International political economy - Module 2

How to draw an isovalue line

C F= fixed a value, you can reach it if you produce more food and less cloth and vice versa. Everything is gonna be represented by a straight line. If you resolve the equation, bring one element to one side, and the rest to the other side, dividing everything by Pf. You are gonna have an equation, which gives you Qf as a function on V and Qc. PC/P● slope of isovalue line is -

How to draw this line V = P Q + P QC C F F- V = 50- Cloth price 10, food price 5- Then can produce for example 5 cloth and 0 food (5*10+0*5) or 0 cloth and 10 food(0*10+10*5), or also 3 cloth and 4 food (3*10+4*5).- Each isovalue line represents all combinations of production that leads to the same value (given the prices of the goods). This graph shows the PPF, the lines that are represented by equal value. The more I move away from the origin, the more I have a high value: the line above the curve has a big value. They may have a combination of more food and more cloth. Usually people will pick the combination of quantity

of food and cloth that is exactly tangent to the PPF, between the PPF and the isovalue line. Only the points that are below the curve are the points that are feasible. The best line is the one below the curve, but that touches the curve.

The economy produces at the point that maximizes the value of production given the price it faces; this is the point on the highest possible isovalue line. At that point, the opportunity cost of cloth in terms of food is equal to the relative price of cloth, P/P.CF

Given the relative price of cloth, the economy produces at the point Q that touches the highest possible isovalue line. At that point, the relative price of cloth equals the slope of the PPF, which equals the opportunity cost of producing cloth.

The trade-off in production equals the trade-off according to market prices.

LECTURE 7 (03/12)

Choosing the Mix of Inputs

• Producers may choose different amounts of factors of production used to make cloth or food.
• Their choice depends on the wage, w,

paid to labor and the rental rate, r, paid when renting capital.

● As the wage w increases relative to the rental rate r, producers use less labor and more capital in the production of both food and cloth.

→ Different amount of factors might be used to produce cloth or food

Factor substitution: production of 1 unit of cloth using 3 units of capital and 1 unit of labor

Example: Case Japan from 80s --> huge producer, industrial growth as much as in Italy but difference is a big rise in salary; response of firms was to invest in automation and capital to make up for the rise of costs of labor (substitution of the expensive labor) hence increasing production of capital (car factories in Japan in 90s: labor so expensive that car factories were widely automated)

Depending on the relative price of the two inputs you ought to substitute one over the other and this depends on the wage of labor (w) and rental rate of capital (r)

The idea of lot of these models is that there is a price for renting

labor and a price for renting capital and this price is INTEREST RATE (because in order to get machines you rent them by borrowing money and the cost of borrowing money to have capital in your firm is the interest rate that will affect the money which are used to pay back as compensation for renting those capitals)

As the wage increases (w) relative to the rental rate (r) producers will of course use less labor and more capital in the production of food and cloth; if labor becomes expensive both sectors will be incentivized to switch labor with more capital. 68

This gives us a curve called "Input possibilities in Food Production" and it tells us the difference combinations of capital and labor at the same level of one good (in this case food).

X = amount of labor input in the food industry
Y = amount of capital input

The blue line gives the combination of labor and capital that deliver the same amount of food as output; this curve is defined in a convex way: In the middle area of the line

You would have a high amount of labor and a similar proportion of capital, you can easily substitute one unit of labor with one unit of capital and vice versa (1 to 1 basis). The more I move forward the 0 on that part of the graph or toward infinite, it becomes more difficult to substitute one factor that is more abundant than the other that is instead more scarce, so it is not a 1 to 1 basis. For example, moving to the right, 1 unit of capital would replace a lot of units of labor, so the last unit of capital is very hard to substitute (1 unit of capital for thousands of units of labor, expensive to do the contrary). The same is if we move to the vertical axis, you can see that it is abundant in capital with respect to labor, so these few units of labor (ex. Japanese workers) would be costly to substitute. For example, a factory in Japan: almost complete substitution of labor with automated machines, so only 4 workers that cannot be substituted, as well as in a farm where mostly labor is used, is hard to substitute it.

right(CC) would use relatively more labor than capital.

Factor Prices and Goods Prices

Factor (wage and rental rate) and Good Prices (food and cloth) → set of prices because two inputs and two outputs.

1. In competitive market cost of goods = marginal cost of production if it is not the case, hence if the cost of one good is higher than its marginal cost of production, producing one extra unit would give a profit because that unit would be sold at a higher price than the cost of production. If it instead is lower, this would lead to an incentive to switch to another production because the price of the good is lower than its cost of production hence loss so it is not convenient to produce that last unit (perfect competition).
2. How changes in the wage and rent affect the cost of producing a good depends on the mix of factors used. An increase in the rental rate of capital should affect the price of food more than the price of cloth since food is a capital intensive industry.

Now we want to see

how changes in the wage and rent affect the cost of producing a good depends on the MIX OF FACTORS USED→ Increasing rental rate of capital should affect the price of food more than the price of cloth

Intuition? Before in our given assumption, food is more capital intensive as a production than cloth production (that uses more labor) and this means that if the rental rate of capital increases so the capital price goes up and if it is used more intensively in the production of 70 food this means that the price of food is more affected because I am using more capital than labor.

Ex. I tend to use one unit of labor and one unit of capital for cloth while 3 units of capital and one unit of labor for food; if the price of capital goes up the cost of producing food will be more affected because of the cost of rental capital and for the effect of perfect competition described above.

Changes in the price of inputs fundamental changes in the price of goods (output) for this model because of the

intensity and extent of production of one good over the other are influenced by the price of those particular inputs in different ways (one production using a particular factor will be more influenced than one which uses another). Changes w / r are tied to changes in Pc / Pw.

Representation If cloth would be relatively intensive in labor for production while food production is relatively intensive in capital, the higher the relative cost of labor (hence higher wage) relative to rental rate to hire new capital, labor becomes more expensive than capital, the price of cloth would go up relative to the price of food as a consequence otherwise loss, I would not break even.

STOLPER-SAMUELSON THEOREM--> If the relative price of a good increases then the real wage or rental rate of the factor used intensively in the production of that good increases while the real wage or rental rate of the other factor decreases.

Same idea but seen from the other side: what happens if wage increases relative to

The rental rate? The price of the goods using labor intensively goes up and if we are in an equilibrium (cost of the goods = marginal cost of production) it is true the opposite hence price of cloth increases it must be the case that the factor mostly used in cloth hence labor, must be paid more. Since the cost of the goods must be equal to the marginal cost, eventually wages go up but since the marginal cost to produce cloth must be equal to the marginal cost, the cost for the good would also go up. So for the equilibrium principle, if the price of cloth goes up the price of the factor of production readjust and should be paid more and vice versa. The price of food using more capital goes up, the rental rate goes up and the price of the other input goes down.

Intuition -> Any change in the relative price of the good alters the distribution of INCOME. In real terms, if the price of a good increases the relative purchase power of consumers goes down and goes up for the other good that has