Annex 2A


BC, e.g. the combination A. Any combination below the curve BC means that not all
production resources are used (under-employment) and that the economy does not fully
realise its productive potential.

In the short run the curve is fixed, while in the long run it may contract or expand through
changes in the resource endowment or the technology applied. Economic growth can be
shown as an expansion (right-upward shift) of the transformation curve. Here it is assumed
that the curve is given and fixed.

I, I and I" represent a sample of (an unlimited number of) indifference curves. One
indifference curve shows the consumers' preference between tradables and non-tradables at a
constant level of utility. I" stands for a lower level of satisfaction or welfare than I, while I'
signifies a higher level of utility. The typical concave shape of the indifference curves is
based on the plausible assumption that the consumers need to substitute a certain amount of
tradables with an increasing amount of non-tradables (and vice versa) in order to maintain the
same level of utility. To give an example: If somebody had an abundant supply of rice
tradablee) but no vegetables (non-tradable), he would be prepared to exchange a substantial
amount of rice for a little quantity of vegetables. The more vegetables he has already, the
smaller the amount of rice he would be prepared to give in exchange for an additional amount
of vegetables.

Assuming rational economic behaviour, a household will try to attain the highest possible
level of utility with the income (or expenditure budget) available. The budget line is given by
the line DE which represents the combinations of tradable and non-tradable goods which can
be purchased at a given amount of income (expenditures) and at given prices of t and n. The
slope of the DE curve is determined by the price relation (internal terms of trade) Pt/Pn. If all
expenditures were devoted to non-tradables, the quantity D could be purchased at the given
price, or the quantity E, if all money is spent for tradables. These cases are, however, not
feasible under the given conditions, as the maximum quantity of non-tradables which the
economy produces is given by the level B, the maximum quantity of tradables is given by the
level C (The implications of an excess demand over production are discussed further below).

The only point where the given budget line meets the production possibility frontier is A,
where the quantity nl of non-tradables and the quantity tl of tradables are produced. Point A
represents, at the same time, the point where a household (or the economy as a whole as
assumed in the model) can realise its maximum level of welfare with a given level of income,
by allocating the budget to buy nj quantities of non-tradables and tj quantities of tradables.
At point A, the marginal costs of production of tradables/non-tradables are proportional to the
relative prices (line ED, and the marginal rate of production substitution (tangent to BC
curve) is equal to the marginal rate of consumption preferences (tangent to I curve).

In summary, point A represents the theoretical optimum as well as the only equilibrium
situation, characterized by the following features and conditions:

* the demand for tradables and non-tradables equals supply,
* the economy achieves the maximum level of welfare at a given income and income
 distribution,


-291 -