Problems

1. Consider the two hypothetical indifference curves in the figure below. Point A is on both indifference
curves, I1 and I2. By construction, the consumer is indifferent between A and B, as both points are on
I2. In like fashion, the consumer is indifferent between A and C, as both points are on I1. But at
point C, the consumer has more consumption and more leisure than at point B. As long as the
consumer prefers more to less, he or she must strictly prefer C to A. We therefore contradict the
hypothesis that two indifference curves can cross.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 28

2. u= al + bC
(a) To specify an indifference curve, we hold utility constant at u . Next rearrange in the form:
u a
C= l
b b
Indifference curves are therefore linear with slope, a /b, which represents the marginal rate of
substitution. There are two main cases, according to whether a /b > w or a /b < w. The top
panel of the left figure below shows the case of a /b < w. In this case the indifference curves are
flatter than the budget line and the consumer picks point A, at which l = 0 and C = wh + T .
The right figure shows the case of a /b > w. In this case the indifference curves are steeper than
the budget line, and the consumer picks point B, at which l = h and C= T . In the
coincidental case in which a /b = w, the highest attainable indifference curve coincides with the
indifference curve, and the consumer is indifferent among all possible amounts of leisure and
hours worked.

(b) The utility function in this problem does not obey the property that the consumer prefers diversity,
and is therefore not a likely possibility.
(c) This utility function does have the property that more is preferred to less. However, the marginal
rate of substitution is constant, and therefore this utility function does not satisfy the property of
diminishing marginal rate of substitution.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 29

3. When the government imposes a proportional tax on wage income, the consumers budget constraint
is now given by:
C= w(1 t )(h l ) + T ,
where t is the tax rate on wage income. In the figure below, the budget constraint for t = 0, is FGH.
When t > 0, the budget constraint is EGH. The slope of the original budget line is w, while the slope
of the new budget line is (1 t)w. Initially the consumer picks the point A on the original budget
line. After the tax has been imposed, the consumer picks point B. The substitution effect of the
imposition of the tax is to move the consumer from point A to point D on the original indifference
curve. The point D is at the tangent point of indifference curve, I1, with a line segment that is parallel
to EG. The pure substitution effect induces the consumer to reduce consumption and increase leisure
(work less).
The tax also makes the consumer worse off, in that he or she can no longer be on indifference curve,
I1, but must move to the less preferred indifference curve, I2. This pure income effect moves the
consumer to point B, which has less consumption and less leisure than point D, because both
consumption and leisure are normal goods. The net effect of the tax is to reduce consumption, but the
direction of the net effect on leisure is ambiguous. The figure shows the case in which the substitution
effect on leisure dominates the income effect. In this case, leisure increases and hours worked fall.
Although consumption must fall, hours worked may rise, fall, or remain the same.

4. The increase in dividend income shifts the budget line upward. The reduction in the wage rate flattens
the budget line. One possibility is depicted in the figures below. The original budget constraint HGL
shifts to HFE. There are two income effects in this case. The increase in dividend income is a positive
income effect. The reduction in the wage rate is a negative income effect. The drawing in the top
figure shows the case where these two income effects exactly cancel out. In this case we are left with
a pure substitution effect that moves the consumer from point A to point B. Therefore, consumption
falls and leisure increases. As leisure increases, hours of work must fall. The middle figure shows a
case in which the increase in dividend income, the distance GF, is larger and so the income effect is
positive. The consumer winds up on a higher indifference curve, leisure unambiguously increases,
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 30

and consumption may either increase or decrease. The bottom figure shows a case in which the
increase in dividend income, the distance GF, is smaller and so the income effect is negative. The
consumer winds up on a lower indifference curve, consumption unambiguously decreases, and
leisure may either increase or decrease.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 31

5. This problem introduces a higher, overtime wage for hours worked above a threshold, q. This
problem also abstracts from any dividend income and taxes.
(a) The budget constraint is now EJG in the figure below. The budget constraint is steeper for levels of
leisure less than h q, because of the higher overtime wage. The figure depicts possible choices for
two different consumers. Consumer #1 picks point A on her indifference curve, I1. Consumer #2
picks point B on his indifference curve, I2. Consumer #1 chooses to work overtime; consumer #2
does not.

(b) The geometry of the figure above makes it clear that it would be very difficult to have an
indifference curve tangent to EJG close to point J. In order for this to happen, an indifference
curve would need to be close to right angled as in the case of pure complement. It is unlikely that
consumers wish to consume goods and leisure in fixed proportions, and so points like A and B
are more typical. For any other allowable shape for the indifference curve, it is impossible for
point J to be chosen.
(c) An increase in the overtime wage steepens segment EJ of the budget constraint, but has no effect
on the segment JG. For an individual like consumer #2, the increase in the overtime wage has no
effect up until the point at which the increase is large enough to shift the individual to a point like
point A. Consumer #2 receives no income effect because the income effect arises out of a higher
wage rate on inframarginal units of work. An individual like consumer #1 has the traditional
income and substitution effects of a wage increase. Consumer #1 increases her consumption, but
may either increase or reduce hours of work according to whether the income effect outweighs
the substitution effect.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 32

6. Lump-sum Tax vs. Proportional Tax. Suppose that we start with a proportional tax. Under the
proportional tax the consumers budget line is EFH in the figure below. The consumer chooses
consumption, C *, and leisure, l *, at point A on indifference curve I1. A shift to a lump-sum tax
steepens the budget line. The absolute value of the slope of the budget line is (1 t )w, and t has
fallen to zero. The imposition of the lump-sum tax shifts the budget line downward in a parallel
fashion. By construction, the lump-sum tax must raise the same amount of revenue as the
proportional tax. The consumer must therefore be able to continue to consume C * of the
consumption good and l * of leisure after the change in tax collection. Therefore, the new budget
line must also pass through point A. The new budget line is labeled LGH in the figure below. With
the lump-sum tax, the consumer can do better by choosing point B, on the higher indifference curve,
I2. Therefore, the consumer is clearly better off. We are also assured that consumption will be greater
at point B than at point A, and that leisure will be smaller at point B than at point A.

7. Leisure represents all time used for nonmarket activities. If the government is now providing for
some of those, like providing free child care, households will take advantage of such a program,
thereby allowing more time for other activities, including market work. Concretely, this translates in
a change of preferences for households. For the same amount of consumption, they are now willing to
work more, or in other words, they are willing to forego some additional leisure. On the figure below,
the new indifference curve is labeled I2. It can cross indifference curve I1 because preferences, as we
measure them here, have changed. The equilibrium basket of goods for the household now shifts
from A to B. This leads to reduced leisure (from l*1 to l*2), and thus increased hours worked, and
increased consumption (from C*1 to C*2) thanks to higher labor income at the fixed wage.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 33

8. The firm chooses its labor input, Nd, so as to maximize profits. When there is no tax, profits for the
firm are given by
= zF ( K, N d ) wN d .
That is, profits are the difference between revenue and costs. In the top figure on the following page,
the revenue function is zF (K, N d ) and the cost function is the straight line, wNd. The firm
maximizes profits by choosing the quantity of labor where the slope of the revenue function equals
the slope of the cost function:
MPN = w.
The firms demand for labor curve is the marginal product of labor schedule in the bottom figure on
the following page.
With a tax that is proportional to the firms output, the firms profits are given by:
zF (K, N d ) wN d tzF (K, N d )
=
= (1 t )zF (K, N d ),
where the term (1 t )zF ( K, N d ) is the after-tax revenue function, and as before, wNd is the cost
function. In the top figure below, the tax acts to shift down the revenue function for the firm and
reduces the slope of the revenue function. As before, the firm will maximize profits by choosing
the quantity of labor input where the slope of the revenue function is equal to the slope of the cost
function, but the slope of the revenue function is (1 t ) MPN , so the firm chooses the quantity of
labor where
(1 t ) MPN =
w.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 34

In the bottom figure below, the labor demand curve is now (1 t ) MPN , and the labor demand curve
has shifted down. The tax acts to reduce the after-tax marginal product of labor, and the firm will hire
less labor at any given real wage.

9. The firm chooses its labor input Nd so as to maximize profits. When there is no subsidy, profits for
the firm are given by
= zF ( K, N d ) wN d .
That is, profits are the difference between revenue and costs. In the top figure on the following page
the revenue function is zF (K, N d ) and the cost function is the straight line, wNd. The firm
maximizes profits by choosing the quantity of labor where the slope of the revenue function equals
the slope of the cost function:
MPN = w.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 35

The firms demand for labor curve is the marginal product of labor schedule in the bottom figure
below.
With an employment subsidy, the firms profits are given by:
= zF (K, N d ) (w s) N d
where the term zF (K, N d ) is the unchanged revenue function, and (w s)Nd is the cost function. The
subsidy acts to reduce the cost of each unit of labor by the amount of the subsidy, s. In the top figure
below, the subsidy acts to shift down the cost function for the firm by reducing its slope. As before,
the firm will maximize profits by choosing the quantity of labor input where the slope of the revenue
function is equal to the slope of the cost function, (t s), so the firm chooses the quantity of labor
where
MPN= w s.
In the bottom figure below, the labor demand curve is now MPN + s, and the labor demand curve
has shifted up. The subsidy acts to reduce the marginal cost of labor, and the firm will hire more labor
at any given real wage.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 36

10. Minimum Employment Requirement. Below N *, no output is produced. Thereafter, the production
function has its usual properties. Such a production function is reproduced in the first two figures
below. At high wages, the firms cost curve is entirely above the revenue curve, so the firm hires no
labor, to prevent incurring losses. Only if the wage rate is less than w will the firms choose to hire
anyone. At w = w , the firm chooses N*, just as it would in the absence of the constraint. Below w,
the labor demand curve is unaffected. The labor demand curve is reproduced in the bottom figure.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 37

11. The level of output produced by one worker who works h l hours is given by
=Ys zF ( K, h l ).
This equation is plotted in the figure below. The slope of this production possibilities frontier is
simply MPN .

12. As the firm has to internalize the pollution, it realizes that labor is less effective than it previously
thought. It now needs to hire N(1 + x) workers where N were previously sufficient. This is qualitatively
equivalent to a reduction of z, total factor productivity. The figure below highlights the resulting
outcome: the firm now hires fewer people for a given wage and thus its labor demand is reduced.
 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 38

13. Y = zK 0.3 n 0.7