Production Possibilities Frontier and Output Market Efficiency. 1 Production Possibilities Frontier
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1 Production Possibilities rontier. Principles of Microeconomics, all hia-hui hen October, Lecture Production Possibilities rontier and Output Market Efficiency Outline. hap : Production Possibilities rontier. hap : Output Market Efficiency Production Possibilities rontier Marginal rate of transformation (MRT ): How much clothing must be given up to produce one additional unit of food. The absolute value of the slope of the production possibilities frontier. If MRT increases in food, then the production possibilities frontier is concave. M MRT =. M Proof. Reducing $ input from clothing, decreases by ; adding $ M input to food, increases by. Thus, M Δ M M MRT = = =. Δ M M Output Market Efficiency Suppose we have two industries, clothing and food, in the market. onsumers have demand for the two goods. They have a representative utility U(, ). A Pareto efficient result occurs when the production possibilities frontier is tangent to the indifference curve (see igure ). That is to say, MRT = MRS. ite as: hia-hui hen, course materials for. Principles of Microeconomics, all. MIT OpenourseWare ( Massachusetts Institute of Technology. Downloaded on [DD Month
2 Output Market Efficiency O O igure : Production ontract urve. lothing Production Possibilities rontier ood igure : Production Possibilities rontier. ite as: hia-hui hen, course materials for. Principles of Microeconomics, all. MIT OpenourseWare ( Massachusetts Institute of Technology. Downloaded on [DD Month
3 Output Market Efficiency Production Possibilities rontier Indifference urve igure : Production Possibilities rontier and Indifference urve. Production Possibilities rontier Indifference urve igure : Equilibrium in the Output Market. ite as: hia-hui hen, course materials for. Principles of Microeconomics, all. MIT OpenourseWare ( Massachusetts Institute of Technology. Downloaded on [DD Month
4 . General equilibrium in the output market The prices are P for food, and P for clothing. When the market reaches its equilibrium, industries are maximizing their profits, so M (q) = P ; M (q) = P. Thus, M P MRT = =. M P onsumers maximize their utility, so P MRS =. P ombining the equations together, we obtain (see igure ) MRT = P P onsider non-equilibrium prices P and P, P P = MRS. P P <. Given the prices, food has a shortage and clothing has an excess (see igure ). The prices will change to adjust to the equilibrium state, namely, P increases and P decreases.. General equilibrium in the output market Example (Gains from ree Trade). Assume that Holland and Italy both produce cheese and wine, unit of labor required is provided in Table.). If these heese Wine Holland Italy Table : Unit of Labor Required in heese and Wine Production. two countries cannot trade cheese or wine, we consider the domestic markets separately. The price ratio is not the same: P W H P H P W I P I <. onsumer utility levels are U H and U I, respectively. However, if they can trade, Holland exports cheese and imports wine, and Italy exports wine and imports cheese. The prices ratio will adjust to agree, and people in both countries are better off because both indifference curves move upwards (see igure ). The new utility levels are U H and U I. ite as: hia-hui hen, course materials for. Principles of Microeconomics, all. MIT OpenourseWare ( Massachusetts Institute of Technology. Downloaded on [DD Month
5 . General equilibrium in the output market Supply Demand igure : Non-equilibrium onsumption and Production. ite as: hia-hui hen, course materials for. Principles of Microeconomics, all. MIT OpenourseWare ( Massachusetts Institute of Technology. Downloaded on [DD Month
6 . General equilibrium in the output market Holland U H U H (a) Trade in Holland. Italy U I U I W (b) Trade in Italy. igure : Gains from ree Trade. ite as: hia-hui hen, course materials for. Principles of Microeconomics, all. MIT OpenourseWare ( Massachusetts Institute of Technology. Downloaded on [DD Month
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