Some Analytical Tools

TLDR: In this paper, the authors present a set of tools that can be used in the study of the allocation affects of different distortions in the welfare problem, including linearly homogeneous production functions.

Abstract: The welfare problem is complicated and in order to carry out a more profound analysis we need to master some technical refinements, ‘tools’, that may be used in the study of the allocation affects of different distortions. The present chapter provides a set of such tools. We begin with a look at the characteristics of linearly homogeneous production functions (which are often preferred to a more general formulation because they are easier to handle). Thereafter we move on to a specific graphic technique of presenting the production function, the so-called factor diagram. With the aid of this, another graphic tool, the box diagram, can be constructed, which allows us to take both commodity and factor markets into account simultaneously. From the box diagram the production possibility curve may be derived, and this shows all the combinations of (two) goods that an economy can produce with given resources. If this is combined with social indifference curves (showing the preferences of society) and relative commodity prices we may shed light on the interaction between production (supply) and demand.