General Equilibrium, Production II

Two inputs, two goods, two consumers

Assumptions
1) isoquants convex/smooth
2) inputs essential to production of goods
3) production function returns to scales
4) production has no externalities

*efficiency in consumption MRS identical for all individuals

Production Possibilities
Resource/technical limitations restrict what economy can
produce
Set of feasible output bundle = production possibility
o All combos of goods that can be produced
Production possibility frontier = sets outer boundary
Production possibility function (ppf): marginal rate of
product transformation
(identical)
-

if there are no production

externalities PPF = concave
w.r.t the origin
why?

of comparative advantage

set

treatment =

MRT = slope of PP
(tangent to point on PPF)
MRT = MP21/MP11 =
MP22/MP21
MP11= x1/z1
MP1^2 = x2/z1

(1) text
b/c efficient production requires exploitation

Comparative Advantage
Two agents : RC and Man Friday
(MF)
o RC can produce at most
20 coconut
or, 30 fish
o MF can produce at most
50 coconuts
or, 25 fish

more producers with diff opp. Cost => smooth out

ppf

(2) different inputs are more productive in [production of different goods

{variation on comparative adv some inputs better suited to production of certain goods that other
inputs}
Production Efficiency with Homogenous Factors, Different Production Technologies
economy producing food and manufactures both use land (T) and labour (L)
o both inputs homogenous every hectare of land is the same, all workers clones of each
other
o fixed amount of land available, fixed amount of labour both are supplied perfectly
inelastic
assume both goods are produced using Cobb-Douglas, Constant Returns to Scale
tech
o use of each input ALONE is characterized by diminishing marginal product
(short-run)
o isoquants (long run) for each output are radial blow ups of unit isoquant
isoquant slope = along any ray from origin
to generate concave PPF need diff in factor-intensities

assume food = land-intensive (high land/labour ratio in production), manufacture = labour

intensive (low ratio)
o production functions

Allocation of Inputs
FACTORS are allocated between industries
o Any land not used in food will be used in
manufactures
o Any labour not used in food production used in manufactures
o both inputs fully employed ; but it matters how its allocated among
two industries
Edgeworth Bowley Box
variation horizontal axis = total land avail.
vertical axis = total labour
available
isoquant map for food normal shape starts lower left, output increased as we move up right
isoquant map for manufactures rotated 180
o overlapping both isoquant maps
Contract Curve
allocations of land/labour at which food isoquant is just tangent to a manufactures isoquant =
Productive Efficiency
o producing max food for some output manufactures (or equivalently)
o producing max manufactures for specific amount of food
allocations of land/labour for which these are true contract curve = Efficiency
Locus
Mapping PPF from the Box
each pt on Efficiency Locus corresponds to all allocation of land and labour
between sectors
o with each allocation:
associated quantity of food output
associates quantity of manufactures output
map from on to the other

Production Efficiency
only allocations points on efficiency locus to points on PPF = efficient production
other allocations output combination INSIDE PPF
o given quantity of 1 output amount produced of the other is not max possible
Inefficient Factor Allocations

Slope of PPF
Intuition ABSOLUTE slope = # of unites of good y (y = food) that must be sacrificed if we
produce 1 more units of good x ( manufacture)
o Marginal Rate of Product Transformation
Transform take some input formerly used in Food and reallocate this input to
production of Manufactures

MRPT
Reallocate some labour:
o Change in labour used in food
o Change in food
o Change in labour used in man.
o Change in man

Reallocate some land:

o Change in land used in food -dT
o Change in food
o Change in land used in man +dT
o Change in man

-dL
dF = -dL*MPL(F)
+dL
dM = dL*MPL(M)

dF = -dT*MPT(F)
dM = dT*MPT(M)

Right one?
If production efficiency attained (moving between 1 output combo on the PPF to another on the
PPF)
o The two ratios (MPLs and MPTs) must be the SAME
o Doesnt matter which one we use

From Box:
o At any factor allocation on efficiency locus slope of isoquant for 1 output = slope of
another
Both isoquants back-to-back

Isoquant Slope
Change amount land used by man by dT, change amount labour used by dL change in manufacture
output:

Along isoquant change n output = 0

At efficient factor allocations

o Slopes of 2 isoquants are the same
o rearrange
o ratio of marginal products of land = MP of labour
o both equal MRT of food into manufactures

Coordination Production and Consumption

which are Pareto efficient for consumers?

MRS doesnt = MRPT

o Inefficient coordination of production and consumption

MRS = MRPT necessary for Pareto optimal economic state
When exchange efficient MRSRC = MRSMF
o Both = ratio of prices in exchange (consumption)
o MRSCommon(C,F) = PF/PC consumers
If producers sell at competitive $ slope of PPF (MRPT) = ratio of prices
changed by sellers

MRPT(C,F) = PF/PC producers

MRS = MRPT Consumer Price Ratio = Producer Price Ratio

Allocative Efficiency (Product-Mix Efficiency) Condition

Output at which sum of consumers surplus + producers surplus is maximized
the output at which
o The price consumers are willing to pay = marginal cost
o P = MC
Occurs when sum os CS & PS is maximized
Total Surplus = maximizes only at perfectly competitive level of output (P =
MC)

is

P = MC; Implies Price Ratio = MRTS

If P = MC for both outputs, then ratio of prices of

MC = increase in cost associated with small increase in output

Suppose increase food output using small amount of additional labour; each unit of labout costs
w=wage rate
o Change in output
dF = dLF*MPL(F)
o Change in cost
= d(TC) = dLF*w

From ratio of MCF TO MCM

If p = MC for each good

o
o

MCs

Ratio of producer prices(seller prices) = MRPT when reallocating labour

If production on PPF (of productive efficient attained)
Ratio of Marginal Products of Labour = Ratio of Marginal Products of Land
Producer prices = MC ratio of Producer Prices = MRPT

Decentralized Coordination of Production and Consumption

Competitive market, profit-maximization (P=MC) and utility max all together imply:

Condition necessary for Pareto optimal

- MRPT deduced from ratios of MP of 2 inputs

Relative Price of X for consumers:
- Competitive exchange RELATIVE price (ratio of consumer prices):
o 1st determine incomes of 2 consumers
(rent*capital supplied) + (wage*labour supplied)
o substitute total income for each into expression for Cobb-Douglas demands
set quantities demande for X = to quantitiey available (produced) and solve for Px
o then do the same for good Y, solve for Py
o form ratio Px/Py = relative price of X

factor prices r,w and amoutns of factores supplied are

demands for X:

Ka,Kb,La,Lb

then can find price of X that clears market for X by setting sum of quantities demand = to amounts
available

solve relative consumer price of X as Px/Py

this is what we compare to MRPT (relative price of X (Px/Py) for producers)

*if producer prices = MC (rent of MPk, or wage over MPl) total revenue is less than the amount of factor
payments
b/c prices of capital and labout were fudged to yield numbers with only 1 deciman