firm has more capital, this causes the marginal product of labor to
decline.
Answer: FALSE
these properties.
15) True or False: As the labor input falls, holding constant the capital input, the marginal
product of labor increases.
Answer: TRUE
these properties.
16) True or False: The firm maximizes the welfare of its workers.
Answer: FALSE
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17) True or False: When the firm is optimizing, the marginal product of labor equals the market
real wage.
Answer: TRUE
Difficulty: easy
18) True or False: If the firm pays a proportional tax on its profits, this causes the firm's output to
fall.
Answer: FALSE
19) True or False: If the firm faces a higher real wage rate, it hires less labor.
Answer: TRUE
20) True or False: If total factor productivity decreases, then profits must go down for the firm.
Answer: TRUE
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4.3 Essay Questions
1) Show the indifference curves for a consumer who has, respectively, perfect substitutes
preferences and perfect complements preferences. Comment on how each set of preferences does
or does not satisfy standard properties that we assumed consumer preferences have.
Answer: Perfect substitutes preferences imply indifference cures that have constant marginal
rate of substitution — they are downward-sloping straight lines. These preferences satisfy more-
is-preferred to less, but do not satisfy preference for diversity, as the consumer does not care at
all about diversity in his or her consumption bundle. Perfect complements preferences are right
angles along a straight line from the origin. These preferences satisfy more-is-preferred to less.
With respect to preference for diversity, these preferences exhibit this property to an extreme.
Holding constant the consumption of one good and giving the consumer more of the other good
does not make him or her better off, but giving the consumer more of both goods always makes
him or her better off.
2) Explain why we assume that taxes are lump sum in our consumer behavior model. Are there
taxes in the real world that are lump sum? Why or why not?
Answer: Lump sum taxes are assumed simply because it makes our life easier as macro
modelers to assume that taxes are independent of the consumer's actions. But doing so in many
circumstances does not do much harm. In practice, essentially no taxes are lump sum. Sales taxes
and income taxes, for example, are all affected by how we behave — how much goods and
services we buy, or how hard we work. There is always some lump sum tax that some consumer
could not pay. And not being able to pay is determined by our actions. Thus, no tax can be lump
sum.
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3) Explain why optimization by the consumer should imply that the marginal rate of substitution
of leisure for consumption is equal to the market real wage.
Answer: The consumer optimizes by choosing the consumption bundle — the combination of
leisure and consumption goods — that makes him or her as well off as possible, while being
feasibility. Feasibility means that the consumption bundle must be inside the budget set, or on
the budget constraint. But a consumption bundle within the budget set is not optimal, as more is
preferred to less. Therefore, the consumer must be optimizing by choosing a consumption bundle
on the budget constraint. Suppose M is the marginal rate of substitution of leisure for
consumption and w is the real wage. If M > w, then the consumer could be better of by
consuming more leisure and less consumption goods, and if M < w, the consumer could be better
off by consuming less leisure and more consumption goods. Therefore, the consumer optimizes
by choosing a consumption bundle on the budget constraint with M = w.
4) What will a consumer do if dividend income falls?

Answer: This shifts in the budget constraint — it's a pure income effect. As a result, given that
both goods are normal, the consumer chooses to consume less and to take less leisure — he or
she works more.
or her choices.
Difficulty: easy
5) What will a consumer do if the real wage falls?

Answer: The consumer's response entails income and substitution effects. The fall in the real
wage shifts in the budget constraint, which is a negative income effect for the consumer, so this
will cause both consumption and leisure to fall. But, the fall in the real wage makes leisure
cheaper relative to consumption goods, so the consumer will substitute leisure for consumption.
On net, consumption must fall, but leisure could rise or fall, depending on the strength of the
opposing income and substitution effects.
or her choices.
Difficulty: easy
19
6) Suppose that the consumer receives a subsidy s for working, i.e. he or she gets s for each hour
of work. What is the effect on consumption and leisure?
Answer: The subsidy implies that the consumer now has an effective wage of w+s instead of w.
As a result, the consumer's budget constraint shifts out, and becomes steeper. There is a positive
income effect, which causes both consumption and leisure to increase. But consumption becomes
cheaper relative to leisure, so the consumer substitutes from leisure to consumption.
Consumption must go up, but leisure could rise or fall. The consumer may work more or less,
depending on whether the substitution effect is larger or smaller than the income effect.
or her choices.
7) Suppose that the firm produces output only with labor (no capital), and there is constant
returns to scale. Draw the production function, and explain why it takes the form it does.
Answer: If output is produced only with labor, then the production function is Y = zN, where Y
is output, N is the labor input, and z is total factor productivity. Therefore, the production
function is a straight line, and the marginal product of labor is a constant, z.
these properties.
8) Suppose that the there is a proportional tax on the firm's profits. Determine the effects on the
firm's labor demand decision.
Answer: If the firm has to pay a proportional tax on profits, then profits are given by (1-
t)[F(K,N) — wN]. Therefore, the fact that the firm is taxed will not affect its labor demand
decision, as the firm still maximizes profits by hiring labor to the point where the marginal
product of labor is equal to the real wage.
9) What is the effect of a decrease in total factor productivity on the firm's labor demand
decision?
Answer: If total factor productivity falls, then the marginal product of labor falls for each
quantity of labor input. The marginal product of labor curve is the firm's labor demand curve, so
the decrease in total factor productivity causes labor demand to fall for each real wage.
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10) Suppose that the firm receives a subsidy s for each unit of labor it hires. Determine the
effects on the firm's demand for labor.
Answer: This will work as if the wage fell to w - s from w. Since the firm's demand for labor
decreases when the real wage increases, the subsidy will increase the demand for labor for any
market real wage w.
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Macroeconomics, 6e (Williamson)

4.1 Multiple-Choice Questions

1) A dynamic decision is one that

2) A static decision is one that

3) It is useful to assume that there is a single representative consumer because

5) Leisure includes all of the following except

6) In macroeconomic analysis, the representative consumer

9) In the one-period model, what do we assume about household preferences?

12) We assume leisure is a normal good. This implies that

13) A consumption bundle

14) The fact that indifference curves are downward sloping

17) When consumers act as price-takers, we say that they behave

18) A barter economy

20) Which of the following is false?

21) The real wage denotes

22) A lump-sum tax is a tax that

25) If dividend income increases, the following does not happen:

26) The household budget constraint may have a kink because

28) A positive, pure income effect can be obtained by

31) Theoretically, an increase in the real wage

32) The substitution effect measures

34) A production function describes the

35) The marginal product of a factor of production

37) As the quantity of labor increases, the marginal product of capital

40) An increase in total factor productivity could be the result of

42) An increase in total factor productivity

44) When the representative firm maximizes profits

45) Labor demand is decreasing in the wage because

1) True or False: The consumer's indifference curves are concave.

2) True or False: For a consumer, more is always preferred to less.

3) True or False: An indifference curve is downward sloping because of the consumer's

6) True or False: Dividend income depends on the consumer's behavior.

4) What will a consumer do if dividend income falls?

5) What will a consumer do if the real wage falls?

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