Author: Geoff Riley Last updated: Sunday 23 September, 2012
Efficiency is about a society making optimal use of scarce resources to satisfy wants & needs
There are several meanings of efficiency but they all link to how well a market allocates our scarce resources to satisfy consumers
Normally the market mechanism is good at allocating these inputs, but there are occasions when the market can fail
Allocative efficiency is concerned with whether we are producing the goods and services that match our changing needs and preferences and which we place the greatest value on
Allocative efficiency is reached when no one can be made better off without making someone else worse off. This is also known as Pareto efficiency
Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production.
The condition required for allocative efficiency is that price = marginal cost of supply.
In the diagram above, the market is in equilibrium at price P1 and output Q1. At this point, the total area of consumer and producer surplus is maximised. If for example, suppliers were able to restrict output to Q2 and hike the market price up to P2, sellers would gain extra producer surplus by widening their profit margins, but there also would be an even greater loss of consumer surplus. Thus P2 is not an allocative efficient allocation of resources for this market whereas P1, the market equilibrium price is deemed to be allocative efficient.
We will see when we study the economics of monopoly that when businesses have ‘pricing power’ in their own markets, they may increase their profit margins to squeeze extra profit from consumers (they are turning consumer surplus into producer surplus). This has an effect on allocative efficiency for if a monopoly supplier can select a price well above the costs of supply, consumers will suffer a reduction in their welfare. Have you ever felt ripped off buying sandwiches from a motorway service station? The producer has become better off but someone else has become worse off.
Using the production possibility frontier to show allocative efficiency
Pareto defined allocative efficiency as a position “where no one could be made better off without making someone else at least as worth off.”
This can be illustrated using a production possibility frontier – all points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available
In the diagram below, the combination of output shown by Point A is allocatively efficient as is the combination shown at point B – but at the output combination C we can increase production of both goods by making fuller use of existing resources or increasing efficiency. C represents a loss of economic efficiency.
If an economy is operating within the PPF there will be an under-utilisation of resources causing output of goods and services to be lower than is feasible.
In this sense unemployment is a waste of scare resources; indeed the hours lost through jobless workers can never be recovered – unemployment can be costly from both an economic and social viewpoint.
If every market in the economy is a competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient.
Productive efficiency is achieved when the output is produced at minimum average total cost
Productive efficiency exists when producers minimise the wastage of resources in their production processes.
Dynamic efficiency occurs over time and it focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available.
The socially efficient level of output and or consumption occurs when marginal social benefit = marginal social cost. At this point we have maximized social welfare.
The existence of negative and positive externalities means that the private optimum level of consumption or production often differs from the social optimum leading to some form of market failure and a loss of social welfare.
The price mechanism does not always take into account social costs and benefits of production
In the diagram below the socially optimum level of output occurs where the social cost of production (i.e. the private cost of the producer plus the external costs arising from externality effects) equals demand
A private producer who ignores the negative production externalities might choose to maximise their own profits at point A. This divergence between private and social costs of production can lead to market failure