General Equilibrium with Production I

Single-input, Single-output
Exchange Economies
No production
only endowments
No consideration of how resources are converted to consumables (tech)
General equilibrium: all markets clear simultaneously
1st and 2nd Fundamental Theorems of Welfare Economics
Add Production
add: input/output markets
describe: firms technologies, distributions of firms outputs and profits
2 Kinds of GE with Production
start with single-input production
o input used = labour
o model optimal labour supply, demand for good
then analyze production with more than 1 kind of output
3 sets of conditions describing both equilibrium and welfare max
o exchange efficiency (consumers have same MRS)
o Production Efficiency (producers have same MRTS)
o Product-Mix Efficiency (producer prices = consumer prices)
Single-input, Single output Model
Characterize equilibrium prices (labour and produced good)
Equilibrium prices separation of consumption decision from production decision
o Optimization by consumer is separate from optimization by producer
o Allows for decentralized decision-making
Robinson Crusoes Economy; Single input (Labour), single output
One agent RC endowed fixed quantity of 1 resource 24 hours
Use time for labour (production)/leisure (consumption)
Labour time = L
leisure = 24 L
What will RC choose?
RC Technology
Tech: labour produces output (coconuts) according to concave production
function
RCs Preferences
Coconut =
Leisure =
RCs Choice(blue)

god
good

MR = MPL Condition
MRS: rate at which consumer is willing to sub consumption goods for leisure and be equally well of
-dC/dR
or dC/dL
consumer perspective
MPL: change in output (dC) from using little bit more labour
dC/dL
producers perspective
At utility maximizing optimum (highest attainable indiference curve touches production function)
o Rate at which consumer is willing to trade of leisure for coconuts = rate at which labour is
transformed into coconuts
standard utility-max problems, at optimum
o rate at which consumer is willing to sub one good for another = rate at which she can sub 1
good for another while staying within her budget
marginal product of labour
o rate at which consumer is willing to sub leisure for goods = rate at which he can sub leisure for
goods through transforming hours into goods

*marginal rate of substitution (of leisure for goods - consumer) = marginal rate of transformation (of
labour into goods producter)
*MRS = MRT more than 1 output and more than 1 input
RC as a firm
RC is a:
o Utility-maximizing consumer & profit-maximizing firm (separately)
(1) Profit-Maximizing Firm
coconuts numeraire good (price of coconut $1)
coconut output level = C
RCs wage = w
Real wage = money wage/ money $ of good

Profit = C wL C = + wL eq. of isoprofit line

Slope = + w
general (slope = +w/P)
Intercept =
general (intercept = /P)

Profit-Maximization

(2) Utility-Maximization
Endowed with non-labour income of $* who can work for $w per hour
RCs most preferred consumption bundle?

Budget constraint:
C = * + wL

Utility-Maximization

Utility-Max & Profit-Max

Profit max:
o w = MPL (isoprofit, prodn. fn.)
o quantity of output supplied =
o quantity of labour demanded =
Coconut and labour markets both clear

Pareto Efficiency (must have MRS = MPL)

Utility max:
o w = MRS (budget, indifference)
o quantity of output demanded =
C*

C*
L*

Ex: Real Wage Implementing Pareto-Efficient Plan

Priduction function: X (L) = L2/3
Wage: 10
Px = 45
Utility function of single consumer/labour supplier:
Time endowment = 67.5
Non-labour income= 135

U(R,X) = RX (multiply the 2)

(1st step) Find Profit-Maximizing Combination of Labour (L) and output (X)
Slope of prodn fn = real wage at profit maximizing acitivity level
Real wage = w/Px = 10/45 = 2/9
Find:
o Slope of production fn = marginal product of
X (L) = L2/3 MPL= dX(L)/dL =
o set = to real
o solve for L,X
(2nd step) Find Utility-Maximizing Demand for X,
utility function is Cobb-Douglas with = exponents
expression for demand X and demand for leisure R
price of leisure = w
o total income (m) is = w * time endowment + non-labour income

labour
wage:
Supply of L

use values of time endowment (67.5), non-labour income (135), Px (45), w (10):

optimal amount of X consumers and labour supplied are 9 & 27

same quantities chosen by profit-maximizing

First Fundamental Theorem of Welfare Economics

competitive market equilibrium = Pareto efficient if :
o consumers preferences are convex
o there are no externalities in consumption production
(public goods/collective consumption goods +ve externalities)
Second Fundamental Theorem of Welfare Economics
any Pareto efficient economic state can be achieved as a competitive market equilibrium if:
o consumers preference are convex
o
no externalities
o firms technologies are convex
Non-Convex Technologies
do theorems hold if technology is non-convex?
1st theorem doesnt rely on firms technologies being convex
o competitive equilibrium = pareto-optimal
o with non-convex technologies there is no guarantee
equilibrium exists
o not applicable

that a competitive

2nd theorem requires firm technologies to be convex