Macroeconomic Analysis I

Topic 3

Firm Optimization, Competitive Equilibrium,

Goods Market Equilibrium

( Williamson: Chapter 11
Abel, Bernanke & Croushore: Chapter 4 )

1
 Learning Objectives
• Discuss the two-period model of the firm

• Examine profit maximization by the firm in the two-period model

• Examine the optimal investment rule for the firm in the two-period
model

• Examine competitive equilibrium

• Examine goods market equilibrium

2
 The Representative Firm
• Consider the representative firm in the economy which demands labour
and undertakes investment in production

• We can describe the production technology to each firm by a production

function, which describes the technological possibilities for converting
factor inputs into outputs
Y = AF(K, N)
where A is the total factor productivity
Y is the output of consumption goods
K is the quantity of capital input
N is the quantity of labour input
F is the production function

3
Firm’s Current and Future Production in a Two-period Model
𝑌1 = 𝐴1 𝐹 𝐾1 , 𝑁1
𝑌2 = 𝐴2 𝐹 𝐾2 , 𝑁2

where 𝑌1 = output in period 1

𝐾1 = amount of capital in period 1
𝑁1 = quantity of labour in period 1
𝑌2 = output in period 2
𝐾2 = amount of capital in period 2
𝑁2 = quantity of labour in period 2

4
 Evolution of the Firm’s Capital Stock
𝐾2 = 1 − 𝑑 𝐾1 + 𝐼1

where 𝑑 = depreciation rate

𝐾1 = amount of capital in period 1
𝐾2 = amount of capital in period 2
𝐼1 = Investment in period 1

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 Capital Stock and Investment
Given that 𝐾2 = 𝐼1 + 1 − 𝑑 𝐾1

It follows that
𝐼1 = 𝐾2 − 𝐾1 + 𝑑𝐾1

 Thus investment (𝐼1 ) has two parts

• Net increase in the capital stock 𝐾2 − 𝐾1

• Investment needed to replace depreciated capital (dK1)

6
 Profit Maximization by Firm in Two-period Model
Consider a 2-period model in which the firm’s objective is to maximize the present
value of profits over the current and future periods.
π2
πtotal = π1 +
1+ r

In maximizing the present value of profits, the firm chooses the number of workers to
hire (N) in period 1 and period 2 and the quantity of investment (I) in period 1
Production function: Yt = AtF(𝐾 t , Nt) where t = 1, 2

Moreover, 𝐾2 = (1− d) 𝐾 1 + I1

Assumptions:
(a) The firm can produce 1 unit of capital using 1 unit of output (one-for-one
conversion between output and capital)
(b) Price of capital = 1
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 Profit Maximization by the Firm
For the 2-period model of the firm:
• In period 1, to produce Y1 (output), the firm chooses N1 (labour) and I1 (investment)
• Selecting I1 in period 1 effectively implies that K2 of capital will be employed in period 2
• In period 2, the firm chooses N2 (labour) which is combined with K2 (capital) to produce
output Y2
• At the end of period 2, the firm is liquidated and sells off the depreciated capital (1− d) 𝐾 2
which is equivalent to the same amount of output that adds to profits in period 2

Hence,
First-period profits: 𝜋1 = 𝑌1 − 𝑤1 𝑁1 − 𝐼1
Second period profits: 𝜋2 = 𝑌2 − 𝑤2 𝑁2 + 1 − 𝑑 𝐾2
where d is the depreciation rate, 𝑤1 is the wage rate in the first period and 𝑤2 is the wage
rate in the second period

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 Firm’s Profits in the First and Second Periods
In the first period, the firm’s profits (𝜋1 ) is given by,
𝜋1 = 𝑌1 − 𝑤1 𝑁1 − 𝐼1
st
1st period 1 period 1st period
Production Wage Investment
Cost
In the second period, the firm’s profits (𝜋2 ) is given by,
𝜋2 = 𝑌2 − 𝑤2 𝑁2 + 1 − 𝑑 𝐾2

2nd period 2nd period 2nd period

Production Wage Capital
Cost After Depreciation
The firm maximizes the present value of total profits (𝜋𝑡𝑜𝑡𝑎𝑙 ),
𝜋2
𝜋𝑡𝑜𝑡𝑎𝑙 = 𝜋1 +
1+𝑟

1st period Present Value of

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Profit 2nd period Profit
 Profit Maximization by the Firm
Given that the present value of total profits (𝜋𝑡𝑜𝑡𝑎𝑙 ) is given by:
𝜋2
𝜋𝑡𝑜𝑡𝑎𝑙 = 𝜋1 +
1+𝑟

𝑌2 − 𝑤2 𝑁2 + 1 − 𝑑 𝐾2
𝜋𝑡𝑜𝑡𝑎𝑙 = 𝑌1 − 𝑤1 𝑁1 − 𝐼1 +
1+𝑟

𝑌2 − 𝑤2 𝑁2 + 1 − 𝑑 𝐾2
= 𝑌1 − 𝑤1 𝑁1 − (𝐾2 − 𝐾1 + 𝑑𝐾1 ) +
1+𝑟

The firm has to determine the optimal quantity of the variables: N1 , 𝑁2 and 𝐾 2

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 Profit Maximization by the Firm
With 𝑌1 = 𝐴1 𝐹(𝐾1 , 𝑁1 ) and 𝑌2 = 𝐴2 𝐹(𝐾2 , 𝑁2 )

𝑌2 − 𝑤2 𝑁2 + 1 − 𝑑 𝐾2
𝜋𝑡𝑜𝑡𝑎𝑙 = 𝑌1 − 𝑤1 𝑁1 − 𝐾2 − 𝐾1 + 𝑑𝐾1 +
1+𝑟
First-order condition w.r.t. 𝑁1 ,
𝜕𝜋𝑡𝑜𝑡𝑎𝑙 𝜕𝑌1
= − 𝑤1 = 0
𝜕𝑁1 𝜕𝑁1
𝜕𝑌1
⟹ = 𝑤1
𝜕𝑁1
𝜕𝑌1
𝑀𝑃𝑁1 = = 𝑤1
𝜕𝑁1

Thus, the firm will choose the quantity of labour (𝑁1 ) in period 1 at that point
where marginal product of labour in period 1 is equal to the wage rate in period 1
(𝑀𝑃𝑁1 = 𝑤1 ) 11
 Profit Maximization by the Firm
With 𝑌1 = 𝐴1 𝐹(𝐾1 , 𝑁1 ) and 𝑌2 = 𝐴2 𝐹(𝐾2 , 𝑁2 )

𝑌2 − 𝑤2 𝑁2 + 1 − 𝑑 𝐾2
𝜋𝑡𝑜𝑡𝑎𝑙 = 𝑌1 − 𝑤1 𝑁1 − 𝐾2 − 𝐾1 + 𝑑𝐾1 +
1+𝑟
First-order condition w.r.t. 𝑁2 ,
𝜕𝜋𝑡𝑜𝑡𝑎𝑙 1 𝜕𝑌2
= − 𝑤2 = 0
𝜕𝑁2 1 + 𝑟 𝜕𝑁2
𝜕𝑌2
⟹ = 𝑤2
𝜕𝑁2
𝜕𝑌2
𝑀𝑃𝑁2 = = 𝑤2
𝜕𝑁2

Thus, the firm will choose the quantity of labour(𝑁2 ) in period 2 at that point where
marginal product of labour in period 2 is equal to the wage rate in period 2
(𝑀𝑃𝑁2 = 𝑤2 )
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 Profit Maximization by the Firm
With 𝑌1 = 𝐴1 𝐹(𝐾1 , 𝑁1 ) and 𝑌2 = 𝐴2 𝐹(𝐾2 , 𝑁2 )

𝑌2 − 𝑤2 𝑁2 + 1 − 𝑑 𝐾2
𝜋𝑡𝑜𝑡𝑎𝑙 = 𝑌1 − 𝑤1 𝑁1 − 𝐾2 − 𝐾1 + 𝑑𝐾1 +
1+𝑟
First-order condition w.r.t. 𝐾2 ,
𝜕𝜋𝑡𝑜𝑡𝑎𝑙 1 𝜕𝑌2
= −1 + + 1−𝑑 =0
𝜕𝐾2 1 + 𝑟 𝜕𝐾2
𝜕𝑌2
⟹ −𝑑 =𝑟
𝜕𝐾2

⟹ 𝑀𝑃𝐾2 − 𝑑 = 𝑟
Thus, the firm will choose the amount of capital (𝐾2 ) in period 2 at that point where
the net marginal product of capital 𝑀𝑃𝐾2 − 𝑑 is equal to the real interest rate 𝑟 .
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 Optimal Capital for the Firm
𝑟

𝑟 = 𝑀𝑃𝐾2 − 𝑑

𝑟 = 𝑟 ∗ (𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)

𝑟∗

𝐾2∗ 𝐾2 = 𝐼1 + 1 − 𝑑 𝐾1
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 The Representative Firm’s Investment Decision
We could explain the firm’s choice of 𝐾2 in terms of the optimal investment rule
for the firm whereby the firm invests to the point where the marginal benefit
from investment equals the marginal cost.

The marginal cost of investment is 1, as the firm gives up one unit of current
profits for each unit it invests, so:
𝑀𝐶 𝐼 = 1

The marginal benefit of investment is the marginal product of capital in period 2

plus the quantity of capital that will be left in the period 2 after depreciation, all
discounted back to the present:
𝑀𝑃𝐾2 + 1 − 𝑑
𝑀𝐵 𝐼 =
1+𝑟

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 Optimal Investment Rule for the Firm
The firm’s optimal investment rule, obtained by equating the marginal benefit and
marginal cost of investment:

𝑀𝑃𝐾2 − 𝑑 = 𝑟

Hence, the firm invests such that the net marginal product of capital in period 2
(𝑀𝑃𝐾2 − 𝑑) is equal to the real interest rate

16
 Adding the Firm’s Profits to Consumer Budget Constraint
Assumption: Consumer owns the firm
• As consumer owns the firm, he will receive dividends of π1 in period 1 and π2 in
period 2

• Moreover, consumer has to pay lump sum taxes of t1 in period 1 and t2 in period 2

Hence, the consumer’s budget constraint in period 1:

c1 + 𝑠1 = 𝑦1 + π1 − t1

Also, the consumer’s budget constraint in period 2:

c2 = 𝑦2 + π2 + (1 + r) 𝑠1 − t2

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Adding the Firm’s Profits to Consumer Budget Constraint
From the consumer’s budget constraint in period 1:
𝑠1 = 𝑦1 + 𝜋1 − 𝑡1 − 𝑐1
Consequently, the budget constraint for period 2 becomes:
𝑐2 = 𝑦2 + 𝜋2 + 1 + 𝑟 𝑦1 + 𝜋1 − 𝑡1 − 𝑐1 − 𝑡2
1 + 𝑟 𝑐1 + 𝑐2 = 1 + 𝑟 𝑦1 + 𝜋1 − 𝑡1 + (𝑦2 + 𝜋2 − 𝑡2 )
Dividing throughout by (1+r), we have,
𝑐2 𝑦2 + 𝜋2 − 𝑡2
𝑐1 + = 𝑦1 + 𝜋1 − 𝑡1 +
1+𝑟 1+𝑟
𝑐2 𝑦2 𝜋2 𝑡2
𝑐1 + = 𝑦1 + + 𝜋1 + − 𝑡1 +
1+𝑟 1+𝑟 1+𝑟 1+𝑟

PV of lifetime PV of lifetime PV of lifetime PV of lifetime

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consumption income dividends taxes
 Competitive Equilibrium
• In the real intertemporal model
• The representative consumer supplies labour in current-period labour market
and demands consumption goods in the current-period goods market.

• The representative firm demands labour in the current period, supplies goods
in the current period and demands investment goods in the current period.

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 Determination of Equilibrium in the Labour Market
Given the Real Interest Rate r
• For a given real interest rate r, the demand and supply in the labour market
determine the market clearing real wage 𝑤 ∗ and the quantity of labour 𝑁 ∗ .

• Given 𝑁 ∗ , the production function determines output 𝑌 ∗ .

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Determination of Equilibrium in the Labour Market
Given the Real Interest Rate r
𝑤
𝑁𝑑 𝑁 𝑠 (𝑟)

𝑤∗

(𝑎) 𝑁∗ 𝑁
𝑌
𝑌 = 𝑧 ⋅ 𝐹(𝐾, 𝑁)
𝑌∗

(𝑏) 𝑁∗ 𝑁 21
 Determination of Equilibrium in the Labour Market
Given the Real Interest Rate r
• An increase in the real interest rate shifts the labour supply curve to the right because the
representative consumer faces a higher return on his saving so he works more in the current
period and saves the proceed so that he can consume more in the future.

• As shown in panel (a), a higher interest rate (from 𝑟1 to 𝑟2 ) shifts the labor supply curve
right, thereby resulting in an increase in the equilibrium labour supplied from 𝑁1 to 𝑁2

• In panel (b), an increase the quantity of labour in equilibrium results in an increase output
by the firms.

• So, higher real interest rate is associated with higher output, due to the intertemporal
substitution effect.

• Therefore the output supply curve in upward sloping as shown in panel (c)
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 Construction of the Output Supply Curve
𝑤 𝑁𝑑 𝑁1𝑠 (𝑟1 )

𝑁2𝑠 (𝑟2 )
𝑤1
𝑤2 𝑟 𝑌𝑠

(𝑎) 𝑁1 𝑁2 𝑁
𝑟2
𝑌 𝑟1
𝑌2
𝑌1 𝑌 = 𝑧 ⋅ 𝐹(𝐾, 𝑁)
𝑌1 𝑌2 𝑌
(𝑐)

(𝑏) 𝑁1 𝑁2 𝑁 23
 The Demand for Current Goods
• Demand for current goods comprise of 3 components:
• Consumption demand as a function of real interest rate 𝐶 𝑑 𝑟
• Investment demand as a function of real interest rate 𝐼 𝑑 𝑟
• Government spending 𝐺

• Where the curve intersects the 45 degree line is determines the level of income
that just supports total demand for that level of income (that is: demand for current
goods = income).

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 The Demand for Current Goods

45° line

Demand for Current Goods

𝐶 𝑑 𝑟 + 𝐼𝑑 𝑟 + 𝐺
𝑆𝑙𝑜𝑝𝑒 = 𝑀𝑃𝐶
𝑌1

𝑌1
𝑌 = Current Income
25
 Construction of the Output Demand Curve
• A higher real interest rate (from 𝑟1 to 𝑟2 ) reduces the demand for consumption and
investment goods, shifting the curve down in the left-hand panel (a).

• This, in turn, determines a lower level of total demand for output and current
income, which falls from 𝑌1 to 𝑌2 .

• Therefore, the output demand curve is downward sloping.

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 Construction of the Output Demand Curve

Demand for Current Goods

𝑟 = Real Interest Rate

45° line 𝑌𝑑

𝐶 𝑑 𝑟1 + 𝐼𝑑 𝑟1 + 𝐺
𝑌1
𝑟2

𝐶 𝑑 𝑟2 + 𝐼𝑑 𝑟2 + 𝐺
𝑌2
𝑟1

𝑌2 𝑌1 𝑌2 𝑌1
(𝑎) (𝑏)
𝑌 = Current Income 𝑌 = Current Income

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 The Complete Real Intertemporal Model

𝑤 = Current Real Wage

𝑟 = Real Interest Rate

𝑑 𝑌𝑑 𝑌𝑠
𝑁 𝑁 𝑠 (𝑟 ∗ )

∗
𝑟∗
𝑤

𝑁∗ 𝑌∗
(𝑎) (𝑏)
𝑁 = Current Employment 𝑌 = Current Output

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 The Complete Real Intertemporal Model
• The model shows the complete real intertemporal model.

• The left panel is the labour market, and the right panel is the goods market.

• The real wage and employment are determined by the intersection of the labour
supply and demand curves, given the real interest rate r.

• The current aggregate output and real interest rate are determined by the
intersection of the output supply and demand curves.

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 Competitive Equilibrium
Given that the government budget constraint (GBC) holds, a competitive
equilibrium is an allocation {Ct*, St* NtS*, NtD*, It*} and prices {rt*, wt*} for all t such
that:

• The representative consumer maximizes utility by choosing {Ct*, St* NtS*} each
period taking {rt*, wt*} as given

• The representative firm maximizes present value of profits by choosing {NtD*, It*}
taking {rt*, wt*} as given

• The labour market clears at wt* (i.e. NtS* = NtD* = Nt*)

• The goods market clears at rt* (i.e. good supplied = goods demanded each period)

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 Goods Market Equilibrium
With our understanding of the behaviour of consumers and firms in optimizing
consumption and investment, we can examine goods market equilibrium

The real interest rate adjusts to bring the goods market into equilibrium
 Y = Cd + Id + G
goods market equilibrium condition

 Cd = desired consumption by consumers which maximizes lifetime utility subject to

the lifetime budget constraints

 Id = desired investment by firms which maximizes present value of profits

 The goods market is in equilibrium when the aggregate quantity of goods supplied
by firms (Y) equals the aggregate quantity of goods demanded (Cd + Id + G)
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 Goods Market Equilibrium
Alternative representation: since
Sd = Y – Cd – G,
Hence,
Sd = Id

Thus, the alternative way of writing the goods market equilibrium condition says
that the goods market is in equilibrium when desired national savings ( Sd ) equals
desired investment ( Id )

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Goods market equilibrium

33
 Goods Market Equilibrium
The saving-investment diagram
o Equilibrium where Sd = Id
o The goods market equilibrium is established through the adjustment of r

Components of Aggregate Demand for Goods (An Example)

34
 Goods Market Equilibrium
Shifts of the saving curve
 Consider an increase in government purchases which shifts S leftwards

The initial equilibrium is at E where the real interest rate is 6% and desired
national saving and desired investment both equal 1000

At the new goods market equilibrium, the real interest rate is 7%, and saving and
investment both fall to 850
o Saving falls because the initial decrease in desired saving is only partially offset
by the higher saving due to the higher interest rate
o Investment falls because the higher real interest rate increases the cost of capital

 Crowding out of investment by increased government purchases

35
A decline in desired saving

36
 Goods Market Equilibrium
Shifts of the investment curve

Consider the case where the Investment curve (I) shifts right

The goods market equilibrium point moves from E to G

The real interest rate rises from 6% to 8% because increased demand for
investment funds causes the real interest rate to be bid up

Saving and investment increase from 1000 to 1100

The higher saving reflects the willingness of savers to save more when the real
interest rate rises.

37
An increase in desired investment

38