UNIT 19 PRODUCTION WITHOUT

CONSUMPTION
Structure
19.0 Objectives
19.1 Introduction
19.2 Set up of the Problem
19.3 Optimising Solution
I
~ 19.4 Production Possibility Frontier
I 9 . Efficiencies of Competitive Equilibrium

r 19.5.1
19.5.2
19.5.3
Productive (Technical) Efficiency
Allocative Efliciency
Product-mix Efficiency
19.6 Linkages between Markets
1 19.6.1
19.6.2
Link between Factor and Goods Markets
Link between Goods and Factor Prices
1 9.7 Theorems of International Trade
19.7.1 Stolper-Sarnuelson Theorem
19.7.2 Rybcznski Theorem
19.8 Optimal Production and Consumption Mix
I
19.9 Let Us Sum Up

I
19.10 Key Words
19.1 1 Some Useful Books
19.12 Answer or Hints to Check Your Progress
19.1 3 Exercises
I
19.0 OBJECTIVES
After going through this unit, you will be able to:
formulate general equilibrium problems with production;
. determine simultaneous clearance of factor and product markets in the
presence consumer choices; and
evaluate important general equilibrium related theorems with international
trade.

19.1 INTRODUCTION
In the preceding unit, we have discussed the general equilibrium conditions in
a pure exchange economy. We extend the analysis now to include production.
While general approach to the problem similar to the one adopted in case of
pure exchange economy, there are some differences we need to account for.
Particularly, we cannot ensure an equilibrium if the production technology
exists in large regions of increasing returns to scale. As increasing returns to
scale implies AC exceeding MC , which means that competitive firm will
make negative profit.
Addition of production to the model implies consumers will not just be trading
goods. Producers' wi\\ be ma\ink gwds as we\\ a~ turning factors of
General Equilibrium production into final consumption goods. Thus, we need to understand how
general equilibrium determines the pattern of production.
Consider, for example, an increase in the price of some final good assuming a
competitive industry. The inputs used in the process can be treated as the
initial endowments that are used to be transform in these goods. Such a feature
requires us to see how market will allocate the following:
a production efficiency: how factors of production are used to produce
goods;
allocative efficiency: how much each consumer consumes of each goods;
and
product-mix efficiency: how total resources are allocated to each sector.
Moreover, each firm will try to expand its output. Thus, factor price (of labor
and capital) will change, as demand for these will go up at an aggregate level.
In a closed economy, the production of the industry, which produces a
complementary good will also be affected. If resources can move from a
substitute good producing industry, then the effect on factor price will be
determined by relative intensity of factor use in each industry.

19.2 SET UP OF THE PROBLEM

Let the economy produce n final goods yl, yz, ..., y, These goods are
produced using m factors of production, X I ,.., xm.The prices of final goods
are pl, ..., p, respectively, assumed to be fixed in the world market. This is
called Small country assumption.
f i t , xij = amount of factor i used in the production of good j i=l, .., m, j=l, ..,
n.
The production function for good j is written as
yj = P (xtj, ...,xmj).
The total resources of the economy are fixed at the levels x,, ...., &,
i.e., the quantities are not choice variables, but parameters.
In a competitive set up, the exhaustion of gains from trade implies that the
value of total (final) output, or GNP is maximised.
The above statement can be written mathematically as
n
maximise Z= CP,Y~
j=l

subject to kx,
1'1
5 xi,,=,,,,,,,

We, for the simplicity of analysis, will assume that there are only two goods
and two factors. Let the factors are labor L and capital K.
Let the labor and capital allocated to industry j be denoted by L, and K,
respectively.

19.3 OPTIMISING SOLUTION

If we consider the problem set up above, then we can write the reduced model
as follows:
 Production without
I , + p2 P?(L~,
maximise P ~ ( ~ ' ( LKl) K2) Consumption
subject to,
L, + L2 r L
K, + K < K.I,I +1,2
2 - ,K,+K, > 0.

Here, L and K are, respectively, the parametrically 'fixed' total resource

endowment of labor and capital.
Now, we will make another simplifLing assumption, namely, ~ ' ( L IKI),
, and
P(L2, K2) exhibit constant returns to scale (CRS) i.e.,
P(~L,,tK,) = t P(L,, Kk)
=tyj j=1,2.
1
Since this relation holds for all t, take t =-. The production function
J',
becomes,

L,
let, a14= -,aKj Ki
= -.
J'1 YJ
The production function then is,
f' (a~,,a ~ , =
) 1.
We can use the above optimisation programme to derive major theorems of
international trade as well.
We assume that L1, L2, K1 and K2 are fully used up at parametrically given
levels of L and K, respectively.
The Lagrangian for this model is

The first-order conditions for constrained maximum are obtained by

differentiating with respect to the four choice variables L1, L2, KI, K2 and
the two Lagrange multipliers. We get

efKi-A, =O ...(ii)
f K 2 -A,, = 0
)p2 ...(iii)

P ~ ~ = ~O ~ - ...(Aiv) ~

K - K, - K2 = 0 ...(vi)

af' a y
where, f,'= -=-
aL, aL1
General Equilibrium

The second order conditions consist of restrictions on border-preserving

principal minors of the border Hessian determinant formed by differentiating
equations (i) to (vi) again with respect to the L, 's , L, 's and A, ' s .
a2fJ
As above, we denote f ,' = -and so on.
aL,aL,

The border-preserving principal minors of K alternate in sign, the whole

determinant having sign +l.
Assuming the sufficient second-order conditions hold, first order conditions
can be solved for the explicit choice functions.
L, =L~(P,,P,,L,K) i=l,2 ...(vii)

K, = K , * ( ~ ~ , ~ ~i=1,2
,L,K) ...(vii)
and A,=A;(p,,p,,L,K) ...(ix)

A, =A; (p,,p2,L,K) ...(x)

In the above, (vii) and (viii) show the quantities of each factor that will be
used by each industry at given output prices and total resource constraints.
The role of the factor prices is filled by the Lagrange multipliers A, and A, .
Substituting L: 's and K,' 's into the objective function z yields-

Using the Envelope theorem,

Industry supply curve in this model can be derived by substituting the L;'s
and K,*'s in the production function, i.e.,

19.4 PRODUCTION POSSIBILITY FRONTIER

A production possibility frontier (PPF) shows the alternative combinations of
two inputs that can be produced with fixed quantities of inputs when these are
 Productionwithout
employed efficiently. The slope of a PPF depicts the substitution possibilities Consumption
between two outputs when the total resources are held constant. The negative
of the slope is called the rate of product transformation (RPT). Thus, RPT of
two products X and Y is given by
dY
RPT (of X for Y) =---- .
dx
We can derive the PPF for the economy which can be obtained by eliminating
prices from the equations (a) and (b).
This can be done as follows:
Consider y; ( t p , , ~ ~L,, ,K) = y; ( p , ,P,, L, K ) j = 1,2.

i.e., the supply functions are homogeneous of degree zero in prices. (This can
easily be proved).
I PI
Now,let t = - and p=-.
Pz P2
Then (a) and (b) can be written as

y; (P,, p2,L, K ) = Y,' = Y,* (P, L,K) ....(c)

and

=Y,*(P,L,K) ...( 4
a?*
Assume -t.0,j = 1,2.
8~
Thus, we can eliminate the relative price p, from the equation (c) and (d), to
obtain
G(Y;.Y;.L,K)=o.
The above equation can also be written in the form
Y; = P,(Y;,L,K)
This production function as shown in the diagram below is concave to the
origin.

Fig. 19.1: Production Possibility Frontier

General Equilibrium The concave shape is implied by sufficient second-order equations for the !
i
model.
It may be useful to remember the following features of PPF:
PPF represents the alternative combinations of two final goods that can be
produced with fixed quantities of inputs.
The frontier of this set corresponds to the technically efficient, feasible
combinations of outputs.
The slope of the PPF not the marginal rate of technical substitution
(MRTS) between K and L (i.e., the slope of the production isoquants).
Instead, it gives the marginal rate of product transformation (MRTS)
between final goods. That is, the rate of technical transformation from one
good to the other. 1
The cost of one more unit of X therefore is best measured as the rate of
product transformation (RPT) of X for Y at the prevailing point on the i
PPF.
Example:
Assume that X and Y use only labour for production such that
x =(L,:)o5
Y = 0.5 ( L , with a budget constraint
L, + L, = 100. Obtain the PPF.
Solution:
From X = (LX)U5and Y = 0 . 5 ( 4 ) and
~~
budget constraint, get

Differentiate totally to get PPF:

Determination of Equilibrium Prices

PPF gives all of the efficient combination of supply of goods. So we need the
demand for goods to determine the equilibrium position. If we remember, the
demand for goods can be derived from consumer preferences (utility curves).
Let us assume an aggregate utility function, which can be represented using a
set of 'community indifference curves'. These curves reflect the aggregation
of individual preferences. In order words, the society is willing to trade-off
among goods. If we take two goods, X and Y, the equilibrium price ratio 5
p.
will equate demand and supply for the both goods. In the process, (i) each
consumer wouId take the price as given and maximise per utility subject to her
budget constraints, (ii) each producer would take prices as given and
maximise her profit given such prices. Subsequently, market of clears at the
tangency point of PPF and community indifference curve.
 Production without
19.5 EFFICIENCIES OF COMPETITIVE Consumption

--- EQUILIBRIUM
We now turns to three important efficiencies generated by the free market
when on equilibrium, viz., (i) productive eff~ciency,(ii) allocative efficiency
and (iii) product-mix efficiency.
19.5.1 Productive (Technical) Efficiency
Productive efficiency requires that we cannot produce more of a good without
producing less of another. In order to appreciate its underlying idea, we may
have to recall the concept of opportunity cost. That is, the cost of producing
more X can be readily measured by the reduction in Y output.
Let us consider the marginal conditions described in (i) - (iv). Combining (i)
and (iii) we get,

and combining (ii) and (iv) we get,

This means when we consider economic efficiency, marginal revenue product

of labor (and capital) must be the same in both the industry. This mechanism
is analogous to Smith invisible hand mechanism, which says that if the above
two relationships do not hold, there will be competitive bidding among the
employers in the concerned industries such that the equality will again be
restored.
It can be proved that A, is the imputed value of labor and A, is the imputed
value of capital. Thus, we can use above two Lagrange multipliers as proxy
for wages and rent respectively.
Then, from (i) and (ii), we get

And from (iii) and (iv), we get

Combining the above results, we get

f,l
- f:-!!
- ....(xi)
f: - f,'
that is, the sector equates the ratios of marginal productivities cf factors to the
price ratio and these ratios are equated across sectors. Consequently, we can
say that productive (technical) efficiency is satisfied in the equilibrium.
We can explain the above result using the Edgeworth Box diagram (see Figure
19.2).
Figure 19.2 shows the set of factor allocations in production for which Pareto
efficiency is achieved. (By Pareto efficiency we mean no further gains from
trade can be obtained if one moves from the above allocation. i.e., there is no
mutually possible betterment if one move from a Pareto efficient allocation).
General Equilibrium L 4-
K -

KZ
I
I \
I
K

-
I
I
I
I

4 L
Fig. 19.2: Edegeworth Box lor Technical Effiency
The X-axis and Y-axis of the box are total endowment of labor and capital
respectively. Labor is plotted horizontally and capital vertically. With respect
to the origin O1 we have drawn the isoquants for the first industry and with
respect to the origin O2we have drawn isoquants for the second industry.
The efticient factor allocation consists of the points are those input
combinations for which slopes of the isoquants for the two industries are
equal. This condition is given by the equation (xi).
The curve O1O2 is known as the efficiency locus or the contract curve, which
is obtained by joining the points at which isoquants are tangent to each other.
Any point, which is off the curve, is inefficient in Pareto sense. For example
consider the initial endowment point A. Movement form A to points B or C
(both of which are on the contract curve will lead to increase in output for at
least one industry while the output of the other industry will remain constant.
Thus, there is scope for mutual betterment if the allocation point is off the
contract curve.
At all points on the contract curve, all possible gains fiom trade are exhausted.
The efficiency locus will be obtained through the above invisible hand (i.e.,
bargaining) mechanism if there is no transaction cost involved in the process
of bidding.
It is to be noted that every point on the contract curve corresponds to a point
on the production possibility frontier. Thus, the production possibility'frontier
is one to one mapping of the contract curve from the input space to the output
space.
19. 5.2 Allocative Efficiency
Note that resources must be allocated in efficient way such that overall
productive efficient is ensured. That is, the marginal physical product of any
resource in the production of particular good is the same irrespective of the
firm producing it.
The cost of one more unit of X therefore is best measured as the rate of
product transformation (RPT) of X for Y at the prevailing point on the PPF.
Suppose that two firms are producing the same good (X) and their production
functions are given as
 Production without
Consumption

I1 Assume that total supplies of capital and labour are given by K and z.The
- allocation problem is then to maximise

subject to the constraints

K, + K ? = K

... (ii)
Substituting these to (i) above, we get,
... (iii)
First order conditions for a maximisation are
ax - a ? %
---+-+-=---
aK, OK, aK,
afz
dK,
a?
aK,
af,
aK,
=,
... (iv)

and a ! ---a ?
-
aL, dL,
19.5.3 Product-mix Efficiency
If the product-mix is inappropriate, then a change in it can help reach a
Pareto-superior allocation. In order to ensure Pareto efficiency, we need to
consider individual's preferences and production possibilities together. The
necessary condition to achieve this is that the marginal rate of substitution for
any two goods must be equal to the rate of product transformation of the two
goods. Thus, consider that goods are X and Y; one individual (or, community)
whose utility function is given by U(X,Y); and society's production
possibility frontier is written as T(X,Y)=O. The problem is to maxmise utility
subject to this production constraints. Setting up the Lagrangian expression
' we have,

The first order conditions for an interior maximum are

Combining the first two of the above equations,

General Equilibrium aY
or, MRTS (X for Y)= -- (along T) =MRPT (X for Y)
ax
px So we get
Further, we know that MRPT (X for Y) = -.
9"

19.6 LINKAGES BETWEEN MARKETS

19.6.1 Link between Factor and Goods Markets
The linkage between factor and goods markets is given by

This equation says that the marginal rate of substitution in consumption must
be equated with the marginal rate of transformation.
If the marginal utility of X is relatively high (relative to Y), then we want the
marginal product of K in production of Y to be relatively low (relatilie to the
marginal product of K in Y). The reason is that if we get more utility from
consumption of X at the margin, we must be willing to allocate relatively
more K to its production.
The marginal condition is satisfied because of the tangency condition between
the community indifference curve and the PPF. That is,
MRTS (X for Y) = MRPT (X for Y).
If you consider shifting one unit of K from the production of X to that of Y,
then using PPF we get
dY " I a K
--- = MRPT(Xfar Y ) and
dY - dX l d K

But the tangency condition between the community indifference curve and the
PPF gives

MRTS(X for Y )= = MRPT(Xfor Y )

BUIBY
which implies,

19.6.2 Link between Goods and Factor Prices

The link between prices of goods and prices of factors can be seen from
 Production without
PK - (8x18~)
-_ P, - ( ~ Y I ~ ) K ) P ,
-
Consumption
P, (BY I a ~P, ) (axI a ~P, )
This is true because in equilibrium

But prices of capital and labour are equal to their marginal contributions to
production of X and Y. So
P, = ( a u i a x ) . ( a x ~ a=~P,
) ( a ~ l a ~and
) ,

Note that we can write the analogous equations for P, ,P,, in the production of
Y rather than X.
These equations indicate that P,,P, reflect the marginal contribution of K, L
to consumer utility though their production of consumer goods X and Y. So in
short these equations say,

Remember that consumers do not obtain utility from capital and labour.
However, the prices of K and L, reflect the 'indirect utility' generated by
capital and labour through transformation into X and Y, which are consumed.
Check Your Progress 1
I'
1) In the analysis of exchange using the Edgeworth Box, why do you think
that both consumers' marginal rates of substitution are equal at every
point on the contract curve?

2) In the Edgeworth box, what condition must hold for an allocation to be

on the production contract curve?

3) How is the production possibilities frontier related to the production

contract curve?
General Equilibrium 4) What is marginal rate of transformation (MRT)? Explain MRT of one
good for another is equal to the ratio of the marginal costs of producing
the two goods.

5) Explain why goods not be distributed efficiently among consumers if the

marginal rate of transformation is not equal to the consumers' marginal
rate of substitution.

19.7 THEOREMS OF INTERNATIONAL TRADE

Now we will discuss two important theorems of international trade - namely,
Stolper-Sumuelson Theorem (which talks about the relationship between
relative commodity prices and factor prices) and Rybcznski Theorem (which
talks about output mix and factor endowment) with the above framework.
We will make the assumption that both the industries consist of firms of
identical size. Two important conclusions that follow immediately are
a) each firms are factor price takers - on the aggregate, however, they affect
factor prices
b) industry production can be assumed to be linear homogeneous, i.e.,
exhibiting constant returns to scale.
As we have shown in the beginning, the firm's unit isoquants are given by
the equations,
P (a~,,aKJ)= 1 j=I, 2.
where a ~ jaKJ
, are variable input-output coefficients.
Let us now rewrite the resource constraints in terms of auk.

i.e., aL1 yl + a ~ y22 = L

Similarly, capital constraint is
akl yl + ak2 Y2 = K.
The model for revenue maximisation can, therefore, be written as -
maximise z = pl yl + p2 y2
subject to a,, y, + a,,?y2 < L
 Production without
the Lagrange for the above problem is Consuniption

For simplicity, we treat the inequality constraints as equality constraints. w

and r are imputed value for wages and rent respectively and are used as
Lagrange multiplier. The first order conditions for maximisation are,
r
af = p l - a l , w - a q r = o
- ....(xii)
a~I

...(xiv)

af
-=-yy2+A2-- 8f2 - 0 ....(xvii)
aaK2 daKz
and the constraints are
af = L - a , y I - alqy2= 0
- ....(xviii)
aw

af
ar = k - aKiYl =o
- aK2y2 ....(xix)

Solving the equation set ,'(xiv), (xv) (xx) and (xvi), (xvii) (xxi) we can
determine the cost minimising input combinations ( a , a ) and (a:,, a;,),
along the unit isoquants for each industry. We also get two marginal cost
functions (XIy;) (&Iy;).
and

The remaining four variables need to be determined are yf ,y;, w and r.

The remaining four first order conditions are (xii), xiii), (xviii) and (xix).
Substituting the solution values above, we get,
a,,w+aKlr= PI ...(xxii)
General Equilibrium
alw+a;,r = p, ...(xxiii)

and a:,l~,+a:,z~,=L ...(xxiv)

aL,yl+aLzy2 = K ...(xxv)
Solving the first two equations, we get,
w = w* (PI,p2) and
r = r* (PI,~ 2 ) .
Similarly, solving the last two equations, we get,
Y I = Y I * (PI,p2,L, K) and
Y2 = ~ ' P2, L, K)
2 (PI,

ay,* 0 (i
It can be shown that --> = 1 , 2) i.e., the industry supply curves are
ap,
upward sloping.
19.7.1 Stolper-Samuelson Theorem
We observe that factor prices are completely determined by the equations
(xxii) and (xxiii).
To determine the effects of changes in output prices on factor prices we
differentiate the above two cautions with respect to prices. We have,
&*
all.-+w
,a
.-+a,,-+r
ar*. ..--Isail -
and,
PI PI PI PI
a,?.
aw*+w,.-a , + a K zar* . aa'
. - + r .- Kz -
-1
(xxvi)

PI PI ap, PI
Now, consider the production function f'( a , , a;!) = I
Differentiating which respect to pl,

Using the first order conditions

and eliminating the factor yl / X I in each term, we get

aa;q , 8a;
Similarly, w .-+ r = 0.
.A
PI PI
Thus, the equation system (xxvi) transforms into
 Production without
Consumption

&* dr*
Solving for -,- by Cramer's rule, we get,
ap, ap,
dw' - a; ----
--- dr* -
ap, D ' ap, . D
Analogously, it may be easily verified that
*
aw*
-- - akl
--and-
I

ar* = -
a,,
ap* D 8 ~ 2 D
D * 0 is guaranteed if either

a:, ar.
y>+
aK, '=K,
I

a/, a,,,
or, <
.-,
QK, UK,

That is, if one industry is more labor intensive than the other, the above
comparative - statics result is well defined.
For example, suppose industry-l is labor intensive, then

These results are known as the Stolper-Samuleson theorem. Essentially, the

insight thrown by these is: if the price of labor-intensive industry is increased,
nominal wage rate will rise whereas capital rental rates will fall. Generally
speaking, the price of a factor of production will rise if the output price of the
industry, in which that factor is most intensively used, rises; it will fall if the
output price of the industry, which is less intensive in that factor, increases.
Let us now present this diagrammatically (see Figure 19.3).
General Equilibrium

0,
11.
Fig. 19.3: Output, Price and factor Intensity

PI
Consider an increase in -such that the price line (t,) is steeper than (t2). In a
P2
full employment economy, efficient production point moves from C to D such
that production of yl rises and y2 falls. Correspondingly, the economy moves
from EO to El along the contract curve 01 0 2 . Due to CRS, along any ray
through the origin MRTS,, is the same. Thus, we have
MRTS,, 1 . = MRTS,, I 4
. Given diminishing MRTS, along on isoquant we

have, MRTS,, I,< W

MRTS,,J..Since MRTS,, =- is the optimum point, we get
r
W

I r l E ' rlE,
- =- > -
r
W W P W
i.e., as 1rises, - rises. Thus, producers in both sectors
P2 r
substitute K for L. The increase in capital intensity implies MPLrises and MPk
falls in both the sectors. Profit maximisation requires, MPL= real wage to rise
and MPK= re 1 rental to fall.
9
19.7.2 ~ ~ b k z n s Theorem
ki
Now, we consider the effect of charges in endowment (of labor or capital) on
the output. For this we need to consider only the equations (xxiv) and (xxv).
We have already noted the coefficients are functions of factor prices only, i.e.,

Thus, if either L or K changes, aij's remain constant. Under this assumption,

differenting (xxiv) and (xxv) i.e., with respect to L, we have,

Using Cramer's rule, we again have,

 Production without
Similarly, differentiation with respect to K yields, Consumption

Assuming again industry -1 is labor intensive, we have,

These results are known as the Rybcznski theorem. They are perfectly
intuitive. It can, for example, be said that an increase in endowment of labor
(holding output prices constant) will increase the output of the labor-intensive
industry and decrease the output of the capital-intensive industry. Analogous
explanation follows for an increase in the endowment of capital.
Now, we offer a diagrammatic illustration for the proof of Rybcznski theorem
(see Figure 19.4). Here, assumption is that there is multiple production
technique such that the contract curve is smooth and always lies below the
diagonal.

Fig. 19.4: Multiple Production Technique and the Contract Curve

Since the wage-rental ratio is unchanged, optimum factor will be unchanged.
The new production point is El. 0 2 ' El and O2 Eo are parallel to each other.
Clearly, there is an increase in the production of good yl (of the sector -1) and
fall in production of y2 (good of the sector -2), since 021 El = 0 2 G < 0 2 Eo.
lncrease in the endowment of labor causes expansion of labor intensive good
(here XI). Since endowment of capital is fixed it is to be released from the
sector-2, which involve contraction of y. Therefore, production of increases
more than the actual increase in the endowment of labor. This is known as the
'magnification effect'.
Example
i) Consider an increase in both supply of labor and capital. However,
supply of labor increases more than proportionately. Show the effects
graphically (assuming yl is labor intensive and y 2 is capital intensive)
with PPC.
General Equilibrium

Fig. 19.5: Shift in Production Possibility C u w e

Here, the production possibility curve (PPC) will shifi from TT top TI
TI. The shift will be greater along the horizontal axis, which measures
the labor-intensive commodity. This is due to Rybcznski Theorem and
magnification effect.
What is meant by export-biased import biased and neutral technical
progress?
Export-biased technical progress increases the output of nation's export
commodity more than that of its import competing industry.
Import based technical progress is exactly the opposite. Neutral
technical progress increases the output of the nation's export and import
competing commodities by the same proportion.
iii) Consider a simplified variant of the general equilibrium model presented
above.
Here we have fixed coefficient technology, such that aL,'sare fixed. The
optimal coefficients are given as follows:
Labor Capital
Y1 4 3
Y2 5 1
-
p, =2,p2=/2,,L = ~ o o , K = ~ o .
Determine labor and capital constraints.
Determine * , y2* by setting up the appropriate optimisation
programme.
-
Consider an increase in the endowment of labor. Now, =XO.
Determine the changes in ( y,*, y2*)and justify the change.
Here, a,, = 4 , ah = 5,

Hence, the constraints are

The appropriate linear programming problem (LPP) is given by -

 Production without
maximise z* = 2yl* + y2* Consumptiom
subject to, 4y; + 5y; 1200
3yr + y; 5 9 0
yf,yf 2 0 .
The optimal solutions are
250 240 740
Yl =-,y2- , z =-
11 11 11
c) The LPP is
maximise i*= 2y; + y;
subject to, 4y; + 5y; i 250

The optimal solutions are

200 390 *, 790
y, =-,y2-,z = .
II 11 11
i.e., y, falls and y; rises.

Here, --- 4 ah -
- < -- 5
aK, 3 aK2
i.e., yz is labor-intensive commodity.
Thus, when endowment of labor rises, production of labor-intensive
commodity (y2) must rise and production of capital-intensive commodity
(yl) must fall a. la. Rybcznski Theorem.

19.8 OPTIMAL PRODUCTION AND

CONSUMPTION MIX
Let, every individual of the society has preference function. A social welfare
function (SWF) is a function of utility of all the members of the society.
Thus, it is in turn a function of the output level.
Plotting the SWF in output space as is done in Figure 19.6 we get the different
possible social utility corresponding to the different output mix. Optimality is
achieved when SWF is tangent to production possibility locus.

Fig. 19.6: Social Welfare Function and PPC at Equilibrium

General Equilibrium Mathematically, Let the SWF be given w = w (yl, yz)
Then the optimisation problem to find equilibrium point E is-
maximise w ( y ~y2)
,
subjectto, ~(jl,,~,)=O;y,,y,20

where G is the production possibility locus.

Check Your Progress 2
1) In an economy, shelter and food are produced by using labour and
capital. Suppose prices of labour and capital are w = r = Rs.4/hr. Further,
I
assume that in shelter production Me, 1MPK = 2 in case food, it is - . Is
2
this economy producing efficiently? If not, how would you suggest a
reallocation of inputs in it?

2) Consider the third example given in above.

a) Set up the appropriate optimisation programme to determine the
optimal values of w* and r . (price of labor and capital respectively).
b) Now, consider a parametric increase in the price of y2. Let new p2 =
5. Calculate new values of w*and r* and justify the change.
c) Comment on any similarity between the problems in example - (iii)
and exercise above.

19.9 LET US SUM UP

In this unit, we have discussed the market equilibrium that would
simultaneously satisfy the technical, allocative and produce mix efficiencies in
the presence of production and consumption activities. Both goods and factor
markets clear and all gains frame trade among consumers and reallocation of
resources across goods are exhausted. Thus, the equilibrium attained is Pareto
efficient. We also have discussed the Stolper-Samuelson and Rybcznski
theorems. It is seen that an increase in the relative price of a commodity raises
the real income of the factor used intensively and reduces that of the other.
We also have seen that optimal production and consumption mix could be
achieved when social welfare function is tangent to the production possibility
locus.
19.10 KEYWORDS
Production Possibility Frontier: This a locus of output of an economy when
resources are optimally allocated.
 Production without
Stolper-Samuelson Theorem: An increase in the relative price of a Consumption
commodity raises the real income of the factor used intensively in the
commodity's production and reduces the real income of the other factor.
Rate of Product Transformation (RPT): The rate at which one output can
be traded for another in the productive process while holding the total
quantities of inputs constant. The RPT is the absolute value of the slope of the
production possibility frontier.
Rybcznski Theorem: 'only when one factor rises the output of commodity
that intensively use the factor expands while the output of the other
commodity contracts, assuming that the coefficients of the production are
unchanged.
Social Welfare Function: This is a mapping of individual utility functions to
an aggregate utility function.

19.11 SOME USEFUL BOOKS

Jones, R.W. and J.P. Neary (1984): "The positive theory of international
trade," Section 2, in R.W. Jones and P.B. Kenen (eds.): Handbook of
International Economics: Volume 1 International Trade, Amsterdam: North-
Holland, Chapter 1.
Kreps, D. (1990) A Course in .Microeconomic Theory, Princeton, NJ:
Princeton University.
Mas-Colell, A., M. Whinston, and J. Green (1992), Microeconomic Theory,
New York, NY: Oxford University Press.
Nicholson, Walter (1992), Microeconomic Theory: Basic Principles and
Extensions, The Dryden Press, Harecourt Brale Jovanovich, Orlando.
Varian, H. (1992) Microeconomic Analysis, 3rd ed. New York, NY: W.W.
Norton.

19.12 ANSWER OR HINTS TO CHECK YOUR

PROGRESS
Check Your Progress 1
1) See Section 19.4 and answer
2) See Section 19.4 and answer
2) See Section 19.4 and answer
3) See Section 19.4 and answer
4) See Section 19.4 and answer
Check Your Progress 2
1) DoYourself
2) a) The problem (LPP) is
minimise C = 200 w + 90 r
subject to, 4w + 3r 2 12
5w+r>5
w,r 1 0 .
3 *4
*
Thesolutionis w =-,r -,c
;
=-.960
11 11 I1
General Equilibrium b) LPP is
minimise c = 200 w + 90 r
+
subject to, 4w 3r 2 12
5w+r210
w,r 2 0.
.
18 .20
The solution is w = -,r - , c
. 5900
= -.
11 11 11
Use the Stolper-Samuelson theorem argument.
c) The problems are dualistic in nature. Basically the former is price
solution and latter is a quantity solution. .
19.13 EXERCISES
1) Consider a' competitive economy with two consumers, Mann and Bitu
and one firm. There are 2 goods in the economy, labor, x, and
consumption, y (both measured positively). Each consumer has 18 units
of labor, which are supplied inelastically, and utility function log[y]. The
production function of the firm is y = x'I2.
a) Find competitive equilibrium prices and quantities assuming Mann
own the firm.
b) Find competitive equilibrium prices and quantities assuming Bitu
own the firm.
2) Consider a two-good (apples, denoted x, and apple juice, denoted y, both
measured positively) competitive economy with two agznts, Mann and
Bitu and one firm. Mann has utility function
uA= 210g[l+xA]+ 3yA.
Bitu has utility function
uB= 210g[l +xB]+ 3yB.
Both have the nonnegative quadrant as the consumption possibility set
and each has an initial endowment of 4 apples.
The firm can convert apples into apple juice. If it uses xf apples (with xf
>k), it produces (xf -k)'I2 units of apple juice. The firm is owned by
Mann
Assume k=2.
Find competitive prices and quantities.
3) In a perfectly competitive economy there are 2 goods, X and Y,
produced using capital, K, and labor L, according to the following
production functions:
X = min [Kx,L,] and Y min [K,, b ]
Where K,, L,are the inputs of K and L into the production of x, and K,,
L, are defined similarly. There is a fixed total supply of capital (200
units) and of labor (440 units), fully mobile between sectors. All
consumers are identical and have preferences represented by the utility
function U = f i .
 Production without
a) Describe the conditions for a general equilibrium, paying particular Consumption
attention to the possibility that one factor may be less than fully
employed.
b) Calculate the equilibrium quantities of X and Y, the relative price
P,/P, and the factor price ratio wlr.
Consider a competitive economy with 2 individuals, Mann and Bitu.
There is one non-produced good (labor) in the economy and each
individual has an endowment of 3 units of labor. There are 2 firms in the
economy - firm FMand Fa. Mann owns firm FM while Bitu owns firm
Fe. Both firms convert labor (L) into good x. the production functions
are as follows:
Firm F, :x, = L,

Firm F, : x, = 2&
Also, production by firm FR creates pollution where pollution z = XB
( i . , output of firm FB). finally. utility of each is
1
u' (L' ,x' = (3 - L')li2 . ( x 1 ) 1 I 2- z I8 ; i = A,B (note: L1represents ipslabor

a) Derive the competitive equilibrium ofthis economy (i.e., equilibrium

prices, production and consumption plans). [Restrict your attention
to an interior allocation where (i) both firms are producing positive
amounts of good x and (ii) consumer choices are interior.]
b) Is the equilibrium a Pareto optimum? Explain.
NOTES