How can you determine a pre-trade equilibrium using PPF and indifference curves？

Expert Solution

Autarky is a state where countries produce and consume in isolation, they do not trade with each other.

Here we take a concave production possibility Frontier. Assume that labours are not homogeneous.

We plot the community indifference curves IC0, IC1, IC2 etc. If there is perfectly competitive market then the economy reaches under pre trade equilibrium at a point where production possibility Frontier is tangent to a community indifference curve. This point is shown as B which is an optimum since, the indifference curve IC1 is highest attainable given the constraints shown by production possibility Frontier. At point B , the the marginal rate of substitution in consumption (which is slope of indifference curve) and the opportunity cost of production (given by slope of production possibility Frontier) are equal. The price ratio that would be produced by such in equilibrium is given by the slope of the common tangent PdPd.

Rahul Sunny answered 2 years ago

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