General Equilibrium

UNIT 1 GENERAL EQUILIBRIUM WITH with Production

PRODUCTION
Structure
1.0 Objectives
1.1 Introduction
1.2 Meaning of ‘Partial Equilibrium Analysis’ and ‘General Equilibrium
Analysis’
1.3 General Equilibrium with Production
1.4 Production Efficiency
1.4.1 Edgeworth Box for Production
1.4.2 Contract Curve or Efficiency Production Set
1.4.3 Pareto Efficiency in Production
1.5 General Equilibrium with Competitive Input Markets
1.5.1 Production and the First Welfare Theorem
1.5.2 Production and the Second Welfare Theorem
1.6 Transformation Curve
1.7 Let Us Sum Up
1.8 Some Useful References
1.9 Answers or Hints to Check Your Progress Exercises

1.0 OBJECTIVES

After going through the unit, you will be able to explain:

x the meaning of ‘Partial Equilibrium’ and ‘General Equilibrium’;
x the concept of Edgeworth box in production;
x Pareto efficiency in production;
x optimal allocation of factors under perfect competition;
x first welfare theorem in production;
x second welfare theorem in production;
x limitations of welfare theorems in production; and
x derivation of transformation curve from general equilibrium in
production.

1.1 INTRODUCTION

In Unit 8 of Intermediate Microeconomics-I course in Semester III, you were

introduced to the concept of general equilibrium in a pure exchange
economy. There we considered a case of two goods and two consumers
endowed with some amounts of both the goods. The assumption of no
9
General Equilibrium production was also made, and general equilibrium resulted from mutual
exchanges of the two goods between the two consumers till a Pareto
efficient allocation was reached as a competitive equilibrium. We also came
across the two most fundamental results of general equilibrium analysis—
the first and second welfare theorems. Now we add production to this
model. In other words, consumers will not just be exchanging goods to reach
a Pareto efficient allocation; producers will be producing those goods as
well—turning factors of production into final consumption goods. As it turns
out, this adds some complexity to the analysis of general equilibrium.

In this unit we will focus on general equilibrium analysis wherein we will

study a complex problem of attaining equilibrium simultaneously in all the
markets where demand and supply in the markets of related goods interact
to determine equilibrium prices and quantities. This is a more realistic view
and a comprehensive analysis of the economic system as we always expect
inter-relationships and inter-dependence among different markets for
commodities and factors and the decision-making agents such as consumers,
producers and resource owners.

1.2 MEANING OF ‘PARTIAL EQUILIBRIUM ANALYSIS’

AND ‘GENERAL EQUILIBRIUM ANALYSIS’
Let us first revisit the concepts of partial and general equilibrium. In
Economics a distinction is made between Partial equilibrium and General
equilibrium analysis. Partial equilibrium analysis is a study of individuals, that
is, it involves studying a single good market, a single factor market, a single
consumer or a single producer in isolation. Under partial equilibrium
analysis, we explain the determination of equilibrium price and quantity of a
product or factor through its demand and supply ignoring the prices of and
market conditions for other related goods. This is based on the assumption
that the price of other products or factors does not change when there is
some change in the price of the commodity under consideration.

Therefore, the analysis in which we do not consider the inter-dependence of

product and factor markets and the prices of other related commodities and
factors is called Partial Equilibrium Analysis. Utility maximisation by an
individual, cost minimisation by a producer, equilibrium analysis of tea
industry or textile industry are all examples of partial equilibrium analysis.
However this is not realistic scenario because markets are generally inter-
related and inter-dependent, and change in the price of related goods has
repercussions on the demand and supply of commodity under consideration.
For instance, equilibrium analysis of automobiles market cannot be studied
in isolation of the changes in petrol market.

A more appropriate analysis that takes into account the inter-relationship

and inter-dependence between different markets and studies the
determination of equilibrium simultaneously in all the markets is called the
10
 General Equilibrium
General Equilibrium Analysis. General equilibrium analysis is a study of with Production
simultaneous equilibrium in all the markets and considers all prices as
variable. Under it, an economy is studied as a closed system, with all prices
being determined simultaneously. General equilibrium analysis takes into
account the effect of change in price and market conditions in other goods’
markets on the price of the good under consideration. For instance, it takes
into account the effect of change in the price of petrol on the demand of
automobiles, as change in price of petrol is expected to have a strong impact
on demand for automobile— a link which is ignored under partial
equilibrium analysis.

Check Your Progress 1

1) Distinguish between Partial equilibrium and General equilibrium analysis.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

2) General equilibrium takes into account inter-dependence and inter-

relationship between different markets. Comment.

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

1.3 GENERAL EQUILIRBIUM WITH PRODUCTION

General equilibrium is concerned with analysing all the markets, along with
considering the mutual dependence between them. In Unit 9 of
Intermediate Microeconomics-I course, we discussed the concept of General
equilibrium in a pure exchange economy with the assumption of no
production taking place. The consumers were actively trading to reach a
general equilibrium where we discussed Pareto optimality (Pareto efficiency)
and market equilibria and showed the crucial connection between Pareto
optimality and market equilibria as captured in the first and second
fundamental theorems of welfare economics. Recall that the first theorem
broadly says that a market equilibrium is Pareto optimal and the second says
that any Pareto optimal allocation can be achieved with the market
mechanism. Now in this unit, we discuss the production economy along with
market equilibria and identify the Pareto optimal production outcome in
11
General Equilibrium that economy. Just like before, the Edgeworth box is employed to capture
the essential features of general equilibrium. In the pure exchange case
without production, we assumed two consumers A and B, and two
commodities X and Y. There general equilibrium entailed Pareto optimal
allocation of commodities X and Y among consumers A and B (who were
assumed to be endowed with some quantities of both the commodities X
and Y). Now from the perspective of attaining general equilibrium with
production, we consider two factors of production Labour (L) and Capital (K)
that firms employ for the production of the commodities X and Y. To keep
the analysis simple and to concentrate on the basic characteristics of general
equilibrium with production, it is assumed that—

i) There prevails perfect competition in all the markets.

ii) Both Labour and Capital are available in fixed quantities in the
economy.
iii) The technology is given.

Considering the above mentioned assumptions, in the context of General

Equilibrium with production, we intend to solve the problem of Production
Efficiency, that is to determine how much of the capital and labour factors to
be used for production of each commodity. Thus, the task under general
equilibrium here is to determine equilibrium relative prices and quantities of
both the factors employed, labour (L) and capital (K), corresponding to the
point at which all markets reach equilibrium simultaneously.

1.4 PRODUCTION EFFICIENCY

1.4.1 Edgeworth Box for Production
Similar to the Edgeworth box we drew for commodity exchange, we
construct an Edgeworth box for production in order to visualise production
efficiency diagrammatically. A rectangular Edgeworth box with fixed
dimensions (given by total endowment of capital and labour) depicts all
possible allocations of capital and labour employed for the production of
commodities X and Y. Commodity X is represented by origin OX at the lower-
left corner, while commodity Y by OY at the upper-right corner. From origin
OX, height of the box (OXK0) represents total endowment of capital available
in the economy, while its width (OXL0)represents total endowment amount
of labour available. Similarly, the respective opposite sides from origin OY
represents the total capital and labour available in the economy. Isoquants
with respect to origin OX (i.e., X0, X1, X2 such that X0 < X1 < X2) represent
different combinations of capital and labour required for producing a given
level of output of commodity X, while those with respect to origin OY gives
capital-labour production combinations producing a given level of output of
commodity Y (i.e., Y0, Y1, Y2 such that Y0 < Y1 < Y2). Reaching a final general
equilibrium involves allocation of the two factors of production K and L
12 among the production of two commodities X and Y.
 General Equilibrium
/DERXUWRFRPPRGLW\< with Production
K0 OY

Y0
&DSLWDOWRFRPPRGLW\;

Y1 Y1

&DSLWDOWRFRPPRGLW\<
X2
X0 X1
OX L0
/DERXUWRFRPPRGLW\;
Fig. 1.1: Edgeworth Box with Production

1.4.2 Contract Curve or Efficiency Production Set

Now, consider Fig. 1.2 where point T represent the initial factor allocation among
production of commodities X and Y. Here X1 amount of commodity X is produced
using ܱ௑ ‫ܮ‬௑ଵ amount of labour and ܱ௑ ‫ܭ‬ଵ௑ amount of capital and Y1 amount of
commodity Y is produced with remaining amounts (i.e.ܱ௒ ‫ܮ‬௒ଵ amount of labour
and ܱ௒ ‫ܭ‬ଵ௒ amount of capital)of two factors of production. All other points also
represent the similar allocation of total amount of both the factors of
production. Isoquants representing input allocation for the production of
commodities X and Y passing through the initial factor allocation point T form a
lens-shaped area (shaded-region). The significance of this lens-shaped area is
that every allocation of inputs identified by a point inside this area involves larger
outputs of both commodities (called Pareto improvement) than at point T. For
instance, point Q can be reached as improvement from point T by increasing
production of both commodities. Movement from point T to Q involves shifting
some labour from good X to Y industry and some capital from good Y to X
industry, increasing outputs of both the commodities at no additional cost.
Possibility for such an improvement exists in case of all the points where
isoquants for both the commodities intersect.

Fig. 1.2: General Equilibrium under Production

13
General Equilibrium As you may notice, at point Q, possibility for further increasing the output of
both or any of the commodity X or Y without incurring additional cost in
terms of lower output of the other commodity ceases. Such a resource
allocation is efficient in the sense that output of one commodity cannot be
increased without decreasing the output of the other. Indeed, an efficient
resource allocation occurs at the point of tangency of the isoquants
representing respective commodities, else there exist scope for increasing
the production of either or both the commodities through resource
reallocation. If we take the locus of all the tangency points of the isoquants
from the origins, we get a contract curve or an Efficient Production Set. In the
figure the curve from Ox joining all the tangency points of the isoquants till
Oy is the contract curve. The general equilibrium, that is, when all markets
are simultaneously in equilibrium will lie somewhere on this contract curve.
Any point other than the one on the contract curve cannot be a point of
general equilibrium as there will always be a scope for improvement in
terms of increased total output. Let us understand this by considering point
T in Fig. 1.2. As one may notice in Figure 1.2, movement from point T to any
point like N, M or Q will lead to increased production of commodity X, Y or
both, respectively. Thus T cannot represent an efficient resource allocation.

1.4.3 Pareto Efficiency in Production

Pareto efficiency in production implies factors of production should be so

allocated that through any reallocation it will not be possible to increase the
output of any one commodity without decreasing the output of the other
commodity or to increase the production of both the commodities together.
Such an allocations lies on the contract curve where slopes of the isoquants
representing resource allocation possibilities of commodities X and Y are
equal, that is where the isoquants are tangent to each other. Slope of an
isoquant is given by the Marginal rate of technical substitution between
capital and labour for production of a good (MRTSLK), hence at an efficient
resource allocation point

MRTSXLK = MRTSYLK

The above condition reads— marginal rate of technical substitution between

capital and labour for production of good X is equal to marginal rate of
technical substitution between capital and labour for production of good Y.
Given an initial resource allocation between commodity X and Y (here point
T), a reallocation of factors for the production of both the goods to reach a
tangency condition of isoquants (like point Q) exhausts all Pareto
improvements possible over the initial allocation condition. Allocation like Q
represents Pareto efficiency in production.

However, on the contract curve you cannot tell which point is best as all are
Pareto efficient. Which point would be the final equilibrium will depend
directly on the initial allocation of resources and other factors like demand
14 and preferences for the final goods, as well as indirectly on the ownership of
 General Equilibrium
factors of productions and their relative prices. Also if the initial production with Production
occurs somewhere on the contract curve then there is no scope for Pareto
improvement. Hence, depending upon the initial allocation, the final
equilibrium allocation would vary and is not unique.

Check Your Progress 2

1) Explain the construction of Edgeworth box and show how General
equilibrium is attained in production.
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
2) What is a Contract curve? How is it the locus of efficient outcomes?
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
3) What does determine the final general equilibrium outcome on the
contract curve?
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
4) Can there be a Pareto efficient allocation where someone is worse off
than the initial endowment which was Pareto inefficient?
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
5) True or False
a) Someone can be made better off by moving from one Pareto efficient
point to another Pareto efficient point.
15
General Equilibrium b) Someone can be made better off by moving from one Pareto efficient
point to another Pareto efficient point without making anybody else
worse off.
c) We know the final trading outcome if we know the initial endowment
and the contract curve.
…………………………………………………………………………………………………………..
…………………………………………………………………………………………………………..
…………………………………………………………………………………………………………..
…………………………………………………………………………………………………………..
…………………………………………………………………………………………………………..

1.5 GENERAL EQUILIBRIUM WITH COMPETITIVE INPUT

MARKETS
When there exists perfect competition in factor markets, a point on the
production contract curve, that is, the efficient production set will be
attained as general equilibrium. This results from the fact that firms in a
perfect competitive industry face the same input prices. Here, this tendency
means that the wage rate earned by labourers will be the same in the
production of commodity X and Y, and similarly for the rental price of
capital. Furthermore, every firm will minimise cost by employing inputs in
quantities so that MRTSLK equals the ratio of input prices (cost minimising
condition requiring equality between slope of isoquants and isocosts). For a
wage rate of w and a rental price of capital of r, the condition for cost
minimisation will be:
‫ݓ‬
ൌ ‫ܴܵܶܯ‬௅௄
‫ݎ‬
Geometrically, this equality is shown by the tangency between an isocost
௪
line (with a slope of ௥ ) and an isoquant (with the slope MRTSLK).In a
competitive equilibrium, each producer of commodity X operates at a point
where the slope of its isoquant equals the ratio of input prices. Also, each
producer of commodity Y operates at a point where the slope of its isoquant
also equals the same input price ratio. Hence, slopes of the isoquants
representing commodities X and Y must equal one another since both are
equal to the same input price ratio. That is, in a competitive equilibrium
௪
= MRTSXLK = MRTSYLK
௥

Consequently, the competitive equilibrium must lie on the contract curve,

which identifies resource allocations where the slopes of isoquants of the
two commodities are equal to the factor price ratio. In Fig. 1.2, line JJ passing
through the tangency point Q of the two isoquants and the initial allocation
௪
point T has slope equal to the factor price ratio ( ௥ ሻ.Mathematically, the
condition can be established as follows:
16
 General Equilibrium
Under perfect competition, price of labor (w) and capital (r) is assumed as with Production
given and same for all the producers. Producers tend to minimise the cost
given by wL + rK (where L and K stands for the units of labour and capital
employed to produce output level ܻത respectively) for producing a given level
of output ܻത = f (L, K) (output as a function of factor inputs L and K). The
constrained optimisation exercise is given by:

Min ‫ ܮݓ‬൅ ‫ܭݎ‬

Such that ݂ሺ‫ܮ‬ǡ ‫ܭ‬ሻ ൌ ܻത

To solve this, we write down a Lagrangean function (ࣦ)

ࣦ ൌ ‫ ܮݓ‬൅ ‫ ܭݎ‬െ ߣሺ݂ሺ‫ܮ‬ǡ ‫ܭ‬ሻ െ ܻതሻ

The first-order condition is to differentiate ࣦ with respect to ‫ܮ‬ǡ ‫ ߣ†ƒܭ‬and

put the resultant equal to zero.
డࣦ డ௙ሺ௅ǡ௄ሻ
డ௅
ൌͲฺ‫ݓ‬െߣ డ௅
ൌͲ
డࣦ డ௙ሺ௅ǡ௄ሻ
డ௄
ൌͲฺ‫ݎ‬െߣ డ௄
ൌͲ
డࣦ
డఒ
ൌ Ͳ ฺ ݂ሺ‫ܮ‬ǡ ‫ܭ‬ሻ െ ܻത ൌ Ͳ

Rearranging the above equations, we get

ങ೑ሺಽǡ಼ሻ
ങಽ ௪
ങ೑ሺಽǡ಼ሻ ൌ
௥
ങ಼

௒ ௪
‫ܴܵܶܯ‬௅௄ ൌ ௥

௑ ௪
Similarly for output X ‫ܴܵܶܯ‬௅௄ ൌ ௥

Therefore, we get

௑ ௒
‫ݓ‬
‫ܴܵܶܯ‬௅௄ ൌ ‫ܴܵܶܯ‬௅௄ ൌ
‫ݎ‬
Hence, perfect competition ensures optimum allocation of resources in the
production of two commodities X and Y.

We already discussed the first and the second welfare theorems in Unit 8 of
the Intermediate Microeconomics-I course of Semester III. Let us briefly
recall them here from the perspective of the general equilibrium with
production.

1.5.1 Production and the First Welfare Theorem

The first welfare theorem ensures that any perfectly competitive equilibrium
allocation is Pareto efficient. When all producers act rationally to maximise
profits under perfect competition, the competitive equilibrium is Pareto
efficient. The conditions for the theorem are quite restrictive, as the result
17
General Equilibrium holds only if perfect competition prevails. Thus this theorem takes away the
possibility of increasing returns to scale. Perfectly competitive equilibrium
exists for non-increasing returns to scale. We also assume convex isoquants
and concave transformation curves as this assumption is required to fulfill
the second order condition of equilibrium. Thus the existence of perfect
competition does not confirm the fulfillment of second order condition of
equilibrium.

It also assumes that there is no production externalities (that is — one

producer’s decision does not affect the production possibilities of other
firms) as well as, consumption externalities — as this theorem has nothing to
do with the impact of production on distribution of income and thus on
consumption. It also completely ignores the concept of equity in distribution
and ensures only efficiency. In other words, a factor allocation where one
producer is allocated with all the factor inputs, could be a Pareto efficient
factor allocation (since no other producer can be made better off without
harming the producer with all the factor inputs), but definitely not equitable.
Further, one important condition for Pareto optimality is the existence of
general equilibrium. If all markets are not simultaneously in equilibrium
there would always exist a possibility for Pareto improvement. From welfare
point of view perfect competition will not result in Pareto optimality if
income distribution is not optimal. Also if there exists unemployment or
underutilisation of resources, Pareto optimality will not be achieved as any
point inside the PPC cannot be Pareto optimal. So Pareto optimality is
ensured if and only if there exists full employment of all resources.
Therefore, it can be claimed that perfect competition is a necessary but not
a sufficient condition for Pareto optimality.

1.5.2 Production and the Second Welfare Theorem

Second welfare theorem states that any Pareto efficient allocation can be
rationalised as competitive market equilibrium under certain assumptions.
In other words, any socially desirable efficient allocation can be reached by
way of the market mechanism (or as a competitive equilibrium) beginning
from the endowment modified with the help of lump-sum transfers. This is
in response to the distinct issues of efficiency and equity that are not
addressed by the First welfare theorem. For instance, a Pareto efficient
factor allocation where one producer is allocated with all the factors is
inequitable from society’s point of view. A redistribution of endowment
among different producers will result in a different Pareto optimal allocation
which can be relatively more socially desirable depending on the
redistributed endowment and can be achieved through the use of
competitive markets. However it involves a lot of practical difficulties in
redistributing the endowment among different economic agents of the
economy.

In an economy any Pareto optimal combination which is considered fair on

18 distributional grounds can be achieved through perfectly competitive
 General Equilibrium
markets. So the endowment can be redistributed first and then relative with Production
prices can be used to reflect the scarcity. This leads to a policy intervention
on equity grounds and is easily done through taxation which involves
transfer of purchasing power from one hand to another without physically
altering the initial endowment. However if taxation alter the decision of the
agents (as happens when labour income is taxed and there is resulting fall in
labour supply) then taxes are distortionary in nature. A lump-sum tax is non-
distortionary in nature and any Pareto optimal allocation that is considered
just by the society can be achieved by imposing such lump-sum tax.
Therefore, the important implication of second welfare theorem is that
prices must be used to reflect relative scarcity and a lump-sum tax could be
in place to achieve just distribution in the society.

1.6 TRANSFORMATION CURVE

A Transformation curve (also called the Production Possibility Frontier)
shows the maximum amount of different combinations of the two goods
that an economy can produce by fully utilising all its resources. It basically
shows the transformation of one good into another by transferring
resources between the productions of two goods. The Edgeworth box
depicts isoquant map of two commodities in the factor-space. To depict a
clear picture in the output-space we need to derive the production
possibility curve from the Edgeworth box.

We derive the transformation curve from the contract curve by bringing

down the various combinations of the output of two goods produced from
fixed endowments of factors of production from the input-space to the
output-space. To derive the Transformation curve, consider the contract
curve RH in Fig. 1.2. Now refer Fig. 1.3 where we plot point Q’ in the output
space (Transformation curve) corresponding to point Q on the contract
curve that depicts X2 amount of good X and Y2 amount of good Y. Next
consider point N on the contact curve and the corresponding to that the
point N’ on the transformation curve depicts the production combination X3
and Y1. Similarly, consider point M’ corresponding to point M on the contract
curve RH. We can, in this manner, capture each point in output space for the
corresponding points in the input space along the contract curve. Joining all
such points in the output space we obtain the transformation curve TT in
Fig. 1.3.

19
General Equilibrium

Fig.1.3: Transformation Curve

Important Features of the Transformation Curve

i) The transformation curve represents a set of technically efficient

combinations of two final goods that can be produced with fixed
endowment of factor inputs. The points inside the curve are feasible but
are technically inefficient or in other words, factor inputs are not
efficiently employed when such output combinations are produced.
Similarly, points outside this curve might be technically efficient and are
certainly more desirable than the points on the curve but are not
feasible.

ii) Slope of the transformation curve measures the rate of technical

transformation from one good to the other (at the margin) known as the
marginal rate of product transformation between two goods X and Y
(‫ܴܶܲܯ‬௑௒ ). It simply equals the amount of good Y sacrificed by releasing
resources from its production to produce additional units of good X. It
equals:
ெ஼೉
‫ܴܶܲܯ‬௑௒ ൌ ெ஼ೊ

Where

‫ܥܯ‬௑ is marginal cost of production of good X

‫ܥܯ‬௒ is marginal cost of production of good Y

iii) Transformation curve is concave to the origin because the amount of Y

that has to be given up for increasing the production of good X increases
as one produces more of good X. This in turn may result from several
reasons including:

Diminishing returns, that is, fall in the efficiency with increase in the
scale of production. But this might not be true in aggregate.
20
 General Equilibrium
Differing factor intensities of the products: If we assume, Good X to be with Production
capital intensive and good Y to be labour intensive, then marginal
productivity of the sector producing good X will decline as more and more
labour gets shifted to that sector, and vice versa for the sector producing
good Y as more and more capital gets allocated to it. So, even if there is no
diminishing returns in each sector, we will get diminishing returns as we
force a sector to use a comparatively less technically productive mix of
inputs.

All points on the transformation curve are the points of general equilibrium
in production as it is a mapping of points from the factor space to the output
space. If technology exhibits constant returns to scale then production
possibility curve will be a linear function. Suppose Raj can produce 60 chairs
in an hour when he produces only chairs. Whereas, when he devotes his
time to producing only tables, he produces 30 tables in an hour; though he
may produce combinations of both chairs and tables simultaneously as well.
On plotting these production possibilities we get the production possibility
curve given by the Fig 1.4 (a). The curve is straight-line and downward
sloping indicating a linear and a negative relationship between the
productions of the two goods. The negative slope indicates the scarcity of
the factor resources. Producing more tables require shifting of factor
resources out of chair production and thus fewer chairs. Slope of this curve
଺଴
equals െ2ቀൌ െ ଷ଴ቁ, giving the rate at which Raj must give up production of
chairs to produce an additional table.The absolute value of the slope
measures the opportunity cost of producing an additional unit of table
measured in terms of the quantity of chairs that must be forgone.

PPF for Raj PPF for Ram

Chairs

60

૚
Chairs

Slope = െ2 Slope = െ ૛

30

0 60 Tables
0 30 Tables
Fig. 1.4 (a): Production Possibility Frontier Fig. 1.4 (b): Production Possible Frontier

There is another individual Ram who can produce either 30 chairs or 60

tables in one hour’s time. The corresponding PPC is given in Fig. 1.4 (b) with
slope െ1/2.Clearly Raj has a comparative advantage in producing chairs and
Ram has a comparative advantage in producing tables. By comparative
advantage it means opportunity cost for producing a chair is lower for Raj
(for every extra chair that Raj produces, he has to produce 0.5 units less of
table) as compared to Ram (for every extra chair that Raj produces, he has to 21
General Equilibrium produce 2 units less of table), and similarly opportunity cost for producing a
table is lower for Ram when compared to Raj.

Let us now consider the maximum output of the two individuals combined. If
they produce one of the two commodities, then together they can produce
either maximum of 90 tables or 90 chairs. In Fig. 1.5 point A represents total
chairs produced in one hour when both Ram and Raj produce only chairs and
no table. Similarly, point C represents total tables produced when they both
produce only tables and no chair. However if they both specialise in
producing the good in which they have a comparative advantage (with Raj
producing 60 chairs and Ram, 60 tables) a combination represented by point
B will be reached. The combined transformation curve will now have a kink
with Marginal rate of transformation changing from െ1/2 to െ2 (see Figure
1.5).We see that in the region above the kink, more than 60 chairs (the
maximum amount produced by the expert in producing chair, namely Raj)
could be produced. So in this region above the kink Raj spends all day on
producing chairs while Ram produces the rest. In the region below the kink,
more than 60 tables (the maximum amount produced by the expert in
producing table, namely Ram) could be produced. So in the region below the
kink Ram spends all day on producing tables while Raj produces the rest.
This way of dividing up the work between them is the most efficient possible
in the sense that it leads to the highest possible combined production
possibility frontier.

A
90 ૚
Slope = െ ૛

60 B
Chairs

Slope = െ2

C
0 60 90 Tables

Fig. 1.5: Combined Production Possibility Curve

Check Your Progress 3

1) Define marginal rate of product transformation. Explain why marginal
rate of product transformation of one good into another equals the
ratio of their marginal costs.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
22
 General Equilibrium
2) Derive the transformation curve using the concept of general with Production
equilibrium in production.

………………………………………………………………………………………………………………

………………………………………………………………………………………………………………

………………………………………………………………………………………………………………

………………………………………………………………………………………………………………

3) Suppose in an economy there are two individuals, Robinson and Friday
who can produce using only one factor of production i.e. labour. Answer
the following:

i) Robinson using all his labour can produce either 5 units of food or
10 units of clothing per day and Friday can produce either 10 units
of clothing or 15 units of food a day. Derive the production
possibility frontier for such an economy using the information.
………………………………………………………………………………………………………..
………………………………………………………………………………………………………..
………………………………………………………………………………………………………..
………………………………………………………………………………………………………..

1.7 LET US SUM UP

In this unit we have studied the difference between partial equilibrium
analysis and general equilibrium analysis. Partial equilibrium analysis is a
study of a single market whereas general equilibrium is concerned with
equilibrium in all the markets simultaneously. We learnt how the Edgeworth
Box can be used to study general equilibrium in production and reach the
condition of Production Efficiency. Such a condition involves efficient
allocation of two factors of production (labour and capital here) for the
production of two goods (good X and Y here).

The concept of Pareto optimality is an important condition for optimal

allocation of factor resources in a general equilibrium. It allows us to reach
the condition of general equilibrium where all markets are simultaneously in
equilibrium. It eliminates all the possibilities of Pareto improvements. Each
party involved exploits maximum possible gain by efficiently allocating factor
resources for the production of an efficient output combination given the
initial factor allocation among them. A condition is given by the tangency of
the isoquants of both the parties involved where the factor price ratio is
equal to the slope of the line passing through this tangency point the initial
endowment point. We further learnt about the first and the second welfare
theorem and its applicability and limitations in general equilibrium with
production. We finally derived the transformation curve (or the PPF) using
23
General Equilibrium the concept of general equilibrium in production and the concept of
comparative advantage.

1.8 SOME USEFUL REFERENCES

x Hal R. Varian (2006), 7th edition Intermediate Microeconomics, Chapter
(31-33), East – West Press.
x C.Synder and W.Nicholson (2010), Indian edition Fundamental of
Microeconomics, Chapter 13 , Cengage Learning India.
x A.Koutsoyiannis (1985), 2nd edition Modern Microeconomics, Chapters
21-23, English language book society/Macmillian (ELBS).

1.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Refer Section 1.2 and answer.
2) Refer Section 1.2 and answer
Check Your Progress 2
1) For construction of Edgeworth box in 2x2 model for production refer
Section 1.4.
2) Contract curve is the locus of tangency points of the isoquants in the
Edgeworth box for production. It depicts all Pareto optimal points
reaching which eliminates all the possibilities of Pareto improvements.
Any factor allocation point on the contract curve is efficient in the sense
that no producer can be made better off with any possible factor
reallocation without harming the other producer in terms of lower
output production.
3) Initial endowment determines the final general equilibrium on the
contract curve.
4) No
5) a and c true, b false
Check Your Progress 3
1) Marginal rate of product transformation is the rate at which resources
from one good is taken away to produce additional unit of another
good.
2) Check the derivation in Section 1.6
3) a) Production possibility curve is kinked.
b) Individually: 12 hrs, 6.6 hrs. Combined: 8 hrs and 5.2 hrs
c) Equilibrium at the kink of the PPC.

24