Chapter 4

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

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Chapter 4 Topics

• Behavior of the representative consumer

• Behavior of the representative firm

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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?

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Representative Consumer’s
Indifference Curves

• 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).

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Figure 4.1
Indifference Curves

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Figure 4.2
Properties of Indifference Curves

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The Consumer’s Time Constraint

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The Consumer’s Budget Constraint

• Consumption is equal to total wage income, plus dividend

income, minus taxes.

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The Consumer’s Budget Constraint,
Accounting for the Time Constraint

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Rewriting the Budget Constraint

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Rewriting the Budget Constraint Again

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Figure 4.3
Representative Consumer’s Budget Constraint
when T > π

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Figure 4.4
Representative Consumer’s Budget Constraint
when T < π

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Consumer Optimization

The consumer chooses the consumption bundle that is on his

or her highest indifference curve, while satisfying his or
her budget constraint.

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Figure 4.5
Consumer Optimization

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Optimization Implies:

The marginal rate of substitution of leisure for consumption

equals the real wage.

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Figure 4.6
The Representative Consumer Chooses
Not to Work

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Real Dividends or Taxes Change for
the Consumer

• 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).

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Figure 4.7
An Increase in π - T for the Consumer

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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.

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

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Figure 4.9
Labor Supply Curve

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Figure 4.10
Effect of an Increase in Dividend Income or a
Decrease in Taxes

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Figure 4.11
Perfect Complements

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The Representative Firm

• The production function.

• Profit maximization and labor demand.

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The Firm’s Production Function

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Properties of the Firm’s Production
Function

• 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.

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Figure 4.12
Production Function, Fixing the Quantity of Capital
and Varying the Quantity of Labor

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

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Figure 4.14
Marginal Product of Labor Schedule for the
Representative Firm

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Figure 4.15
Adding Capital Increases the Marginal Product of
Labor

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Figure 4.16
Total Factor Productivity Increases

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Figure 4.17
Effect of an Increase in Total Factor Productivity on
the Marginal Product of Labor

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Specific Production Function

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Solow Residual

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Figure 4.18
The Solow Residual for the United States

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Profit Maximization

When the firm maximizes profits, the marginal product of

labor equals the real wage.

MPN = w

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Figure 4.19
Revenue, Variable Costs, and Profit Maximization

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Figure 4.20
The Marginal Product of Labor Curve Is the Labor
Demand Curve of the Profit-Maximizing Firm.

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Productivity in the 2008-09 Recession

• Problem: Timely measures of total factor

productivity are not available, as we measure
the capital stock with a lag.
• Can get timely measures of average labor
productivity – closely related to total factor
productivity, but not the same thing.

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Average Labor Productivity

• Given our specific Cobb-Douglas production

function, average labor productivity is:
.36
Y K
= z 
N N

• Thus, average labor productivity is

proportional to TFP, but depends on the
capital/labor ratio.

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Puzzle

• In the 2008-09 recession, average labor

productivity has declined much less than in
typical recessions of the same severity.
• Why? Potential reasons are:
1. The causes of the 2008-09 recession are
different – housing sector problems and
problems in the financial system.
2. Long term shifts in employment across
sectors – from construction and
manufacturing to services.

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Figure 4.21
Average Labor Productivity

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Figure 4.22
Percentage Deviations from Trend in
Average Labor Productivity

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