Consumer and Firm Behavior

Question 1

Dynamic vs static decisions

Answer 1

• Dynamic decision making involves planning over more than one period
• Static decision making decision for one period only without planning ahead

Question 2

The representative consumer

Answer 2

• The representative consumer is a stand-in for the many consumers that exist in an actual economy.
• Formally, having one representative consumer is identical to having many consumers who are all the same, in a competitive equilibrium model.
• The basic working parts are the consumer’s preferences and his or her budget constraint.
• Once we have that set up, we can ask what the consumer does when he or she optimizes, treating market prices as given.

Question 3

The representative consumer’s indifference curves

Answer 3

• Defined over 2 goods: Consumption & Leisure
• Each indifferent curve represents a set of consumption bundles for which the consumer is indifferent
• Properties:
  
  • More is preferred to less (Indifference curves slope downwards)
  • The consumer has a preference for diversity in his or her consumption bundle (Indifference curve is convex)
  • Consumption and leisure are normal goods (quantity of the good purchased increases when income increases)
• The marginal rate of substitution of leisure for consumption, denoted MRC l,C is the rate at which the consumer is just willing to substitute leisure for consumption goods

Question 4

Barter economy

Answer 4

• Economy without monetary exchange

Question 5

The Consumer’s Time Constraint

Answer 5

• l + N^s = h
• l ~ leisure supply
• N^s ~ labour supply
• h ~ hours of time available

Question 6

The Consumer’s Budget Constraint

Answer 6

• C = wN^s + π – T
  
  • The quantity on the right-hand side of the equation is disposable income, equal to wage income plus dividend income received from the representative firm, minus lump-sum taxes paid to the government. Note that the consumer chooses consumption and hours of work, treating the market wage, dividend income, and taxes as given.
• C = w(h-l) + π – T
  
  • If we substitute the time constraint in the budget constraint, we get a budget constraint written in terms of the two goods we are interested in – consumption and leisure.
• C + wl = wh + π – T
  
  • In this form, effective expenditure is on the left-hand side of the equation, and effective income is on the right-hand side. That is, the effective price of leisure is the real wage w, as this is the opportunity cost of leisure. On the right-hand side, the real wage w is also the price of the endowment of time the consumer has.
• C=-wl+wh+ π-T
  
  • This is just the budget constraint in slope-intercept form with slope = -w and y-intercept = wh+ π-T

Question 7

Study graphs p 128, 129

Answer 7

Study graphs p 128, 129

Question 8

Consumer optimization

Answer 8

• The consumer chooses the consumption bundle that is on his or her highest indifference curve, while satisfying his or her budget constraint (Rational consumer)
• MRC l,C = w
• It’s theoretically possible that there is a corner solution at B (kink), where the consumer does not work. This can’t happen when we put the whole model together though, as if the consumer does not work there is no dividend income to consume.

Question 9

Real Dividends or taxes change for the consumer

Answer 9

• Assume that consumption and leisure are both normal goods.
• An increase in dividends or a decrease in taxes will then cause the consumer to increase consumption and reduce the quantity of labor supplied (increase leisure).
• It is a pure income effect because prices remain the same while Y^d increases

Question 10

An increase in the market real wage rate

Answer 10

• 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.

Question 11

Labour supply curve

Answer 11

• Tells us how much labour the representative consumer wishes to supply at any given wage rate
• N^s(w) = h – l(w)
• If substitution effect > income effect  Upward sloping; and vice versa
• If dividend income increases, this is a pure income effect which increases leisure and reduces labor supply for any real wage. (Shifts to the left)

Question 12

Perfect complements

Answer 12

• No substitution effects, only income effect
• Perfect complements indifference curves are right angles along the line C/l = a, where a is the fixed proportion that the consumer wishes for consumption and leisure.
• Formulas bl 142

Question 13

The Representative Firm

Answer 13

The production function (production technology available)

Profit maximization and labor demand.

Question 14

The firm’s production function

Answer 14

• Y = zF(K, N^d)
• z ~ total factor productivity
• Y ~ Output of consumption goods
• K ~ Quantity of capital input
• N^d ~ Variable factor of production

Question 15

Marginal Product

Answer 15

• The marginal product of a factor of production is the additional output that can be produced with one additional unit of that factor input, holding constant the quantities of the other factor inputs

Question 16

Properties of the firm’s production function

Answer 16

• Constant returns to scale.
• Output increases with increases in either the labor input or the capital input.
• The marginal product of labor decreases as the labor input increases.
• The marginal product of capital decreases as the capital input increases.
• The marginal product of labor increases as the quantity of the capital input increases. (Shift MPl curve upwards)

Question 17

Adding capital

Answer 17

• Increases the Marginal Product of Labor for any quantity of labor input (MPn shifts upwards)

Question 18

Total Factor Productivity Increases

Answer 18

• An increase in z shifts up the production function upwards and increases its slope for any labor input.
• An increase in z also shifts MP of labor rightwards
• Weather, technology and government regulations can cause a change in z

Question 19

Profit Maximization

Answer 19

• MPn = w
  Maximize π= zF(K, N^d) – wN^d
• We assume that the firm maximizes profits.
• The firm has a stock of capital that it cannot change in the short run, and chooses the quantity of labor input so as to maximize profits, assuming the firm sells its output in a competitive market
• One extra unit of labor input costs the firm w, and the firm produces an extra quantity of output equal to the marginal product of labor
• The firm will keep producing more as long as adding more labor to the production process is profitable
• At the point where the real wage equals the marginal product of labor, the firm is optimizing.
• Figure p 154
• Since the marginal product of labor equals the real wage when the firm maximizes profits, the marginal product of labor schedule is the firm’s demand curve for labor. The curve tells us how much labor the firm will hire given any market wage.