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
C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Households: Consumption and
Labor Supply Decisions
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Keynesian Theory of
Consumption: A Review
• The average propensity to
consume (APC) is the proportion of
income households spend on
consumption. Determined by
dividing consumption (C) by income
(Y).
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C
APC 
Y
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Life-Cycle Theory of Consumption
© 2004 Prentice Hall Business Publishing
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Life-Cycle Theory of Consumption
© 2004 Prentice Hall Business Publishing
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Life-Cycle Theory of Consumption
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Life-Cycle Theory of Consumption
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Labor Supply Decision
• Factors that determine the quantity
of labor supplied include:
• The wage rate
• Prices
• Wealth and nonlabor income
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Labor Supply Decision
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Labor Supply Decision
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Labor Supply Decision
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Labor Supply Decision
• Workers do not care about their
nominal wage—they care about the
purchasing power of this wage—the
real wage rate.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Labor Supply Decision
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Labor Supply Decision
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Labor Supply Decision
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Interest Rate Effects on Consumption
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Interest Rate Effects on Consumption
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Government Effects on Consumption
and Labor Supply: Taxes and Transfers
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
A Possible Employment
Constraint on Households
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
A Possible Employment
Constraint on Households
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
A Possible Employment
Constraint on Households
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Keynesian Theory Revisited
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Keynesian Theory Revisited
• To the extent that Keynes
emphasized the relationship
between consumption and
income, Keynesian theory is
considered to pertain to
periods of unemployment.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
A Summary of Household Behavior
• 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
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Consumption Expenditures,
1970 I – 2003 II
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Housing Investment of the
Household Sector, 1970 I – 2003 II
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Labor-Force Participation Rates for Men 25 to 54, Women
25 to 54, and All Others 16 and Over, 1970 I – 2003 II
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Firms: Investment and
Employment Decisions
• Inputs are the goods and
services that firms
purchase and turn into
output.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Investment Decisions
• 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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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Employment Decisions
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Employment Decisions
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Decision Making
and Profit Maximization
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Decision Making
and Profit Maximization
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Decision Making
and Profit Maximization
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Expectations and Animal Spirits
• Investment decisions require looking
into the future and forming
expectations about it.
• Expectations are always formed with
imperfect information.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Expectations and Animal Spirits
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Accelerator Effect
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Accelerator Effect
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Excess Labor and
Excess Capital Effects
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Excess Labor and
Excess Capital Effects
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Inventory Investment
Stock of inventorie s (end of period)  Stock of inventorie s (beginning of
period)  Production – Sales
• Inventories are counted as part of a
firm’s capital stock.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Inventory Investment
• 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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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Inventory Investment
• 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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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Inventory Investment
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Inventory Investment
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
A Summary of Firm Behavior
• 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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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
A Summary of Firm Behavior
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Plant and Equipment Investment
of the Firm Sector, 1970 I – 2003 II
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Karl Case, Ray Fair
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Employment in the Firm Sector,
1970 I – 2003 II
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Karl Case, Ray Fair
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Inventory Investment of the Firm Sector and
the Inventory/Sales Ratio, 1970 I – 2003 II
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Productivity and the Business Cycle
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Productivity and the Business Cycle
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Employment and Output
over the Business Cycle
© 2004 Prentice Hall Business Publishing
• 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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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Productivity in the Long Run
• 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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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Productivity in the Long Run
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Relationship Between
Output and Unemployment
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Relationship Between
Output and Unemployment
•
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
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Relationship Between
Output and Unemployment
•
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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Size of the Multiplier
• 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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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Size of the Multiplier
• 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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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
The Size of the Multiplier
• 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.
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C H A P T E R 17: Household and Firm Behavior in the
Macroeconomy: A Further Look
Review Terms and Concepts
accelerator effect
excess capital
adjustment costs
excess labor
animal spirits of
entrepreneurs
income effect of a
wage rate increase
average propensity to
consume (APC)
inputs
capital-intensive
technology
constrained supply of
labor
desired, or optimal, level
of inventories
inventory investment
labor-intensive
technology
life-cycle theory of
consumption
nominal wage rate
Okun’s Law
permanent income
plant-and-equipment
investment
productivity, or labor
productivity
real wage rate
substitution effect of a
wage rate increase
unconstrained supply
of labor
discouraged-worker effect
© 2004 Prentice Hall Business Publishing
nonlabor, or nonwage,
income
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