We’re doing static analysis; i.e. it’s very LR or very SR.

Numerous agents of each sector are grouped into a representative agent.

  1. Representative household

    Objective: maximize utility over consumption () and Leisure () within the utility function

    → Labor Supply and # of laborers

    → Goods Demanded

  2. Representative Firm

    Objective: maximuze profit () over capital () and Labor () within the production function

    → Labor Demand

    → Goods Supplied

  3. Government

    Role: collect taxes and pay transfers (); spend remaining on the goods market

Household Optimization

  • For households the price of consumption goods and the price of leisure [=wage] is an exogenous variable; i.e. it cannot be controlled
  • Households have a time endownment of which they can use for leisure () or consumption ()

The Household Utility Function


  1. …i.e. More consumption/leisure is always better
  2. …i.e. the Marginal Utility always diminishes
  3. [= utility function is differentiable] …i.e. are somewhat substitutable →

Household Budget Constraint

  • is the representative wage
  • is the hours of labor a HH chooses
  • is profit or dividends if the HH is also an owner of a firm
  • is the net transfers (+transfers-taxes)
  • is consumption (in units: # of goods)

Firm Optimization

  • The representative firm employs Factors of Production () to produce output
  • Profit of the firm is
  • The firm is the average firm of the whole economy, which is unlike a microecon firm in many ways

The Firm Production Function


  1. Constant Returns to Scale (M&A is useless) → This is probable, since output as a whole in general has CRS
  2. More capital or more labor always means more output , equivalently → Probable; throw another pencil into the economy, it’ll produce more
  3. Diminishing Marginal Product
  4. Marginal product of capital increase with more labor, and vice versa [= positive cross-derivative]

Profit Function

↑ Must satisfy both conditions

⇒ The Cobb-Douglas Production Function satisfies all these assumptions:

  • Profit
  • Capital Demand, at
  • Labor Demand, at

Government Plans

The government’s goals are more vague, threefold:

  1. Allocative: resources are used in certain proportions
  2. Distributive: income, wealth is distributed at tolerable equalities
  3. Stabilization: business cycle is smoothed out
    1. Automatic stabilizers; e.g. unemployment benefits
    2. government purchases ()