Allocative and Productive Efficiency

Supplement (A Level only)

Basic Economic Ideas (A Levels Only)

1. Basic economic ideas (A Level only)

Efficient resource allocation

Concept of economic efficiency: productive and allocative efficiency

Examples of other concepts and terms included:

Optimum resource allocation

Pareto optimalityEfficiencyin general, describes the extent to which time, effort or cost is well used for the intended task or purpose. It is often used with the specific purpose of relaying the capability of a specific application of effort to produce a specific outcome effectively with a minimum amount or quantity of waste, expense, or unnecessary effort. "Efficiency" has widely varying meanings in different disciplines.

In economics, the termeconomic efficiencyrefers to the use of resources so as to maximize the production of goods and services.A broad term that implies an economic state in which every resources are optimally allocated to serve each person in the best way while minimizing waste and inefficiency. When an economy is economically efficient, any changes made to assist one person would harm another.Aneconomic systemis said to bemore efficientthan another (in relative terms) if it can provide moregoods and servicesforsocietywithout using more resources. In absolute terms, a situation can be called economically efficientif:

No one can be made better off without making someone else worse off (commonly referred to asPareto efficiency).

No additional output can be obtained without increasing the amount of inputs.

Production proceeds at the lowest possible per-unit cost.

Productive Efficiency:Productive efficiency refers to a firm's costs of production and can be applied both to the short and long run. It is achieved when the output is produced at minimum average total cost (AC). For example we might consider whether a business is producing close to the low point of its long run average total cost curve. When this happens the firm is exploiting most of the available economies of scale. Productive efficiency exists when producers minimise the wastage of resources in their production processes.

When production can be achieved with lower possible costs. Products must be made with the least possible resources. There is a state of productive inefficiency if the Production cost > Minimum possible costs. e.g a firm that produces 1000 units at a cost of Rs. 100,000/- is said to be productive inefficient if it could have produced the same number of units at a cost of Rs. 80,000/-.

Production Possibility Frontier

Productive efficiency is said to occur on the production possibility frontier. On the PPF curve, it is impossible to produce more of one good without producing less of another. In the diagram below. If you are at point A you cant produce more services without foregoing goods.

Point C in graph is productively inefficient because you can produce more goods or services without an opportunity cost.

Lowest Point on SRAC CurveProductive efficiency also involves producing at the lowest point of the short run average cost curve (where MC cuts the bottom of the SRAC curve).

Usually, productive efficiency refers to the short run (i.e. producing at lowest point of SRAC curve) But if can also refer to producing at the lowest point on the Long Run Average Cost curve LRAC i.e. benefiting fromeconomies of scaleExistence of Productive efficiency is only possible with the existence of the technical efficiency, where TECHNICAL EFFICIENCY is where the production can be carried out with the minimum inputs. The concept of technical efficiency is also related toX-inefficiency. X-inefficiency is said to occur when a firm fails to be technically efficient because of an absence of competitive pressures. e.g. a monopoly employs inefficient working practises because it has no incentive to cut costs.MARKET CONDITION: Competitive markets such as perfect competition need to achieved productive efficiency as the firms need to produce at a minimum possible cost (to enhance the profits). Allocative efficiency :The efficiency is not restricted to the condition of being produced at a minimum possible cost, but the right type of product / service should be produced and provided according to the nature of demand by the members of the economy. Allocative efficiency is concerned with whether we are producing the goods and services that match our changing needs and preferencesand which we place the greatestvalueon

So, the allocative efficiency in an economy is to do with the use of scarce resources to produce a combination of the products that are required the most i.e to achieve the maximum level of satisfaction amongst the consumers.

If the marginal cost was 10, and people were only willing to pay 5 for the good (at output 5), this is allocatively inefficient. This is because the value people get (2) is less than the cost of producing. The cost is greater than the benefit and it is inefficient.

If the marginal cost of a good was 5, and the price was 10 . The price (MU) is greater than marginal cost suggesting under-consumption. If output increased and price fell, society would benefit from enjoying more of the good.

Allocative efficiency occurs at an output of 8.

Firms in perfect competition are said to produce at an allocative efficient level because at Q1 P=MC

Monopolies allocatively inefficient

Monopolies can increase price above the marginal cost of production and are allocatively inefficient. This is because monopolies have market power and can increase price to reduce consumer surplus.

Monopoly sets a price of Pm. This is allocatively inefficient because Price is greater than MC.

Alloactive efficiency would occur at the point where the MC cuts the Demand curve so Price = MC.

Allocative efficiency is reached when no one can be made better off without making someone else worse off. This is also known asPareto efficiencyUsing the production possibility frontier to show allocative efficiencyParetodefined allocative efficiency as a positionwhere no one could be made better off without making someone else at least as worth off.This can be illustrated using aproduction 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

Allocative efficiency is achieved when the value consumers place on a good or service (reflected in the price they are willing to pay) equals the cost of the resources used up in production. Condition required is that price = marginal cost. When this condition is satisfied, total economic welfare is maximised.

Paretodefined allocative efficiency as a situation where no one could be made better off without making someone else at least as worth off.

Under monopoly, a business can keep price above marginal cost and increase total revenue and profits as a result. Assuming that a monopolist and a competitive firm have the same costs, the welfare loss under monopoly is shown by a deadweight loss ofconsumer surpluscompared to the competitive price and output. This is shown in the diagram below.

Trade-offs between efficiency and equity

There is often a trade-off betweeneconomic efficiencyandequity.Efficiencymeans that all goods or services are allocated to someone (theres none left over). When a market equilibrium is efficient, there is no way to reallocate the good or service without hurting someone.Equityconcerns the distribution of resourcesand is inevitably linked with concepts of fairness and social justice. A market may have achieved maximum efficiency but we may be concerned that the "benefits" from market activity are unfairly shared out.