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Economic Efficiency


There are several meanings of the term - but they generally relate to how well an economy allocates scarce resources to meets the needs and wants of consumers.


Static Efficiency

Static efficiency exists at a point in time and focuses on how much output can be produced now from a given stock of resources and whether producers are charging a price to consumers that fairly reflects the cost of the factors of production used to produce a good or a service. There are two main types of static efficiency, allocative and productive.


Allocative Efficiency

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. Allocative efficiency occurs when price = marginal cost, when this condition is satisfied, total economic welfare is maximised.

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


In perfect competition allocative efficiency is achieved as output takes place where price is equal to marginal cost, this is shown below.



Under monopoly, a business can keep price above marginal cost and increase total revenue and profits as a result, this is shown below.



Assuming that a monopolist and a competitive firm have the same costs, the welfare loss under monopoly is shown by a deadweight loss of consumer and producer surplus compared to the competitive price and output. This is shown in the diagram below.



The previous diagram allows us to state that society would be better off under perfect competition rather than monopoly, as monopoly leads to a higher price and a lower level of output.  This is also reflected in the deadweight welfare loss.


This can also be illustrated using a production possibility frontier - all points that lie on the PPF can be said to be allocatively efficiency because we cannot produce more of one product without affecting the amount of all other products available. Point A is allocatively efficient - but at B we can increase production of both goods by making fuller use of existing resources or increasing the efficiency of production.



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.


Under perfect competition, the firm produces at the lowest point on the AC curve in the long run, thereby being productively efficient.



Under monopoly, however, the presence of barriers of entry allow the monopolist to earn abnormal profits in the long run.  The monopolist is not forced to operate at the lowest point on the AC curve.  The monopolist is therefore unlikely to be productively efficient (unlike the firm in perfect competition).



Trade-Offs Between Efficiency And Equity

There is often a trade-off between economic efficiency and equity. Efficiency means that all goods or services are allocated to someone (there’s none left over). When a market equilibrium is efficient, there is no way to reallocate the good or service without hurting someone. Equity concerns the distribution of resources and 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.


Social Efficiency

The socially efficient level of output and or consumption occurs when social marginal benefit = social marginal cost. At this point we maximise social economic welfare. The presence of externalities means that the private optimum level of consumption / production often differs from the social optimum.


In the diagram above the social optimum level of output occurs where social marginal cost = social marginal benefit (point B). A private producer not taking into account the negative production externalities might choose to maximise their own profits at point A (where private marginal cost = private marginal benefit). This divergence between private and social costs of production can lead to market failure.




E-mail Steve Margetts