Two-Good, Two-Factor Model

We assume there are two factor inputs – labour and capital.

So the production function is:

yi = fi ( Li , Ki ) i = 1, 2

These production functions are assumed to be increasing, concave and

homogeneous of degree one in the inputs (Li, Ki).

Constant returns to scale in the production of each good.

Labour and capital are fully mobile between the two industries – long
run point of view.

The resource constraints are:

L1 + L2  L

K1 + K 2  K

Where the endowment L and K are fixed.

Now, Max y2 = f 2 ( L2 , K 2 )

s. t. y1 = f1 ( L1 , K1 )

and L1 + L2  L
K1 + K 2  K
Gives y2 = h( y1 , L, K )
1
The PPF graph shows y2 as a function of y1.

y2 is a concave
function of y1. .
PP Frontier
y2 That means,

y a = ( y1a , y2a )
 2 h( y1 , L, K )
0
y1 2

 y a + (1 −  ) y b

y b = ( y1b , y2b )

PP Set

y1

Another way of expressing this is to consider all points S = ( y1 , y2 ) ,

that are feasible to produce given the resource constraint
( L1 + L2  L , K1 + K 2  K ).

This production possibilities set S is convex meaning that

If y = ( y1 , y2 ) and y = ( y1 , y2 ) are both elements of S, then any

a a a b b b

point between them  y + (1 −  ) y is also in S, for 0    1

a b

2
The production possibility frontier summarises the technology of the
economy, but in order to determine where the economy produces on
the PPF we assume:

• Perfect competition in products markets

• Perfect competition in the factor markets

• Product prices are given exogenously: Small country assumption

GDP Function

With the assumption of perfect competition the amount produced in

each industry will maximise GDP for the economy.

That is, the industry outputs of the competitive economy will be

chosen to maximise GDP:

G ( p1 , p2 , L, K ) = max p1 y1 + p2 y2
y1 , y2

s.t. y2 = h( y1 , L, K )

we substitute the constraint into the objective function

to maximise p1 y1 + p2 h( y1 , L, K )

The first-order condition p1 + p2 (h / y1 ) = 0

3
Or,

p1 h y2
p= =− =−
p2 y1 y1

Thus the economy will produce where the relative price of good 1
p1
p=
p2 is equal to the slope of the PPF.

y2 An increase in price ratio will

raise the slope. The economy
will produce more of good 1
and less of good 2.
A

B p

y1

Differentiating the GDP function with respect to the price of good i,

G  y y 
= yi +  p1 1 + p2 2 
pi  pi pi 

4
  y1 y2 
But,  1 p
p + p =0
pi 
2
 i

Why?

“Envelope theorem”: when we differentiate a function that has been

maximised (such as GDP) with respect to an exogenous variable (such
as pi), then we can ignore the changes in the endogenous variables (y1
and y2) in the derivative.

G ( p1 , p2 , L, K ) = max p1 y1 + p2 y2
y1 , y2

Totally differentiating with respect to y1 and y2

p1dy1 + p2 dy2 = 0

This equality must hold for any small movement in y 1 and y2 around
the PPF, and in particular, for the small movement in outputs induced
by the change in pi.

 y1 y2 
In other words,  1 p
p + p =0

2
 i pi 

G
= yi
So, pi

The derivative of the GDP function with respect to prices equals the
outputs of the economy.

5
Equilibrium Conditions

What are the equilibrium conditions to determine factor prices

and outputs?

Let’s consider the unit-cost functions – the dual to the production

functions fi ( Li , Ki ) as defined by:

ci ( w, r ) = min wLi + rKi fi ( Li , Ki )  1

Li , Ki 0

ci ( w, r ) is the minimum cost to produce one unit of output.

Because of assumption of CRS these unit costs are equal to MC and

AC.

The ci ( w, r ) functions are non-decreasing and concave in (w, r).

The minimisation problem can be written as:

ci ( w, r ) = waiL + raik

Where aiL is the optimal choice for Li , and aiK is the optimal choice
for Ki .

Optimal choice for labour aiL ( w, r )

Optimal choice for capital aiK ( w, r )

6
Min
ci ( w, r ) = waiL + raik

Differentiating with respect to wage

ci  a a 
= aiL +  w iL + r iK 
w  w w 

 a a 
Following the ‘envelope theorem’ show that  w w + r w  = 0
iL iK

 

Constraint in the cost minimisation problem can be written as the

isoquant

fi (aiL , aiK ) = 1
Totally differentiating

fiL daiL + fiK daiK = 0

f i f i
f  f 
Where iL Li and K i
iK

This equality must hold for any small movement of labour daiL and
capital daiK around the isoquant, and in particular, for the change in
labour and capital induced by a change in wages.

7
Therefore,

 a   aiK 
f iL  iL +
 iK  w
f =0
 w   

Now multiplying through by the product price pi

 a   aiK 
pi f iL  iL  + pi iK 
f =0
 w   w 
or
 aiL   aiK 
w  + r  w =0
 w   

[ Since from the profit maximisation condition for a competitive firm

pi fiL = w
pi fiK = r ]

Therefore,

ci
= aiL
w

8
The first set of equilibrium conditions for the 2 2 economy is
that profit equals zero.

p1 = c1 ( w, r )
p2 = c2 ( w, r )

The second set of equilibrium conditions is full employment of both

resources