(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 638

CHAPTER 16 • General Equilibrium and Economic Efficiency 613

between the goals of equity and efficiency, and hard choices must be made.
Welfare economics, which builds on the first and second theorems, provides a
useful framework for debating the normative issues that surround the equity–
efficiency issue in public policy.

16.4 Efficiency in Production
Having described the conditions required to achieve an efficient allocation in
the exchange of two goods, we now consider the efficient use of inputs in the
production process. We assume that there are fixed total supplies of two inputs,
labor and capital, which are needed to produce the same two products, food
and clothing. Instead of only two people, however, we now assume that many
consumers own the inputs to production (including labor) and earn income by
selling them. This income, in turn, is allocated between the two goods.
This framework links the various supply and demand elements of the economy. People supply inputs to production and then use the income they earn
to demand and consume goods and services. When the price of one input
increases, the individuals who supply a lot of that input earn more income and
consume more of one of the two goods. In turn, this increases the demand for
the inputs needed to produce the good and has a feedback effect on the price of
those inputs. Only a general equilibrium analysis can find the prices that equate
supply and demand in every market.

Input Efficiency
To see how inputs can be combined efficiently, we must find the various combinations of inputs that can be used to produce each of the two outputs. A particular allocation of inputs into the production process is technically efficient
if the output of one good cannot be increased without decreasing the output of
another good. Because technical efficiency requires the appropriate combination of inputs, we will also call it input efficiency. Efficiency in production is
not a new concept; in Chapter 6 we saw that a production function represents
the maximum output that can be achieved with a given set of inputs. Here we
extend the concept to the production of two goods rather than one.
If input markets are competitive, a point of efficient production will be

achieved. Let’s see why. If the labor and capital markets are perfectly competitive, then the wage rate w will be the same in all industries. Likewise, the rental
rate of capital r will be the same whether capital is used in the food or clothing
industry. We know from Chapter 7 that if producers of food and clothing minimize production costs, they will use combinations of labor and capital so that
the ratio of the marginal products of the two inputs is equal to the ratio of the
input prices:
MPL/MPK = w/r
But we also showed that the ratio of the marginal products of the two inputs is
equal to the marginal rate of technical substitution of labor for capital MRTSLK.
As a result,
MRTSLK = w/r

(16.2)

• technical efficiency
Condition under which firms
combine inputs to produce a
given output as inexpensively as
possible.

In §7.3, we explain that the
rental rate is the cost per
year for renting a unit of
capital.
In §6.3, we explain that the
marginal rate of technical
substitution of labor for capital is the amount by which
the input of capital can be
reduced when one extra unit
of labor is used, so that output remains constant.