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**ECO 2021 Intermediate Macroeconomic Theory
**

Professor C. K. Yip 1

Consumer and Firm Behavior:

The Work-Leisure Decision

and Profit Maximization

Chapter 4

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 2

Static vs Dynamic Decision Making

• In this and the next chapters, we are considering static decision making,

i.e., planning over a single period.

• From chapter 6 to 9, we are going to discuss dynamic decision making, i.e.,

planning over more one period.

• Chapter 4 first recalls what you’ve learnt in the last semester: the micro

behavior of a representative consumer and a representative firm.

• Chapter 5 then assembles these in a macro model in order to address

some important macro issues. The role of government is also introduced.

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Professor C. K. Yip 3

Objectives of the Representative Consumer &

the Representative Firm

• Representative Consumer: To maximize utility subject to budget (and time)

constraint by allocating time between work and leisure;

• Representative Firm: To maximize profits subject to technological

constraint by deciding how much labor to be hired.

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Professor C. K. Yip 4

Assumptions of the Model

1) Two Goods:

– Consumption good, which is an aggregation of all consumer goods in the

economy.

– Leisure, which is any time spent other than working in the market.

e.g. Recreational activities, sleep and household work.

2) One Consumer:

– All consumers are identical in terms of preferences, ability, time constraint

and budget constraint. Then, the economy will behave as if there were only

one consumer, one that we refer to as the representative consumer.

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 5

Assumptions of the Model

3) Price-Taking:

– The representative consumer is a price-taker, i.e., he takes all market prices

as given, and acts as if his actions had no effect on those prices.

4) No Money:

– The economy we’re considering is a barter economy, i.e., all trade involves

barter exchanges of goods for goods in the absence of money.

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Professor C. K. Yip 6

The Representative Consumer’s

Optimization Problem

• Objective: to make himself as well off as possible given the constraints

he faces.

• Two Ingredients in this problem:

– Consumer’s preferences

– Consumer’s budget constraint

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Professor C. K. Yip 7

Preferences

• The preferences of the representative consumer is captured by the

utility function,

U(C , l)

where C is the quantity of consumption,

l is the quantity of leisure

• Any particular pair of consumption and leisure (C , l) is called a

consumption bundle.

• For each consumption bundle, the utility function U assigns a real

number so that different bundles can be ranked.

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Professor C. K. Yip 8

Preferences

• Consider two distinct bundles (C

1

, l

1

) and (C

2

, l

2

)

– (C

1

, l

1

) is strictly preferred to (C

2

, l

2

) if

U(C

1

, l

1

) > U(C

2

, l

2

)

– Consumer is indifferent between the two bundles if

U(C

1

, l

1

) = U(C

2

, l

2

)

• Assumptions on Preferences:

1) More is always preferred to less

– A consumer always prefers a consumption bundle that contains more

consumption, more leisure, or both.

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Professor C. K. Yip 9

Preferences

2) Consumer prefers a more diversified consumption bundle.

– If the consumer is indifferent between (C

1

, l

1

) and (C

2

, l

2

), then some

mixture of the two will be preferable to either one.

– Example: Consider a new bundle (C

3

, l

3

), where C

3

= ìC

1

+ (1 – ì)C

2

,

l

3

= ìl

1

+ (1 – ì)l

2

and ì lies between 0 and 1 (a fraction), then

U(C

3

, l

3

) > U(C

1

, l

1

) = U(C

2

, l

2

)

3) Consumption and leisure are normal goods.

– A good is normal (inferior) for a consumer if the quantity of the good that

he/she purchases increases (decreases) when income increases.

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 10

Graphical Representation of Preferences

• An indifference curve connects a set of points, with these points

representing consumption bundles among which the consumer is

indifferent.

• A family of indifference curves is called indifference map.

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Professor C. K. Yip 11

Properties of Indifference Curves

• Consider a consumption bundle

B. Since a consumer prefers

more to less, any bundle that is

indifferent to B must lie within

quadrant II and IV.

• Implication: An indifference curve

slopes downward.

B

I

II III

IV

Leisure

Consumption

.

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Professor C. K. Yip 12

Properties of Indifference Curves

• Consider any two bundles A and

B, since a consumer prefers a

more diversified bundle C to

either A or B, the set of bundles

that are indifferent to A and B

must lie below the straight line

AB.

• Implication: An indifference curve is

convex, that is bowed-in toward the

origin.

A

B

C

Consumption

Leisure

.

.

.

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Professor C. K. Yip 13

Graphical Representation of Preferences

A

Leisure, l

Consumption, C

.

.

.

B

D

I

1

l

2

l

1

C

2

C

1

I

2

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Professor C. K. Yip 14

Marginal Rate of Substitution

• Marginal rate of substitution of

leisure for consumption (MRS

l,C

) is

the rate at which the consumer is

just willing to substitute leisure for

consumption good.

• It is also minus the slope of the

indifference curve.

• Convexity of indifference curve is

equivalent to

– Diminishing marginal rate of substitution.

(compared slope at A and slope at

B)

A

Leisure, l

Consumption, C

.

B D

I

1

l

2

l

1

C

2

C

1

I

2

.

.

.

Slope = MRS

l,C

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Professor C. K. Yip 15

Marginal Rate of Substitution

• The MRS at A is larger (in terms of

absolute magnitude) than the MRS

at B.

• As we increase l and reduce C, i.e.

moving from A to B along I

1

, the

consumer needs to be

compensated more in terms of l to

give up another unit of C.

• The consumer requires this extra

consumption because of a

preference for diversity.

A

Leisure, l

Consumption, C

.

B D

I

1

l

2

l

1

C

2

C

1

I

2

.

.

.

Slope = MRS

l,C

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Professor C. K. Yip 16

Marginal Rate of Substitution

Mathematical Derivations:

• Suppose indifference curve I

1

represents the utility level ,

• Totally differentiate this with

respect to C and l gives

U

U l C U = ) , (

c

l

C l

l c

U

U

dl

dC

MRS

dl U dC U

= ÷ =

= +

,

0

A

Leisure, l

Consumption, C

.

B D

I

1

l

2

l

1

C

2

C

1

I

2

.

.

.

Slope = MRS

l,C

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Professor C. K. Yip 17

Constraints faced by The Representative

Consumer

• Two constraints:

– Time constraint for l

– Budget constraint for C

• The time constraint for the consumer is given by

l + N

s

= h

where h is the total number of hours available (e.g., 24 hours a day), l is

the leisure time and N

s

is the time spent working (or labor supply).

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Professor C. K. Yip 18

Budget Constraint

• Sources of income:

1) Real wage income, wN

s

– w is the real wage, i.e., the price of one unit of labor time in terms of

consumption goods (the numeraire).

2) Real dividend income, t

– Since the firms are owned by the representative consumer, any profits made

by firms are distributed to him as dividends.

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Professor C. K. Yip 19

Budget Constraint

• Taxation T: A lump-sum tax, i.e. a tax that does not depend on the

actions of the economic agent who is being taxed.

• Real Disposable Income = wN

s

+ t – T

• The consumer first receives income and pays taxes in terms of

consumption goods, and then decides on how much to consume out of

the disposable income.

• All disposable income is consumed, i.e.

C = wN

s

+ t – T

= w(h – l) + t – T

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Professor C. K. Yip 20

Budget Constraint

• Reasons:

– Since the consumer only lives for one period, there is no incentive to save

anything.

– Since more is preferred to less, any wastage is not optimal.

• The consumer’s budget constraint can be written as

C + wl = wh + t – T

• RHS = Total implicit real disposable income

• LHS = Implicit real expenditure on consumption goods and leisure

• Note: w can also be interpreted as the market price, or the opportunity

cost, of leisure time.

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Professor C. K. Yip 21

Graphical Representation of the Budget

Constraint

• Budget constraint:

C = –wl + (wh + t – T)

thus slope = –w.

• The vertical intercept, wh + t – T,

is the maximum consumption that

can be achieved when the

consumer consumes no leisure.

• Case 1: t < T

Leisure, l

Consumption, C

h + (t – T)/w h

wh + t – T

A

B

C = –wl + wh + t – T

.

.

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Professor C. K. Yip 22

Graphical Representation of the Budget

Constraint

• Case 2: t > T

– The consumer can still enjoy

C = t – T > 0 even if he

chooses not to work.

– When C = 0, l = h + (t – T)/w,

but it is not feasible as the

maximum time can only be h

– When l = h, C = t – T

D

Leisure, l

Consumption, C

h

A .

.

t – T .

B

C = –wl + wh + t – T

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Professor C. K. Yip 23

Graphical Representation of the Budget

Constraint

• The budget constraint tells us what

consumption bundles are feasible

to consume given the market real

wage (w), dividend income (t) and

taxes (T).

• The consumption bundles within

the shaded regions and on the

budget constraint, are feasible.

• Thus the shaded region together

with the budget constraint is called

the feasible set.

Not Feasible

D

Leisure, l

Consumption, C

h

A .

.

.

B

Feasible

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Professor C. K. Yip 24

Consumer Optimization

• The representative consumer is assumed to be rational, i.e. he always

chooses the best feasible consumption bundle, or the optimal

consumption bundle.

• “Best” in the sense that it lies on the highest possible indifference curve.

• “Feasible” in the sense that it lies within the feasible set.

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Professor C. K. Yip 25

Graphical Solution

• Suppose t > T.

• Claim: H is the optimal consumption

bundle.

Reasons:

• Any bundle inside the budget

constraint is not optimal

(compare J to F).

• B is preferred to any point on

BD.

• For any point on AB, the

consumer can always improve by

moving closer to H.

D

Leisure, l

Consumption, C

h

A .

.

t – T .

B

F

.

H

E

I

2

I

1

.

.

.

J

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Professor C. K. Yip 26

Mathematical Solution

• The consumer tries to solve the following constrained optimization problem

max U(C , l)

C , l

subject to C = w(h – l) + t – T

and C > 0, h > l > 0.

• Lagrangian

L = U(C , l) + ì[w(h – l) + t – T – C]

where ì is the Lagrangian multiplier.

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Professor C. K. Yip 27

Mathematical Solution

• We assume that an interior solution can be obtained. This means

choosing C = 0, l = h or l = 0 are not optimal (so that we can ignore the

last two constraints).

• Formally, we can impose the restrictions:

U

c

(0 , l) = ∞ and U

l

(C , 0) = ∞

For any C and l, to guarantee an interior solution.

• First-order (Necessary) conditions (FOCs):

– Obtained by differentiating the Lagrangian with respect to C, l and ì.

(Recall: Lagrangian equation L = U(C , l) + ì[w(h – l) + t – T – C]

U

c

(C , l) = ì,

U

l

(C , l) = ìw,

w(h – l) + t – T – C = 0.

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Professor C. K. Yip 28

Mathematical Solution

• From the FOCs, we obtain

• At H, where an indifference curve

is just tangent to the budget

constraint, the above equality holds.

• If MRS > w (e.g. at F), the

consumer would be better off by

increasing l and reducing C, thus

moving closer to H.

D

Leisure, l

Consumption, C

h

A .

.

t – T .

B

F

.

H

E

I

2

I

1

.

.

.

J

w

l C U

l C U

MRS

c

l

C l

= =

) , (

) , (

,

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 29

Comparative Statics

• To determine how C and l changes when any of t, T and w changes.

• Recall the FOC of the consumer’s problem,

which can be written as

U

l

(C , l) – wU

c

(C , l) = 0. (1)

• From the budget constraint,

w(h – l) + t – T – C = 0. (2)

• The two form a system of equations in terms of C and l (endogenous

variables).

w

l C U

l C U

c

l

=

) , (

) , (

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Professor C. K. Yip 30

Comparative Statics

• Totally differentiate the two equations

–dC – wdl + (h – l)dw + dt – dT = 0 from (2)

[U

cl

– wU

cc

]dC + [U

ll

– wU

cl

]dl – U

c

dw = 0 from (1)

In matrix form,

• Determinant of the bordered Hessian matrix A is

V = –U

ll

+ 2wU

cl

– w

2

U

cc

• Strict quasiconcavity of U V > 0.

A

dT d dw

U

l h

dl

dC

wU U wU U

w

c cl ll cc cl

(

¸

(

¸

+

(

¸

(

¸

÷

+

(

¸

(

¸

÷ ÷

=

(

¸

(

¸

(

¸

(

¸

÷ ÷

÷ ÷

0

1

0

1 ) ( 1

t

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 31

1) Changes in t and/or T

• Using Cramer’s Rule, we get

• The assumption that consumption and leisure are normal goods is

equivalent to the conditions –U

ll

+ wU

cl

> 0 and U

cl

– wU

cc

> 0.

. 0

) (

, 0

) (

>

V

÷

= ÷ = =

÷

>

V

+ ÷

= ÷ = =

÷

cc cl

cl ll

wU U

dT

dl

d

dl

T d

dl

wU U

dT

dC

d

dC

T d

dC

t t

t t

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Professor C. K. Yip 32

1) Changes in t and/or T

Graphical Illustration

• Consider a net increase in t – T.

• Since w (slope) remains the same,

the budget constraint makes a

parallel shift (from AB to FJ).

• Since disposable income |, while

prices remain the same, there is

only a pure income effect on the

consumer’s choices.

• The new optimal consumption

bundle is K, where both C and l

| (normal goods).

D

Leisure, l

Consumption, C

h

A

.

B

K

I

2

I

1

.

H

.

.

.

J

.

. F

C

1

C

2

l

1

l

2

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 33

1) Changes in t and/or T

Graphical Illustration

Remark:

• The increase in consumption

(C

2

– C

1

) is less than the increase

in nonwage income (distance

AF).

• Since the consumer is working

less (leisure |), wage income +.

• This will offset part of the

consumption increase.

D

Leisure, l

Consumption, C

h

A

.

B

K

I

2

I

1

.

H

.

.

.

J

.

. F

C

1

C

2

l

1

l

2

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 34

2) Changes in w

• Using Cramer’s rule,

• C is normal good –U

ll

+ wU

cl

> 0, together with V > 0 and U

c

> 0

.

) )( (

,

) )( (

V

÷ ÷ + ÷

=

V

+ ÷ ÷ +

=

cc cl c

cl ll c

wU U l h U

dw

dl

wU U l h wU

dw

dC

. 0 >

dw

dC

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 35

2) Changes in w

• However, we cannot determine the effect of a change in w on l.

• Reason: It depends on the relative magnitude of the opposing income

and substitution effects.

• Substitution effect: w| Opportunity cost of leisure |

(l becomes more expensive relative to C)

Demand for leisure +

• Income effect: w | Wage income |

Demand for leisure | (normal good)

0 ) ( <

V

÷ =

c

U

subst

dw

dl

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 36

2) Changes in w

Graphical Illustration

• Suppose t > T and w |.

• The budget constraint shifts from

ABD to EBD (with a steeper

slope).

• This shows a special case in which

leisure remains unaffected.

• Pure substitution effect: Movement

from F to O (on the same

indifferent curve).

• Pure income effect: Movement from O

to H.

• Both income and substitution

effects act to | C.

D

Leisure, l

Consumption, C

h

A

.

B

H

I

2

I

1

F

K

E

C

1

C

2

l

1

.

O

.

.

.

.

.

.

.

J

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 37

2) Changes in w

Graphical Illustration

• Labor supply curve which specifies

how much labor the consumer wishes

to supply given any real wage.

• Algebraically, the labor supply curve is

N

s

(w) = h – l(w),

where l(w) is the demand function for

leisure.

• Substitution effect > Income effect

Upward sloping labor supply curve

• Net | in (t – T)

Upward shift in labor supply curve

N

s

Real Wage, w

Employment, N

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 38

Example: C and l are perfect complements

• Suppose the consumer’s utility

function can be represented by

U(C , l) = min{C , al}.

(Leontief Function)

where a is a positive constant.

• Note that more is not always

preferred to less. The consumer can

be better off only if he receives

more of both goods.

• Thus, it is always optimal to choose

C = al.

D

Leisure, l

Consumption, C

h

A

.

B

F

.

E

.

.

C = al

I

2

I

1 .

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 39

Example: C and l are perfect complements

• Combining C = al and the budget constraint gives

• In this case,

• This is because with perfect complements, there are no substitution

effects. Thus leisure | as real wages |.

,

w a

T wh

l

+

÷ +

=

t

.

) (

w a

T wh a

C

+

÷ +

=

t

0 >

+

÷

=

w a

l h

dw

dl

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Professor C. K. Yip 40

The Representative Firm

• The firm owns productive capital and hires labor to produce

consumption goods.

• Production technology is captured by the production function, which

describes the technological possibilities for converting factor inputs

(capital K and labor N

d

) into outputs Y.

Y = zF(K , N

d

)

where z is total factor productivity.

• z | both K and N

d

will be more productive.

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 41

Assumptions on Production Function

• Production function exhibits constant returns to scale (or homogenous of

degree one).

– For any x > 0, xY = zF(xK , xN

d

).

– If all factor inputs are changed by a factor x, then output changes by the

same factor x.

– In this case, a perfectly competitive economy with numerous small firms

will behave in exactly the same way as one with a single representative

firm (same level of efficiency).

– Increasing return to scale: zF(xK , xN

d

) > xzF(K , N

d

).

– Decreasing return to scale: zF(xK , xN

d

) < xzF(K , N

d

).

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Professor C. K. Yip 42

Assumptions on Production Function

• Positive marginal product of capital

(MP

K

) and marginal product of labor

(MP

N

).

– MP

K

(MP

N

) is the additional output

that can be produced with one

additional unit of capital (labor),

holding constant the quantities of labor

(capital).

– Fix the quantity of labor at N

*

, then

the MP

K

at K

*

is the slope of the

production function at point A.

A

Output, Y

Capital Input, K

F(K , N

*

)

Slope = MP

K

K

*

.

) , (

) , (

d

K

d

K

N K zF

K

N K F

z MP =

c

c

=

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 43

Assumptions on Production Function

– Algebraically, we assume that,

F

K

(K , N

d

) > 0 and F

N

d

(K , N

d

) > 0.

– Conceptually, this simply means:

more inputs yield more output.

• Diminishing Marginal Product

– The declining MP

K

and MP

N

is

equivalent to the concavity of the

production function.

– Algebraically, this means

F

KK

(K , N

d

) < 0,

and F

N

d

N

d

(K , N

d

) < 0.

– Implicitly, we assume that

F(. , .) is twice differentiable.

M

a

r

g

i

n

a

l

P

r

o

d

u

c

t

o

f

L

a

b

o

r

,

M

P

N

Labor Input, N

d

MP

N

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 44

Assumptions on Production Function

• MP

N

| as K |

– Algebraically, this means

– Increase in the quantity of

machinery and equipment

enhances the productivity of the

workers.

• F(. , .) is quasiconcave.

M

a

r

g

i

n

a

l

P

r

o

d

u

c

t

o

f

L

a

b

o

r

,

M

P

N

Labor Input, N

d

MP

N

1

MP

N

2

0

) , (

2

>

c c

c

d

d

N K

N K F

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ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 45

Cobb-Douglas Production Function

• Probably the most commonly used form of production function which

satisfies all the above properties

Y = zK

a

(N

d

)

b

where 0 < a, b < 1.

• a + b = 1 Constant return to scale.

a + b > (<) 1 Increasing (decreasing) return to scale.

• If there are profit-maximizing price-taking firms and a + b = 1, then a

will be the share that capital receives of national income.

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Professor C. K. Yip 46

Changes in Total Factor Productivity (z)

• Changes in z is critical to our

understanding of the causes of

economic growth and business cycles

(real business cycles theory).

• Effects of z |:

1) Output | for given values of K

and N

d

.

2) MP

N

| for given value of K.

• Factors that would affect z:

– Technological innovation

– Weather

– Government regulations

– Price of energy

Labour Input, N

Output, Y

Z

1

F(K

*

, N

d

)

Z

2

F(K

*

, N

d

)

Marginal Product of Labor, MP

N

Labor Input, N

d

MP

N

1

MP

N

2

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 47

Profit Maximization Problem

• Assume that capital K is fixed. Then the firm’s problem is to choose a

quantity of N

d

in order to maximize its profits.

• The representative firm is assumed to behave competitively, i.e. taking

the real wage w as given.

• The problem can be stated as (choosing N

d

)

max t = zF(K , N

d

) – wN

d

• Similar to the consumer’s problem, we assume

F

N

d

(K , 0) = ∞ and F

N

d

(K , ∞) = 0

to ensure interior solution in the firm’s profit maximization problem.

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 48

Profit Maximization Problem

• The optimal condition (FOC) is

z[∂F(K , N

d

)/∂N

d

] = w

• This states that it is optimal for the

firm to hire workers up to a level in

which the MP

N

equals the real wage.

• Graphically, the optimal quantity of

labor N

*

is at A, where the slope of

total revenue function is equal to

the slope of the total variable cost

function.

• The maximized profits t

*

is given

by the distance AB.

A

Revenue, Variable Costs

Labor Input, N

d

zF(K , N

d

)

N

*

.

B

.

.

.

wN

d

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 49

Profit Maximization Problem

• The FOC of the profit-

maximization can also be

interpreted as the firm’s demand

curve for labor, for given values

of z and K .

• The optimal condition (FOC) is

MP

N

(K , N) = w.

• Diminishing MP

N

implies w and

N are inversely related.

Real Wage, w

Quantity of Labor Demanded, N

d

MP

N

or Labor Demand Curve

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 50

Comparative Statics

• Recall the FOC of the firm’s problem

zF

N

d

(K , N

d

) = w

• Totally differentiate this gives

zF

N

d

N

d

dN

d

– dw + F

N

d

dz + zF

KN

d

dK = 0.

Thus, we obtain

0

, 0 , 0

1

> ÷ =

> ÷ = < =

d d

d

d d

d

d d

N N

KN

d

N N

N

d

N N

d

zF

zF

dk

dN

zF

F

dz

dN

zF dw

dN

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 51

Quasiconcavity

• A function f(x) is quasiconcave if

f(x

1

) > f(x

2

) f[ox

1

+ (1 – o)x

2

] > f(x

2

)

for any 1 > o > 0.

• f is strictly quasiconcave if

f(x

1

) > f(x

2

) f[ox

1

+ (1 – o)x

2

] > f(x

2

)

for any 1 > o > 0.

• Consider a strictly quasiconcave utility function U(C , l).

Suppose x

1

= (C

1

, l

1

), x

2

= (C

2

, l

2

), then

U(x

1

) = U(x

2

) U[ox

1

+ (1 – o)x

2

] > U(x

1

) = U(x

2

)

for any 1 > o > 0.

Thus the indifference curves are strictly convex.

2013/7/17

ECO 2021 Intermediate Macroeconomic Theory

Professor C. K. Yip 52

Quasiconcavity

• Strict quasiconcavity also implies that the bordered Hessian matrix of

the utility function is negative definite, i.e.,

–U

ll

+ 2wU

cl

– w

2

U

cc

> 0

0 1

1 0

>

÷

÷

÷ ÷

ll lc

cl cc

U U w

U U

w

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