CHAPTER 17

Household and Firm Behavior

in the Macroeconomy:
A Further Look

Prepared by: Fernando Quijano

and Yvonn Quijano

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
 Households: Consumption and
Labor Supply Decisions
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Keynes suggested that consumption

is a positive function of income, and
that high-income households
consume a smaller portion of their
income than low-income households.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 64
 The Keynesian Theory of
Consumption: A Review
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The average propensity to

consume (APC) is the proportion of
income households spend on
consumption. Determined by
dividing consumption (C) by income
(Y).
C
APC 
Y
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 64
 The Life-Cycle Theory of Consumption
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The life-cycle theory

of consumption is an
extension of Keynes's
theory. It states that
households make
lifetime consumption
decisions based on
their expectations of
lifetime income.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4 of 64
 The Life-Cycle Theory of Consumption
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• People tend to
consume less than they
earn during their main
working years, and
dissave, or use up
savings, during their
early and later years.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 5 of 64
 The Life-Cycle Theory of Consumption
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Consumption decisions are likely to

be based on permanent income
rather than on current income.

• Permanent income is the average

level of one’s expected future
income stream.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6 of 64
 The Life-Cycle Theory of Consumption
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Policy changes, like tax-rate

changes, are likely to have more of
an effect on household behavior if
they are expected to be permanent
rather than temporary.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 8 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Factors that determine the quantity

of labor supplied include:
• The wage rate

• Prices

• Wealth and nonlabor income

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• An increase in the wage rate causes

the opportunity cost of leisure to rise,
leading to a larger labor supply—a
larger labor force. This is called the
substitution effect of a wage rate
increase.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• A higher wage means that people

will spend some of it on leisure by
working less. This is the income
effect of a wage rate increase.

• Data suggests that the substitution

effect prevails over the income
effect, so higher wages lead to an
increase in labor supply.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Prices also play a major role in the

consumption/labor supply decision.

• The nominal wage rate is the wage

rate in current dollars.

• The real wage rate is the amount

that the nominal wage rate can buy
in terms of goods and services.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Workers do not care about their

nominal wage—they care about the
purchasing power of this wage—the
real wage rate.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Wealth fluctuates over the life cycle.

• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• An increase in wealth can be looked

on as an increase in nonlabor income.

• Nonlabor, or nonwage, income is

income received from sources other
than working – inheritances, interest,
dividends, and transfer payments,
and so on.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 15 of 64
 The Labor Supply Decision
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• An unexpected increase in nonlabor

income will have a positive effect on
a household’s consumption.

• An unexpected increase in wealth or

nonlabor income leads to a decrease
in labor supply.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16 of 64
 Interest Rate Effects on Consumption
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• A rise in the interest rate increases

the reward to saving and lowers
consumption. This is the substitution
effect of an interest rate change.

• There is also an income effect of an

interest rate change. A fall in the
interest rate leads to a fall in
nonlabor income and consumption.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17 of 64
 Interest Rate Effects on Consumption
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• For households with positive wealth,

the income effect of an interest rate
change works in the opposite
direction from the substitution effect.

• When a household is a debtor, a fall

in the interest rate means a fall in
interest payments, so the income
and substitution effects work in the
same direction.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18 of 64
 Government Effects on Consumption
and Labor Supply: Taxes and Transfers
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The government influences

household behavior mainly through
income tax rates and transfer
payments.

• Transfer payments are payments

such as Social Security benefits,
veterans benefits, and welfare
benefits.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 19 of 64
 Government Effects on Consumption
and Labor Supply: Taxes and Transfers
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 20 of 64
 A Possible Employment
Constraint on Households
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The budget constraint, which

separates those bundles of goods
that are available to a household
from those that are not, is
determined by income, wealth, and
prices.

• Households consume less if they are

constrained from working.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 21 of 64
 A Possible Employment
Constraint on Households
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The amount that a household would

like to work within a given period at
the current wage rate if it could find
the work is called the unconstrained
supply of labor.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 22 of 64
 A Possible Employment
Constraint on Households
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The amount that a household

actually works in a given period at
the current wage rate is the
constrained supply of labor.

• A household’s constrained supply of

labor is not a variable over which it
has any control.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 23 of 64
 Keynesian Theory Revisited
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• It is incorrect to think consumption

depends only on income, at least
when there is full employment.

• But if there is unemployment, the

level of income depends exclusively
on the employment decisions made
by firms.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 24 of 64
 Keynesian Theory Revisited
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• To the extent that Keynes

emphasized the relationship
between consumption and
income, Keynesian theory is
considered to pertain to
periods of unemployment.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 25 of 64
 A Summary of Household Behavior
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Factors that affect household

consumption and labor supply
decisions include:
• 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

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 26 of 64
 Consumption Expenditures,
1970 I – 2003 II
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 27 of 64
 Housing Investment of the
Household Sector, 1970 I – 2003 II
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 28 of 64
 Labor-Force Participation Rates for Men 25 to 54, Women
25 to 54, and All Others 16 and Over, 1970 I – 2003 II
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 29 of 64
 Firms: Investment and
Employment Decisions
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Inputs are the goods and

services that firms
purchase and turn into
output.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 30 of 64
 Investment Decisions
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• There are two ways that a firm can

add to its capital stock:
• Plant-and-equipment investment
refers to 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.

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 Employment Decisions
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 32 of 64
 Employment Decisions
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The demand for new capital, or

planned investment spending, which
is partly determined by the interest
rate, is as important as the demand
for labor.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 33 of 64
 Decision Making
and Profit Maximization
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• A profit-maximizing firm chooses the

technology that is most efficient—the
one that minimizes the cost of
production.

• The most efficient technology

depends on the relative prices of
capital and labor.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 34 of 64
 Decision Making
and Profit Maximization
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• A labor-intensive technology is a
production technique that uses a
large amount of labor relative to
capital.

• A capital-intensive technology is a
production technique that uses a
large amount of capital relative to
labor.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 35 of 64
 Decision Making
and Profit Maximization
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Firms’ decisions about labor demand

and investment are likely to depend
on the relative costs of labor and
capital.

• The relative impact of an expansion

of output on employment and on
investment demand depends on the
wage rate and the cost of capital.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 36 of 64
 Expectations and Animal Spirits
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Investment decisions require looking

into the future and forming
expectations about it.

• Expectations are always formed with

imperfect information.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 37 of 64
 Expectations and Animal Spirits
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Keynes concludes that much

investment activity depends on
psychology and on what he calls the
animal spirits of entrepreneurs (a
phrase that describes investors’
feelings), which help to make
investment a volatile component of
GDP.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 38 of 64
 The Accelerator Effect
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The accelerator effect is the

tendency for investment to increase
when aggregate output increases
and decrease when aggregate
output decreases, accelerating the
growth or decline of output.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 39 of 64
 The Accelerator Effect
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• If aggregate output (income) (Y) is

rising, investment will increase even
though the level of Y may be low,
further accelerating the growth of
output.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 40 of 64
 Excess Labor and
Excess Capital Effects
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Excess labor and/or excess

capital are labor and capital that are
not needed to produce the firm’s
current level of output.

• Decreasing its workforce and capital

stock quickly can be costly for a firm.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 41 of 64
 Excess Labor and
Excess Capital Effects
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Adjustment costs are the costs that

a firm incurs when it changes its
production level—for example, the
administration costs of laying off
employees or the training costs of
hiring new workers.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 42 of 64
 Inventory Investment
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

Stock of inventories (end of period)  Stock of inventories (beginning of

period)  Production – Sales

• Inventories are counted as part of a

firm’s capital stock.

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 Inventory Investment
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The desired, or optimal, level of

inventories is 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 decreased
storage costs).

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 Inventory Investment
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• There is a trade-off between holding

inventories and changing production
levels.

• A firm’s production should fluctuate

less than its sales, with changes in
inventories absorbing the difference
each period.

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 Inventory Investment
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• 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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 46 of 64
 Inventory Investment
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• A firm’s planned production path

depends on the level of its expected
future sales.

• Future sales expectations are likely

to have an important effect on
current production.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 47 of 64
 A Summary of Firm Behavior
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The following factors affect firms’

investment and employment
decisions:
• The wage rate and the cost of capital.

• Firms’ expectations of future output.

• The amount of excess labor and excess

capital on hand.

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 A Summary of Firm Behavior
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The most important points to remember

about the relationship between production,
sales, and inventory investment are:
• Inventory investment (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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 49 of 64
 Plant and Equipment Investment
of the Firm Sector, 1970 I – 2003 II
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 50 of 64
 Employment in the Firm Sector,
1970 I – 2003 II
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 51 of 64
 Inventory Investment of the Firm Sector
and the Inventory/Sales Ratio, 1970 I –
2003 II
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 52 of 64
 Productivity and the Business Cycle
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Productivity, or labor productivity,

is defined as output per worker hour
(Y/H); the amount of output
produced by an average worker in 1
hour.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 53 of 64
 Productivity and the Business Cycle
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Productivity tends to rise during

expansions and fall during
contractions.

• During expansions, output rises by a

larger percentage than employment,
and the ratio of output to workers
rises.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 54 of 64
 Employment and Output
over the Business Cycle
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• In general,
employment does not
fluctuate as much as
output over the
business cycle.
• As a result, measured
productivity tends to
rise during expansions
and decline during
contractions.
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 Productivity in the Long Run
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Theories of (long-run) economic

growth focus on productivity, as
measured by output per worker, or
GDP per capita.

• Using productivity figures to

diagnose the economy in the short
run can be misleading.

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 Productivity in the Long Run
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The tendency of firms to hold excess

labor and capital, and its implications
for the measurement of productivity
throughout the business cycle, has
nothing to do with the economy’s
long-run potential to produce output.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 57 of 64
 The Relationship Between
Output and Unemployment
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Okun’s Law is a theory put forth by

Arthur Okun, that the unemployment
rate decreases about one
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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 58 of 64
 The Relationship Between
Output and Unemployment
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Three “slippages” that make the change

in the unemployment rate less than the
percentage change in output in the short
run:
1. When output rises by 1 percent, the number of
jobs does not tend to rise by 1 percent also.
2. Some of the jobs are filled by people who
already have one job.
3. The response of the labor force to an increase
in output.

u  1 E / L
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 59 of 64
 The Relationship Between
Output and Unemployment
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The discouraged-worker effect is

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.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 60 of 64
 The Size of the Multiplier
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• Factors that lower the multiplier of

government spending include:
• Automatic stabilizers
• Interest rate
• Price level
• Excess capital and excess labor
• Inventories
• Life-cycle story and expectations

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 The Size of the Multiplier
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• In practice, the multiplier probably

has a value of around 1.4, at its
peak. For example, if government
spending rises by $1 billion, then
GDP rises by about $1.4 billion.

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 The Size of the Multiplier
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

• The response of the economy to a

change in monetary or fiscal policy is
not likely to be large and quick and,
in the final analysis, the effects are
much smaller than the simple
multiplier would lead one to believe.

© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 63 of 64
 Review Terms and Concepts
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look

accelerator effect excess capital nonlabor, or nonwage,

income
adjustment costs excess labor
Okun’s Law
animal spirits of income effect of a
entrepreneurs wage rate increase permanent income
average propensity to inputs plant-and-equipment
consume (APC) investment
inventory investment
capital-intensive productivity, or labor
labor-intensive
technology productivity
technology
constrained supply of real wage rate
life-cycle theory of
labor
consumption substitution effect of a
desired, or optimal, level wage rate increase
nominal wage rate
of inventories
unconstrained supply of
discouraged-worker effect labor
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 64 of 64