Lecture8 - ECON 301 LECTURE #8 PRODUCTION ECONOMY The...

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1 ECON 301 – LECTURE #8 PRODUCTION ECONOMY The production economy introduces, you guessed it, production into the pure exchange general equilibrium model. This analysis is considerably more complicated than the pure exchange model without production since now we must trace the interaction between consumers and producers in both the goods markets and the factor markets. So now we have two goods, X and Y, two factors, K and L, and two consumers, A and B. The consumers play the dual role of buyers in the goods markets and sellers in the factor markets while the opposite is true for the producers. Using this simple structure, we will be able to trace the inter-relationship between three basic components of the economy: consumers, producers and markets. Here are the details: Commodities Good X Good Y Capital (K) Labour (L) Prices P X P Y r w Buyers Consumer A Consumer B Consumer A Consumer B Producer X Producer Y Producer X Producer Y Sellers Producer X Producer Y Consumer A Consumer B Consumer A Consumer B In this case, we are using the terminology of “producer” to mean a firm, industry, or a sector. Additionally, we will assume that each producer produces only one good at a time (i.e. producer X produces good X while producer Y produces good Y). That is, we will not consider the very complex case of joint production where all producers can make several different types of products. We will approach the distribution of endowments differently in this model as well. Unlike the pure exchange model which has initial endowments defined in terms of goods, the production economy takes a step back and defines the initial endowment distribution in terms of factors as follows: Capital (K) Labour (L) Consumer A K A L A Consumer B K B L B Total K T L T where K A , K A denote the amounts of capital and labour originally owned by consumer A and K B , L B denote the amounts of capital and labour originally owned by consumer B. The total (or market supply) of capital and labour owned by both consumers are: K T = K A + K B L T = L A + L B How does this factor endowment distribution affect the consumer optimizing behavior?
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2 The interesting part of the factor endowment distribution is that the endowments of each consumer need to be determined at market prices. They can fluctuate along with market prices and hence, influence each consumer’s decision in other markets. For example, if wage increases then the consumers’ endowment incomes will increase accordingly. Under normal circumstances we would expect that, with more income in their hands, consumers will increase their demands for the goods. This triggers an increase in the production of goods which, on turn, feeds back to the demand for factors and ultimately back to the income side. Let’s look at how the factor endowments enter the utility maximization problems of both
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This note was uploaded on 03/28/2010 for the course ECON 301 taught by Professor Coreyvandewaal during the Winter '09 term at Waterloo.

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Lecture8 - ECON 301 LECTURE #8 PRODUCTION ECONOMY The...

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