Transcript Chapter 16

Chapter 16
General Equilibrium and
Economic Efficiency
Topics to be Discussed
 General Equilibrium Analysis
 Efficiency in Exchange
 Equity and Efficiency
 Efficiency in Production
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Topics to be Discussed
 The Gains from Free Trade
 An Overview: The Efficiency of
Competitive Markets
 Why Markets Fail
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General Equilibrium Analysis
 Up to this point, we have been focused
on partial equilibrium analysis
Activity in one market has little or no effect
on other markets
 Market interrelationships can be
important
Complements and substitutes
Increase in firms’ input demand can cause
market price of the input and product to rise
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General Equilibrium Analysis
 To study how markets interrelate, we can
use general equilibrium analysis
Simultaneous determination of the prices and
quantities in all relevant markets, taking into
account feedback effects
 The feedback effect is the price or
quantity adjustment in one market
caused by price and quantity adjustments
in related markets
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Two Interdependent Markets –
Moving to General Equilibrium
 Scenario
The competitive markets of:
 DVD
rentals
 Movie theater tickets
These goods are substitutes
Changing prices in one market are likely to
affect the other market
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Two Interdependent Markets –
Moving to General Equilibrium
 Scenario
Equilibrium price of movies is $6.00
Equilibrium price of DVD rentals is $3.00
Government places a $1.00 tax on each
movie ticket
Need to look at effect of tax on
 Market
for DVDs
 Feedback effects in movie market
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Two Interdependent Markets –
Movies and DVDs
Price
$1 tax on each movie
ticket causes supply to fall
S*M
Price
General Equilibrium Analysis:
Increase in movie ticket prices
increases demand for videos.
SV
SM
$3.50
$6.35
$3.00
D’V
$6.00
DM
Q’M
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QM
Number of
Movie Tickets
DV
QV Q’V
Number
of Videos
8
Two Interdependent Markets –
Movies and DVDs
Price
The increase in the price
of videos increases the
demand for movies.
S*M
$6.82
$6.75
Price
General Equilibrium Analysis:
The Feedback effects continue.
SV
SM
$3.58
$3.50
$6.35
D*V
$3.00
D*M
$6.00
D’V
D’M
DM
Q’M Q”M Q*M QM
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Number of
Movie Tickets
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DV
QV Q’V Q*V
Number
of Videos
9
Two Interdependent Markets –
Movies and DVDs
 Observation
Without considering the feedback effect with
general equilibrium, the impact of the tax
would have been underestimated
This is an important consideration for policy
makers
 You can check for yourself that in the
market for complements, the tax would
be overestimated
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Reaching General Equilibrium
 Must be able to determine the equilibrium
price of both movies and DVDs
simultaneously
We must simultaneously find two prices that
equate quantity demanded and quantity
supplied in all related markets
The requires finding the solution to four
equations: demand and supply for DVDs and
movies
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The Interdependence of
International Markets
 Brazil and the United States compete in
the world soybean market, so one market
can affect the other
 Brazil limited exports of soybeans in the
late 1960’s and early 1970’s, causing
price in Brazil to fall
 Eventually the export controls were to be
removed, and Brazilian exports were
expected to increase
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The Interdependence of
International Markets
 Expectation was based on partial
equilibrium analysis
Program actually increased the price and
production of soybeans in US as well as US
exports
This caused Brazil to have difficulties
exporting even after control was removed
Can show how each market was affected
and compare to general equilibrium analysis
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Soybean Exports – Brazil and
US
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Efficiency in Exchange
 We showed before that competitive
markets are efficient because consumer
and producer surpluses are maximized
 We can study this in more detail by
examining an exchange economy
Market in which two or more consumers
trade two goods among themselves
Same for two countries
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Efficiency in Exchange
 An efficient allocation of goods is one
where no one can be made better off
without making someone else worse off
 Pareto efficiency
 Voluntary trade between two parties is
mutually beneficial and increases
economic efficiency
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The Advantages of Trade
 Assumptions
Two consumers (countries)
Two goods
Both people know each other’s preferences
Exchanging goods involves zero transaction
costs
James and Karen have a total of 10 units of
food and 6 units of clothing
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The Advantage of Trade
Individual Initial
Trade
Allocation
James
7F, 1C
-1F, +1C
Karen
3F, 5C
+1F, -1C
Final
Allocation
6F, 2C
4F, 4C
 To determine if they are better off, we
need to know the preferences for food
and clothing
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The Advantage of Trade
 Karen has a lot of clothing and little food
MRS of food for clothing is 3
To get 1 unit of food, she will give up 3 units
of clothing
 James’ MRS of food for clothing is only ½
He will give up ½ unit if clothing for 1 unit of
food
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The Advantage of Trade
 There is room for trade
James values clothing more than Karen
Karen values food more than James
Karen is willing to give up 3 units of clothing
to get 1 unit of food, but James is willing to
take only ½ unit of clothing for 1 unit of food
 Actual terms of trade are determined
through bargaining
Trade for 1 unit of food will fall between ½
and 3 units of clothing
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The Advantage of Trade
 Suppose Karen offers James 1 unit of
clothing for 1 unit of food
James will have more clothing, which he
values more than food
Karen will have more food, which she values
more
 Whenever two consumers’ MRSs are
different, there is room for mutually
beneficial trade
Allocation of resources is inefficient
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The Advantage of Trade
 From this analysis we obtain an
important result:
An allocation of goods is efficient only if the
goods are distributed so that the marginal
rate of substitution between any pair of
goods is the same for all consumers
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The Edgeworth Box Diagram
 A diagram showing all possible
allocations of either two goods between
two people or of two inputs between two
production processes is called an
Edgeworth Box
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The Edgeworth Box Diagram
 Food is measured across the horizontal
axis
 Clothing is measured on the vertical axis
 Length of box is the total amount of food
– 10 units
 Height of box is the total amount of
clothing – 6 units
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The Edgeworth Box Diagram
 Each point describes the market baskets
of both consumers
James’ basket is read from origin OJ
Karen’s basket is read from origin OK, in the
reverse direction
James has 7 units of food and 1 unit of
clothing – point A
Karen has 3 units of food and 5 units of
clothing – point A from different axis
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Exchange in an Edgeworth Box
Karen’s Food
10F
3F
0K
6C
James’
Clothing
The initial allocation
before trade is A: James
has 7F and 1C & Karen
has 3F and 5C.
Karen’s
Clothing
1C
5C
A
6C
0J
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7F
James’ Food
10F
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Exchange in an Edgeworth Box
Karen’s Food
10F
6C
4F
3F
0K
The allocation
after trade is B: James
has 6F and 2C & Karen
has 4F and 4C.
James’
Clothing
Karen’s
Clothing
B
2C
4C
+1C
1C
5C
A
-1F
6C
0J
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6F
Chapter
James’
Food16
7F
10F
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Efficient Allocations
 A trade from A to B makes both Karen
and James better off
Is it efficient?
 If James’ and Karen’s MRS are the same
at B, the allocation is efficient
This depends on the shape of their
indifference curves
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Efficient Allocations
 James’ indifference curves are drawn as
we usually see them
 Karen’s indifference curves are rotated
180o convex to her axis
 The indifference curves that go through
point A have different slopes and
therefore different MRSs
The allocation is not efficient
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Efficient Allocations
 The shaded area between these two
indifference curves represents all the
possible allocations of food and clothing
that would make both James and Karen
better off than A
Describes all mutually beneficial trades
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Efficient Allocations
 We can see both parties are better off at
point B since they both end up on a
higher indifference curve
Not efficient since MRSs are different –
indifference curves have different slopes
 Although a trade might make both parties
better off, the new allocation is not
necessarily efficient
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Efficient Allocations
 How do these parties reach an efficient
allocation?
When there is no more room for trade
When their MRSs are equal
They will keep trading, reaching higher
indifference curves, until they can no longer
do so and still make each better off
This is when indifference curves are tangent
– they have the same slope and same MRS
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Efficiency in Exchange
Karen’s Food
10F
0K
6C
James’s
Clothing
A: UJ1 = UK1,
but the MRS
is not equal.
All combinations
in the shaded
area are
preferred to A.
Karen’s
Clothing
Gains from
trade
0J
A
UJ1
UK1
10F
James’s Food
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6C
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Efficiency in Exchange
Karen’s Food
10F
0K
6C
D is also a
At
point
C,
Point
B is on
possible
MRSs
higher
ICare
but
efficient
equal
and
is allocation
not efficient
allocationon
is
depending
bargaining
efficient
James’s
Clothing
D
Karen’s
Clothing
C
UJ3
B
A
UK3
UK
2
0J
UK1
6C
10F
James’s Food
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UJ2
UJ1
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Efficiency in Exchange
 Any move outside the
shaded area will make
one person worse off
(closer to their origin)
 B is a mutually beneficial
trade--higher indifference
curve for each person
 Trade may be beneficial
but not efficient
 MRS is equal when
indifference curves are
tangent and the allocation
is efficient
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Karen’s Food
10F
0K
6C
James’
Clothing
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D
Karen’s
Clothing
C
UJ3
B
A
0J
UJ2
UJ1
6C
UK3 UK2 UK1
James’ Food
10F
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Efficiency in Exchange
 The Contract Curve
To find all possible efficient allocations of
food and clothing between Karen and James,
we would look for all points of tangency
between each of their indifference curves
The contract curve shows all the efficient
allocations of goods between two
consumers, or of two inputs between two
production functions
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The Contract Curve
Karen’s Food
E, F, & G are
Pareto efficient.
0K
Contract
Curve
G
James’
Clothing
F
Karen’s
Clothing
E
0J
James’ Food
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Contract Curve
 All points of tangency between the
indifference curves are efficient
MRS of individuals is the same
No more room for trade
 The contract curve shows all allocations
that are Pareto efficient
Pareto efficient allocation occurs when
further trade will make someone worse off
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Efficiency in Exchange
 Application: The policy implication of
Pareto efficiency when removing import
quotas:
1. Remove quotas

US consumers gain
 Some US workers lose
2. Removal of quotas and subsidies to the
workers
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Efficiency in Exchange
 US consumers would be better off and
after a time, the US workers are no worse
off and might be better off
Package will increase efficiency
 Efficiency, therefore, can be reached
when the combined set of changes
leaves someone better off and no one
worse off
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Efficiency in Exchange
 Consumer Equilibrium in a Competitive
Market
Competitive markets have many actual or
potential buyers and sellers, so if people do
not like the terms of an exchange, they can
look for another seller who offers better
terms
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Consumer Equilibrium in a
Competitive Market
 There are many Jameses and Karens
 They are price takers
 Relative price of food and clothing = 1
Trade depends on relative prices, not actual
prices
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Consumer Equilibrium in a
Competitive Market
 We can show opportunities for trade for
many consumers
When prices of food and clothing are equal,
we can show the price line, PP’ with a slope
of –1
 Shows
all possible allocations that exchange
can achieve
James buys 2 clothing for 2 food: A to C
Karen buys 2 food for 2 clothing: A to C
Both increase satisfaction
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Consumer Equilibrium in a
Competitive Market
10F
6C
Begin at A:
Each Karen buys 2F and
sells 2C moving from
UK1 to UK2, which
is preferred (A to C).
0K
Karen’s Food
Begin at A:
Each James buys 2C and sells 2F
moving from UJ1 to UJ2, which
is preferred (A to C).
Price Line
P
Karen’s
Clothing
C
James’
Clothing
UJ2
A
UK2
0J
P’
6C
10F
James’ Food
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UK1
UJ1
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Consumer Equilibrium in a
Competitive Market
 The amount of clothing that Karen
wanted to sell is equal to the amount of
clothing that James wanted to buy
 An equilibrium is a set of prices at which
the quantity demanded equals the
quantity supplied in every market
Also called competitive equilibrium
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Consumer Equilibrium in a
Competitive Market
 Not all prices lead to equilibrium
 If the MRSs of the players are not equal,
then we are not in equilibrium
 If the price of food is 1 and price of
clothing is 3:
James is unwilling to trade, MRS = ½
Karen is happy to sell clothing at that price
but has no one to sell to
Market is in disequilibrium
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Consumer Equilibrium in a
Competitive Market
 Disequilibrium is only temporary in a
competitive market
Excess demand will cause price to rise
Excess supply will cause price to fall
 In our example, we have excess supply
of clothing and excess demand of food
Should expect the price of food to increase
relative to price of clothing
Prices adjust until equilibrium is reached
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Economic Efficiency of
Competitive Markets
 As shown before, we can see that the
allocation in a competitive equilibrium is
economically efficient
The efficient point must occur where the two
indifference curves are tangent
If not, one of the consumers can increase
their utility and be better off
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Consumer Equilibrium in a
Competitive Market
 In a general equilibrium setting where all
markets are perfectly competitive, we can
show the same result
Best example of Adam Smith’s invisible hand
Economy will automatically allocate all
resources efficiently without need for
regulatory control
 Supports
argument for less government
intervention and more highly competitive
markets
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Consumer Equilibrium in a
Competitive Market
 First Theorem of Welfare Economics
If everyone trades in a competitive
marketplace, all mutually beneficial trades
will be completed and the resulting
equilibrium allocation of resources will be
economically efficient
Welfare economics involves the normative
evaluation of markets and economic policy
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Consumer Equilibrium in a
Competitive Market
 Competitive equilibrium
1. Because the indifference curves are tangent, all
MRSs are equal between consumers
2. Because each indifference curve is tangent to
the price line, each person’s MRS is equal to
the price ratio of the two goods
MRS
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J
FC

PC
PF
Chapter 16
 MRS
K
FC
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Consumer Equilibrium in a
Competitive Market
 Difficult for efficient allocation with many
consumers and producers unless all
markets are perfectly competitive
 Efficient outcomes can also be achieved
by centralized system
 Competitive outcome preferred since
consumers and producers can better
assess their preferences and supplies
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Equity and Efficiency
 Although there are many efficient
allocations, some may be more fair than
others
 The difficult question is, what is the most
equitable allocation?
 We can show that there is no reason to
believe that efficient allocation from
competitive markets will give an equitable
allocation
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The Utility Possibilities Frontier
 From the Edgeworth Box, we showed a
two person exchange
 The utility possibilities frontier
represents all allocations that are efficient
in terms of the utility levels of the two
individuals
Shows the levels of satisfaction that are
achieved when the two individuals have
reached the contract curve
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The Utility Possibilities Frontier
Karen’s
Utility
OJ – James has zero utility
OK – Karen has zero utility
E, F, G – points on contract
curve
H – inefficient – can do better
in shaded area
L - unobtainable
OJ
L
E
F
H
G
OK
James’ Utility
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The Utility Possibilities Frontier
Karen’s
Utility
Are all efficient points equitable?
•Efficient points E or F make both
persons better off without making
one worse off from H
•If only possible points are H and
G, can argue that one is more
equitable to James and one to
Karen
OJ
E
F
H
G
OK
James’ Utility
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The Utility Possibilities Frontier
 From previous example, can see that an
inefficient allocation might be more
equitable than an efficient one
 But how do we define an equitable
allocation?
It depends on what we believe equity to
entail
Requires interpersonal comparisons of utility
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Social Welfare Functions
 Weights are often applied to individual’s
utility to determine what is socially
desirable
How these weights are applied comes from
the social welfare functions
 The utilitarian function weights
everyone’s utility to maximize utility for
the whole society
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Social Welfare Functions
 Each social welfare function is
associated with a particular view of equity
 Some views of equity do not assign
weights and cannot be represented by a
welfare function
Competitive market process is equitable
because it rewards those who are most able
and work hardest
Believes competitive equilibrium would be
most equitable
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Social Welfare Functions
 The Rawlsian view is that individuals
don’t know what their endowment will be
 Rawls argues that if you don’t know your
own fate, you will opt for the system in
which the least well-off person is treated
reasonably well
 The most equitable allocation maximizes
the utility of the least well-off person in
society
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Social Welfare Functions
 An egalitarian view believes that goods
should be equally shared by all
individuals in society
 Could have situation where more
productive people are rewarded, thereby
producing more goods and then having
more to reallocate to all of society
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Four Views of Equity
Egalitarian
All members of society receive equal
amount of goods
Rawlsian
Maximize the utility of the least-welloff person
Utilitarian
Maximize the total utility of all
members of society
Market Oriented
The market outcome is the most
equitable
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Equity and Perfect Competition
 A competitive equilibrium can occur at
any point on the contract curve
depending on the initial allocation
 Since not all competitive equilibriums are
equitable, we rely on the government to
help reach equity by redistributing
income
Taxes
Public services
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Equity and Perfect Competition
 Must a society that wants to be more equitable
necessarily operate in an inefficient world?
Second Theorem of Welfare Economics
If individual preferences are convex, then every
efficient allocation (every point on the contract
curve) is a competitive equilibrium for some
initial allocation of goods
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Equity and Perfect Competition
 Any equilibrium that is equitable can be
achieved by redistributing resources and
may be efficient
 Typical ways to redistribute goods,
however, are costly
Taxes lead to bad incentives
 Firms
devote fewer resources to production in
order to avoid taxes
 Encourage individuals to work less
©2005 Pearson Education, Inc.
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Efficiency in Production
 From the discussion of exchange of two
goods, we can extend to the efficient use
of inputs used for production
 Assume:
Two fixed inputs: capital and labor
Produce same two goods: food and clothing
Many consumers own inputs to production
and earn income from selling them
Income allocated between goods
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Efficiency in Production
 Using the Edgeworth Box diagram, we
can show efficient use of inputs in
production
Labor on horizontal axis
Capital on vertical axis
50 hours of labor and 30 hours of capital
available
Each origin is an output
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Production in an Edgeworth Box
Labor in Clothing Production
50L
15L
0C
30K
Capital in Food
Production
The initial allocation is A.
Every combination of labor
and capital used to produce
two goods is represented
as a point in the box.
5K
Capital in
Clothing
Production
25K
A
30K
0F
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35L
Labor in Food Production
50L
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Production in an Edgeworth Box
 Each point in the box represents the
labor and capital inputs in the production
of food and clothing
 Can use production isoquants to show
levels of output produced with each
combination of inputs
3 isoquants representing 50, 60 and 80 units
of food
3 isoquants representing 10, 25 and 30 units
of clothing
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B
Production in an Edgeworth Box
Labor in Clothing Production
50L
15L
0C
30K
3 isoquants representing
foodand
production
food
clothing
production
Capital in Food
Production
25C
10C
Capital in
Clothing
Production
30C
60F
A
5K
25K
50F
30K
0F
©2005 Pearson Education, Inc.
35L
Labor in Food Production
50L
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Production in an Edgeworth Box
 To find efficient production, must find
different combinations of inputs used to
produce the two outputs
 An allocation of inputs is technically
efficient if the output of one good cannot
be increased without decreasing the
output of another good
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Production in an Edgeworth Box
 Production at point A is inefficient since
we can increase production of both
goods
Shaded area indicates increases in
production of both goods if begin at A
Allocation A could exist if a labor union
market has enforced inefficient work rules
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Production in an Edgeworth Box
Labor in Clothing Production
50L
15L
0C
30K
Can place
move in
from
A to B
or
Any
shaded
area
C increase
which increases
will
efficiency
fromefficiency.
allocation A.
D
Capital in Food
Production
25C
10C
30C
Capital in
Clothing
Production
C
B
60F
A
5K
25K
50F
30K
0F
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35L
Labor in Food Production
50L
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Production in an Edgeworth Box
 Points B and C are efficient allocations
and therefore lie on the production
contract curve
Curve showing all technically efficient
combinations of inputs
Curve connects the origins OF and OC
All points on curve are tangencies between
two isoquants
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Production in an Edgeworth Box
Labor in Clothing Production
50L
15L
0C
30K
Capital in Food
Production
Production
Contract
Curve
D
25C
10C
30C
Capital in
Clothing
Production
C
B
60F
A
5K
25K
50F
30K
0F
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35L
Labor in Food Production
50L
75
Producer Equilibrium –
Competitive Input Markets
 If input markets are competitive, an
efficient point will be achieved
 In competitive input markets
Wage rate, w, will be equal in all industries
Rental rate of capital, r, will be equal in all
industries
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Producer Equilibrium –
Competitive Input Markets
 We saw before that if producers minimize
costs, they will choose inputs to the point
where the ratio of the marginal products
of the two inputs is equal to the ratio of
input prices:
MPL w

MPK
r
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Producer Equilibrium –
Competitive Input Markets
 Ratio of marginal products is the same as
the marginal rate of technical substitution
of labor for capital:
MPL w
  MRTS LK
MPK r
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Producer Equilibrium –
Competitive Input Markets
 The MRTS is the slope of the isoquant,
so competitive equilibrium exists only if:
Slopes of the isoquants are equal to one
another
These also equal the ratio of the prices of
two inputs
 Competitive equilibrium lies on the
production contract curve, and the
competitive equilibrium is efficient in
production
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Production Possibilities Frontier
 PPF shows the various combinations of
two goods that can be produced with
fixed quantities of inputs
 Frontier is derived from the production
contract curve
 Points on PPF show efficiently produced
levels of both goods
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Production Possibilities Frontier
Clothing
(units)
• Point A is inefficient
• Points B, C and D are efficient
• All points in triangle ABC
completely utilize capital and
labor, but distortion in labor
market leads to inefficient use
OF
B
A
C
D
OC
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Food
(units)
81
Production Possibilities Frontier
 PPF is downward sloping
In order to produce more of one good, must
give up producing some of the other good
 PPF is concave
Slope is the MRTS which increases as the
level of production of food increases
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Production Possibilities Frontier
 Marginal rate of transformation (MRT) of
food for clothing is the magnitude of the
slope of the frontier at each point
Amount of one good that must be given up to
produce one additional unit of a second good
How much clothing must be given up to
produce one additional unit of food
As we increase the production of food by
moving along the PPF, the MRT increases
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Marginal Rate of Transformation
 The productivity of labor and capital
differs depending on whether the inputs
are used to produce more food or
clothing
Starting where only clothing is produced, MP
of labor and capital are relatively low
Transferring some to food production where
MP is relatively high
As we do this, MP in food decreases and MP
in clothing increases
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Production Possibilities Frontier
Clothing
(units)
OF
MRT < 1
B  MRT = 1
D  MRT = 2
MRT > 1
OC
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Food
(units)
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Marginal Rate of Transformation
 Can also describe in terms of costs
When producing at OF, the MC of food is very low
and the MC of clothing is very high
When MRT is low, so is the ratio of the MC of
producing food to clothing
Slope of PPF measures the MC of producing one
good relative to the MC of producing the other
MC F
MRT 
MC C
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Output Efficiency
 For efficiency,
Good produced at minimum cost
Must be produced in combinations that
match people’s willingness to pay
MRS = consumer’s WTP for additional food
by consuming less clothing
MRT = cost of additional unit of food in terms
of producing less clothing
 Efficiency means MRS = MRT
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Output Efficiency
 What if MRT  MRS?
Suppose MRT = 1 and MRS = 2
Consumer willing to give up 2 units of
clothing to get 1 unit of food
Cost of getting additional food is only 1 unit
of lost clothing
Too little food is being produced
Food production must increase, MRS falls
and MRT increases until two are equal again
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Output Efficiency
MRS = MRT
Clothing
(units)
60
PPF
Indifference Curve
100
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Food
(units)
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Efficiency in Output Markets
 For perfectly competitive markets, all
consumers allocate their budgets so their MRS
between two goods are equal to the ratio of
prices
 Profit maximizing firms produce output to the
point where price is equal to MC
 MRT is equal to the MRS
MC
F
MRT 
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MC C
Chapter 16
P
 F
PC
 MRS
90
Efficiency in Output Markets
 Efficiency in competitive markets is
achieved when there is separate
production and consumption
 Market price ratio of P1F/P1C
 Food and clothing are produced at A
where price ratio equals MRT
 This price causes consumer to maximize
utility and consume at B
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Efficiency in Output Markets
Clothing
(units)
• Produce at A
• Consume at B
• Inefficient at PF1/PC1
• Need to move to C
PF1/PC1
C1
PF*/PC*
A
B
C2
C*
U2
C
U1
F1
©2005 Pearson Education, Inc.
F*
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F2
Food
(units)
92
The Gains from Free Trade
 We have showed gains from trade in an
Edgeworth Box, but what about gains
from trade in two countries where one
has the comparative advantage?
A country has a comparative advantage over
another country in the production of a good if
the first country can produce the good at a
lower opportunity cost than the other country
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The Gains from Free Trade
 Ex: Two countries producing two goods
Holland and Italy
Cheese and Wine
Holland has comparative advantage in
cheese production
Italy has comparative advantage in wine
production
Trade is good for both countries
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The Gains from Free Trade
Hours of Labor Required to
Produce Cheese and Wine
Cheese
Wine
(1 LB)
(1 GAL)
Holland
1
2
Italy
6
3
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The Gains from Free Trade
 When there is comparative advantage,
free trade allows the country to consume
outside its PPF
 Before trade
Produces at A on indifference curve U1
where MRT and pre-trade price ratio is 2
Holland would want to export 2 pounds of
cheese for 1 gallon of wine
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The Gains from Free Trade
 After trade
Suppose they choose to trade 1 gallon of
wine for 1 pound of cheese
Holland will produce at the point of tangency
on the 1/1 price line and PPF – point B
Consumption will occur at D, on a higher
indifference curve U2 tangent to the trade
price line
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The Gains from Trade
Cheese
(lbs)
World Prices Pre-Trade Prices
CB
•Trade allows
Holland to consume
outside PPF
B
Exports
A
D
CD
U2
U1
WB
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Imports
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Wine
(gal)
98
Overview – Efficiency of
Competitive Markets
1. Efficiency in Exchange
 MRSJFC = MRSKFC
 MRSJFC = PF/PC = MRSKFC
2. Efficiency in the use of inputs in
production
 MRTSFLK = MRTSCLK
 MRTSFLK = w/r = MRTSCLK
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Overview – Efficiency of
Competitive Markets
3. Efficiency in the output market




MRTFC = MRSFC (for all consumers)
PF = MCF, PC = MCC resulting in
MRTFC = MCF/MCC = PF/PC; therefore
MRSFC = MRTFC
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Why Markets Fail
 Market Power
Those with market power choose the price
and quantity
Less output is sold than in competitive
markets
Inefficiency
Can have market power as producers or as
inputs
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Why Markets Fail
 Incomplete Information
Consumers must have accurate information
about market prices or production quality for
markets to operate efficiently
Lack of information can change supply
 Buy
products with no value
 Don’t buy enough of products with value
Some markets may never develop
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Why Markets Fail
 Externalities
Market prices do not always reflect the
activities of either producers or consumers
Consumption or production has indirect
effect on other consumption or production not
reflected in market prices
May be impossible to get insurance because
suppliers of insurance lack information
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Why Markets Fail
 Public Goods
Nonexclusive, nonrival goods that can be
made available cheaply but which, once
available, are difficult to prevent others from
consuming
Company thinking about researching a new
technology if can’t get patent
 Once
©2005 Pearson Education, Inc.
it’s made pubic, others can duplicate it
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