Case Econ08 Ab - Az.ppt 30

Chapter
30
Household and Firm
Behavior in the
Macroeconomy:
A Further Look
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Household and Firm
Behavior in the
Macroeconomy:
30
Chapter Outline
Households: Consumption and
A Further Look Labor Supply Decisions
The Keynesian Theory of Consumption: A Review
The Life-Cycle Theory of Consumption
The Labor Supply Decision
Interest Rate Effects on Consumption
Government Effects on Consumption and Labor
Supply: Taxes and Transfers
A Possible Employment Constraint on Households
A Summary of Household Behavior
ht r u F A: y mo noce orc a M
The Household Sector Since1970

Firms: Investment and Employment Decisions
Expectations and Animal Spirits
Excess Labor and Excess Capital Effects
Inventory Investment
A Summary of Firm Behavior
The Firm Sector Since 1970
Productivity and the Business Cycle
TP A HC
The Relationship Between Output and

Unemployment
The Size of the Multiplier
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 34
HOUSEHOLDS: CONSUMPTION AND LABOR
SUPPLY DECISIONS
THE KEYNESIAN THEORY OF CONSUMPTION: A

REVIEW
average propensity to consume
(APC) The proportion of income
households spend on consumption.
Determined by dividing
consumption (C) by income (Y).
C
APC =
Y
Although the idea that consumption depends on income is
a useful starting point, it is far from a complete description
of the consumption decision.
TP A HC
SUPPLY DECISIONS
THE LIFE-CYCLE THEORY OF CONSUMPTION
life-cycle theory of consumption

A theory of household consumption:
Households make lifetime
consumption decisions based on
their expectations of lifetime income.
permanent income The average

level of one’s expected future
income stream.
TP A HC
SUPPLY DECISIONS
THE LIFE-CYCLE THEORY OF CONSUMPTION

TP A HC
FIGURE 17.1 Life-Cycle Theory of Consumption
SUPPLY DECISIONS
THE LABOR SUPPLY DECISION

Households make consumption and labor supply decisions simultaneously.
Consumption cannot be considered separately from labor supply, because it is
precisely
by selling your labor that you earn income to pay for your consumption.
The Wage Rate

According to the substitution effect of a wage rate
increase, a higher wage leads to a larger quantity
of labor supplied—a larger workforce.
According to the income effect of a wage rate

increase, if we assume that leisure is a normal
good, people with higher income will spend
some of it on leisure by working less.
TP A HC
SUPPLY DECISIONS
Prices
nominal wage rate The wage rate
in current dollars.
real wage rate The amount

that the nominal wage rate can
buy in terms of goods and
services.
Households look at expected future real wage rates as well as the current real wage rate
in making their current consumption and labor supply decisions.
TP A HC
SUPPLY DECISIONS
Wealth and Nonlabor Income

nonlabor, or nonwage, income
Any income received from sources
other than working—inheritances,
interest, dividends, transfer
payments, and so on.
Holding everything else constant (including the stage in the life cycle), the more wealth
a household has, the more it will consume, both now and in the future.
An unexpected increase in nonlabor income will have a positive effect on a household’s

consumption.
TP A HC
An unexpected increase in wealth or nonlabor income leads to a decrease in labor

supply.
SUPPLY DECISIONS
INTEREST RATE EFFECTS ON CONSUMPTION
A rise in the interest rate leads me to consume

less today and save more. This effect is called
the substitution effect of an interest rate change.
There is also an income effect of an interest rate

change on consumption. If a household has
positive wealth and is earning interest on that

wealth, a fall in the interest rate leads to a fall in
interest income.
TP A HC
SUPPLY DECISIONS
GOVERNMENT EFFECTS ON CONSUMPTION

AND LABOR SUPPLY: TAXES AND TRANSFERS
The Effects of Government on Household Consumption and

Labor Supply
Income Tax Rates Transfer Payments

INCREASE DECREASE INCREASE DECREASE
Effect on consumption Negative Positive Positive Negative

Effect on labor supply Negative* Positive* Negative Positive
*If the substitution effect dominates.
Note: The effects are larger if they are expected to be permanent instead of temporary.
TP A HC
SUPPLY DECISIONS
A POSSIBLE EMPLOYMENT CONSTRAINT ON

HOUSEHOLDS
Households consume less if they are constrained from working.
unconstrained supply of labor

The amount a household would like
to work within a given period at the
current wage rate if it could find the
work.
constrained supply of labor The

amount a household actually works
in a given period at the current wage
rate.
TP A HC
SUPPLY DECISIONS
A POSSIBLE EMPLOYMENT CONSTRAINT ON

HOUSEHOLDS
Keynesian Theory Revisited
In Keynesian theory, current income determines
current consumption. It is incorrect to think
consumption depends only on income, at least
when there is full employment. However, if there
is unemployment, Keynes is closer to being
correct because income is not determined by

households. When there is unemployment, the
level of income (at least workers’ income)
depends exclusively on the employment decisions
made by firms.
TP A HC
SUPPLY DECISIONS
A SUMMARY OF HOUSEHOLD BEHAVIOR
The following factors affect household consumption and labor supply decisions:
■ Current and expected future real wage rates

■ Initial value of wealth
■ Current and expected future nonlabor income
■ Interest rates
■ Current and expected future tax rates and transfer payments
TP A HC
SUPPLY DECISIONS
THE HOUSEHOLD SECTOR SINCE 1970

Consumption
TP A HC
FIGURE 17.2 Consumption Expenditures, 1970 I–2005 II
SUPPLY DECISIONS

Housing Investment
TP A HC
FIGURE 17.3 Housing Investment of the Household Sector, 1970 I–2005 II
SUPPLY DECISIONS

Labor Supply
TP A HC
FIGURE 17.4 Labor Force Participation Rates for Men 25 to 54, Women 25
to 54, and All Others 16 and Over, 1970 I–2005 II
FIRMS: INVESTMENT AND EMPLOYMENT
DECISIONS
inputs The goods and services

that firms purchase and turn into
output.
Investment Decisions
plant-and-equipment
investment Purchases by firms of
additional machines, factories, or
buildings within a given period.
inventory investment Occurs

when a firm produces more output
than it sells within a given period.
TP A HC
DECISIONS
Employment Decisions
The demand for labor is quite important in

macroeconomics. If the demand for labor
increases at a time of less-than-full employment,
the unemployment rate will fall. If the
demand for labor increases when there is full
employment, wage rates will rise.
TP A HC
DECISIONS
Decision Making and Profit Maximization
labor-intensive technology A
production technique that uses a
large amount of labor relative to
capital.
capital-intensive technology A
production technique that uses a

large amount of capital relative to
labor.
TP A HC
DECISIONS
EXPECTATIONS AND ANIMAL SPIRITS
animal spirits of entrepreneurs A

phrase coined by Keynes to
describe investors’ feelings.
Because expectations about the future are, as

Keynes points out, subject to great uncertainty,
they may change often. Thus animal spirits help to

make investment a volatile component of GDP.
TP A HC
DECISIONS
The Accelerator Effect
At any given level of the interest rate, expectations are likely to be more optimistic
and planned investment is likely to be higher when output is growing rapidly than
when it is growing slowly or falling.
accelerator effect The tendency

for investment to increase when
aggregate output increases and to
decrease when aggregate output

decreases, accelerating the growth
or decline of output.
TP A HC
DECISIONS
EXCESS LABOR AND EXCESS CAPITAL

EFFECTS
excess labor, excess

capital Labor and capital that
are not needed to produce the
firm’s current level of output.
adjustment costs The costs that

a firm incurs when it changes its

production level—for example,
the administration costs of laying
off employees or the training
TP A HC
costs of hiring new workers.

DECISIONS
INVENTORY INVESTMENT
The Role of Inventories
stock of inventories (end of period) = stock of inventories (beginning of period)
+ production – sales
The Optimal Inventory Policy
desired, or optimal, level of

inventories The level of inventory
at which the extra cost (in lost sales)

from lowering inventories by a small
amount is just equal to the extra gain
(in interest revenue and
TP A HC
decreased storage costs).

DECISIONS
INVENTORY INVESTMENT
The Optimal Inventory Policy
An unexpected increase in inventories has a negative effect on future production, and
an unexpected decrease in inventories has a positive effect on future production.
The level of a firm’s planned production path depends on the level of its expected
future sales path. If a firm’s expectations of the level of its future sales path decrease,
the firm is likely to decrease the level of its planned production path, including its
actual production in the current period. Current production depends on expected
future sales.
TP A HC
DECISIONS
A SUMMARY OF FIRM BEHAVIOR
The following factors affect firms’ investment and employment decisions:

■ Wage rate and cost of capital (the interest rate is an important component of the
cost
of capital)
■ Firms’ expectations of future output
■ Amount of excess labor and excess capital on hand
The most important points to remember about the relationship among production, sales,
and inventory investment are:
■ Inventory investment—that is, the change in the stock of inventories—equals

production minus sales
■ An unexpected increase in the stock of inventories has a negative effect on future
production
■ Current production depends on expected future sales
TP A HC
DECISIONS
THE FIRM SECTOR SINCE 1970

Plant-and-Equipment Investment
TP A HC
FIGURE 17.5 Plant and Equipment Investment of the Firm Sector, 1970 I–2005 II
DECISIONS

Employment
TP A HC
FIGURE 17.6 Employment in the Firm Sector, 1970 I–2005 II
DECISIONS

Inventory Investment
TP A HC
FIGURE 17.7 Plant and Equipment Investment of the Firm Sector, 1970 I–2005 II
PRODUCTIVITY AND THE BUSINESS CYCLE
productivity, or labor productivity Output
per worker hour; the amount of output
produced by an average worker in 1 hour.
During expansions in the

economy, output rises
by a larger percentage than
employment, and the ratio of
output to workers rises.
During downswings, output falls

faster than employment and the

ratio of output to workers falls.
TP A HC
FIGURE 17.8 Employment and Output over the Business Cycle
PRODUCTIVITY AND THE BUSINESS CYCLE
Productivity in the Long Run
Productivity figures can be misleading when used to diagnose the health of the economy
over the short run, because business cycles can distort the meaning of productivity
measurements. Output per worker falls in recessions because firms hold excess labor
during slumps. Output per worker rises in expansions because firms put the excess labor
back to work. Neither of these conditions has anything to do with the economy’s long-run
potential to produce output.
TP A HC
THE RELATIONSHIP BETWEEN OUTPUT
AND UNEMPLOYMENT
Okun’s Law The theory, put forth by

Arthur Okun, that the unemployment rate
decreases about 1 percentage point for
every 3 percent increase in real GDP.
Later research and data have shown that
the relationship between output and
unemployment is not as stable as Okun’s
“Law” predicts.
TP A HC
THE RELATIONSHIP BETWEEN OUTPUT
AND UNEMPLOYMENT
Let E denote the number of people employed, let L denote

the number of people in the labor force, and let u denote the
unemployment rate. In these terms, the unemployment rate
is u = 1 – E/L. The unemployment rate is 1 minus the
employment rate, E/L.
discouraged-worker effect The decline in

the measured unemployment rate that
results when people who want to work but
cannot find work grow discouraged and stop
looking for jobs, dropping out of the ranks of

the unemployed and the labor force.
The relationship between output and unemployment depends on the state of the economy
at the time of the output change.
TP A HC
THE SIZE OF THE MULTIPLIER
The value of the multiplier in reality is smaller than the simple

multiplier. We can now summarize why.
 There are automatic stabilizers.
 The interest rate and the crowding-out effect.
 The effect of expansionary policy on the price level.
 The fact that firms hold excess capital and excess
labor.
 Inventories.
 Expectations.
The Size of the Multiplier in Practice

In practice, the multiplier probably has a value of around 1.4.
Its size also depends on how long ago the spending increase
began.
TP A HC
REVIEW TERMS AND CONCEPTS
accelerator effect inputs

adjustment costs inventory investment
animal spirits of labor-intensive technology
entrepreneurs life-cycle theory of consumption
average propensity to nominal wage rate
consume (APC) nonlabor, or nonwage, income
capital-intensive technology Okun’s Law
constrained supply of labor permanent income
desired, or optimal, level of plant-and-equipment investment
inventories productivity, or labor productivity

discouraged-worker effect real wage rate
excess capital unconstrained supply of labor
excess labor
C
APC =
TP A HC
Y

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Chapter

Fernando & Yvonn Quijano

The Household Sector Since1970

The Relationship Between Output and

THE KEYNESIAN THEORY OF CONSUMPTION: A

THE LIFE-CYCLE THEORY OF CONSUMPTION

life-cycle theory of consumption

permanent income The average

THE LIFE-CYCLE THEORY OF CONSUMPTION

FIGURE 17.1 Life-Cycle Theory of Consumption

THE LABOR SUPPLY DECISION

The Wage Rate

According to the income effect of a wage rate

THE LABOR SUPPLY DECISION

real wage rate The amount

THE LABOR SUPPLY DECISION

Wealth and Nonlabor Income

An unexpected increase in nonlabor income will have a positive effect on a household’s

An unexpected increase in wealth or nonlabor income leads to a decrease in labor

INTEREST RATE EFFECTS ON CONSUMPTION

A rise in the interest rate leads me to consume

There is also an income effect of an interest rate

positive wealth and is earning interest on that

GOVERNMENT EFFECTS ON CONSUMPTION

The Effects of Government on Household Consumption and

Income Tax Rates Transfer Payments

Effect on consumption Negative Positive Positive Negative

A POSSIBLE EMPLOYMENT CONSTRAINT ON

unconstrained supply of labor

constrained supply of labor The

A POSSIBLE EMPLOYMENT CONSTRAINT ON

correct because income is not determined by

A SUMMARY OF HOUSEHOLD BEHAVIOR

■ Current and expected future real wage rates

THE HOUSEHOLD SECTOR SINCE 1970

FIGURE 17.2 Consumption Expenditures, 1970 I–2005 II

THE HOUSEHOLD SECTOR SINCE 1970

FIGURE 17.3 Housing Investment of the Household Sector, 1970 I–2005 II

THE HOUSEHOLD SECTOR SINCE 1970

inputs The goods and services

inventory investment Occurs

The demand for labor is quite important in

Decision Making and Profit Maximization

production technique that uses a

EXPECTATIONS AND ANIMAL SPIRITS

animal spirits of entrepreneurs A

Because expectations about the future are, as

they may change often. Thus animal spirits help to

The Accelerator Effect

accelerator effect The tendency

decrease when aggregate output

EXCESS LABOR AND EXCESS CAPITAL

excess labor, excess

adjustment costs The costs that

a firm incurs when it changes its

costs of hiring new workers.

The Optimal Inventory Policy

desired, or optimal, level of

at which the extra cost (in lost sales)

decreased storage costs).

A SUMMARY OF FIRM BEHAVIOR

The following factors affect firms’ investment and employment decisions: