CONSUMER AND FIRM BEHAVIOR: THE WORK-LEISURE

DECISION AND PROFIT MAXIMIZATION

CHAPTER 4
Consumer Optimization

▶ Once we have preferences and budget constraint, we next put them together to analyze
how the representative consumer behaves
▶ We assume that the consumer is rational i.e. the consumer knows his or her own
preferences and budget constraint and can evaluate which feasible consumption bundle is
best for him or her.
▶ The optimal consumption bundle is the point representing a consumption–leisure pair that
is on the highest possible indifference curve and is on or inside the consumer’s budget
constraint.

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Consumer Optimization
▶ First, the consumer would never choose a consumption bundle inside the budget
constraint, because the consumer prefers more to less (F vs J).
▶ The consumer would not choose any points along BD other than B, because more
consumption goods are preferred to less consumption goods.

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Consumer Optimization

▶ Optimal bundle is the point at which an indifference curve is tangent to AB

▶ At F, slope of the indifference curve is greater than slope of the budget constraint i.e. the
rate at which the consumer is willing to trade leisure for consumption is greater than the
rate at which the consumer can trade leisure for consumption in the market, or
M RSl,C > w.
▶ Similarly, at E, M RSl,C < w, so better to move to H
▶ At H, the rate at which the consumer is willing to trade leisure for consumption is equal
to the rate at which leisure trades for consumption in the market, and, thus, the
consumer is at his or her optimum
▶ At optimum, M RSl,C = w i.e. marginal rate of substitution of leisure for consumption
equals the relative price of leisure in terms of consumption goods.

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No Extremes
▶ It could be that the consumer’s highest indifference curve is reached at point B, in which
case the consumer would choose to consume all of his or her time as leisure
▶ It would imply that the representative consumer would not work, in which case nothing
would be produced, and, therefore, the consumer would not have anything to consume
▶ The assumption that the consumer always wishes to consume some of both goods (the
consumption good and leisure) prevents the consumer from choosing either point A or
point B

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Is Optimization Plausible?

▶ Is it plausible to assume that a consumer makes optimizing decisions?

▶ Main defense: mistakes by consumers are not likely to persist for a long time.
▶ Also, what is important for macroeconomic models is that people on average behave
optimally, not that each individual in the economy always does so

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Labor Supply

▶ Labor supply curve: Tells us how much labor the representative consumer wishes to
supply given any real wage.
▶ To construct the labor supply curve, one could imagine presenting the representative
consumer with different real wage rates and asking what quantity of labor the consumer
would choose to supply at each wage rate.
▶ Formally, suppose l(w) is a function that tells us how much leisure the consumer wishes
to consume, given the real wage w.
▶ Then the labor supply curve is given by:

N s (w) = h − l(w)

▶ Assuming that the substitution effect of an increase in the real wage dominates the
income effect (to be covered later), the labor supply curve is upward-sloping.

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The Labor Supply Curve

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The Representative Firm

▶ Consider a single representative firm

▶ The firms in this economy own productive capital (plant and equipment)
▶ They hire labor to produce consumption goods
▶ Production function: describes the technological possibilities for converting factor
inputs into outputs
▶ Algebraically, it is written as:
Y = zF (K, N d ),
where z is total factor productivity
Y is output of consumption goods
K is the quantity of capital input in the production process
N d is the quantity of labor input measured as total hours worked by employees
F is a function

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The Representative Firm

▶ Since model is static, we treat K as being a fixed input to production, and N d as a

variable factor of production
▶ This means that in the short run, firms cannot vary the quantity of plant and equipment
(K) they have, but they have flexibility in hiring and laying off workers (N d )
▶ Total factor productivity z captures the degree of sophistication of the production
process
▶ An increase in z makes both factors of production, K and N d , more productive

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Marginal Product
▶ 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.
▶ Suppose we fix capital at K∗ and allow the labor input to vary
▶ Slope of the production function is the additional output produced from an additional
unit of the labor input
▶ Thus the marginal product of labor (M PN ) is given by the slope of the production
function

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Marginal Product
▶ Suppose we fix labor at N ∗ and allow the capital input to vary
▶ Slope of the production function is the additional output produced from an additional
unit of the capital input
▶ Thus the marginal product of capital (M PK ) is given by the slope of the production
function

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Properties of the production function
▶ The production function exhibits constant returns to scale.
▶ Constant returns to scale means that, given any constant x > 0, the following relationship
holds:
zF (xK, xN d ) = xzF (K, N d ).
▶ If all factor inputs are changed by a factor x, then output changes by the same factor x
▶ With constant returns to scale, a small firm is just as efficient as a large firm.
▶ Given a constant-returns-to-scale production function, the economy behaves in exactly
the same way if there were many small firms producing consumption goods as it would if
there were a few large firms, provided that all firms behave competitively (they are
price-takers in product and factor markets).
▶ This makes it very easy to assume a representative firm
▶ No harm in assuming that there exists constant returns to scale in production at the
aggregate level, because even the largest firm in the U.S. economy produces a small
amount of output relative to U.S. GDP
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Properties of the production function

▶ The production function has the property that output increases when either the capital
input or the labor input increases.
▶ In other words, the marginal products of labor and capital are both positive: M PN > 0
and M PK > 0.

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Properties of the production function
▶ The marginal product of labor decreases as the quantity of labor increases.
▶ The declining marginal product of labor is reflected in the concavity of the production
function i.e. the slope of the production function decreases as Nd increases.

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Properties of the production function
▶ The marginal product of capital decreases as the quantity of capital increases.
▶ The marginal product of labor increases as the quantity of the capital input increases.

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The Profit Maximization Problem of the Representative Firm

▶ The representative firm behaves competitively, in that it takes as given the real wage,
which is the price at which labor trades for consumption goods.
▶ The goal of the firm is to maximize its profits:

π = Y − wN d

where π is real profit

Y is the total revenue that the firm receives from selling its output, in units of the
consumption good
wN d is the total real cost of the labor input, or total real variable costs.
▶ Substituting for Y using the production function:

π = zF (K, N d ) − wN d ,

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The Profit Maximization Problem of the Representative Firm

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The Profit Maximization Problem of the Representative Firm

▶ Profit is then the difference between total revenue and total variable cost.
▶ The maximized quantity of profits, π∗, is the distance AB.
▶ At the profit-maximizing quantity of labor, N, the slope of the total revenue function is
equal to the slope of the total variable cost function
▶ Hence we have M PN = w

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The Profit Maximization Problem of the Representative Firm

▶ The contribution to the firm’s profits of having employees work an extra hour is the extra
output produced minus what the extra input costs i.e. M PN − w.
▶ Given a fixed quantity of capital, M PN is very large for Nd = 0, so that M PN − w > 0
for Nd = 0, and it is worthwhile for the firm to hire the first unit of labor, as this implies
positive profits.
▶ As the firm hires more labor, M PN falls, so that each additional unit of labor is
contributing less to revenue, but contributing the same amount, w, to costs.
▶ Eventually, at Nd = N , the firm has hired enough labor so that hiring an additional unit
implies M PN − w < 0, which in turn means that hiring an additional unit of labor only
causes profits to go down, and this cannot be optimal.

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The Labor Demand Curve
▶ The representative firm’s marginal product of labor schedule is the firm’s demand curve
for labor
▶ The firm maximizes profits for the quantity of labor input that implies M PN = w
▶ So given a real wage w, the marginal product of labor schedule tells us how much labor
the firm needs to hire such that M PN = w

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Example

▶ Suppose there is an accounting firm

▶ Output for the firm can be measured in terms of the clients the firm has
▶ Each client pays $20,000 per year to the firm
▶ The wage rate for an accountant is $50,000 per year
50,000
▶ Therefore, the real wage is 20,000 = 2.5 clients
▶ If the firm has 1 accountant, it can handle 5 clients per year
▶ If it has 2 accountants it can handle 9 clients per year
▶ If it has 3 accountants it can handle 11 clients per year
▶ What is the profit-maximizing number of accountants for the firm to hire?

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Example

▶ If firm hires A, her marginal product is 5 clients per year, which exceeds the real wage of
2.5 clients, and so it would be worthwhile for the firm to hire A
▶ If the firm hires B, then B’s marginal product is 4 clients per year, which also exceeds the
market real wage, and so it would also be worthwhile to hire B
▶ If the firm hires C, then C’s marginal product is 2 clients per year, which is less than the
market real wage of 2.5 clients
▶ Therefore, it would be optimal in this case for the firm to hire two accountants, A and B.

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