Chapter 4

# Chapter 4 - 1 Outline of Chapter 4 A. The Representative...

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Unformatted text preview: 1 Outline of Chapter 4 A. The Representative Consumer 1. Labor Supply B. The Representative Firm 1. Production Function 2. The Marginal Productivity of labor and Capital 3. Supply Shocks C. Equilibrium in the Classical Labor Market A. Full Employment B. Factors that change equilibrium 2 The Supply of Labor Determined by individuals (or families) Choice problem: market work vs. non- market activities (leisure, home production) Individual compares the cost of working to the benefits of working. The decision depends on the marginal cost of an extra hour of work versus the marginal benefit of working the extra hour. Benefit = Cost = Tradeoff is analogous to the firms problem: balance the benefit (MRP) to hiring an extra hour of work versus the cost (real wage) The representative consumer chooses between a consumption bundle, C, and leisure, L. 3 C has many goods in it Why do we use a representative consumer if people are different? Microfoundations for the Labor Supply Curve Optimization subject to constraints Start by specifying a utility function (or preferences): U(C,L) We can compare two bundles: (C 1 ,L 1 ) and (C 2 ,L 2 ) If U(C 1 ,L 1 ) &gt; U(C 2 ,L 2 ) then bundle 1 is strictly preferred to bundle 2 If U(C 1 ,L 1 ) &lt; U(C 2 ,L 2 ) then bundle 2 is strictly preferred to bundle 1 If U(C 1 ,L 1 ) = U(C 2 ,L 2 ) then the consumer is indifferent between the two bundles 4 Important Properties of Preferences 1. More is preferred to less 2. Consumer prefers diversity in consumption/ leisure bundle These properties can be interpreted with indifference curves or restrictions on the derivatives of the utility function Restrictions on derivatives Indifference curve: a curve which connects a set of points which represent consumption bundles among which consumer is indifferent (Graph) (C 1 ,L 1 ) and (C 2 ,L 2 ) bundles are on the same indifference curve (I 1 ), so the consumer is indifferent between the bundles all bundles on I 2 are preferred to those on I 1 Indifference curves slope downward. Why? An indifference curve is convex (bowed towards the origin). Why? 5 We now have the representative consumers preferences, we need the consumers constraints and assumptions about the economic environment. Behavioral assumption: the consumer takes prices as given and acts as if his/her actions have no effect on prices (this is perfectly valid if consumer is small relative to the market) The consumers constraints The consumer buys good C in the market at price P The consumer sells labor at price W The consumer has a total of H hours available for work/leisure NS represents the labor supplied to the market [we will determine what this is] Consumers time constraint: NS + L = H 6 Consumers nominal budget constraint: C = WNS + T C = real consumption W = real wage = real profits from owning the representative firm [could be any other...
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## This note was uploaded on 10/22/2009 for the course ECG 703 taught by Professor Maia,l during the Fall '08 term at N.C. State.

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Chapter 4 - 1 Outline of Chapter 4 A. The Representative...

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