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Chapter 2 Supply & Production Possibilities. WHY INTERNATIONAL TRADE OCCURS. Many of the causes of international trade are found in countries’ differing abilities to produce certain goods . Examples: Different labor productivity Different factor endowments
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WHY INTERNATIONAL TRADE OCCURS • Many of the causes of international trade are found in countries’ differing abilities to produce certain goods. • Examples: • Different labor productivity • Different factor endowments • Different government policy (taxes & subsidies) • Different competition condition (perfect/imperfect competition)
Production function • Commodities are produces with certain primary factors and certain technical knowledge of technology • Production function X = F (K, L) (2.1) • X represents output quantity • Function F represent technology level • K represent capital • L represent labor • To make it easier to analyze graph, economist usually will fix one of the variables, X, L or K. • fixed the level of output X • Fixed one production factor, K or L
Isoquants • Isoquants is a curve that show all possible combinations input (K & L) that could be used to produce the same level of output of (X). • Higher isoquants will show a higher level of output.
Total and marginal product curves • Production of varying only one input, i.e. labor (L) & fixedinput i.e. capital (K): • Q = f ( ) • Panel on Figure 2.3: • Total production curve starts from the origin – there’s no output unless there is a possible amount of labor • TP curve towards L axis – additional units of labor unit input will increase output X, but the rate of increase of output is assumed to diminish. (Law of diminishing returns)
Total and marginal product curves • Different amount of fixed input will produce different total product curve • For capital K1 > K0, the total product curve with K1 lies on the total product output with K0. • Question: Sketch a total product curve with fixed input L? • Marginal Product (MP) =additional unit of output associated with adding one more unit of input • MPLX = ∆TPx / ∆L (marginal product of labor) • MPLX = dX / dL (= the slope of total product curve)
Returns to scale • Shows the relationship between input & output, that is the response of output to equal proportional changes in both of the inputs • Constant Returns to Scale (CRS) • When all input (K&L) increased at the same rate, the output will also increase with the same rate as the input’s increase rate. • Increasing Returns to Scale (IRS) • Output’s increment > input’s increment • Decreasing Returns to Scale (DRS) • Output’s increment < input’s increment.
Returns to scale • Point A; 10 unit of output can be produced using 6 labor & 7 capital. • If we double all input, that is 12 labor & 14 capital (point B), what is the value of output X? • B = 20 unit if constant returns to scale • B > 20, if increasing returns to scale • B < 20, if decreasing returns to scale
Equilibrium for a single producer • Assume that: • Producer wish to maximize output subject to the condition that they must spend no more inputs than an amount (C0). • Labor wage (w) & rental on capital equipment (r) treated as constant. • Isocost shows the set of combinations of K and L that can be purchased for a cost of C0. C0 = wL + rK (2.2) (2.3) • C0/r is the intercept of axis-K & w/r is the slope of isocost.
Optimum production Maximum output (point A) when isocost tangent with highest Isoquants (X1). • At the point of tangen, • Isoquants’s slope (MRTSLK) = isocost’s slope MRTSLK = w/r • And MRTSLK = MPL/MPK. Thus, the combination of cost input minimum when MPL/MPK = w/r (2.7) MPL/w = MPK/r
The two-good, two-factor model Assume that • 2 commodities X & Y are produced with 2 factors, capital & labor. X = Fx ( Kx , Lx ) Y = FY ( KY , LY ) (2.8) • The economy is assumed to have fixed total supplies of both capital and labor. • Equation (2.9) shows that the allocation of 2 factor between the 2 production process. The = sign shows that the 2 production process use all the available , that is full employment.
The two-good,two-factor model An assumption central to the analysis: • Production functions X & Y are different. Represented by Isoquants Y0 & X0. • Capital-labor ratios k = K/L for industry X & Y represented by ky & kx . • if ky > kx , Y is said to be capital intensive & X labor intensive.
Competitive Equilibrium • Condition for profit maximization for a competitive industry is that firms hire factors up to the point where the value of the marginal product contributed by an additional unit of the factor hired equals the price of that factor. • The value of the marginal product of a factor= price of good x marginal product of the factor. • Competitive equilibrium involves four of these conditions, two factor for each of two industries. Let MPLX = marginal product of labor in the production of X. pxMPLX = w pxMPKX = r pyMPLY = wpyMPKY = r (2.10) • Divide the top equations by the lower equations • rearrange
Competitive Equilibrium • MPLX = X/ Lx. Thus, • But because factors are in fixed total supply, Lx = - Ly dan Kx = - Ky. • MRT = slope of PPF • Production occurs where the price ratio is tangent to PPF.
Competitive Equilibrium • If world price are given byp ( = px / py), then an economy will select production point A (that is the commodity price ratio tangent with PPF).
