Unit II – Labor Markets

Chapter 4 – Consumer and Firm Behavior: The

Work-Leisure Decision and Profit
Maximization
n Solutions to End-of-Chapter 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.

2.

(a) To specify an indifference curve, we hold utility constant at Next rearrange in the
form:

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23 Williamson • Macroeconomics, Sixth Edition

Indifference curves are therefore linear with slope, a/b, which represents the marginal rate of
substitution. There are two main cases, according to whether or The top panel of the left
figure below shows the case of In this case the indifference curves are flatter than the budget line
and the consumer picks point A, at which and The right figure shows the case of
In this case the indifference curves are steeper than the budget line, and the consumer picks point
B, at which and In the coincidental case in which 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.

3. (a) Using the formulas in the example from the textbook, one obtains:

l = C = (0.75  16 - 0.8 - 6)/(1 + 0.75) = 3.89

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 24

Given the numbers provided, we can precisely determine the coordinates of the points in the figure
above: A is (0,6.8), B is (3.89,3.89), D is (9.07,0), with the slope of ABD being - 0.75.

(b) With the new wage, we obtain: l = C = (1.5  16 - 0.8 - 6)/(1 + 1.5) = 7.52

where A, B and D have the same coordinates as above, and E is (0, 12.8), F is (7.52, 7.52), H is
(12.53,0), and the slope of EFH is - 1.5. As there are no substitution effects when goods are
perfect complements, the entire move from point B to point F is due to the income effect.

4. When the government imposes a proportional tax on wage income, the consumer’s budget
constraint is now given by:

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.

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25 Williamson • Macroeconomics, Sixth Edition

5. The budget constraint has a kink due to the tax deduction and is represented in the following
figures by ABDh. Reducing the tax deduction pushes the budget constraint to FEDh.

First consider a consumer who does not pay taxes. In the old regime, he would have an optimal
bundle somewhere between B and D. Two things can happen. If the bundle is between E and D,
there is no change. If it is between B and E, say at H, then the household will reoptimize with the
new tax deduction. The new bundle is then either somewhere between E and F, and the MRS
equals w(1 - t). Or we obtain a corner solution at E, and the MRS is somewhere between w and
w(1 - t). The move from H to E is due to the income effect, and if there is an optimal strictly
between E and F, the move from E to that point is due to the substitution effect.

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 26

For a consumer who pays taxes, his wage, and thus his MRS, does not change. Thus the move
from H to J is a pure negative income effect.

6. There are two effects we could think about in this instance, and possibly both are at work here.
First, as workers pass their peak in productivity later in life, their wages will begin to fall. As an
older worker’s wage falls, then this works in the opposite direction to Figure 4.8 in Chapter 4.
There are income and substitution effects at work, and so the theory predicts that an older worker
whose wage falls may work more, if the income effect dominates, or less, if the substitution effect
dominates. So, this could explain why older workers work less before retirement, provided that we
have some assurance that there are strong substitution effects. Second, it is possible that
preferences change as workers get older. Suppose that older workers develop a greater preference
for leisure – they can earn as high a wage if they choose to work, but at the margin they like
leisure more. This means that indifference curves are steeper for each consumption bundle. Then,
given the same budget constraint, older workers will take more leisure and work less.

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27 Williamson • Macroeconomics, Sixth Edition

7. 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.

8. Lump-sum Tax vs. Proportional Tax. Suppose that we start with a proportional tax. Under the
proportional tax the consumer’s budget line is EFH in the figure below. The consumer chooses
consumption, and leisure, 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 and t has
fallen to zero. The imposition of the lump-sum tax shifts the budget line downward in a parallel

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 28

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 of the
consumption good and 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.

9. 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.

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29 Williamson • Macroeconomics, Sixth Edition

10. Supposing that the only options open to the consumer are working q hours and paying a tax T, or
working zero hours and receiving an unemployment insurance benefit b, consumption will be w(h-
q)-T if the consumer works, and b if the consumer decides not to work. Then, either the consumer
prefers not to work, as in the Figure 10.1, where the highest indifference curve is achieved at point
A rather than at point B, or the consumer prefers to work, as in Figure 10.2. There is also another
case where the consumer is just indifferent between working and not working, but that case is not
important.

(a) Think of the economy as consisting of many consumers, some of whom are in a situation
as in the Figure 10.1 and some as in Figure 10.2. Some consumers do not work, and some
choose to work. If the wage goes up, then that will make working preferable for some
consumers who formerly did not choose to work. An increase in the wage will not
discourage anyone from working, but those who were working already will not choose to
vary hours of work (they cannot). But total employment in the economy will increase, as
now more people are working. With the constraint on hours of work, there are no issues
related to income and substitution effects. A higher wage always increases the total
quantity of labor supplied.

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 30

Figure 10.1

Figure 10.2

(b) Similar to part (a), if the unemployment insurance benefit increases, this will make not
working preferable to some consumers who were formerly working, and employment will
fall. An increase in the unemployment insurance benefit unequivocally reduces the
quantity of labor supplied.

11. We can write the household’s budget constraint as

C=w 1 ( h1−l 1 ) +w 2(h2−l 2)

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31 Williamson • Macroeconomics, Sixth Edition

This makes the problem seem complicated, but because w1 > w2, and the household cares
collectively only about total consumption and total leisure time of the household, it will be optimal
for only person 1 to work so long as person 1 is not supplying all available time as labor. Therefore
the budget constraint for the household looks like the following:

The household’s budget constraint is ABDF. Only person 1 works if the household chooses a point
on DB, while both members of the household work if the household chooses a point on FD, with
person 1 supplying all of his or her available time as labor. If the wage of person 2 increases, ABD
remains the same in the figure, but FD becomes steeper. Therefore, if the household had
previously chosen a point on DB, then the household’s behavior would not change, except if the
household had chosen point D and person 2’s wage increased sufficiently. However, if person 2
were working initially (a point on DF) was chosen, then our analysis would be exactly the same as
for a consumer facing a market wage that increases. There would be income and substitution
effects involved in the household’s labor supply decision, and person 2 might work more or less as
a result.

12. The firm chooses its labor input, Nd, so as to maximize profits. When there is no tax, profits for the
firm are given by

That is, profits are the difference between revenue and costs. In the top figure on the following
page, the revenue function is 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:

The firm’s demand for labor curve is the marginal product of labor schedule in the bottom figure
on the following page.

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 32

With a tax that is proportional to the firm’s output, the firm’s profits are given by:

where the term is the after-tax revenue function, and as before, wNd is the cost
function. In the first of the following figures, 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 so the firm chooses
the quantity of labor where:

In the second figure, the labor demand curve is now 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.

13. The firm chooses its labor input Nd so as to maximize profits. When there is no subsidy, profits for
the firm are given by

That is, profits are the difference between revenue and costs. In the first of the following set of
figures on the the revenue function is 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:

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33 Williamson • Macroeconomics, Sixth Edition

The firm’s demand for labor curve is the marginal product of labor schedule in the second of the
following figures.

With an employment subsidy, the firm’s profits are given by:

where the term 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
first of the following figures, 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:

In the second figure, the labor demand curve is now 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.

14. In Figure 13.1, given the minimum quantity of employment that the firm requires to operate, the
production function (identical to the total revenue function) follows ABD, and then continues
along the same production function we would have without the minimum quantity of employment.
The firm maximizes profits, which implies that, if the market wage rate is greater than w* the firm
will earn negative profits for any quantity of labor input greater than or equal to N*. Therefore, if
w > w* then If the real wage rate is less than or equal to w* (so that the firm can earn

positive profits for at least some positive quantities of labor input), but larger than (the
marginal product of labor when ), then the firm will choose to maximize

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 34

profits, as is the case in Figure 13.1 when . That is, choosing is better than
choosing in this case, because the firm will earn positive profits rather than zero profits.

However, if the firm increases the labor input above N*, this will just reduce profits, as

when . Now, if , then the minimum quantity of employment does not make

any difference for what the firm chooses to do. The firm sets so that , and the firm

will choose , as in Figure 4.14 when the firm faces a market wage and chooses

. Therefore, the labor demand curve is as depicted in Figure 13.2. The interesting feature
of the firm's behavior is that labor demand does not change smoothly in response to the real wage.
There is a critical wage rate w* at which the firm is willing to start up, and at that wage it will
actually hire more labor than would an identical firm that did not face a minimum employment
constraint. In reality, firms may face constraints like this, for example a restaurant needs at least
one cook, one waiter, and one cashier to operate, and this may cause employment to increase and
decrease by larger amounts in response to changes in market wages than would otherwise be the
case.

Figure 13.1

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35 Williamson • Macroeconomics, Sixth Edition

Figure 13.2

15. The level of output produced by one worker who works h – l hours is given by

This equation is plotted in the figure below. The slope of this production possibilities frontier is

simply

16. 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 that

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 36

follows highlights the resulting outcome: the firm now hires fewer people for a given wage and
thus its labor demand is reduced.

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37 Williamson • Macroeconomics, Sixth Edition

17.

(a) See the top figure below. The marginal product of labor is positive and
diminishing.

(b) See the figures below.

(c) See the figures below.

(d) See the bottom figure below.

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 38

Chapter 6 – Search and Unemployment

n Solutions to End-of-Chapter Problems

1. If the separation rate s increases, this has two effects. In Figure 6.14, this shifts down the curve
Ve(w), as a job is now worth less – a worker has a greater chance of being separated from the job at
any wage. As a result, the reservation wage w* will increase, as the consumer becomes more picky
about the jobs he or she will take. That is, unemployment is more attractive relative to working.
So, H(w*), which is the chances of receiving a job offer that is acceptable, falls. So in the second
panel of Figure 6.14, UpH(w*) shifts down, and s(1-U) shifts up. Therefore, on net, the long-term
unemployment rate must rise. That is, workers are being separated from jobs at a higher rate,
causing a higher flow from employment to unemployment, and the unemployed are accepting jobs
at a lower rate, creating a lower flow from unemployment to employment. These two effects both
work to increase the unemployment rate.

2. If TFP increases, so that wages increase for all jobs, this has no effect on the reservation wage, as
neither Ve(w) nor Vu changes. But H(w) increases for each w, as the chances of receiving a job
offer higher than w increases for any w. Thus, in the second panel of Figure 6.14, the curve
UpH(w*) shifts up, and the long-term unemployment rate falls. As wages are higher, workers have
a better chance of finding an acceptable job, which acts to increase the flow from unemployment
to employment, which reduces the unemployment rate.

3. If it is harder to qualify for unemployment insurance, this works in the same way as a reduction in
the unemployment insurance benefit b. From Figure 6.15, the reservation wage falls, and the long-
term unemployment rate falls.

4. More labor-saving devices has the effect of reducing the payoff to working at home for all
consumers, which reduces v(Q) for each value of Q. As a result, the curve in panel (a) of Figure
6.1 shifts up. In equilibrium, Q increases, but j remains unchanged. The unemployment rate and
the vacancy rate are unaffected, but the labor force Q increases. Since j = A/Q, therefore the
number of firms A increases. Aggregate output Y = Qem(1,j), so Y increases, as Q has risen and j
is unchanged. Labor saving devices make searching for work more attractive relative to working at
home for consumers. With more consumers in the market, labor market tightness tends to go
down, which attracts more firms into the labor market. Ultimately, the number of active firms
increases proportionally to the number of consumers searching for work, and there is no change in
labor market tightness in equilibrium. Output goes up because there are more successful matches
in the labor market.

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39 Williamson • Macroeconomics, Sixth Edition

Figure 6.1

5. (i) With a subsidy s to hiring a worker, for a successful match, the surplus of the firm is z+s-w, the
surplus of the worker is w-b, total surplus is z+s-b, and the wage (from Nash bargaining) is w=a(z+s)
+(1-a)b. Then, on the supply side of the labor market, the equation determining the curve in panel (a)
of Figure 6.2 is given by

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 40

v(Q)=b+em(1,j)a(z+s-b),

and on the demand side of the market, the equation determining j is

(k/((1-a)(z+s-b)))=em((1/j),1)

Then, in Figure 6.2, comparing the equilibrium when s=0 to one with s>0, the subsidy acts to increase
labor market tightness, j, and to increase the labor force, Q. The subsidy acts to induce more firms to
enter the labor market to search for workers, which makes j=(A/Q) higher. This in turn acts to make
search more attractive for workers, as it is now easier to find a job. As well, the subsidy increases the
wage, which further increases the incentive to search for work. The unemployment rate is 1-em(1,j),
which falls when j increases, so the subsidy reduces the unemployment rate.

(ii) If the government pays would-be workers to stay out of the labor market, this has no effect on
the demand side (firms' behavior). However, the supply side of the labor market is now characterized
by the equation

q+v(Q)=b+em(1,j)a(z+s-b),

Therefore, when q>0, this shifts the curve in the upper panel of Figure 6.2 to the right. There is no
effect on labor market tightness, j, and therefore no effect on the unemployment rate. However, Q
falls. Since j does not change, this implies that A falls as well, since j=(A/Q). Therefore, this policy has
the effect not only of reducing the number of would-be workers looking for work, but it reduces the
number of firms searching for workers. The policy has an unintended side effect and has no effect on
the unemployment rate.

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41 Williamson • Macroeconomics, Sixth Edition

Figure 6.2

6. The lower recruiting cost, k, affects only the demand side of the labor market. In Figure 6.3, labor
market tightness increases from j₁ to j₂, and the labor force increases from Q₁ to Q₂. The
unemployment rate is 1-em(1,j), which decreases because of the increase in j, and the vacancy rate is
1-em((1/j),1), which increases. Since j=(A/Q), and since Q and j increase, A also increases. Aggregate
output is Qem(1,j)z, which increases, as Q and j both increase. Thus, the lower cost of recruiting
induces more firms to enter the labor market, which increases labor market tightness, inducing more
workers to enter the labor market to search for work, as the chances are now better of finding a job.

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 42

Figure 6.3

7. For this question, re-define labor market tightness as j = (A+G)/Q. Then, the diagram we work with
looks identical to Figure 6.10 in Chapter 6, and Q and j are determined as in Figure 6.10. Note in
particular that G is irrelevant for determining Q and j, so government activity is irrelevant for the size
of the labor force and labor market tightness. Further, government activity will not matter for the
unemployment rate, the vacancy rate, or aggregate output. However, since j and Q do not change
when G changes, A+G = jQ does not change either. But then an increase in G must reduce A by the
same amount. Therefore, government activity simply reduces the number of private firms by an
equal amount, and there is otherwise no effect on economic activity. The key to this result is that the
government was assumed to be no better or worse at producing output than private sector firms.
Therefore, the scale of government activity could not matter for aggregate variables.

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43 Williamson • Macroeconomics, Sixth Edition

8. If all social welfare programs simultaneously become more generous, suppose that we represent this
as a payment p to each person not in the labor force, and an increase by p in the employment
insurance benefit. Then, the equation that summarizes behavior on the supply side of the labor
market becomes

v(Q) + p = b + p + em(1,j)a(z-b-p),

or, simplifying,

v(Q) = b + em(1,j)a(z-b-p).

As well, the equation summarizing demand-side behavior in the labor market can be written as

em(1/j,1) = k/(1-a)(z-b-p)

Therefore, in Figure 6.4, labor market tightness falls from j1 to j2, and the labor force falls from Q1 to
Q2. As a result, the unemployment rate increases and the vacancy rate decreases. The number of
firms is A=jQ, so A decreases. As well, output is Y=zQem(1,j), so output also falls. Consumers are
affected by two social programs – one that pays a benefit to people not in the labor force, and one
that pays an employment insurance benefit to the unemployed. Since the consumer receives the
employment insurance benefit only in the event that search for work is unsuccessful, the increase in
generosity of all social programs will on net discourage consumers from searching for work. Further,
more generous social programs reduce the total surplus from a successful match, and this
discourages firms from posting vacancies. On net, labor market tightness goes down, the labor force

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 Chapter 4 Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization 44

contracts, and aggregate output decreases, with the unemployment rate increasing and the vacancy
rate decreasing.

Figure 6.4

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