Chapter 33

PRODUCTION
Learning Outcomes

 Production Possibilities

 Production Efficiency
The Robinson Crusoe Economy

 Robinson Crusoe plays a dual role.

 he is both a consumer and a producer.
 Spend his time btw Leisure(resting in the beach) and working (gathering
coconut)
 How much does Robinson work and how much does he consume?
 Where the slope of the indifference curve is equal the slope of the production
function.
 marginal product of an extra hour of labor must equal the marginal rate of
substitution between leisure and coconuts
The Robinson Crusoe Economy

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Crusoe, Inc.

 One day he will behave entirely as a producer, and the next day he will
behave entirely as a consumer
 He sets up a labor market and a coconut market.
 He also sets up a firm, Crusoe, Inc., and becomes its sole shareholder.
 The firm is going to look at the prices for labor and coconuts and decide how
much labor to hire and how many coconuts to produce.
 3 roles: worker, shareholder, consumer
 coconuts are the numeraire good for this economy
 What should his wage rate be in order to make this market work?
The Firm

 price of coconuts=1 and the wage rate of labor=w

 We first consider all combinations of coconuts and labor that yield a constant
level of profits, π.
 π = C − wL
 C = π + wL
 this formula describes the iso-profit lines—all combinations of labor and
coconuts that yield profits of π.
 Crusoe, Inc. will choose a point where the profits are maximized.
 this implies a tangency condition: the slope of the production function—the
marginal product of labor—must equal w.
The Firm

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Robinson’s Problem

 Robinson receives his dividend of π∗ dollars.

 he thinks how much he wants to work and consume.
 Since labor is a bad, by assumption, and coconuts are a good, the indifference
curve has a positive slope as shown in the diagram
 Robinson’s budget line It has a slope of w and passes through his endowment
point (π∗, 0)
 At his optimal consumption, the marginal rate of substitution between
consumption and leisure must equal the wage rate.
Robinson’s Problem

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Putting Them Together

 slopes of the indifference curve and the production set are the same.

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Production and the First Welfare
Theorem
 First Theorem of Welfare Economic also applies in production economy.
 Some assumptions:
 Competitive equilibrium should exists
 No consumption externalities
 No production externalities
Production and the Second Welfare
Theorem
 In the case of an economy involving production, the same
 result like pure exchange is true, but now we require not only that
consumers’ preferences are convex, but also that firms’ production sets are
convex.
 with constant or decreasing returns to scale, the Second Welfare Theorem
works fine. Any Pareto efficient allocation can be achieved through the use of
competitive markets.
Production Possibilities

 A production possibilities set: measures the set of outputs that are feasible
given the technology and the amounts of inputs.
 The shape of the production possibilities set will depend on the nature of the
underlying technologies.
 The slope of this production possibilities set = marginal rate transformation:
 how much of one good Robinson can get if he decides to sacrifice some of the
other good.
Production Possibilities

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Comparative Advantage

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Pareto Efficiency

 for Pareto efficiency not only each consumer’s MRS should be the same, but
also each consumer’s MRS should be equal to the MRT.

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Castaways, Inc.

 two outputs: C and F

 two input, Crusoe’s labor (LC) and Friday’s labor(LF ).
 Given the price of coconuts (pC ) and the price of fish (pF ) and the wage
 rates of Crusoe and Friday (wC and wF ), the profit-maximization problem is:
 Max C, F, LF ,LC p C C + p F F − w C LC − w F LF
 Let L∗ = wC L*C + wF L*F
 π = p C C + p F F - L∗
 Rearranging this equation we have
 C- F
 Since L∗ is fixed by assumption higher profits will be associated with
 isoprofit lines that have higher vertical intercepts.
Castaways, Inc.

 Maximum profit is where the isoprofit line is tangent to the production

 possibilities set.
 MRT= -

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Robinson and Friday as Consumers

 What do the consumers do with the money from the firm?

 they use the money to purchase consumption goods. Each person chooses the
best bundle of goods that he can afford at the prices pF and pC.
 the optimal consumption bundle for each consumer must satisfy the condition
that MRS= -
 Thus the necessary conditions for Pareto efficiency are met the MRS of each
consumer equals the MRT.