13.

Production

Varian, Chapter 31
 Making the right stuff
• The exchange economy examined the
allocation of fixed quantities of goods
amongst agents

• Here we examine the production of goods

as well
– How much of each gets produced
– Who produces what
– Does “the market” do things well?
 Production functions
Output, c
e.g., coconuts

c = f(L)

Slope = marginal product of labor, f’(L)

Input, e.g., labor, L

Here, f(.) exhibits declining marginal product of labor,
or decreasing returns to scale
 Constant returns to scale
Output, c
e.g., coconuts

c = f(L) = a.L
where a is a constant

Input, e.g., labor, L

Here, f(.) exhibits a constant marginal product of labor,
or constant returns to scale
 Increasing returns to scale
Output, c
e.g., coconuts
c = f(L)

Input, e.g., labor, L

Here, f(.) exhibits increasing marginal product of labor,
or increasing returns to scale
 Definitions
• Increasing returns to scale: production
function f(x) has increasing returns to scale
if f’’(x) > 0
• Constant returns to scale: production
function f(x) has constant returns to scale if
f’’(x) = 0
• Decreasing returns to scale: production
function f(x) has decreasing returns to scale
if f’’(x) < 0
 Production terminology
• Production possibility sets: set of all
bundles that can be produced
• Production possibility frontier: set of all
bundles that can be produced such that one
good can only be increased by decreasing
another
• Marginal rate of transformation: (-1*) The
slope of the PPF
 From production functions to
production possibility sets
Coconuts
Slope = Marginal rate
of transformation, MRT

PPS – Production PPF – Production

Possibility Set Possibility Frontier

Leisure, l
• For a given consumption of leisure, what is the highest
number of coconuts that can be produced?
PPS with constant returns to scale
Coconuts
MRT is constant

PPS
PPF

Leisure, l
Finding the MRT
 Subsistence farming
Autarky: Production and consumption decisions
are made without trade
Coconuts

At optimum,
u0
MRS = MRT
PPF

fish, f
Exactly analogous to the utility maximization problem
Example: Production and no trade
• PPF given by 500 =c2+4f 2
• Utility: u(c,f) = c+f
• What c, f will producer/consumer choose?
 Production and trade
• As well as producing fish and coconuts, agent can also trade f
for c at prices pf and pc
• Each production choice is like an endowment
Coconuts

Slope = -pl/pc
Budget Set

Exactly analogous to profit maximization fish, f

 Profit maximization
• The market value of a chosen endowment point is
v(c,l) = pcc + pll
• Value is constant along iso-profit lines
pcc + pll = k
or
c = k/pc – (pl/pc)l
• So choosing largest budget set is the same as
maximizing market value, or profit
 Example: Production and trade
• PPF given by 500 =c2+4f 2
• Prices pc=pf=5
• What c, f will producer choose?
 Production and consumption
decisions Self-sufficiency,
or autarky, at
At optimum
gives lower utility
Coconuts production,
MRT = pl/pc At optimal
Sales of consumption,
coconuts MRS = pl/pc

Production
of coconuts

Production Purchases of Lemons, l

of lemons lemons
 A “separation” result
• Given a PPS and market prices, an agent
should
– Choose production bundle so as to maximize
profits
• This gives him a budget
– Choose best consumption bundle, subject to this
budget constraint
 A “separation” result
• Agent owns a firm that produces output
which it sells on the market
– Firm maximizes profit
– Profit goes to shareholder, ie consumer
• Consumer takes profit, uses prices to decide
consumption
• Agents with different preferences should
choose the same production point, but
different purchases with the profit
 Example: Production and trade
• PPF given by 500 =c2+4f 2
• Prices pc=pf=5
• What c, f should they produce?
• u(c,f)=min{c,f}
• What c, f should they consume?
 General Equilibrium with
Production
• Now we introduce a second agent into the
economy

• There are still two goods, coconuts and lemons

• Each agent has a production possibility set

• Both agents make production and trade (i.e.,

consumption) decisions
 Constructing an Edgeworth box
Coconuts

Edgeworth
box Agent B

Endowment

Agent A Lemons, l
 Inefficient production
Coconuts
Extent of productive inefficiency:
A produces too many coconuts
B produces too many lemons

Edgeworth
box Agent B

Endowment

Agent A Lemons, l
 Aggregate production
possibilities
• If a total of l0 lemons are produced, what is the
largest number of coconuts that can be produced?
Coconuts
Agent B
B’s
production This point must be
of coconuts
A’s on the aggregate
production B’s PPF
c0
of lemons production
A’s of lemons
production
of coconuts

Agent A l Lemons, l
 Some algebra
• Let cA(lA) be the largest number of coconuts
A can produce if he picks lA lemons.

• Let cB(lB) be the largest number of coconuts

B can produce if he picks lB lemons.

• We want to solve:
Max cA(lA) + cB(lB) s.t. lA + lB = l0
(lA ,lB)
 Algebra and geometry
• But this means
Max cA(lA) + cB(l0 - lA)
lA

• Solution: c’A(lA) = c’B(l0 - lA) = c’B(lB)

A’s marginal B’s marginal

cost cost

Efficient allocation
of production
lA lB
l0
Constructing the aggregate PPF
Coconuts

Aggregate PPF

Agent A Lemons, l
 Production efficiency
• Aggregate production is efficient if it is not
possible to make more of one good without
making less of the (an) other

• All points on the aggregate PPF are efficient

• At such points, production is organized so

that the MRT is the same for both agents
 Production efficiency means
equal MRTs
Coconuts
Agent B

Aggregate PPF

Agent A Lemons, l
 Production inefficiency means
unequal MRTs
Coconuts
Agent B

Aggregate PPF
X, an
inefficient
Each of these bundle
bundles produces
aggregate bundle, X

Agent A Lemons, l
 Equilibrium
• Prices pl and pc constitute an equilibrium if:
• When each agent maximizes profits at those
prices,
• ….. and then maximizes utility,
• ….. both markets clear
– i.e, there is no excess demand or excess supply
in either market
 Dis-equilibrium prices

Coconuts Agent B

Aggregate PPF

• Excess demand
for lemons
• Excess supply
of coconuts

Agent A Lemons, l
 Price adjustment
• At these prices, there is
– excess demand for lemons
– excess supply of coconuts

• Lowering pc/pl does two things

– Reduces demand for lemons
– Increases production of lemons
 Equilibrium prices
• At equilibrium,
Aggregate PPF MRTA = MRTB = MRSA = MRSB
Coconuts
Agent B

Pareto set

Agent A Lemons, l
 Example: finding equilibrium
• Person A • Person B
• PPF given by • PPF given by
500=cAS2+4fAS2 500= 4cBS2+fBS2
• uA(cA,fA)= • uB(cB,fB)=
min{cA,fA} min{cB,fB}

Find equilibrium prices (pc,pf),

production (cAS,fAS) and (cBS,fBS),
and consumption (cA,fA), and (cB,fB)
 The solution method
1. Find production as function of p
2. Using production as endowment, find
consumption as function of p
3. Use feasibility to solve for p
4. Substitute p back into demand, production
decisions
 Comparative advantage
• If producer A has a lower opportunity cost
to producing good x compared to producer
B, then producer A has a comparative
advantage in producing good x.
• 2 good, 2 producer economy – each
producer has a comparative advantage in
one of the goods.
 Comparative advantage

coconuts coconuts

lemons lemons
Agent A Agent B
Good at making Good at making
coconuts lemons
 Aggregate PPS
A makes only coconuts,
coconuts B makes both
A makes only coconuts
Max # coconuts
B makes only lemons

B makes only lemons,

A makes both

lemons
Max # lemons
 Equilibrium

coconuts

Equilibrium almost certainly

has each agent doing the
thing he is relatively good at

lemons
Pinning down the equilibrium prices

coconuts

Endowment

lemons
 Absolute advantage
• If producer A can produce more of good x
for a given set of inputs, compared to
producer B, then producer A has an absolute
advantage in producing good x.
• A single producer may have absolute
advantage in every good.
 Comparative or absolute advantage?

coconuts coconuts

lemons lemons
Agent A Agent B
Bad at both, but Good at both, but
better at making coconuts better at making lemons
 Equilibrium

coconuts

Equilibrium still almost

certainly has each agent
doing the thing he is
relatively good at

lemons