Efficient Allocation of Resources in the

economy

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.

Production Possibilities

Fish

Coconuts

Production possibility frontier (ppf)

Production Possibilities

Fish

Coconuts

Production possibility frontier (ppf)

Production possibility set

Production Possibilities

Fish

Coconuts

Feasible butinefficient

Production Possibilities

Fish

Coconuts

Feasible butinefficient

Feasible and efficient

Production Possibilities

Fish

Coconuts

Feasible butinefficient

Feasible and efficient

Infeasible

Production Possibilities

Fish

Coconuts

Ppf’s slope is the marginal rateof product transformation.

Production Possibilities

Fish

Coconuts

Ppf’s slope is the marginal rateof product transformation.

Increasingly negative MRPT increasing opportunitycost to specialization.

Production Possibilities

If there are no production externalities then a ppf will be concave w.r.t. the origin.

Why?

Production Possibilities

If there are no production externalities then a ppf will be concave w.r.t. the origin.

Why? Because efficient production

requires exploitation of comparative advantages.

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.

Comparative Advantage

F

C

F

C

RC

MF

20

50

30

25

Comparative Advantage

F

C

F

C

RC

MF

20

50

30

25

MRPT = -2/3 coconuts/fish so opp. cost of onemore fish is 2/3 foregone coconuts.

Comparative Advantage

F

C

F

C

RC

MF

20

50

30

25

MRPT = -2/3 coconuts/fish so opp. cost of onemore fish is 2/3 foregone coconuts.

MRPT = -2 coconuts/fish so opp. cost of onemore fish is 2 foregone coconuts.

Comparative Advantage

F

C

F

C

RC

MF

20

50

30

25

MRPT = -2/3 coconuts/fish so opp. cost of onemore fish is 2/3 foregone coconuts.

MRPT = -2 coconuts/fish so opp. cost of onemore fish is 2 foregone coconuts.

RC has the comparativeopp. cost advantage inproducing fish.

Comparative Advantage

F

C

F

C

RC

MF

20

50

30

25

MRPT = -2/3 coconuts/fish so opp. cost of onemore coconut is 3/2 foregone fish.

Comparative Advantage

F

C

F

C

RC

MF

20

50

30

25

MRPT = -2/3 coconuts/fish so opp. cost of onemore coconut is 3/2 foregone fish.

MRPT = -2 coconuts/fish so opp. cost of onemore coconut is 1/2 foregone fish.

Comparative Advantage

F

C

F

C

RC

MF

20

50

30

25

MRPT = -2/3 coconuts/fish so opp. cost of onemore coconut is 3/2 foregone fish.

MRPT = -2 coconuts/fish so opp. cost of onemore coconut is 1/2 foregone fish.

MF has the comparativeopp. cost advantage inproducing coconuts.

Comparative Advantage

F

C

Economy

F

C

F

C

RC

MF

20

50

30

25

70

55

50

30

Use RC to producefish before using MF.

Use MF toproducecoconuts before using RC.

Comparative Advantage

F

C

Economy

F

C

F

C

RC

MF

20

50

30

25

70

55

50

30

Using low opp. costproducers first resultsin a ppf that is concave w.r.t the origin.

Comparative Advantage

F

C

Economy

More producers withdifferent opp. costs“smooth out” the ppf.

Coordinating Production & Consumption

MRS MRPT inefficient coordination of production and consumption.

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

Decentralized Coordination of Production & Consumption

Competitive markets, profit-maximization, and utility maximization all together cause

the necessary condition for a Pareto optimal economic state.

MRPTpp

MRSF

C ,