The Labour-Leisure Choice

Part II: A Competitive Labor Market

Dynamic Macroeconomic Analysis

Universidad Aut
onoma de Madrid

Autumn 2012

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 Labor-leisure choices in a competitive economy

Suppose now that the economy is populated by many identical agents.

Each agent maximizes his or her own utility taking prices as given.
In our simple example there are just two markets for labour services
and capital (machines).
There are also many identical firms who hire labor and capital. The
production function of firms is given by:

y = f (l, k ) = Al k 1 para (0, 1)

The price of the final good is normalized to one, while the wage rate
and the rental price of capital are denoted by w and r , respectively.

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 The representative firm

With constant returns to scale the firm-size distribution of firms is

irrelevant (see problem set 1). In equilibrium, all firms opt for the same
capital-labour ratio and total output does not depend on the number of
firms.

Thus, without loss of generality we can assume the existence of a single

representative firm.

The representative firm acts as a price taker and in equilibrium it hires the
entire stock of capital, K , and labor, L.

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 The problem of the representative firm

The problem of the representative firm is given by:

max = A (Lf ) Kf1 wLf rKf

Lf ,Kf

where Lf (Kf ) denotes the firms demand for labor (capital).

The two FOCs for capital and labor are given by:

(1 ) AKf (Lf ) = r (1)

| {z }
MPK

AKf (Lf )1 = w (2)

| {z }
MPL

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 The problem of a representative individual

Like before we assume that each individual is endowed with one unit of
capital (a machine) and time. But this time we assume that workers
cannot operate their own machines.

Hence, each individual faces the following problem:

max [log(c ) + log(1 l )] ,

c,l

subject to
c = wl + }r .
| {z
total income

Hence, each individual obtains income from renting work, wl, and capital,
r , to firms. Notice that the supply of capital is totally inelastic.

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 The solution

After substituting the budget constraint into the objective function, we

obtain the following problem:

max [log(wl + r ) + log(1 l )] .

l

The FOC is given by

1 1
w= .
wl + r 1l

which can be solved for the optimal solutions

w r 1 r w +r
l = = and c = .
2w 2 2w 2

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 The individual problem

consumo u2 u1

c=wl+r

A
c*

wl

l* trabajo l

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 Equilibrium

We are now in a position to derive the equilibrium and to demonstrate the

equivalence between Robinsons choices in autarky and in the market
equilibrium.
Suppose there is a total of N Robinsons in the economy
The total or aggregate supply of capital is Ks = N
Aggregate labor supply is Ls = Nl .
In equilibrium all agents solve their individual problem taking prices
as given and we have two market-clearing conditions

Kf = Ks (capital market equilibrium)

y
Lf = Ls (labor market equilibrium)

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 Equilibrium
Lets start with the case of the representative firm:

In equilibrium, the output of the firm is given by

Yf = A(Kf1 Lf ) = A(N 1 (Nl ) ) = AN (l ) .

while the output per worker satisfies:

Yf
y= = A (l )
N
Similarly, the equilibrium factor prices are

r = (1 )A(N ) (Nl ) = (1 )A (l ) ,

y
w = AKf1 Lf1 = A(N )1 (Nl )1 = A (l )1 .

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 Equilibrium
In equilibrium the representative firm earns zero profit as

= A(Kf1 Lf ) wLf rKf

= [AN 1 (Nl ) A (l )1 (Nl ) (1 )A (l ) (N )].
= AN (l ) AN (l ) (1 )AN (l )
= 0.

The equilibrium income of each individual agent is equal to per capita

output y :

i = wl + r =
= A (l )1 l + (1 )A (l )
= A (l ) + (1 )A (l )
= y.

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 Equilibrium
Summary

All markets clear (demand equal supply at the equilibrium prices)

The relevant (relative) prices are

r = (1 )A (l ) and w = A (l )1 .

Each individual earns an income of y as

i = A (l ) + (1 )A (l ) = A (l ) .
| {z } | {z }
labor income capital income

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 Equilibrium
Summary

Per capita consumption is equal to

c = A (l ) .

Optimal individual labor supply is

w r
l = .
2w
Aggregate consumption equals aggregate output

Yf = AN (l ) = Nc = NA (l )

The representative firm obtains zero profits

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 Equilibrium
Summary

It is important to notice that the equilibrium choices of Robinson

coincide with the choices Robinson would take in autarky. In the
market equilibrium, Robinsons labor supply decisions are a function
of the wage rate w . By contrast, in autarky Robinsons decisions are
driven by the value of MPL as he solves

log(c ) + log(1 l ),
suject to
c = A (l ) .
But in equilibrium w = MPL.

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 The Labor Market
Lets analyze the labor market in some more detail.
On the one hand, we found that
 
1 r
Ls = Nl = N , (3)
2 2w
Hence, Ls is an increasing function of w (for given values of r ). Does
this make sense?

On the other hand, the optimal demand of labor Lf of the

representative firm is implicitly defined by
AKf1 Lf1 = w ,
which implies that
! 11
AKf1 AKf1
L1f = = Lf = (4)
w w
In other words, aggregate labor demand is a strictly decreasing
function of w .
Dynamic Macroeconomic Analysis (UAM) The Labour-Leisure Choice Autumn 2012 14 / 25
 The Labor Market
The previously defined functions of aggregate labor demand and labor
supply give rise to the standard diagram of the classical model of the labor
market.

w
ls = Nl*

lf

l* ls and lf

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 The Capital Market

Each individual supplies one unit of capital to the market and so the
aggregate supply is capital is totally inelastic and equal to Ks = N.
Aggregate demand for capital is implicitly defined by the
corresponding FOC
A(1 )Kf Lf = r .
For given values of Lf

A(1 )Lf
 
Kf= (5)
r
1
A(1 )

Kf = Lf ,
r

is a decreasing function of r .

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 The Capital Market
The equilibrium in the capital market is trivial:

ks = N
r

ke

N ks and ke

]
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 A Useful Numerical Example

In general, it is hard to calculate the exact equilibrium values for

{w , r , l, Y , K , L}. But sometimes we are lucky as the following
example illustrates.
Suppose = 0.5, N = 100, A = 1.
We know that

Yf = A(Kf1 Lf ) = (1000.5 (100l )0.5 ) = 100 (l )0.5 .

while the expression for capita output is given by

Yf 100 (l )0.5
y= = = (l )0.5
N 100

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 A Useful Numerical Example

In our example the equilibrium prices are given by:

r = A(1 )(N ) (Nl ) = 0.5 (l )0.5 ,

and
w = AKf1 Lf1 = 0.5 (l )0.5 .
From these two equations it follows that:

r 0.5 (l )0.5
= = l
w 0.5 (l )0.5

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 A Useful Numerical Example

Hence, in any equilibrium it must be true that

r = wl .

Inserting r = wl in our expression for l

w r
l = ,
2w
we find that
2wl = w r = w wl
which gives rise to the following solution
1
3wl = w = l = .
3

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 A Useful Numerical Example
We now have a complete solution for all the relevant equilibrium
quantities and prices:

Yf = 100 (1/3)0.5 = 57.735.

while per capita output is equal to

Yf 100 (l )0.5
y= = = (l )0.5 = (1/3)0.5 = 0.57735
N 100
Similarly, the equilibrium factor prices are:

r = A(1 )(N ) (Nl ) = 0.5 (l )0.5 = 0.5 (1/3)0.5 = 0.28868,

and

w = AKf1 Lf1 = 0.5 (l )0.5 = 0.5 (1/3)0.5 = 0.86603.

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 A Useful Numerical Example

Next,
c = y = 0.57735,
and per capita income is
1
y = wl + r = 0.86603 + 0.28868 = 0.57735.
3
Notice also that
1
wl 0.86603 r 0.28868
= 3 = 0.5 y = = 0.5
y 0.57735 y 0.57735
Hence, is not only the elasticity of the production function w.r.t. L.
It also defines what is called the labor share i.e. the share of total
income that accrues to workers. This last object can be measured in
the data.

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