Consumer Behavior Representative Consumer Rationale Two goods Consumption bundles

Representative Consumer: Preferences Three properties of preferences: 1.More is preferred to less 2.Likes diversity 3.C and L are normal goods

Preferences, Utility function, and Indifference Curves Utility function What is an indifference curve? Properties of indifference curves (derived from properties of preferences).

MRS(l,C), Marginal Rate of Substitution of l for C MRS(l,C) amount of C we would give up to get one additional unit of l (at the margin). Equal to (-1) times the slope of the indifference curve Properties:

Consumer Choice Consumer’s “problem” is to choose the best consumption bundle subject to constraints: – Time constraint – Budget constraint

Budget Set (T < π case)

Consumer Optimization

Income (or “Wealth”) Effects: “What happens when non-wage income changes?” Change in non-wage income induces a “pure income (wealth) effect”. Recall “both goods are normal” assumption… So what is the net effect of Δ(π – T ) > 0 ?

Increase in the real wage rate: Income and substitution effects Key: w is 1. wage earned on labor hours, but also 2. Price of leisure relative to consumption! Increase in w increases (w*h + π – T) Then both goods normal, so… But w increases price of l relative to C, so… Conclusion: Consumption must rise, but leisure may rise or fall.

Increase in the real wage rate: Income and substitution effects

Labor Supply Curve Ns(w) = h – l(w) What is the effect of an increase in non-wage income? (dividends or lump- sum taxes)

Production of Goods What are goods good for? “Technology”: the Production Function: Y = zF( K, Nd ) – K and Nd are inputs or “factors of production”. – z is total factor productivity. K is determined by past investment Nd may be varied in the short run.

Marginal Products, MPN Marginal product of labor (MPN) is the amount of additional output produced by adding an additional unit of Nd (holding K fixed).

Marginal Products, MPK Marginal product of capital (MPK) is the amount of additional output produced by adding an additional unit of K (holding Nd fixed).

Cobb-Douglas Production Fn Y = zKa (Nd)b

Assumptions about the production function 1. Constant returns to scale (CRS) Increasing production fn: 2. ↑K or ↑Nd causes ↑Y Equivalent statement: MPN>0, MPK>0, Diminishing marginal products: 3. MPN decreases as N increases. 4. MPK decreases as K increases. Complementarities in production: 5. MPN increases as K increases (and MPK increases as N increases).

Complementarities in prod’n: 5. MPN increases as K increases (and MPK increases as N increases).

Figure 4.17 Adding Capital Increases the Marginal Product of Labor

What’s z? Total factor productivity represents level of technology or efficiency in prod’n. Examples of z changes – technological advance, discovery of new techniques,etc. – Random economic shocks (weather) – Inefficiency induced by gov’t regulation – Energy price shocks

Figure 4.18 Total Factor Productivity Increases

Figure 4.19 Effect of an Increase in Total Factor Productivity on the Marginal Product of Labor

The Objective of the Firm is… MAXIMIZE PROFIT! Profit is... – Revenue minus costs: π = Y – w*Nd= zF( K, Nd ) – w*Nd

Cobb-Douglas Production fn and the Solow Residual Y = zKa (Nd)b – Exhibits CRS if b = 1 – a Theory says that share of Y paid to labor should be 1-a: 1 – a = w*N / Y Looking at data, set 1 – a =.64 (a =.36). The “Solow residual” is measure of TFP (z) obtained this way: z = Y / ( K.36 (Nd).64 )

Figure 4.20 The Solow Residual for the United States