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No Such Thing as a Free Lunch: Principles of Economics (Part 155)

Economics is not a science; it is a quasi-religion: part superstition, part mystique, part sentimentality. Bankers dream like other men, the only difference being that when their dreams turn to nightmares, we all lose sleep. There can be no trusting the muttering of any prelate when it comes to money.

Howard Jacobson

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part E)

by

Charles Lamson

Expectations and Animal Spirits

In addition to the cost of capital and the cost of labor, expectations about the future play a big role in investment and employment decisions.

Time is a key factor in investment decisions. A developer who decides to build an office tower is making an investment that will be around (barring earthquakes, floods, or tornadoes) for several decades. In deciding where to build a plant, a manufacturing firm is committing a large amount of resources to purchase capital that will presumably yield services over a long time. Furthermore, the decision to build a plant or to purchase large equipment must often be made years before the actual project is completed. While the acquisition of a small business computer may take only a few days, the planning process for downtown developments in large U.S. cities has been known to take decades.

For these reasons, investment decisions require looking into the future and forming expectations about it. In forming their expectations, firms consider numerous factors. At a minimum, they gather information about the demand for their specific product, about what their competitors are planning, and about the macroeconomy's overall health. A firm is not likely to increase its production capacity if it does not expect to sell more of its product in the future. Hilton will not put up a new hotel if it does not expect to fill the rooms at a profitable rate. Ford will not build a new plant if it expects the economy to enter a long recession.

Forecasting the future is fraught with dangers. Many events cannot be foreseen. Investments Are therefore always made with imperfect knowledge. John Maynard Keynes pointed this out in 1936:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield 10 years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the city of London amounts to little and sometimes nothing.

Kane's concludes from this that much investment activity depends on psychology and on what he calls the animal spirits of entrepreneurs:

Our decisions . . . can only be taken as a result of animal spirits. In estimating the prospect of investment, we must have regard, therefore, to nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends. [John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), pp. 149, 152]

Because expectations about the future are, as Keynes points out, subject to Great uncertainty, they may change often. The animal spirits help to make investment a volatile component of GDP.

The Accelerator Effect Expectations, at least in part, determine the level of planned investment spending. At any interest rate, the level of investment is likely to be higher if businesses are optimistic. If businesses are pessimistic, the level of planned investment will be lower, but what determines expectations?

One possibility born out empirically is that expectations are optimistic when aggregate output (Y) is rising and pessimistic when aggregate output is falling.

At any given level of the interest rate, expectations are likely to be more optimistic and planned investment is likely to be higher when output is growing rapidly than when it is growing slowly or falling.

It is easy to see why. If firms expect future output to grow, they must plan now to add productive capacity. One indicator of future prospects is the current growth rate.

If this is the case in reality, and evidence indicates it is, the ultimate result will be an accelerator effect. If aggregate output (income) (Y) is rising, investment will increase even though the level of Y may be low. Higher investment spending leads to an added increase in output, further "accelerating" the growth of aggregate output. If Y is falling, expectations are dampened, and investment spending will be cut even though the level of Y may be high, accelerating the decline. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 618-620*

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No Such Thing as a Free Lunch (Principles of Economics (Part 154)

Economics is mostly how humans rationalize who gets what and why. It's how we instantiate our preferences about status, privileges, and power.

Nick Hanauer

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part D)

by

Charles Lamson

Firms: Investment and Employment Decisions

Having taken a closer look at the behavior of households in the macroeconomy, we now look more closely at the behavior of firms---the other major decision making unit in the economy. In discussing firm behavior in earlier posts, we assumed that planned investment depends only on the interest rate. However, there are several other determinants of planned investment. We now discuss them and the factors that affect firms' employment decisions. Once again, microeconomic theory can help us gain some insight into the working of the macroeconomy.

In a market economy, firms determine which goods and services are available to consumers today and which will be available in the future, how many workers are needed for what kinds of jobs, and how much investment will be undertaken. Stated in macroeconomic terms, the decisions of firms, taken together, determine output, labor demand, and investment.

In this section, we concentrate on the input choices made by firms. By inputs, we mean the goods and services that firms purchase and turn into output. Two important inputs that firms use are capital and labor. (Other inputs are energy, raw materials, and semifinished goods.) Each period, firms must decide how much capital and labor to use in producing output. Let us look first at the decision about how much capital to use.

Investment Decisions At any point in time a firm has a certain stock of capital on hand. Stock of capital means the factories and buildings (sometimes called "plants") firms own, the equipment they need to do business, and their inventories of partly or wholly finished goods. There are two basic ways a firm can add to its capital stock. One is to buy more Machinery or build new factories or buildings.This kind of addition to the capital stock is plant-and-equipment investment.

The other way a firm adds to its capital stock is to increase its inventories. When a firm produces more than it sells in a given period, the firm's stock of inventories increases. This type of addition to the capital stock is inventory investment. Unplanned inventory investment is different from planned inventory investment. When a firm sells less than it expected to, it experiences an unplanned increase in its inventories and is forced to invest more than it plan to. Unplanned increases in inventories result from factors beyond the firm's control. (We take up inventory investment in detail in a later post.) 

Employment Decisions In addition to investment decisions, firms make employment decisions. At the beginning of each, a firm has a certain number of workers on its payroll. On the basis of its current situation and its upcoming plans, the firm must decide whether to hire additional workers, keep the same number, or reduce its workforce by laying off some employees.

Until this point, our description of firm behavior has been quite simple. In an earlier post we argued that firms increase production when they experience unplanned decreases in inventory and reduce production when they experience unplanned increases in inventory. We have also alluded to the fact that the demand for labor increases when output grows. In reality, the set of decisions facing firms is much more complex. A decision to produce additional output is likely to involve additional demand for both labor and capital.

The demand for labor is quite important in macroeconomics. 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. The demand for capital (which is partly determined by the interest rate) is important as well. Recall, planned investment spending is a component of planned aggregate expenditure. When planned investment spending (I, the demand for new capital) increases, the result is additional output (income).

Decision Making and Profit Maximization To understand the complex behavior of firms in input markets, we must assume that firms make decisions to maximize their profits. One of the most important profit-maximizing decisions that a firm must make is how to produce its output. In most cases, a firm must choose among alternative methods of production or technologies. Different technologies generally require different combinations of capital and labor.

Consider a factory that manufactures shirts. Shirts can be made entirely by hand, with workers cutting the pieces of fabric and sewing them together. However, shirts exactly like those can be made on huge complex machines that cut and sew and produce shirts with very little human supervision. Between the two extremes are dozens of alternative technologies. Shirts can be partly hand sewn, with the stitching done on electric sewing machines.

Firms' decisions concerning the amount of capital and labor that they will use in production are closely related. If firms maximize profits, they will choose the technology that minimizes the cost of production. That is, it is logical to assume that firms will choose the technology that is most efficient.

The most efficient technology depends on the relative prices of capital and labor. A shirt factory in the Philippines that decides to increase its production base has a large supply of relatively inexpensive labor. Wage rates in the Philippines are quite low. Capital equipment must be imported and is very expensive. A shirt factory in the Philippines is likely to choose a labor-intensive technology---a large amount of labor relative to capital. When labor-intensive technologies are used, expansion is likely to increase the demand for labor substantially while increasing the demand for capital only modestly.

A shirt factory in Germany that decides to expand production is likely to buy a large amount of capital equipment and to hire relatively few new workers. It will probably choose a capital-intensive technology---a large amount of capital relative to labor. German wage rates are quite high, higher in many occupations than in the United States. Capital, however, is plentiful.

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. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 617-618*

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No Such Thing as a Free Lunch: Principles of Economics (Part 153)

"Economic growth without social progress lets the great majority of people remain in poverty, while a privileged few reap the benefits of rising abundance."

John F. Kennedy

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part C)

by

Charles Lamson

Interest Rate Effects on Consumption

Recall from previous posts that the interest rate affects a firm's investment decision. A higher interest rate leads to a lower level of planned investment, and vice versa. This was a key link between the money market and the goods market, and it was the channel through which monetary policy had an impact on planned aggregate expenditure.

We can now expand on this link: The interest rate also affects household behavior. Consider the effect of a fall in the interest rate on consumption. The fall in the interest rate lowers the reward to saving. If the interest rate falls from 10 percent to 5 percent, I earn 5 cents instead of 10 cents per year on every dollar saved. This means that the opportunity cost of spending a dollar today (instead of saving it and consuming it plus the interest income a year from now) has fallen. I will substitute toward current consumption and away from the future consumption when the interest rate falls: I consume more today and save less. A rise in the interest rate leads me to consume less today and save more. This effect is called the substitution effect.

There is also an income effect of an interest rate change on consumption. If a household has positive wealth and is earning interest on that wealth, a fall in the interest rate leads to a fall in interest income. This is a decrease in its nonlabor income, which will have a negative effect on consumption. For households with positive wealth, the income effect works in the opposite direction from the substitution effect. On the other hand, if a household is a debtor and is paying interest on its debt, a fall in the interest rate leads to a fall in interest payments. The household is better off in this case and will consume more. In this case the income and substitution effects work in the same direction. The total household sector of the United States has positive wealth, and so in the aggregate the income and substitution effects work in the opposite direction.

On balance, the data suggest that the substitution effect dominates the income effect, so that the interest rate has a negative net effect on consumption (Case & Fair, 2004).

Government Effects on Consumption and Labor Supply: Taxes and Transfers

The government influences household behavior mainly through income tax rates and transfer payments.

When the government raises income tax rates, after-tax real wages decrease, lowering consumption. When the government lowers income tax rates, after-tax real wages increase, raising consumption.

A change in income tax rates also affects labor supply. If the substitution effect dominates, as we are generally assuming, then an increase in income tax rates, which lowers after-tax wages, will lower labor supply. A decrease in income tax rates will increase labor supply.

Transfer payments are payments such as Social Security benefits, veterans benefits, and welfare benefits. An increase in transfer payments is an increase in non-labor income, which we have seen has a positive effect on consumption and a negative effect on labor supply. Increases in transfer payments thus increase consumption and decrease labor supply, while decreases in transfer payments decrease consumption and increase labor supply. Table 1 summarizes these results.

TABLE 1

A Possible Employment Constraint on Households

Our discussion of the labor supply decision has so far proceeded as if households were free to choose how much to work each. If a member of our household decides to work an additional 5 hours a week at the current wage rate, we have assumed the person can work 5 hours more---that work is available. If someone who has not been working decides to work at the current wage rate, we have assumed that the person can find a job. 

There are times when these assumptions do not hold. The Great Depression, when unemployment rates reached 25 percent of the labor force, led to the birth of macroeconomics in the 1930s.

All households face a budget constraint regardless of the state of the economy. This budget constraint, which separates those bundles of goods that are available to our household from those that are not, is determined by income, wealth, and prices. When there is unemployment, some households feel an additional constraint on their behavior. Some people may want to work 40 hours per week in the current wage rates but can find only part-time work. Others may not find work at all.

How does a household respond when it is constrained from working as much as it would like? It consumes less. If your current wage rate is $10 per hour and you normally work 40 hours a week, your normal income from wages is $400 per week. If your average tax rate is 20 percent, your after-tax wage income is $320 per week. You are likely to spend much of this income during the week. If you are prevented from working, this income will not be available to you, and you will have less to spend.

You will spend something, of course. You may receive some form of nonlabor income, and you may have assets, such as savings deposits or stocks and bonds, that can be withdrawn or sold. You may also be able to borrow during your period of unemployment. Even though you will spend something during the week, it is almost certain that you will spend less than you would have if you had your usual income of $320 in after-tax wages.

Households consume less if they are constrained from working.

A household constrained from working as much as it would like at the current wage rate faces a different decision from the decision facing a household that can work as much as it wants. The work decision of the former household is, in effect, forced on it. The household works as much as it can---a certain number of hours per week or perhaps not at all---but this amount is less than their household would choose to work at the current wage rate if it could find more work. The amount that a household would like to work at the current wage rate if it could find the work is called its unconstrained supply of labor. The amount that the household actually works in a given period at current wage rates is called its constrained supply of labor.

Household constrained supply of labor is not a variable over which it has any control. The amount of labor the household supplies is imposed on it from the outside by the workings of the economy. However, the household's consumption is under its control. We have just seen that the less a household works---that is, the smaller the household's constrained supply of labor is---the lower its consumption. Constraints on the supply of labor are an important determinant of consumption when there is unemployment.

Keynesian Theory Revisited Recall the Keynesian theory (from part 151) that current income determines current consumption. We now know the consumption decision is made jointly with the labor supply decision and the two depend on the real wage rate. It is incorrect to think consumption depends only on income, at least when there is full employment. However, if there is unemployment, Keynes is closer to being correct because income is not determined by households. When there is unemployment, the level of income (at least workers' income) depends exclusively on the employment decisions made by firms. There are unemployed workers who are willing to work at the current wage rate, and their income is in effect determined by firms' hiring decisions. This income affects current consumption, which is consistent with Keynes's theory. This is one of the reasons Keynesian theory is considered to pertain to periods of unemployment. It was, of course, precisely during such a period that the theory was developed.

Summary of Household Behavior

This completes our discussion of household behavior in the macroeconomy. Household consumption depends on more than current income. Households determine consumption and labor supply simultaneously, and they look ahead in making their decisions.

The following factors affect household consumption and labor supply decisions:

• 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

If households are constrained in their labor supply decisions, income is directly determined by firms' hiring decisions. In this case, we can say (in the traditional, Keynesian way) that "income" affects consumption. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 612-614*

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No Such Thing as a Free Lunch: Principles of Economics (Part 152)

Without labor nothing prospers.

Sophocles

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part B)

by

Charles Lamson

The Labor Supply Decision

The size of the labor force in an economy is of obvious importance. A growing labor force is one of the ways in which national income/output can be expanded, and the larger the percentage of people who work is, the higher the potential output per capita.

So far, we have said little about the things that determine the size of the labor force. Of course, demographics are a key; the number of children born in 2020 will go a long way toward determining the potential number of 20 year old workers in 2040. In addition, immigration, both legal and illegal, plays a role.

Also behavior plays a role. Households make decisions about whether to work and how much to work. These decisions are closely tied to consumption decisions, because for most households the bulk of their spending is financed out of wages and salaries.

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 alternative to supplying your labor in exchange for a wage or salary is leisure or other nonmarket activities. Nonmarket activities include raising a child, going to school, keeping a house, or---in a developing economy---working as a subsistence farmer.

What determines the quantity of labor supplied by a household? Among the list of factors are the wage rate, prices, wealth, and nonlabor income.

The Wage Rate A changing wage rate can affect labor supply, whether the effect is positive or negative is ambiguous. For example, an increase in the wage rate affects a household in two ways. First, work becomes more attractive relative to leisure and other nonmarket activities. Because every hour spent in leisure now requires giving up a higher wage, the opportunity cost of leisure is higher. As a result, you would expect a higher wage would lead to a larger labor supply---a larger workforce. This is called the substitution effect of a wage rate increase.

On the other hand, households who work are clearly better off after a wage rate increase. By working the same number of hours as they did before, they will earn more income. If we assume that leisure is a normal good, people with higher income will spend some of it on leisure by working less. This is the income effect of a wage rate increase.

When wage rates rise, the substitution effect suggests that people will work more, while the income effect suggests that they will work less. The ultimate effect depends on which separate effect is more powerful. The data suggests that the substitution effect seems to win in most cases. That is, higher wage rates usually lead to a larger labor supply, while lower wage rates usually lead to a lower labor supply.

Prices Prices also play a major role in the consumption/labor supply decision. In our discussions of the possible effect of an increase in the wage rate, we have been assuming that the prices of goods and services do not rise at the same time. If the wage rate and all other prices rise simultaneously, the story is different. To make things clear we need to distinguish between the nominal wage rate and the real wage rate.

The nominal wage rate is the wage rate in current dollars. When we adjust the nominal wage rate for changes in the price level, we obtain the real wage rate. The real wage rate measures the amount that wages can buy in terms of goods and services. Workers do not care about their nominal wage---they care about the purchasing power of this wage---the real wage.

Suppose skilled workers in Indianapolis were paid a wage rate of $20 per hour in 2020. Now suppose that their wage rate rose to $22 in 2021, a 10 percent increase. If the prices of goods and services were exactly the same in 2021 as they were in 2020 the real wage rate would have increased by 10 percent. An hour of work in 2021 ($22) buys 10 percent more than an hour of work in 2020 ($20).

What if the prices of all goods and services also increased by 10 percent between 2020 and 2021? The purchasing power of an hour's wages has not changed. The real wage rate has not increased at all. In 2021, $22 bought the same quantity of goods and services that $20 bought in 2020. 

To measure the real wage rate, we adjust the nominal wage rate with a price index. There are several such indexes that we might use, including the Consumer Price Index and the GDP Price Index.

We can now apply what we have learned from the life cycle theory to our wage/price story. Recall the life cycle theory says people look ahead in making their decisions. Translated to real wage rates, this idea says:

Households look at expected future real wage rates as well as the current real wage rate in making their current consumption and labor supply decisions.

Consider medical students who expect their real wage rate will be higher in the future. This expectation obviously has an effect on current decisions about things like how much to buy and whether or not to take a part-time job.

Wealth and Nonlabor Income Life-cycle theory says wealth fluctuates over the life cycle. Households accumulate wealth during their working years to pay off debts accumulated when they were young and to support themselves in retirement. This role of wealth is clear, but the existence of wealth poses another question. Consider two households that are at the same stage in their life cycle and have pretty much the same expectations about future wage rates, prices, and so forth. They expect to live the same length of time, and both plan to leave the same amount to their children. They differ only in their wealth. Because of a past inheritance, household 1 has more wealth than household 2. Which household is likely to have a higher consumption path for the rest of its life? Household 1 is because it has more wealth to spread out over the rest of its life.

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.

Now consider a household that has a sudden unexpected increase in wealth, perhaps an inheritance from a distant relative. How will the household consumption pattern be affected? The household will increase its consumption, both now and in the future, as it spends the inheritance over the course of the rest of its life.

An increase in wealth can also 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 such as welfare payments and Social Security payments. As with wealth:

An unexpected increase in nonlabor income will have a positive effect on household consumption.

What about the effect of an increase in wealth or nonlabor income on labor supply? We already know an increase in income results in an increase in the consumption of normal goods, including leisure. Therefore, an unexpected increase in wealth or nonlabor income results in both an increase in consumption and an increase in leisure. With leisure increasing, labor supply must fall, so:

An unexpected increase in wealth or nonlabor income leads to a decrease in labor supply.

This point should be obvious. If I suddenly win a million dollars in the state lottery or make a killing in the stock market, I will probably work less in the future than I otherwise would have. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 610-611*

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