(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 638

CHAPTER 16 • General Equilibrium and Economic Efficiency 613 between the goals of equity and efficiency, and hard choices must be made Welfare economics, which builds on the first and second theorems, provides a useful framework for debating the normative issues that surround the equity– efficiency issue in public policy 16.4 Efficiency in Production Having described the conditions required to achieve an efficient allocation in the exchange of two goods, we now consider the efficient use of inputs in the production process We assume that there are fixed total supplies of two inputs, labor and capital, which are needed to produce the same two products, food and clothing Instead of only two people, however, we now assume that many consumers own the inputs to production (including labor) and earn income by selling them This income, in turn, is allocated between the two goods This framework links the various supply and demand elements of the economy People supply inputs to production and then use the income they earn to demand and consume goods and services When the price of one input increases, the individuals who supply a lot of that input earn more income and consume more of one of the two goods In turn, this increases the demand for the inputs needed to produce the good and has a feedback effect on the price of those inputs Only a general equilibrium analysis can find the prices that equate supply and demand in every market Input Efficiency To see how inputs can be combined efficiently, we must find the various combinations of inputs that can be used to produce each of the two outputs A particular allocation of inputs into the production process is technically efficient if the output of one good cannot be increased without decreasing the output of another good Because technical efficiency requires the appropriate combination of inputs, we will also call it input efficiency Efficiency in production is not a new concept; in Chapter we saw that a production function represents the maximum output that can be achieved with a given set of inputs Here we extend the concept to the production of two goods rather than one If input markets are competitive, a point of efficient production will be achieved Let’s see why If the labor and capital markets are perfectly competitive, then the wage rate w will be the same in all industries Likewise, the rental rate of capital r will be the same whether capital is used in the food or clothing industry We know from Chapter that if producers of food and clothing minimize production costs, they will use combinations of labor and capital so that the ratio of the marginal products of the two inputs is equal to the ratio of the input prices: MPL/MPK = w/r But we also showed that the ratio of the marginal products of the two inputs is equal to the marginal rate of technical substitution of labor for capital MRTSLK As a result, MRTSLK = w/r (16.2) • technical efficiency Condition under which firms combine inputs to produce a given output as inexpensively as possible In §7.3, we explain that the rental rate is the cost per year for renting a unit of capital In §6.3, we explain that the marginal rate of technical substitution of labor for capital is the amount by which the input of capital can be reduced when one extra unit of labor is used, so that output remains constant