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Measurement of GDP in the 22 Production Economy and Pareto Eciency of Competitive Equilibrium

In what follows, please refer to the enclosed gure. Because of CRS technologies, there are no prots, and hence the value of GDP can be measured by the total sum of factor payments. In case of competitive equilibrium, the combination (w , R ) of wage and the rental rate is determined by the dual diagram as shown in the lecture. Hence the value of GDP in the competitive equilibrium is given by GDP w L + R K. In the gure, the intersection of the line Lw + KR = GDP with the w-axis captures the level of GDP per capita in the competitive equilibrium. Note that in this equilibrium, K = K x + K y , where K x and K y are the equilibrium amounts of capital used in the two sectors. Dividing through by L, we have that K K x Lx K y Ly = x + y , L L L L L where Lx and Ly are the equilibrium amounts of labor used in the two sectors. It follows that K/L is a weighted average (because Lx /L + Ly /L = 1) of K x /Lx and K y /Ly . This is why the line Lw + KR = GDP has the depicted slope relative to the slopes of the x (w, R) = px and C y (w, R) = py at point (w , R ). curves C1 1 Now suppose that we consider an alternative arbitrary allocation (Lx , K x ) and (Ly , K y ) of labor and capital across the two sectors such that Lx + Ly = L and K x + K y = K . y y x Let the corresponding per-unit factor allocations be (Lx 1 , K1 ) and (L1 , K1 ), respectively. Suppose that this allocation results in value marginal productivity of the two factors in the two sectors being given by (V M P Lx , V M P K x ) and (V M P Ly , V M P K y ). Now consider how a cost minimizing rm in the industry x would behave if facing factor prices for labor and capital given by (V M P Lx , V M P K x ). To produce one unit of output, in the (L, K ) space it would pick such combination of labor and capital which makes the ratio of marginal productivities of labor and capital equal to V M P Lx /V M P K x (a ray from the origin) and that yields an output of 1 (isoquant). But there is only one such combination of labor and x capital, and we know that (Lx 1 , K1 ) ts both conditions, so it must be the cost-minimizing way of producing one unit of output under factor prices (V M P Lx , V M P K x ). Furthermore, since x f x (K1 , Lx 1 ) = 1, the Euler theorem gives
x x M P Lx Lx 1 + M P K K1 = 1.

Multiplying through by px , we obtain


x x x V M P Lx Lx 1 + V M P K K1 = p .

(1)

x x x Hence not only is (Lx 1 , K1 ) cost-minimizing under factor prices (V M P L , V M P K ), but is also gives the unit cost of production equal to px . As a result, x C1 (V M P Lx , V M P K x ) = px , x (w, R) = px curve. An analogous implying that the point (V M P Lx , V M P K x ) lies on the C1 y y argument can be used to show that the point (V M P L , V M P K y ) lies on the C1 (w, R) = py curve.

As an example, the gure is drawn in such a way that, compared to the competitive equilibrium, the proposed alternative factor allocation involves shifting some capital from x to y and/or some labor from y to x. Now we would like to nd the value of GDP in this alternative allocation and compare it with the competitive equilibrium level of GDP given by GDP . The complication is that we can no longer use the simple formula wL + RK , since the marginal productivity of either factor now diers across the two sectors, i.e., there is no common denition of w or R. We will therefore attempt to construct a pair of shadow prices of labor and capital, given by (ws , Rs ), that could be used as common productivity evaluators of labor and capital, respectively, in either of the two sectors. That is, (ws , Rs ) should be such that the GDP is given by ws L + Rs K , and analogously in the two sectors, ws Lx + Rs K x = GDP x px f x (K x , Lx ) and ws Ly + Rs K y = GDP y py f y (K y , Ly ). Dividing each equation by output in that industry, these equations become
s x x w s Lx 1 + R K1 = p

and
y s y ws Ly 1 + R K1 = p . x Looking at equation (1), this implies that (ws , Rs ) must lie on the line with gradient (Lx 1 , K1 ) x x that passes through the point (V M P L , V M P K ). But since we already argued that x (Lx 1 , K1 ) is the cost-minimizing factor combination to produce one unit of x under factor x x x prices (V M P Lx , V M P K x ), (Lx 1 , K1 ) is also the gradient of the C1 (w, R) = p curve at x x s s (V M P L , V M P K ) (this follows from Shepards lemma). Put together, (w , R ) must lie x (w, R) = px at point (V M P Lx , V M P K x ). Analogously, on a tangent line to the curve C1 y s s (w, R) = py at point (V M P Ly , V M P K y ). (w , R ) must lie on a tangent line to the curve C1 Intersection of these two tangent lines then determines (ws , Rs ). Note that one, but not both, shadow prices may be negative.

By construction of (ws , Rs ), we have that GDP = Lws + KRs . In the gure, the intersection of the line Lw + KR = GDP , which passes through the point (ws , Rs ) and has the same slope as the line Lw + KR = GDP , with the w-axis hence captures the level of GDP per capita in this alternative factor allocation. We see that it is lower than in the competitive equilibrium. An analogous argument can be constructed for other alternative allocations (try it!). Therefore the competitive equilibrium produces the highest possible level of GDP in the economy, and it is therefore Pareto ecient.

C1x ( w, R) = p x
VMPKx

C1x ( w, R )

(L , K )
C1y ( w, R )
R*

Rs VMPKy VMPLx ws w*

L w + K R = GDP* C1y ( w, R) = p y
GDP* / L

L w + K R = GDP
GDP / L

VMPLy