Module 3 Class 5 6 7 8

Robinson Crusoe’s Economy
• One agent, RC.

• Endowed with a fixed quantity of one resource—24 hours.
• Use time for labour (production) or leisure (consumption).
• Labour time = L. Leisure time = 24 – L.
• What will RC choose?
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Robinson Crusoe’s Technology
• Technology: labour produces output (coconuts) according to a
concave production function.

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Robinson Crusoe’s Technology

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Robinson Crusoe’s Preferences
• RC’s preferences:
• Coconut is a good.
• Leisure is a good.

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Robinson Crusoe’s Choice

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Robinson Crusoe as a Firm
• Now suppose RC is both a utility maximizing consumer and a profit

maximizing firm.
• Use coconuts as the numeraire good, i.e., price of a coconut = Rs. 1.
• RC’s wage rate is w.
• Coconut output level is C.

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Robinson Crusoe as a Firm
RC’s firm’s profit is
Slope = w.
Intercept = .

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Isoprofit Lines

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Profit Maximization

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Profit Maximization

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Utility Maximization
• Now consider RC as a consumer endowed with Rs.  * who can work
for Rs. w per hour.
• What is RC’s most preferred consumption bundle?
Budget constraint is

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Utility Maximization & Profit Maximization
Profit maximization:
quantity of output supplied = C*

quantity of labor demanded = L* Coconut and labour markets both
clear.
Utility maximization:
quantity of output demanded = C*

quantity of labor supplied = L*

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Utility Maximization & Profit Maximization

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First Fundamental Theorem of Welfare
Economics
• A competitive market equilibrium is Pareto efficient if
• consumers’ preferences are convex;
• there are no externalities in consumption or production.

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Second Fundamental Theorem of Welfare
Economics
• Any Pareto efficient economic state can be achieved as a competitive
market equilibrium if
• consumers’ preferences are convex;
• firms’ technologies are convex;
• there are no externalities in consumption or production.

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Production Possibilities
• Resource and technological limitations restrict what an economy
can produce.
• The set of all feasible output bundles is the economy’s production

possibility set.
• The set’s outer boundary is the production possibility frontier.

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• If there are no production externalities then a PPF will be concave
with respect to the origin.
• Why?
• Because efficient production requires exploitation of comparative
advantages.

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• Suppose that Robinson can produce 10 Kg. of fish per hour or 20 Kg. of coconuts
per hour.
• If he devotes Lf hours to fish production and Lc hours to coconut production
• He will produce 10Lf kg of fish and 20Lc kg of coconuts.
• Suppose that Robinson decides to work 10 hours a day.

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Lf + Lc =10
F = 10Lf
C = 20Lc
Solving,
F/10 + C/20 = 10
Marginal rate of product transformation = -2

(coconut per fish)
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Comparative Advantage
• Two agents, RC and Man Friday (MF).
• RC can produce at most 20 coconuts or 30 fish.

• MF can produce at most 50 coconuts or 25 fish.

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Coordinating Production & Consumption
• The PPF contains many technically efficient output bundles.
• Which are Pareto efficient for consumers?
• MRS  MRPT  inefficient coordination of production and

consumption.
• Hence, MRS = MRPT is necessary for a Pareto optimal economic

state.
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• The Pareto set describes the set of Pareto efficient bundles given the
amounts of goods 1 and 2 available
• But in an economy with production those amounts can themselves be
chosen out of the production possibilities set

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• In a Pareto efficient allocation, the MRS of consumer A had to be equal

to the MRS of consumer B
• i.e. the rate at which consumer A would just be willing to trade one good
for the other should be equal to the rate at which consumer B would just
be willing to trade one good for the other
• If this were not true, then there would be some trade that would make
both consumers better off
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• Marginal rate of product transformation (MRPT) measures the rate at

which one good can be “transformed” into the other
• Meaning, the factors of production are being moved around so as to

produce less of one good and more of the other.

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• Suppose, the consumer’s MRS is 1; the consumer is just willing to substitute good
1 for good 2 on a one-to-one basis
• Suppose that the MRT is 2, which means that giving up one unit of good 1 will
allow society to produce two units of good 2
• Then clearly it makes sense to reduce the production of good 1 by one unit; this
will generate two extra units of good 2
• Since the consumer was just indifferent between giving up one unit of good 1
and getting one unit of the other good in exchange, he or she will now certainly
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Decentralized Coordination of Production &
Consumption
• RC and MF jointly run a firm producing coconuts and fish.
• RC and MF are also consumers who can sell labour.

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Consumption
• LRC, LMF are amounts of labor purchased from RC and MF.

• Firm’s profit maximization problem is to choose C, F, LRC and LMF to

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Consumption
The isoprofit line can be rewritten as

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Consumption

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Consumption

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Consumption

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Consumption
So competitive markets, profit maximization, and utility maximization all together
cause
• the condition necessary for a Pareto optimal economic state.

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Consumption

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Robinson Crusoe’s Economy

• One agent, RC.

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

• Now suppose RC is both a utility maximizing consumer and a profit

© Dr. Abhishek Naresh

RC’s firm’s profit is

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

• What is RC’s most preferred consumption bundle?

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

quantity of output supplied = C*

quantity of output demanded = C*

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

• The set of all feasible output bundles is the economy’s production

• The set’s outer boundary is the production possibility frontier.

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

Marginal rate of product transformation = -2

• RC can produce at most 20 coconuts or 30 fish.

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

• Which are Pareto efficient for consumers?

• MRS  MRPT  inefficient coordination of production and

• Hence, MRS = MRPT is necessary for a Pareto optimal economic

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

• In a Pareto efficient allocation, the MRS of consumer A had to be equal

• Marginal rate of product transformation (MRPT) measures the rate at

• Meaning, the factors of production are being moved around so as to

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

• LRC, LMF are amounts of labor purchased from RC and MF.

© Dr. Abhishek Naresh

The isoprofit line can be rewritten as

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

© Dr. Abhishek Naresh

• the condition necessary for a Pareto optimal economic state.

© Dr. Abhishek Naresh