Real economy: An economy with no money factor
Representative consumer: Agent with attributes that would generally apply to every consumer in the micro economy
o Derives utility from two sources: a consumption good and leisure. U(c, l)
To factor in reality, the consumer wants some of both goods
Both goods are normal goods (as income increases, the customer wants more of the good. vice versa)
o Consumption good:
Only thing that the agent needs or wants
More consumption good the agent has, more utility he has.
Serves as the unit of account for the model (every price is denoted in units of the consumption good)
Thought of as a “good”
Price of leisure is denominated in consumption goods
o Indifference curve: Relationship between consumption and leisure
Level of utility is the same along any given indifference curve.
Bowed in because of diminishing marginal utility.
Higher indifference curves represent higher welfare for the customer
Marginal rate of substitution (MRS):
The rate at which a consumer exchange one good for another
Slope of the indifference curve
o Goal of the consumer is to achieve the highest level of utility possible. Since consumption and leisure are
scarce resources, the consumer is constrained by the amount of resources at can be allocated.
o Time Constraint (h = N + l)
h: Time endowment (total hours available in a period)
N : Labour services that are supplied to the labour market
l: Hours of leisure
o Budget constraint (C = wN + π – T)
C: real consumption
w: Real wage rate (in terms of consumption good)
π: Real dividends (profits received from firms)
T: Real taxes
o Total real consumption / Total real disposable income
C = w(h- l) + π – T
Hours, real dividends, and real taxes are given (exogenous).
Only variables that the consumer determines are leisure and consumption (endogenous).
Real wage determines amount of leisure (amount of consumption good the consumer gives up to
attain an hour of leisure)