Consider a competitive market in which people consume at the point whe

Consider a competitive market in which people consume at the point where their marginal rates of substitution between products X and Y are 3/5.

In this same market, producers produce where their marginal rates of transformation between X and Y are also 3/5. However, producers are producing 7 of Y and 3 of X, and consumers wish to consume 5 of Y and 5 of X per unit of time. Explain how this situation can exist. Also determine if it represents an equilibrium or not. If not an equilibrium, what will tend to happen in the market?

ANSWER

Because MRS = MRT, one would expect output efficiency. However, producers are not producing quantities of X and Y that equal the quantities of X and Y that consumers wish to purchase. In this case producers are producing more of Y and less of X than consumers wish to purchase. Prices in the market will adjust such that the price of Y will fall and the price of X will rise. This means that the ratio of prices PX / PY increases, and the price line will move along the production frontier. An equilibrium results when the price ratio is PX > PX and PY < PY. More of X will be produced and less Y will be produced. At the equilibrium, producers will be producing quantities of both X and Y that just equal the quantities being taken from the market by consumers. At the new equilibrium the new MRT = MRS , and the competitive equilibrium will be efficient.