CONSUMPTION-LABOR FRAMEWORK (aka CONSUMPTION-LEISURE FRAMEWORK) CHAPTER 2 2THE THREE MACRO (AGGREGATE) MARKETS The Road Ahead Goods Markets Labor Markets Financial/Capital/Savings/Asset Markets Will put micro-foundations under all three c P labor wage capital interest rate 3BASICS Introduction Consumption-Leisure Framework – provides foundation for Labor-market supply function Goods-market demand function An application of the basic consumer theory model… …we will put a macro interpretation on it Only one time period – no “future” for which to save Notation c: consumption (“all stuff”) n: number of hours spent working per unit l: number of hours leisure per unit (time spent not working) P: dollar price of one unit of consumption (a nominal variable) W: hourly wage rate in terms of dollars (a nominal variable) t: tax rate on labor income “Weekly,” “monthly,” “yearly” is a detail Just need to take SOME stand on the length of a “period” n + l = 1 n (l) is the percentage of time working (in leisure) n + l = 1 4BASICS Introduction Building blocks of consumption-leisure framework Utility Describes the benefits of engaging in labor market (and other) activities Budget constraint Describes the costs of engaging in labor market (and other) activities Utility and budgets two DISTINCT concepts As in basic consumer analysis (Chapter 1) Only after describing utility and budgets separately do we bring the two together to obtain predictions from the framework 5UTILITY Model Structure Preferences u(c, l) with all the “usual properties” Strictly increasing in c Strictly increasing in l Diminishing marginal utility in c Diminishing marginal utility in l Plotted in good-by-good spaces: Plotted as indifference curves Utility side of consumption-leisure framework identical to Chapter 1 framework c u(c,l) leisure u(c,l) leisure c 6BUDGET CONSTRAINT Model Structure Consumer must work for his income Y no longer “falls from the sky” Pc Y (1 )Pc t Wn Y = (1-t)Wn (all income is after-tax labor income) Rearrange 1 1 2 2Pc Pc Y Spending on c1 Spending on c2 A constant from the point of view of the individual Simply an application/re- interpretation of our basic consumer theory framework Chapter 1 budget constraint (After-tax) wage is opportunity cost of leisure, hence the “price” of leisure - opportunity costs are real economic costs/prices A constant from the point of view of the individual (price- taker) Spending on consumption (1 ) (1 )Pc t Wl t W (1 ) (1 )Pc t W l n = 1 – l “Spending” on leisure 7CONSUMER OPTIMIZATION Model Structure Consumer’s decision problem: maximize utility subject to budget constraint – bring together both cost side and benefit side Choose c and l subject to Plot budget line leisure c (1 ) (1 )c t Wl WP t Isolate c to graph the budget constraint ) (1 )(1c t W tlP W ) 1 )(1 (t W P t W c l P slope = -(1-t)W/P IMPORTANT: the larger is (1-t)W/P, the steeper is the budget line 1 (1 ) (1 )Pc t Wl t W 8CONSUMER OPTIMIZATION Model Structure Consumer’s decision problem: maximize utility subject to budget constraint – bring together both cost side and benefit side Choose c and l subject to Plot budget line Superimpose indifference map At the optimal choice leisure c slope = -(1-t)W/P optimal choice (c*,l*) ( *, *) (1 ) ( *, *) l c u c l t W u c l P CONSUMPTION-LEISURE OPTIMALITY CONDITION - A key building block of modern macro models MRS (between consumption and leisure) price ratio (inclusive of taxes) IMPORTANT: the larger is (1-t)W/P, the steeper is the budget line 1 (1 ) (1 )Pc t Wl t W 9REAL WAGE Macro Fundamentals W/P a crucial measure for macroeconomic analysis Unit Analysis (i.e., analyze algebraic units of variables) Units(W) = $/hour of work Units(P) = $/unit of consumption Units(W/P) = Economic decisions depend on real wages (W/P), not nominal wages (W) Measures the purchasing power of (nominal) wage earnings… …which is presumably what people most care about $ $ unit of consumptionhour of work $ hour of work $ unit of consumption unit of consumption hour of work Will sometimes denote using w (lower-case…) 10 CONSUMER OPTIMIZATION The Graphics of the Consumption-Leisure Model Consumer’s decision problem: maximize utility subject to budget constraint – bring together both cost side and benefit side Choose c and l subject to Plot budget line Superimpose indifference map At the optimal choice leisure c slope = -(1-t)W/P optimal choice (c*,l*) ( *, *) (1 ) ( *, *) l c u c l t W u c l P CONSUMPTION-LEISURE OPTIMALITY CONDITION - key result in modern macro analysis MRS (between consumption and leisure) After-tax real wage Derive consumption-leisure optimality condition using Lagrange analysis IMPORTANT: the larger is (1-t)W/P, the steeper is the budget line 1 (1 ) (1 )Pc t Wl t W 11 LAGRANGE ANALYSIS The Mathematics of the Consumption-Leisure Model Apply Lagrange tools to consumption-leisure optimization Objective function: u(c,l) Constraint: g(c,l) = (1-t)W – Pc – (1-t)Wl = 0 Step 1: Construct Lagrange function Step 2: Compute first-order conditions with respect to c, l, λ Step 3: Combine (1) and (2) (with focus on eliminating multiplier) * * * * ( , ) (1 ) ( , ) l c u c l t W u c l P CONSUMPTION-LEISURE OPTIMALITY CONDITION MRS (between consumption and leisure) After-tax real wage ( , ) 0cu c l P ( , ) (1 ) 0lu c l t W (1 ) (1 ) 0t W Pc t Wl ( , , ) ( , ) (1 ) (1 )L c l u c l t W Pc t Wl 12 MICRO-LEVEL LABOR SUPPLY Labor Supply in the Micro An experiment: how do micro-level consumption/leisure choices change as the real wage changes (assume t = 0 here for simplicity) REAL WAGES: (W/P)1 < (W/P)2 leisure c slope = -(W/P)1 l*1 c*1 slope = -(W/P)2 l*2 c*2 1 13 MICRO-LEVEL LABOR SUPPLY Labor Supply in the Micro An experiment: how do micro-level consumption/leisure choices change as the real wage changes (assume t = 0 here for simplicity) REAL WAGES: (W/P)1 < (W/P)2 < (W/P)3 leisure c slope = -(W/P)1 l*1 c*1 slope = -(W/P)2 l*2 c*2 slope = -(W/P)3 l*3 c*3 1 14 MICRO-LEVEL LABOR SUPPLY Labor Supply in the Micro An experiment: how do micro-level consumption/leisure choices change as the real wage changes (assume t = 0 here for simplicity) REAL WAGES: (W/P)1 < (W/P)2 < (W/P)3 < (W/P)4 leisure c slope = -(W/P)1 l*1 c*1 slope = -(W/P)2 l*2 c*2 slope = -(W/P)3 l*3 = l*4 c*3 slope = -(W/P)4 c*4 1 15 MICRO-LEVEL LABOR SUPPLY Labor Supply in the Micro An experiment: how do micro-level consumption/leisure choices change as the real wage changes (assume t = 0 here for simplicity) REAL WAGES: (W/P)1 < (W/P)2 < (W/P)3 < (W/P)4 < (W/P)5 leisure c slope = -(W/P)1 l*1 c*1 slope = -(W/P)2 l*2 c*2 slope = -(W/P)3 l*3 = l*4 c*3 slope = -(W/P)4 c*4 slope = -(W/P)5 c*5 l*5 1 16 MICRO-LEVEL LABOR SUPPLY Labor Supply in the Micro An experiment: how do micro-level consumption/leisure choices change as the real wage changes (assume t = 0 here for simplicity) REAL WAGES: (W/P)1 < (W/P)2 < (W/P)3 < (W/P)4 < (W/P)5 leisure c slope = -(W/P)1 l*1 c*1 slope = -(W/P)2 l*2 c*2 slope = -(W/P)3 l*3 = l*4 c*3 slope = -(W/P)4 c*4 slope = -(W/P)5 c*5 l*5 SUMMARY 1. For low levels of real wages, a rise in the real wage causes optimal leisure to decrease 2. For intermediate levels of real wages, a rise in the real wage causes optimal leisure to remain unchanged 3. For high levels of real wages, a rise in the real wage causes optimal leisure to increase 1 17 MICRO-LEVEL LABOR SUPPLY Labor Supply in the Micro Using the relation n = 1 - l labor real wage n*1 n*2 n*3 = n*4 n*5 Backward-bending labor supply curve at the micro level… 18 DECOMPOSING EFFECTS OF PRICE CHANGES Micro Fundamentals Substitution effect General two-good case: if relative price of good 1 increases (i.e., P1/P2 increases), purchases of good 1 decrease Good 1 more expensive buy less of it Application to consumption-leisure framework: if real wage W/P increases (i.e., the relative price (opportunity cost) of leisure), choose less leisure choose to work more Income effect General two-good case: if total income increases (i.e., Y increases), purchases of all goods increases Richer buy more of everything Application to consumption-leisure framework: if real wage W/P increases total income increases (holding all else constant…) choose more leisure (leisure is a good) choose to work less Work in opposite directions in C-L framework 19 MICRO-LEVEL LABOR SUPPLY Labor Supply in the Micro Using the relation n = 1 - l labor real wage n*1 n*2 n*3 = n*4 n*5 Backward-bending labor supply curve at the micro level… Substitution effect dominates the income effect Income effect dominates the substitution effect Income effect and substitution effect roughly cancel 20 LABOR SUPPLY Labor Supply in the Micro and the Macro Using the relation n = 1 - l labor real wage n*1 n*2 n*3 = n*4 n*5 Backward-bending labor supply curve at the micro level… Substitution effect dominates the income effect Income effect dominates the substitution effect Income effect and substitution effect roughly cancel labor real wage …but not at the macro level S Individual-level labor supply function Aggregate-level labor supply function Sum over all individuals 21 MACRO VS. MICRO LABOR QUANTITIES Micro-Macro Connections Standard rep-agent framework offers an average theory of employment But not necessarily of unemployment Search and matching theory is a theory of unemployment (will come back to this later…) Aggregate Hours WorkedAverage hours per worker Number of individuals working =Aggregate Hours Worked = Average hours per worker Number of individuals workingx Micro studies measure this “Intensive margin” “Extensive margin” Macro/representative-agent framework typically focuses on this 22 CONSUMPTION DEMAND Consumption Demand in the Micro and the Macro Optimal choice of consumption was always rising as real wage was rising Could have conducted the entire analysis assuming nominal W was held fixed and nominal P was falling Which means real wage W/P is rising Result: Fall in P rise in optimal c always Implies downward-sloping consumption demand function at the micro level… …and at the aggregate level Consumption demand over two-thirds of aggregate demand in developed countries 23 THE THREE MACRO (AGGREGATE) MARKETS The Three Macro Markets Goods Markets Demand derived from “C-L framework” Labor Markets Supply derived from “C-L framework” Financial/Capital/Savings/Asset Markets c P labor wage capital interest rate S D CONSUMPTION-SAVINGS FRAMEWORK (SNEAK PEEK) CHAPTER 3 AND 4 25 THE MACROECONOMICS OF TIME Consumption-leisure model a static (i.e., one time period) model Dynamic frameworks the core of modern macroeconomic theory Explicit consideration of how economic decisions/behaviors/outcomes unfold over multiple time periods Two-period framework (Chapters 3 and 4) the simplest possible multi-period framework Will allow us to begin analyzing issues regarding interest rates and inflation (phenomena that occur across time) Will allow us to think about credit restrictions and the “credit crunch” Infinite-period framework (Chapter 8) Allows a richer quantitative description of the macroeconomy Highlights the role of assets and the intersection between finance and macroeconomics
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