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Efficient Allocation of Resources in the economy

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 .

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Efficient Allocation of Resources in the economy

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  1. Efficient Allocation of Resources in the economy

  2. 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.

  3. Production Possibilities Coconuts Production possibility frontier (ppf) Fish

  4. Production Possibilities Coconuts Production possibility frontier (ppf) Production possibility set Fish

  5. Production Possibilities Coconuts Feasible but inefficient Fish

  6. Production Possibilities Coconuts Feasible and efficient Feasible but inefficient Fish

  7. Production Possibilities Coconuts Feasible and efficient Infeasible Feasible but inefficient Fish

  8. Production Possibilities Coconuts Ppf’s slope is the marginal rate of product transformation. Fish

  9. Production Possibilities Coconuts Ppf’s slope is the marginal rate of product transformation. Increasingly negative MRPT  increasing opportunity cost to specialization. Fish

  10. Production Possibilities • If there are no production externalities then a ppf will be concave w.r.t. the origin. • Why?

  11. 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.

  12. 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.

  13. Comparative Advantage C RC 20 30 F C MF 50 25 F

  14. Comparative Advantage C RC MRPT = -2/3 coconuts/fish so opp. cost of one more fish is 2/3 foregone coconuts. 20 30 F C MF 50 25 F

  15. Comparative Advantage C RC MRPT = -2/3 coconuts/fish so opp. cost of one more fish is 2/3 foregone coconuts. 20 30 F C MF 50 MRPT = -2 coconuts/fish so opp. cost of one more fish is 2 foregone coconuts. 25 F

  16. Comparative Advantage C RC MRPT = -2/3 coconuts/fish so opp. cost of one more fish is 2/3 foregone coconuts. 20 RC has the comparative opp. cost advantage in producing fish. 30 F C MF 50 MRPT = -2 coconuts/fish so opp. cost of one more fish is 2 foregone coconuts. 25 F

  17. Comparative Advantage C RC MRPT = -2/3 coconuts/fish so opp. cost of one more coconut is 3/2 foregone fish. 20 30 F C MF 50 25 F

  18. Comparative Advantage C RC MRPT = -2/3 coconuts/fish so opp. cost of one more coconut is 3/2 foregone fish. 20 30 F C MF 50 MRPT = -2 coconuts/fish so opp. cost of one more coconut is 1/2 foregone fish. 25 F

  19. Comparative Advantage C RC MRPT = -2/3 coconuts/fish so opp. cost of one more coconut is 3/2 foregone fish. 20 30 F C MF 50 MRPT = -2 coconuts/fish so opp. cost of one more coconut is 1/2 foregone fish. MF has the comparative opp. cost advantage in producing coconuts. 25 F

  20. Comparative Advantage C RC Economy C Use RC to produce fish before using MF. 20 70 30 F Use MF to produce coconuts before using RC. C MF 50 50 30 55 F 25 F

  21. Comparative Advantage C RC Economy C Using low opp. cost producers first results in a ppf that is concave w.r.t the origin. 20 70 30 F C MF 50 50 30 55 F 25 F

  22. Comparative Advantage Economy C More producers with different opp. costs “smooth out” the ppf. F

  23. Coordinating Production & Consumption • MRS  MRPT  inefficient coordination of production and consumption. • Hence, MRS = MRPT is necessary for a Pareto optimal economic state.

  24. Decentralized Coordination of Production & Consumption • Competitive markets, profit-maximization, and utility maximization all together causethe necessary condition for a Pareto optimal economic state.

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