CONSUMER AND FIRM BEHAVIOR: THE WORK-LEISURE

DECISION AND PROFIT MAXIMIZATION

CHAPTER 4
Static Model

▶ We now turn to the construction and analysis of a particular macroeconomic model

▶ To start, we consider a one period model
▶ Consumers and firms make static decisions
▶ One-period decision making for consumers and firms limits the kinds of macroeconomic
issues we can address
▶ This simplification, however, makes it easier to understand the basic microeconomic
principles of consumer and firm optimization
▶ Optimization:
A consumer wishes to make himself or herself as well off as possible given the constraints he
or she faces
A firm acts to maximize profits, given market prices and the available technology.

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The Representative Consumer

▶ We consider the behavior of a single representative consumer, who acts as a stand-in for
all of the consumers in the economy.
▶ Convenient to suppose that all consumers in the economy are identical.
▶ If all are identical, the economy behaves as if there were only one consumer
▶ Suppose that there are two goods that consumers desire:
1 Consumption good: A physical good, which we can think of as an aggregation of all
consumer goods in the economy, or measured aggregate consumption
2 Leisure: Any time spent not working in the market

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Utility Functions

▶ Consumption bundle: (C1 , l1 ) is a consumption bundle where C1 denotes a particular

quantity of consumption and l1 denotes a particular quantity of leisure
▶ We need a measure of preferences of the representative consumer over leisure and
consumption goods
▶ Denoted by a utility function U (C, l)
where U is the utility function
C is the quantity of consumption
l is the quantity of leisure
▶ U (C, l) represents the level of happiness, or utility, that the consumer receives from
consuming the bundle (C, l)

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Utility Functions
▶ The utility function represents how the consumer ranks different consumption bundles
▶ Consider two different consumption bundles (C1 , l1 ) and (C2 , l2 ).
▶ (C1 , l1 ) is strictly preferred by the consumer to (C2 , l2 ) if

U (C1 , l1 ) > U (C2 , l2 )

▶ (C2 , l2 ) is strictly preferred by the consumer to (C1 , l1 ) if

U (C1 , l1 ) < U (C2 , l2 )

▶ Consumer is indifferent between the two consumption bundles if

U (C1 , l1 ) = U (C2 , l2 )

▶ The actual level of utility is irrelevant; all that matters for the consumer is what the level
of utility is from a given consumption bundle relative to another one.
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Assumptions on Consumers’ Preferences

To use our representation of the consumer’s preferences for analyzing macroeconomic issues,
we must make some assumptions concerning the form that preferences take:
1 More is always preferred to less: A consumer always prefers a consumption bundle that
contains more consumption, more leisure, or both.
2 The consumer likes diversity in his or her consumption bundle: If the consumer is
indifferent between two consumption bundles, then some mixture of the two consumption
bundles is preferable to either one.
3 Consumption and leisure are normal goods:
Normal goods: A good is normal for a consumer if the quantity of the good that he or she
purchases increases when income increases.
Inferior goods: A good is inferior for a consumer if he or she purchases less of that good
when income increases.

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Indifference Curves
▶ Utility functions can be graphically represented using indifference curves.
▶ An indifference curve connects a set of points, with these points representing
consumption bundles among which the consumer is indifferent.

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Properties of Indifference Curves
▶ An indifference curve slopes downward.
▶ An indifference curve is convex, that is bowed-in toward the origin.

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Marginal Rate of Substitution

▶ The marginal rate of substitution of leisure for consumption, denoted M RSl,C is the
rate at which the consumer is just willing to substitute leisure for consumption goods.
▶ M RSl,C = -[the slope of the indifference curve passing through (C, l)]
▶ Minus the slope tells us how much consumption we need to take away for each unit of
leisure added
▶ Stating that an indifference curve is convex is identical to stating that the marginal rate
of substitution is diminishing
▶ This is because, as we increase the quantity of leisure and reduce the quantity of
consumption, the consumer needs to be compensated more and more in terms of leisure
time to give up another unit of consumption.
▶ The consumer requires this extra compensation because of a preference for diversity

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Time Constraint
▶ Next, we need to specify the consumer’s constraints and objectives to predict what he or
she will do
▶ We assume that the representative consumer behaves competitively
▶ Here, competitive behavior means that the consumer is a price-taker; i.e. he or she
treats market prices as being given and acts as if his or her actions have no effect on
those prices.
▶ We also assume that there is no money in this economy
▶ This gives us a barter economy
▶ All trade involves exchanges of goods for goods
▶ The consumer is assumed to have h hours of time available, which can be allocated
between leisure time l and time spent working (or labor supply), denoted by N s
▶ The time constraint for the consumer is then:

l + Ns = h
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Real Disposable Income
Real disposable income = wage income + dividend income - taxes

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Real Disposable Income
Real disposable income = wage income + dividend income - taxes
1 Wage income

One unit of labor time exchanges for w units of consumption goods

w is the real wage, or the wage rate of the consumer in units of purchasing power
If the consumer works N s hours, then his or her real wage income is wN s , which is expressed
in units of the consumption good.
Consumption good plays the role of numeraire, or the good in which all prices and
quantities are denominated. In actual economies, money is the numeraire

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Real Disposable Income
Real disposable income = wage income + dividend income - taxes
1 Wage income

One unit of labor time exchanges for w units of consumption goods

w is the real wage, or the wage rate of the consumer in units of purchasing power
If the consumer works N s hours, then his or her real wage income is wN s , which is expressed
in units of the consumption good.
Consumption good plays the role of numeraire, or the good in which all prices and
quantities are denominated. In actual economies, money is the numeraire
2 Dividend income
The second source of income for the consumer is profits distributed as dividends from firms
In our model, firms are owned by the representative consumer
Thus π, which is the quantity of profits in real terms, also equlas the consumer’s real
dividend income

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Real Disposable Income
Real disposable income = wage income + dividend income - taxes
1 Wage income

One unit of labor time exchanges for w units of consumption goods

w is the real wage, or the wage rate of the consumer in units of purchasing power
If the consumer works N s hours, then his or her real wage income is wN s , which is expressed
in units of the consumption good.
Consumption good plays the role of numeraire, or the good in which all prices and
quantities are denominated. In actual economies, money is the numeraire
2 Dividend income
The second source of income for the consumer is profits distributed as dividends from firms
In our model, firms are owned by the representative consumer
Thus π, which is the quantity of profits in real terms, also equlas the consumer’s real
dividend income
3 Taxes
The consumer pays taxes to the government
We assume that the real quantity of taxes is a lump-sum amount T
A lump-sum tax is a tax that does not depend in any way on the actions of the economic
agent who is being taxed
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Budget Constraint

▶ The consumer receives income and pays taxes in terms of consumption goods
▶ Then he or she decides how much to consume out of this disposable income
▶ One period economy =⇒ no savings motive
▶ Since the consumer prefers more to less, all disposable income is consumed:

C = wN s + π − T

▶ Total real consumption equals real disposable income

▶ This is the consumer’s budget constraint

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Budget Constraint

▶ Substituting for N s in budget constraint:

C = w(h − l) + π − T

▶ RHS is real disposable income, while LHS is expenditure on consumption goods, so that
total market expenditure is equal to disposable income.
▶ Alternatively, if we add wl to both sides

C + wl = wh + π − T

▶ RHS is the implicit quantity of real disposable income the consumer has, and LHS is
implicit expenditure on the two goods, consumption and leisure.
▶ wl is what is implicitly “spent” on leisure. That is, w is the market price of leisure time,
because each unit of leisure is forgone labor, and labor time is priced at the real wage w

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Budget Constraint
▶ To graph the consumer’s budget constraint, it is convenient to write the equation in
slope–intercept form, with C as the dependent variable:
C = −wl + wh + π − T
▶ The representative consumer’s budget constraint tells us what consumption bundles are
feasible for him or her to consume given the market real wage, dividend income, and taxes.
▶ Consumption bundles inside and on the budget constraint are feasible; all other
consumption bundles are infeasible.
▶ Slope of the budget constraint is −w
▶ Vertical intercept is wh + π − T

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Budget Constraint
▶ To graph the consumer’s budget constraint, it is convenient to write the equation in
slope–intercept form, with C as the dependent variable:
C = −wl + wh + π − T
▶ The representative consumer’s budget constraint tells us what consumption bundles are
feasible for him or her to consume given the market real wage, dividend income, and taxes.
▶ Consumption bundles inside and on the budget constraint are feasible; all other
consumption bundles are infeasible.
▶ Slope of the budget constraint is −w
▶ Vertical intercept is wh + π − T
▶ The vertical intercept is the maximum quantity of consumption attainable for the
consumer, which is what is achieved if the consumer works h hours and consumes no
leisure
▶ The horizontal intercept is the maximum number of hours of leisure that the consumer
can take and still be able to pay the lump-sum tax.
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Budget Constraint when T > π

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Budget Constraint when T < π

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Budget Constraint when T < π

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Budget Constraint when T < π

▶ Dividend income minus taxes, π − T , is positive

▶ Budget constraint in this case is kinked
▶ The slope of the budget constraint is −w over its upper portion, and the constraint is
vertical over its lower portion
▶ There is a kink in the budget constraint because the consumer cannot consume more
than h hours of leisure.
▶ Thus, at point B we have l = h, which implies that the number of hours worked by the
consumer is zero

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