Some Basic Assumptions
• A simple economy:Harry and Sally.
• There are two factors of production,
capital, K, and labor, L.
L = LH + LS
• These two factors of production can be
used to produce either apples or
bananas.
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Labor
Bananas
The Production
Frontier
Capital
B
A
MRTSAKL
= MRTSBKL
Apples
Lectures in Microeconomics-Charles W. Upton
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Three Basic Questions
What We Have Seen
1. How many apples and how many
bananas should be produced?
2. How should the apples and bananas
be allocated between Harry and
Sally?
3. How should capital and labor be
allocated to the production of apples
and bananas?
• Markets get us Pareto Optimality in
Distribution.
MRS(Harry) = MRS (Sally)
• There is more to the story.
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Pareto Optimality in Production
Labor
Pareto Optimality in Production
Bananas
Labor
Bananas
The Production
Frontier
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B
A
Apples
Capital
Apples
Capital
B
A
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Pareto Optimality in Production
Labor
Integration
Bananas
Capital
B
A
Apples
The Production
Frontier
Production Possibility
Frontier
MRTSAKL = MRTSBKL
Apples
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Bananas
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Integration
Integration
Apples
Apples
Production Possibility
Frontier
Production Possibility
Frontier
Slope = MRT
Bananas
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Bananas
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Harry and Sally’s
Harry and Sally’s
Contract Curve and
Integration
Slope = MRT
Apples
Apples
Indifference Curves
Production Possibility
Frontier
Contract Curve and
Integration
Indifference Curves
Production Possibility
Frontier
Slope = MRT
Slope = MRS
Bananas
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Bananas
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Integration
Integration
Apples
Apples
The ownership of
capital determines
where we end up.
The ownership of
capital determines
where we end up.
MRS = MRT
Bananas
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Bananas
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Integration
Integration
Apples
Apples
The ownership of
capital determines
where we end up.
The ownership of
capital determines
But we can change
where we end up.
MRS = MRT
the initial
MRS = MRT
endowment
We are Pareto
Optimal
We are Pareto
Optimal
Bananas
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Summing Up
• This is the basic proof of the efficiency of
the free market.
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Bananas
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Summing Up
• This is the basic proof of the efficiency of
the free market.
• MRS = MRT. We are Pareto Optimal..
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Summing Up
• This is the basic proof of the efficiency of
the free market.
• The primary objection people raise is about
the resulting distribution of income.
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Income Distribution
• The primary
objection people
raise is about the
resulting
distribution of
income.
• How can the
market be so good
if a very wealthy
person can feed his
dogs filet minion
while others are
struggling to live
on dog food?
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Income Distribution
• The primary
objection people
raise is about the
resulting
distribution of
income.
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Income Distribution
• The primary
• How can the
objection people
market be so good
raise is about the
if a very wealthy
All
we have shown is that
resulting
person can feed his
the competitive
solution
distribution
of
dogs filet minion
achieves
efficiency.while others are
income
.
struggling to live
on dog food?
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Income Distribution
Income Distribution
• The primary
• How can the
objection people We cannot
marketmake
be so good
one
person
better
raise is about the
if a very
wealthy
offiswithout
All
we have shown
that
resulting
personmaking
can feed his
another
worse
the competitive
solution
distribution
of
dogs
filet off
minion
achieves
efficiency.
income.
while others are
struggling to live
on dog food?
• The primary
• How can the
If we take
filet from
We cannot
objection
people
marketmake
be so good
the
wealthy,
one
person
better
raise is about the
if a very
wealthy
depriving
dogs,
offiswithout
All
we have their
shown
that
resulting
personmaking
can feed his
give toofthe poor,
another
worse
thetocompetitive
solution
distribution
dogs
filet off
minion
we
are
making
one
achieves
efficiency.
income.
while others are
person better off and struggling to live
another worse off on dog food?
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4
Summing Up
Summing Up
• The final distribution of apples and bananas
between Harry and Sally is ultimately
determined by who owns the capital and
labor.
• The final distribution of apples and bananas
between Harry and Sally is ultimately
determined by who owns the capital and
labor.
– If you think Harry is getting too much at the
expense of Sally, economists argue you ought
to redistribute income by redistributing the
ownership of capital from Harry to Sally.
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Summing Up
Summing Up
• The final distribution of apples and bananas
between Harry and Sally is ultimately
determined by who owns the capital and
labor.
• Efforts to interfere with markets lead to
inefficiency. We end up inside the
production possibility curve.
• The final distribution of apples and bananas
between Harry and Sally is ultimately determined
by who owns the capital and labor.
• Efforts to interfere with markets lead to
inefficiency. We end up inside the production
possibility curve.
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– Most distribution schemes involve income taxes
– If I must pay a tax of (say) 50% of my salary, then my
incentives to work are reduced.
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End
©2006 Charles
W. Upton
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