Course: Advanced Macroeconomics (805)

Semester: Autumn, 2021

ASSIGNMENT No. 2
Q.1 How monopoly demand is derived when several inputs are used in the production process?
Thus far we have analysed profit maximization for a monopoly firm in terms of the output decision. As was the
case for perfectly competitive firms, we may also analyses profit maximization in terms of input usage. To start
with we consider the monopoly firm’s input decision assuming that it faces given (constant) prices for the
inputs it purchases.
Input Prices Given:
Suppose a monopoly firm hires a single variable factor and faces a market-determined price for that factor. As
in the case of competition when a monopolist employs an additional unit of the factor, output increases by an
amount equal to the marginal physical product of the factor.
However, since price does not equal marginal revenue, for a monopoly to sell the large output, commodity price
has to be reduced. Hence, total revenue does not increase by price times the marginal product of the factor
input. Rather total revenue changes by marginal revenue times marginal product. This is the marginal revenue
product of the input.
In the case of a competitive firm, VMP declines because marginal physical product falls (due to the operation of
the laws of variable proportions). For a monopolist MRP declines, with increase in the usage of the input not
only because marginal product declines, but also because MR declines as output is increased.

For example, suppose increasing the usage of the variable input by one unit increases output from 30 to 38
units; thus MPP = 8. Also suppose that the firm could sell 30 units at a price of Rs. 25 each; but to sell 38 units,
price has to be reduced to Rs. 22.
Thus, the gross addition to total revenue from hiring the additional unit of the input is 8 (the added production)
times Rs. 22 (the new selling price) or Rs. 8 x Rs. 22 = Rs. 176.
But to sell the additional 8 units, the price of the 30 units that could have been sold at Rs. 25, must fall by Rs. 3.
Thus the lost revenue from the price reduction is Rs. 3 x 30 = Rs. 90. This loss must be subtracted from the

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
gross gain to give a net gain of Rs. 176 – Rs. 90 = Rs. 86. This net gain — Rs. 86 — is the marginal revenue
product of the input.
A monopolist’s demand for a single variable input is the positive portion of the MRP curve. Since both MP and
MR decline, the input demand function must be downward sloping (from left to right).
In Figure 16.7, the relevant portion of MRP is shown. We start with the price of the input at w 0. The firm will
hire V0 units of the inputs at this price. It is quite obvious that the firm would not hire fewer than v 0, because an
additional unit of input would add more to the firm’s revenue (MRP) than it costs (w0).
It is quite clear that it would not hire more than V0, because an additional unit of the input would add less than it
costs the firm to hire that unit.
If the price of the input rises to w1 the firm – decreases its usage of the input v1 to amount at which MRP and
w1 are equated with, each other. Thus, it is observed that within the relevant range the MRP curve is the
monopolist’s demand curve for a single factor of production.
The derivation of input demand curves is more complicated in the case of several variable inputs.
The MRP curve is no longer the demand for the input, because all the inputs are interdependent in the
production process.
A change in the price of any one input leads to change not only in the usage of that input but in the use of other
inputs, too. It may be recalled that the marginal product curve for an input was derived assuming the usage of
all other inputs was held constant. Thus, changes in the rates of usage of other inputs shift the MRP curve.
However, the monopolist’s demand for an input continues to slope downward. And, what is more important is
that the monopolist still uses that amount of each variable input at which its marginal revenue product equals its
price.
For instance, if the monopoly firm uses three variable inputs — v1,v2 and v3 — all of which have given market-
determined prices — r1r2 and r3 — the firm will maximize profit (or minimize loss) by employing each input
such that the following conditions hold:
MRPV1 = r1
MRPV2 = r2
MRPV3 = r3
Since the inputs are interdependent in the production process, these conditions must hold at the same time. The
implication is that the optimal levels of usage of the inputs have to be determined simultaneously.
Thus, if an input’s price is given to the monopoly we have the following principle.
Principle:
A monopolist’s demand for a variable factor has to be negatively sloped. Although the input demand curve,
when more than one input is variable, is not the MRP curve, at every point on the demand curve, the price of the
input equals its marginal revenue product.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
Upward-Sloping Input Supply:
So long we have assumed that the price of an input is determined by supply and demand in the input market and
is independent of the level of usage of the input by an individual firm. But monopoly firm is so large a part of
the market as to have an appreciable effect upon the price of some of the inputs it uses.
In such situations, the firm has to pay a higher price if- it wishes to hire more units of the input. It not only has
to pay more to the additional units of the resource hired but also must pay the higher price for all units, i.e., new
as well as old units which could be hired at lower price.
Thus, the addition to cost is the cost of the added units hired plus the cost of paying more to the other units
already being used. This extra cost is called the marginal factor cost of an input. Marginal factor cost exceeds
the price of the input.
Therefore, if a monopoly faces an upward-sloping factor supply function, it will reach the point of optimum
purchase of an input by equating the marginal revenue product of the input with the marginal factor cost of the
input (rather than the input price):
MRP = MFC
In such a situation, the input price will be less than MFC.
Q.2 Derive the utility possibility cure from the contract curve of exchange.
In microeconomics, the contract curve or Pareto set[1] is the set of points representing final allocations of two
goods between two people that could occur as a result of mutually beneficial trading between those people
given their initial allocations of the goods. All the points on this locus are Pareto efficient allocations, meaning
that from any one of these points there is no reallocation that could make one of the people more satisfied with
his or her allocation without making the other person less satisfied. The contract curve is the subset of the
Pareto efficient points that could be reached by trading from the people's initial holdings of the two goods. It is
drawn in the Edgeworth box diagram shown here, in which each person's allocation is measured vertically for
one good and horizontally for the other good from that person's origin (point of zero allocation of both goods);
one person's origin is the lower left corner of the Edgeworth box, and the other person's origin is the upper right
corner of the box. The people's initial endowments (starting allocations of the two goods) are represented by a
point in the diagram; the two people will trade goods with each other until no further mutually beneficial trades
are possible. The set of points that it is conceptually possible for them to stop at are the points on the contract
curve.
However, most authors[2][3][4][5][6][7][8][9] identify the contract curve as the entire Pareto efficient locus from one
origin to the other.
Any Walrasian equilibrium lies on the contract curve. As with all points that are Pareto efficient, each point on
the contract curve is a point of tangency between an indifference curve of one person and an indifference curve
of the other person. Thus, on the contract curve the marginal rate of substitution is the same for both people.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
Assume the existence of an economy with two agents, Octavio and Abby, who consume two goods X and Y of
which there are fixed supplies, as illustrated in the above Edgeworth box diagram. Further, assume an initial
distribution (endowment) of the goods between Octavio and Abby and let each have normally structured
(convex) preferences represented by indifference curves that are convex toward the people's respective origins.
If the initial allocation is not at a point of tangency between an indifference curve of Octavio and one of Abby,
then that initial allocation must be at a point where an indifference curve of Octavio crosses one of Abby. These
two indifference curves form a lens shape, with the initial allocation at one of the two corners of the lens.
Octavio and Abby will choose to make mutually beneficial trades — that is, they will trade to a point that is on
a better (farther from the origin) indifference curve for both. Such a point will be in the interior of the lens, and
the rate at which one good will be traded for the other will be between the marginal rate of substitution of
Octavio and that of Abby. Since the trades will always provide each person with more of one good and less of
the other, trading results in movement upward and to the left, or downward and to the right, in the diagram.
The two people will continue to trade so long as each one's marginal rate of substitution (the absolute value of
the slope of the person's indifference curve at that point) differs from that of the other person at the current
allocation (in which case there will be a mutually acceptable trading ratio of one good for the other, between the
different marginal rates of substitution). At a point where Octavio's marginal rate of substitution equals Abby's
marginal rate of substitution, no more mutually beneficial exchange is possible. This point is called a Pareto
efficient equilibrium. In the Edgeworth box, it is a point at which Octavio's indifference curve is tangent to
Abby's indifference curve, and it is inside the lens formed by their initial allocations.
Thus the contract curve, the set of points Octavio and Abby could end up at, is the section of the Pareto efficient
locus that is in the interior of the lens formed by the initial allocations. The analysis cannot say which particular
point along the contract curve they will end up at — this depends on the two people's bargaining skills.
Q.3 Define marginal rate of technical substitution. What does it indicate and how it can be measured?
The marginal rate of technical substitution (MRTS) is the measure with which one input factor is reduced while
the next factor is increased without changing the output. It is an economic illustration that explains the level at
which one factor of input must decline. While maintaining the same level of production, another factor of
production is increased. It shows how you can replace one input with another input without altering the
resulting output.
 The marginal rate of technical substitution (MRTS) examines the level where one input can be
replaced for another resource with production remaining constant.
 The rate of one factor of production is decreased, and another factor is increased while the output
level is maintained.
 When input utilization is optimal, the marginal rate of technical substitution is equivalent to the
cost of the inputs.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021

By substituting two input factors, the producer will need less amount of money to achieve an equilibrium where
the firm realizes maximum profitability with minimum cost.
For example, the labor input can be decreased while the capital input increased with the production level
remaining constant. The MRTS demonstrates the value by which one resource can be substituted with another
input of production without altering the level of output.
The formula for MRTS is as follows:

 
 Where:
 MP is the Margin Product of each input
 Δ K/Δ L is the Capital that can be reduced
 K is the Capital
 L is the Labor
 
The marginal rate of technical substitution ascertains the amount of cost which a specific input can be replaced
for another resource of production while maintaining a constant output. Therefore, the marginal rate of technical
substitution explains when a producer is planning to replace one input of production with the next one.
The company may choose several combinations of inputs that can be alternatively substituted to produce the
same level of output. The pair of inputs determined by the management must be able to achieve the best results.
For example, when factor A can produce a maximum quantity of output than factor B with the same cost
incurred, the producer may end up choosing factor A instead of B.
The marginal rate of technical substitution focuses on the rate at which the producer combines two inputs of
production and substitutes one factor by decreasing it further upon every consecutive substitution. Generally,
the marginal rate of technical substitution specifies the rate at which factors of production can be substituted
without any change in the unit of output.
For example, the MRTS of labor for the unit of capital is the inputs of capital that can be switched with one
input of labor with the output level being constant.
The principle states that one input of production decreases with every subsequent replacement by another factor
of production. This decline, combined with a constant level of output, is known as the principle of diminishing
marginal of technical substitution.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
The marginal rate of technical substitution diminishes when the producer keeps on substituting one resource of
production with another input of production. The following are the main factors as to why the MRTS
diminishes over time during production.
1. Scarcity of the factor of production
Continuous substitution of one factor of production with another one causes inadequacy of the input of
production being replaced. In this case, the factor being substituted will not be able to deliver maximum
contribution for systematic production. Hence, although more inputs of capital were made, the MRTS declined
with successive substitutions.
2. Imperfect substitution of factors of production
It is impossible for two factors of production to substitute each other perfectly since their usage in the
production process is different. Besides, if the two factors could substitute perfectly, a decrease or an increase in
either of them cannot cause any change in the MRTS.
The marginal rate of technical substitution allows the management to determine the factors that can provide the
highest cost-efficient combination for producing a specific quantity of output and find a production point where
the combined factors are minimized to decrease the cost of production.
MRTS Graph
An isoquant is a graphical illustration that explains how much input of labor and capital will produce a constant
output. The gradient of the isoquant indicates the MRTS, any point along the slope specifies how much labor
will be required to replace a unit of capital at that production point.
Q.4 Explain the relationship between factor intensities and factor prices.
The Heckscher-Ohlin (H-O; aka the factor proportions) model is one of the most important models of
international trade. It expands upon the Ricardian model largely by introducing a second factor of production. In
its two-by-two-by-two variant, meaning two goods, two factors, and two countries, it represents one of the
simplest general equilibrium models that allows for interactions across factor markets, goods markets, and
national markets simultaneously.
These interactions across markets are one of the important economics lessons displayed in the results of this
model. With the H-O model, we learn how changes in supply or demand in one market can feed their way
through the factor markets and, with trade, the national markets and influence both goods and factor markets at
home and abroad. In other words, all markets are everywhere interconnected.
Among the important results are that international trade can improve economic efficiency but that trade will
also cause a redistribution of income between different factors of production. In other words, some will gain
from trade, some will lose, but the net effects are still likely to be positive.
The factor proportions model was originally developed by two Swedish economists, Eli Heckscher and his
student Bertil Ohlin, in the 1920s. Many elaborations of the model were provided by Paul Samuelson after the

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
1930s, and thus sometimes the model is referred to as the Heckscher-Ohlin-Samuelson (HOS) model. In the
1950s and 1960s, some noteworthy extensions to the model were made by Jaroslav Vanek, and so occasionally
the model is called the Heckscher-Ohlin-Vanek model. Here we will simply call all versions of the model either
the Heckscher-Ohlin (H-O) model, or simply the more generic “factor proportions model.”
The H-O model incorporates a number of realistic characteristics of production that are left out of the simple
Ricardian model. Recall that in the simple Ricardian model only one factor of production, labor, is needed to
produce goods and services. The productivity of labor is assumed to vary across countries, which implies a
difference in technology between nations. It was the difference in technology that motivated advantageous
international trade in the model.
The standard H-O model begins by expanding the number of factors of production from one to two. The model
assumes that labor and capital are used in the production of two final goods. Here, capital refers to the physical
machines and equipment that are used in production. Thus machine tools, conveyers, trucks, forklifts,
computers, office buildings, office supplies, and much more are considered capital.
All productive capital must be owned by someone. In a capitalist economy, most of the physical capital is
owned by individuals and businesses. In a socialist economy, productive capital would be owned by the
government. In most economies today, the government owns some of the productive capital, but private citizens
and businesses own most of the capital. Any person who owns common stock issued by a business has an
ownership share in that company and is entitled to dividends or income based on the profitability of the
company. As such, that person is a capitalist—that is, an owner of capital.
The H-O model assumes private ownership of capital. Use of capital in production will generate income for the
owner. We will refer to that income as capital “rents.” Thus, whereas the worker earns “wages” for his or her
efforts in production, the capital owner earns rents.
The assumption of two productive factors, capital and labor, allows for the introduction of another realistic
feature in production: differing factor proportions both across and within industries. When one considers a
range of industries in a country, it is easy to convince oneself that the proportion of capital to labor applied in
production varies considerably. For example, steel production generally involves large amounts of expensive
machines and equipment spread over perhaps hundreds of acres of land, but it also uses relatively few workers.
(Note that relative here means relative to other industries.) In the tomato industry, in contrast, harvesting
requires hundreds of migrant workers to hand-pick and collect each fruit from the vine. The amount of
machinery used in this process is relatively small.
In the H-O model, we define the ratio of the quantity of capital to the quantity of labor used in a production
process as the capital-labor ratio. We imagine, and therefore assume, that different industries producing
different goods have different capital-labor ratios. It is this ratio (or proportion) of one factor to another that
gives the model its generic name: the factor proportions model.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
In a model in which each country produces two goods, an assumption must be made as to which industry has
the larger capital-labor ratio. Thus if the two goods that a country can produce are steel and clothing and if steel
production uses more capital per unit of labor than is used in clothing production, we would say the steel
production is capital intensive relative to clothing production. Also, if steel production is capital intensive, then
it implies that clothing production must be labor intensive relative to steel.
Another realistic characteristic of the world is that countries have different quantities—that is, endowments—of
capital and labor available for use in the production process. Thus some countries like the United States are well
endowed with physical capital relative to their labor force. In contrast, many less-developed countries have
much less physical capital but are well endowed with large labor forces. We use the ratio of the aggregate
endowment of capital to the aggregate endowment of labor to define relative factor abundancy between
countries. Thus if, for example, the United States has a larger ratio of aggregate capital per unit of labor than
France’s ratio, we would say that the United States is capital abundant relative to France. By implication,
France would have a larger ratio of aggregate labor per unit of capital and thus France would be labor abundant
relative to the United States.
The H-O model assumes that the only differences between countries are these variations in the relative
endowments of factors of production. It is ultimately shown that (1) trade will occur, (2) trade will be nationally
advantageous, and (3) trade will have characterizable effects on prices, wages, and rents when the nations differ
in their relative factor endowments and when different industries use factors in different proportions.
It is worth emphasizing here a fundamental distinction between the H-O model and the Ricardian model.
Whereas the Ricardian model assumes that production technologies differ between countries, the H-O model
assumes that production technologies are the same. The reason for the identical technology assumption in the
H-O model is perhaps not so much because it is believed that technologies are really the same, although a case
can be made for that. Instead, the assumption is useful in that it enables us to see precisely how differences in
resource endowments are sufficient to cause trade and it shows what impacts will arise entirely due to these
differences.
Q.5 What is a public good? Also discuss its provision by the Government.
In economics, a public good refers to a commodity or service that is made available to all members of a
society. Typically, these services are administered by governments and paid for collectively through taxation.
Examples of public goods include law enforcement, national defense, and the rule of law. Public goods also
refer to more basic goods, such as access to clean air and drinking water.
 Public goods are commodities or services that benefit all members of society, and which are often
provided for free through public taxation.
 Public goods are the opposite of private goods, which are inherently scarce and are paid for separately
by individuals.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
 Societies will disagree about which goods should be considered public goods; these differences are
often reflected in nations’ government spending priorities.
The two main criteria that distinguish a public good are that it must be non-rivalrous and non-excludable. Non-
rivalrous means that the goods do not dwindle in supply as more people consume them; non-excludability
means that the good is available to all citizens. 
An important issue that is related to public goods is referred to as the free-rider problem. Since public goods
are made available to all people–regardless of whether each person individually pays for them–it is possible
for some members of society to use the good despite refusing to pay for it. People who do not pay taxes, for
example, are essentially taking a "free ride" on revenues provided by those who do pay them, as do turnstile
jumpers on a subway system.
The opposite of a public good is a private good, which is both excludable and rivalrous. These goods can only
be used by one person at a time–for example, a wedding ring. In some cases, they may even be destroyed in
the act of using them, such as when a slice of pizza is eaten. Private goods generally cost money, and this
amount pays for its private use. Most of the goods and services that we consume or make use of in our
everyday lives are private goods. Although they are not subject to the free-rider problem, they are also not
available to everyone, since not everyone can afford to purchase them.
In some cases, public goods are not fully non-rivalrous and non-excludable. For example, the post office can
be seen as a public good, since it is used by a large portion of the population and is financed by taxpayers.
However, unlike the air we breathe, using the post office does require some nominal costs, such as paying for
postage. Similarly, some goods are described as “quasi-public” goods because, although they are made
available to all, their value can diminish as more people use them. For example, a country’s road system may
be available to all its citizens, but the value of those roads declines when they become congested during rush
hour. Individual countries will reach different decisions as to which goods and services should be considered
public goods, and this is often reflected in their national budgets. For example, many argue that national
defense is an important public good because the security of the nation benefits all its citizens. To that end,
many countries invest heavily in their militaries, financing army upkeep, weapons purchases, and research and
development (R&D) through public taxation. In the United States, for example, the total expenditures of the
Department of Defense (DOD) was nearly $700 billion in 2019.
Some countries also treat social services–such as healthcare and public education–as a type of public good. For
example, some countries, including Canada, Mexico, the United Kingdom, France, Germany, Italy, Israel, and
China, provide taxpayer-funded healthcare to their citizens. Similarly, government investments in public
education have grown tremendously in recent decades. According to estimates by Our World in Data, the share
of the world population that has benefited from formal education grew from roughly 50% to over 80%
between 1950 and 2010.

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 Course: Advanced Macroeconomics (805)
Semester: Autumn, 2021
Advocates for this kind of government spending on public goods argue that its economic and social benefits
significantly outweigh its costs, pointing to outcomes such as improved workforce participation, higher-skilled
domestic industries, and reduced rates of poverty over the medium to long-term. Critics of this kind of
spending argue that it can pose a burden on taxpayers and that the goods in question can be more efficiently
provided through the private sector.

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