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AS Market Failure

Economic Efficiency

This chapter introduces you to the idea of efficiency, perhaps one of the most important in economics! Efficiency is really about a society making the best or optimal use of our scarce resources to satisfy most wants & needs.

Defining efficiency

Confusingly, there are several meanings of the term economic efficiency but they generally relate to how well a market or the economy allocates our scarce resources to satisfy consumers. Normally the market mechanism is a pretty efficient at allocating these resources, but there are occasions when the market can fail leading to a reduction in efficiency and a subsequent loss of economic welfare. We will return to this when we study market failure in more detail.

Allocative efficiency

Allocative efficiency is concerned with whether the resources we have available are actually used to produce the goods and services that we want and which we place the greatest value on. In other words, are businesses in the economy and also the government (or public) sector supplying the products that are required to meet needs and wants? Allocative efficiency is reached when no one can be made better off without making someone else worse off.

Allocative efficiency and the prices charged for different products

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 technical condition required for allocative efficiency is that price = marginal cost i.e. When this happens, total economic welfare is maximised.

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 significant pricing power in their own particular markets, they may opt to increase their profit margins to squeeze some extra profit from consumers (in economics-speak, they are turning consumer surplus into producer surplus). This has an effect on allocative efficiency in a market for if a monopoly supplier is able to price well above the costs of supply, the likelihood is that consumers will suffer a reduction in their welfare. The producer has become better off but someone else (aka the consumer) has become worse off.

Using the Production Possibility Frontier to show allocative efficiency

Vilfredo 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 can be said to be 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 denoted by the point X we can increase production of both goods by making fuller use of existing resources or increasing the efficiency of production.

An allocation is Pareto-efficient for a given set of consumer tastes, resources and technology, if it is impossible to move to another allocation which would make some people better off and nobody worse off. If every market in the economy is a competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient.

Productive Efficiency

Productive efficiency refers to a firm's costs of production and can be applied both to the short and long run production time-span. It is achieved when the output is produced at minimum average total cost (ATC) i.e. when a firm is exploiting most of the available economies of scale. Productive efficiency exists when producers minimise the wastage of resources in their production processes.

Dynamic Efficiency

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.

At a macroeconomic level, a dynamically efficient economy is increasingly successful in improving existing products and also at developing new products.

A faster pace of invention, innovation and research and development can lead to improvements in dynamic efficiency and this might translate into higher sales in key export markets.

Innovation as a source of dynamic efficiency

Social Efficiency

The socially efficient level of output and or consumption occurs when social benefit = social cost. At this point we maximise 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.

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 reflection of private benefit from consumption.

A private producer who opts to ignore 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.