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Consumer Behavior Representative Consumer Rationale Two goods Consumption bundles
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Representative Consumer: Preferences Three properties of preferences: 1.More is preferred to less 2.Likes diversity 3.C and L are normal goods
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Preferences, Utility function, and Indifference Curves Utility function What is an indifference curve? Properties of indifference curves (derived from properties of preferences).
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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:
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Consumer Choice Consumer’s “problem” is to choose the best consumption bundle subject to constraints: – Time constraint – Budget constraint
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Budget Set (T < π case)
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Consumer Optimization
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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 ?
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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.
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Increase in the real wage rate: Income and substitution effects
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Labor Supply Curve Ns(w) = h – l(w) What is the effect of an increase in non-wage income? (dividends or lump- sum taxes)
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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.
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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).
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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).
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Cobb-Douglas Production Fn Y = zKa (Nd)b
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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).
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Complementarities in prod’n: 5. MPN increases as K increases (and MPK increases as N increases).
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Figure 4.17 Adding Capital Increases the Marginal Product of Labor
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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
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Figure 4.18 Total Factor Productivity Increases
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Figure 4.19 Effect of an Increase in Total Factor Productivity on the Marginal Product of Labor
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The Objective of the Firm is… MAXIMIZE PROFIT! Profit is... – Revenue minus costs: π = Y – w*Nd= zF( K, Nd ) – w*Nd
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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 )
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Figure 4.20 The Solow Residual for the United States
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