two-good output choice
DESCRIPTION
These slides review the basic analytical tools of output choice that we will need to study trade in a 2-good general equilibrium framework.TRANSCRIPT
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GoalDevelop the tools to analyze trade in a 2-good economy:PPF (and budget constraint, a.k.a.
budget line)Preferences (collective and
individual)Choice (how the PPF and
preferences interact)
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PPF
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PPF: Increasing costs• The slope of the PPF is
the opportunity cost of one unit of good 1 in terms of good 2, a.k.a. the marginal rate of transformation of good 1 for good 2
• MRT_1,2 = MC_1/MC_2• With a concave PPF, the
MRT_1,2 is increasing as more of good 1 is produced
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PPF: constant cost
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Indifference curves
An indifference curve is a set of combinations of good 1 and good 2 that yield the same level of welfare to society
We assume society figures out a way to aggregate its individual preferences into a set of collective preferences
We make the following assumptions regarding the collective preferences of society More is better than less: A is preferred to B if it has more of
at least one of the goods Averages are better than extreme combinations: C is
preferred to A and B, if C is a combination that averages A and B
Preferences are consistent: if society prefers A to B and B to C, then society also prefers A to C.
By the 2nd assumption above, we draw the indifference curves as convex curves.
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More is better
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Averages are better
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Preferences are consistent
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Marginal rate of substitution
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Output choice The output bundle (the amounts of good 1 and good
2 produced) will be determined by the interaction between the production possibilities of the economy captured by its PPF and the collective preferences over the two goods captured by its indifference curves.
Our focus is on the mechanics of choice. Once we define an equilibrium (or “optimal output choice”), we’ll want to shock the model to see what happens to this optimal bundle if the economic environment changes.
Again, if this economy does not trade, the output bundle chosen is also necessarily the consumption bundle.
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Output choice: optimal output bundle
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Output choice: optimal output bundle
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Output choice: optimal output bundle 2