Econ 2Hh3: Intermediate Macroeconomics II: Winter 2021 Bettina Brüggemann & Marc-André Letendre

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
(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 4

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
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?

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:
Consumer’s Preferences
• Consumption
bundle:
• is strictly preferred to if
• is strictly preferred to if
• Consumer is indifferent if
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.

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)

Figure 4.1
Indifference Curves
Copyright © 2018 Pearson Canada Inc.

Figure 4.2
Properties of Indifference Curves

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

Figure 4.2
Properties of Indifference Curves

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:

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

Consumer’s Budget Constraint (cont’d)
• Substituting time constraint:
• Put differently:
→ Compares implicit expenditure to implicit real disposable income
• Or (convenient for graph):

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

Figure 4.4
Representative Consumer’s Budget Constraint T  

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:

Figure 4.5
Consumer Optimization

Figure 4.6
The Representative Consumer Chooses Not to Work

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

Figure 4.7
An Increase in the Consumer’s Dividend Income

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

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

Figure 4.10
Labour Supply Curve Labour supply curve:

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

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

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

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

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

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

Figure 4.15
Marginal Product of Labour Schedule for the Representative Firm

Figure 4.16
Adding Capital Increases the Marginal Product of Labour

Figure 4.17
Total Factor Productivity Increases

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

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

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

Figure 4.19
The Solow Residual for Canada, 1961–2017

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:

Figure 4.20
Revenue, Variable Costs, and Profit Maximization

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

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ECON 2HH3:

Bettina Brüggemann & Marc-André Letendre

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 4

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

• Consumer: trade-off between work and leisure

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 6

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

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 9

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 10

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

• Convex indifference curve implies that is diminishing

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 13

Copyright © 2018 Pearson Canada Inc.

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

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 15

• Budget constraint: Total consumption equals real disposable income

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 16

→ Compares implicit expenditure to implicit real disposable income

• Or (convenient for graph):

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 17

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

• The consumer is rational:

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 20

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

• Pure income effect: Disposable income increases without change in

• Both consumption and leisure are normal goods:

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 23

Copyright © 2018 Pearson Canada Inc.

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

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

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

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

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

• Available technology is described by the production function

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 29

• = output of consumption good

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 30

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 31

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 38

• 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

Copyright © 2018 Pearson Canada Inc.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 41

Copyright © 2018 Pearson Canada Inc.

Copyright © 2018 Pearson Canada Inc.

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