Objectives of this Chapter

In this chapter, we describe how economists model the optimizing behavior of households. Specifically, we study how households decide on the quantity of labor to supply to the market and on the allocation of current income and assets to consumption and savings.

Throughout this chapter we assume that households are identical, implying the study of one “representative” household is equivalent to the study of all households. As with the case of our study of firms in Chapter 2, we make this assumption not because we believe it to be true, but because it enables us to write down a model that we can solve and from which we can derive intuition for how the economy functions. If we were to add more realism, the models would be more difficult to solve, and our intuition on the key economic tradeoffs underlying the decision process might not profoundly change.

We start the chapter by studying the optimal labor supply problem of households. We will assume that households receive utility from two goods, consumption and leisure. The key tradeoff is as follows: if households work additional hours, they have more income to spend on consumption but enjoy less leisure. We show that if households have preferences for leisure N and consumption C of the form θ ln (C) + (1 − θ) ln (N), and all income is spent on consumption in each period, then optimal labor supply is independent of the after-tax wage.