EF3441: Intermediate Macroeconomics

Prepared by Dr. Tam

Lecture 2
The Main Goal of this Lecture

▶ Understand the consumer’s/household’s consumption and

leisure decisions in a one-period model. Particularly the
tradeoff between consumption and leisure.
▶ To do that, we need to
▶ list the properties of the consumer’s preferences,
▶ construct the consumer’s budget constraints,
▶ show how the consumer optimizes given preferences and
budget constraints.
The Household

▶ The household (the representative consumer) cares about:

▶ Consumption: c (Recall: in GDP consumption is C ; here is c)
▶ Think of c as a bundle/basket of goods. With the loss of any
generality (If you are interested in the proof, please see Walras’
law. We will not cover this topic in this course.), we normalize
the price of c to 1 (c is called numeraire good.).
▶ Leisure: ℓ
▶ The household (HH) has a goal: be happy.
▶ Assumptions
▶ All the households have the same tastes/preferences (Is it a
realistic assumption?).
▶ Households are very smart (optimization).
▶ Households live for one period (static model for now).
The Decision of the Household

▶ Be happy: maximize utility.

▶ For every bundle (c, ℓ), U(c, ℓ) associates a level of utility
▶ Remember: c and ℓ can not be negative.
▶ We say that (c1 , ℓ1 ) is preferred to (c2 , ℓ2 ) if and only if

U(c1 , ℓ1 ) > U(c2 , ℓ2 )

▶ The objective of the HH is to maximize U(c, ℓ) on every pair
(c, ℓ) that it has available (feasible and affordable)
Properties of the Utility Function

▶ Properties of the utility function:

▶ Utility is increasing (more is preferred to less)
▶ The slopes of the utilities are non-negative. i.e., both the
marginal utility of consumption, ∂U∂c
, and the marginal utility
of leisure, ∂U
∂ℓ
, are non-negative.
▶ Concavity: each additional unit of consumption and leisure
adds less utility (eating twice as much does not make you
twice as happy)
▶ i.e., the second-order derivatives are non-positive, or the
slopes of of the marginal utility are textitnon-positive.
▶ Consumption and leisure are normal goods (leisure is a
consumption good, too!)
Properties of the Utility Function, Con’t
▶ More preferred to less:
▶ Marginal utility of leisure
∂U
= MUℓ > 0
∂ℓ
▶ Marginal utility of labor (supply)
∂U
= MUN s < 0
∂N s
▶ Marginal utility of consumption
∂U
= MUc > 0
∂c
▶ Concavity:
▶ Declining MUℓ
∂MUℓ
<0
∂ℓ
▶ Declining MUc
∂MUc
<0
∂c
From U to Indifference Curves

An indifference curve is a curve connecting all values of

consumption and leisure, among which the consumer is indifferent.
▶ Indifference curves
▶ Downward sloping (more preferred to less)
▶ Convex to the origin (concavity or preference for diversity)
Indifference Curves

▶ A is preferred to B captures the idea that more is preferred to

less
▶ B to D reflects a preference for diversity
From Utility to Indifference Curves

An indifference curve is a curve connecting all values of

consumption and leisure, among which the consumer is indifferent.
▶ Indifference curves
▶ Downward sloping (more preferred to less)
▶ Convex to the origin (preference for diversity)
▶ Marginal rate of substitution (MRS): the marginal rate of
substitution is the rate at which a consumer is willing to give
up one good in exchange for another good while keeping
utility constant.
▶ Negative slope of the indifference curve:
∂U
dc ∂ℓ
dℓ = − ∂U = −MRSℓ,c
∂c
MRS

▶ U = U(c, ℓ), taking total differential, we get

∂U ∂U
dU = dc + dℓ
∂c ∂ℓ
▶ dU = 0 at the indifference curve, so we get

∂U ∂U
0= dc + dℓ
∂c ∂ℓ
or
∂U
dc ∂ℓ Uℓ
= − ∂U =− = −MRSℓ,c
dℓ ∂c
Uc
Indifference Curves
u

Slope = -MRS1,c

C2 ................... ...........................

Leisure, I

▶ In the figure, a preference for diversity implies that any point

on the line segment AB (other than A and B) is strictly
preferred to A or B.
HH Constraints
▶ HH has a limited amount of time available (time constraints):
let N s be time working

ℓ + Ns = h
▶ Limited disposable income: a budget constraint. Let:
▶ c = consumption (c is numeraire by assumption)
▶ h = time endowment. For example, h = 24 hours per day
▶ ℓ = leisure time
▶ w = wage
▶ π = dividend income
▶ T = lump-sum taxes (rebates if T < 0)
A budget constraint

c = wN s + π − T

or combining the time constraint

c + w ℓ = wh + π − T
The Budget Constraint
▶ Suppose T = π
Consumption, c

wh

h
Leisure, l

▶ Wages determines the slope of the budget constraint. i.e.,

rotate the budget line.
The Budget Constraint
▶ Suppose T > π

▶ π − T determine the intercept. i.e., (parallelly) shift the

budget line up/down.
The Budget Constraint

▶ Suppose now T < π positive consumption even with no work

Example 1

Originally a consumer faces the budget line p1 x1 + p2 x2 = m. Then

the price of good 1 doubles, the price of good 2 becomes 8 times
larger, and income becomes 4 times larger. Write down an
equation for the new budget line in terms of the original prices and
income. Graph these two budget lines into the same figure.
Consumer Maximization

A consumption-leisure bundle is:

▶ Feasible: if it lies on or within the budget set.
▶ Optimal: if it is affordable and is on the highest indifference
curve.
Consumer Maximization

▶ Rational behavior: can make informed

max U(c, ℓ)
c,ℓ

s.t. c + w ℓ = wh + π − T
▶ Optimization condition: MRSℓ,c = Relative Price (w ).
▶ A graphical representation
Consumer Maximization

Only H is optimal.
Choosing Unemployment

Only B is optimal.
Consumer Maximization

max U(c, l)
c,ℓ

s.t. c + w ℓ = wh + π − T
Rewrite:

max U (c (ℓ) , ℓ)
ℓ
FOC:

∂U(c, ℓ) dc(ℓ) ∂U(c, ℓ)

× + =0
∂c dℓ ∂ℓ
∂U(c, ℓ) ∂U(c, ℓ)
× (−w ) + =0
∂c ∂ℓ
∂U(c,ℓ)
∂ℓ
∂U(c,ℓ)
= MRSℓ,c = w
∂c
Income and Substitution Effects

Effect of changing parameters of the model (comparative static)

can be decomposed into:
▶ Income effect: the effect on quantities as a result of having
different income holding prices constant.
▶ Substitution effect: the effect on quantities given a price
change holding utility constant.
Income and Substitution Effects: Example

▶ Pure income effect: more income → more leisure.

▶ Pure substitution effect: higher wage for a day → less leisure.
▶ Income + substitution effect: permanent high wage →
leisure?
Comparative Static: Changing π − T

▶ Suppose π increases or T decreases. Since c and ℓ are normal

goods
Comparative Static: Increase in the Real Wage w

▶ This has income and substitution effects.

▶ Substitution effect: the price of leisure rises, so the consumer
substitutes leisure for consumption.
▶ Income effect: the consumer is effectively more wealthy and,
since both goods are normal, consumption increases, and
leisure increases.
▶ Conclusion: consumption must rise, but leisure may rise or fall.
Comparative Static: Increase in the Real Wage w
▶ Suppose your wage goes up. Graph the change of optimal
allocation.
Comparative Static: Increase in the Real Wage w
▶ Draw line JK (tangent to indiffernce curve I1 at point O) to
seperate income effect and substitution effect.

▶ Remember: leisure is more expensive.

▶ In general, this case features both income and substitution
effects → leisure changes are undetermined.
Comparative Static: Increase in the Real Wage w

Comparative Static
c ℓ
Income effect O → H ↑ ↑
Substitution effect F → O ↑ ↓
Net effects F → H ↑ ↑↓
Labor Supply

▶ Labor supply curve (function): N s (w ) = h − ℓ(w ). It

represents the household’s optimal labor supply decision given
wage.
▶ Substitution effect > income effect the upward-sloping labor
supply curve
▶ Substitution effect < income effect downward-sloping labor
supply
Labor Supply Curve

▶ Assumpting the substitution effect dominates the income

effect.
▶ Is it true in the data? Read Pg 140-141.
Effect of an Increase in Dividend or a Decrease in Taxes on Labor Supply
Example 1

Leontief preference: consumption and leisure are perfect

complements. i.e., there is no substitution effect.

max min(c, aℓ)

s.t. c + w ℓ = wh + π − T
where a > 0.
Example 1: Indifference Curves

C
c = al

I4

I3

I2

I1

Leisure, l
Example 1: Optimal Allocation

Assume π > T , graph the optimal allocation:

Aggregation: From One to Many Housholds

▶ So far, we have studied the problem of a single household.

▶ We need to compare aggregate quantities (GDP, C , ...) and
household decision (called ci and ℓi ).
▶ In Macroeconomics, the problem of going from one to many
households is referred to as an aggregation problem.
The issue:
▶ In the data, we have households with disparate income levels.
▶ In the data, we have households with different tastes.
The Solution: Assumptions

▶ Homogeneous function of degree 1: if for all n ∈ R :

n · f (x) = f (n · x)
▶ Key assumptions:
▶ Utility function is homogeneous of degree one. i.e.,

N × U (c, ℓ) = U (N × c, N × ℓ) .
▶ Households have similar preferences.
Aggregation

▶ We have:
N
X
max U(ci , ℓi ) = N max U(c, l) = max U(N · c, N · ℓ)
ci ,ℓi c,l c,ℓ
i=1

▶ C = N · c : aggregate consumption;
▶ L = N · ℓ : aggregate leisure.
Test Similar Preference Assumption: How good is the assumption that ci is the
same for everybody?