Welfare Economics - Efficiency Between Production and Consumption

Efficiency Between Production and Consumption

The relation between production and consumption in a simple seven equation model (2x2x2 model) can be shown graphically. In the diagram below, the aggregate production possibility frontier, labeled PQ shows all the points of efficiency in the production of goods X and Y. If the economy produces the mix of good X and Y shown at point A, then the marginal rate of transformation (MRT), X for Y, is equal to 2.

Point A defines the boundaries of an Edgeworth box diagram of consumption. That is, the same mix of products that are produced at point A, can be consumed by the two consumers in this simple economy. The consumers' relative preferences are shown by the indifference curves inside the Edgeworth box. At point B the marginal rate of substitution (MRS) is equal to 2, while at point C the marginal rate of substitution is equal to 3. Only at point B is consumption in balance with production (MRS=MRT). The curve 0BCA (often called the contract curve) inside the Edgeworth box defines the locus of points of efficiency in consumption (MRS1=MRS ²). As we move along the curve, we are changing the mix of goods X and Y that individuals 1 and 2 choose to consume. The utility data associated with each point on this curve can be used to create utility functions.