Households: Consumption andLabor 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.
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).
The Life-Cycle Theory of Consumption • 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.
The Life-Cycle Theory of Consumption • 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.
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.
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.
The Labor Supply Decision • Households make consumption and labor supply decisions simultaneously. • Consumption cannot be considered separately from labor supply, because it is precisely by selling your labor that you earn income to pay for your consumption.
The Labor Supply Decision • Factors that determine the quantity of labor supplied include: • The wage rate • Prices • Wealth and nonlabor income
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.
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.
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.
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.
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.
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.
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.
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.
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.
Government Effects on Consumptionand 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.
Government Effects on Consumptionand Labor Supply: Taxes and Transfers
A Possible EmploymentConstraint 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.
A Possible EmploymentConstraint 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.
A Possible EmploymentConstraint 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.
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.
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.
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
Labor-Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I – 2003 II
Firms: Investment andEmployment Decisions • Inputs are the goods and services that firms purchase and turn into output.
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.
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.
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.
Decision Makingand 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.
Decision Makingand 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.
Decision Makingand 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.
Expectations and Animal Spirits • Investment decisions require looking into the future and forming expectations about it. • Expectations are always formed with imperfect information.
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.
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.
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.
Excess Labor andExcess 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.
Excess Labor andExcess 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.
Inventory Investment • Inventories are counted as part of a firm’s capital stock.
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).
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.
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.
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.
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.
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.