Economic Efficiency

The fundamental economic problem is a scarcity of resources.

Definition of efficiency

Efficiency is concerned with the optimal production and distribution of these scarce resources.

There are different types of efficiency

1. Productive efficiency

Productive efficiency is concerned with producing goods and services with the optimal
combination of inputs to produce maximum output for the minimum cost.

To be productively efficient means the economy must be producing on its production possibility
frontier. (i.e. it is impossible to produce more of one good without producing less of another).

 Points A and B are productively efficient.

 Point D is inefficient because you could produce more goods or services with no opportunity
cost
 Point C is currently impossible.

Productive efficiency and short-run average cost curve (Technical Efficiency)

A firm is said to be productively technical efficient when it is producing at the lowest point on
the short run average cost curve (this is the point where marginal cost meets average cost).
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PE and X-Efficiency

A firm producing at the lowest AC curve is said to be X-efficient.

X Inefficiency occurs when a firm lacks the incentive to control costs. This causes the average
cost of production to be higher than necessary. When there is this lack of incentives, the firm
will not be technically efficient.

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In theory, the firm could have an average cost curve at “Potential AC” but due to organisational
slack, it’s actual average costs are higher. The difference between actual and potential costs is
the x-inefficiency.

X Efficiency would occur be when competitive pressures cause firms to combine the optimum
combination of factors of production and produce on the lowest possible average cost curve.

Causes of X Inefficiency

1. Monopoly Power. A monopoly faces little or no competition. Therefore, it might be easy for
the monopolist to make supernormal profits. Therefore, in the absence of competitive
pressures, they may not try very hard to control costs.

2. State Control. A nationalised firm owned by the government may face little or no incentive to
try and make a profit. Therefore, it has less incentive to try and cut costs.

3. Principal-agent problem. Shareholders may wish to maximise profits and minimise costs. But,
managers and workers may pursue other objectives – keeping costs low enough to protect their
job but then allowing costs to rise as it makes work more enjoyable.

4. Lack of motivation. Workers and managers may simply lack the necessary motivation to work
hard. For example, if there are poor industrial relations, workers may purposefully take extra
long breaks and not try hard.

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 Examples of X Inefficiency

 Employing workers who aren’t necessary for the productive process. For example, a state-
owned firm may be more concerned about the political implications of making people
redundant than getting rid of surplus workers.
 Lack of Management Control. If a firm doesn’t have supervision of workers, then productivity
may fall as workers ‘take it easy’
 Not finding the cheapest suppliers. Out of inertia, a firm may continue to source raw materials
from a high-cost supplier rather than look for cheaper raw materials.

Allocative Efficiency

Definition of allocative efficiency

This occurs when there is an optimal distribution of goods and services, taking into account
consumer’s preferences.

A more precise definition of allocative efficiency is at an output level where the price equals
the Marginal Cost (MC) of production. This is because the price that consumers are willing to
pay is equivalent to the marginal utility that they get. Therefore the optimal distribution is
achieved when the marginal utility of the good equals the marginal cost.

Thus AE can be judged through various criteria:

1. P=MC
2. Maximum consumer producer surplus and no dead weight loss.
3. MSC=MSB and no divergence between private and social costs.

Example using diagram

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At an output of 40, the marginal cost of the good is £6, but at this output, consumers would be
willing to pay a price of £15. The price (which reflects the good’s marginal utility) is greater than
marginal cost – suggesting under-consumption. If output increased and price fell, society would
benefit from enjoying more of the good.

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 At an output of 110, the marginal cost is £17, but the price people are willing to pay is only £7.
At this output, the marginal cost (£17) is much greater than the marginal benefit (£7) so there is
over-consumption. Society is over-producing this good.

Allocative efficiency will occur at a price of £11. This is where the marginal cost (MC) = marginal
utility.

Perfect competition – allocatively efficient

 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.

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 Monopoly sets a price of Pm. This is allocatively inefficient because at this output of Qm, price
is greater than MC.
 Allocative efficiency would occur at the point where the MC cuts the Demand curve so Price =
MC.
 The area of deadweight welfare loss shows the degree of allocative inefficiency in the economy.

Allocative efficiency and productive efficiency

Productive Efficiency is concerned with producing goods at the lowest cost. This occurs on the
production possibility frontier (PPF).

(Note producing on the production possibility frontier is not necessarily allocatively efficient
because a PPF only shows the potential output. Allocative efficiency is concerned with the
distribution of goods and this requires the addition of indifference curves.

Perfect Competition in the Short run

In the short run, a firm in the perfectly competitive market may not achieve allocative efficiency
and productive efficiency.

When a firm is making abnormal profit

The firm produces at q which is both profit maximising level [MC=MR ] and also the allocative
efficient level q2 [MC=AR]. However there is no productive efficiency q1.

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When a firm is making abnormal loss
The firm produces at q which is both profit maximising level [MC=MR] and also the allocative
efficient level q2 [MC=AR]. However there is not productive efficiency q1.

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Perfect Competition in the long run
A perfectly competitive market will have both productive efficiency and allocative efficiency in
the long run.

Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as
monopoly, monopolistic competition, and oligopoly, which are more frequently observed in the
real world than perfect competition, firms will not always produce at the minimum of average
cost, nor will they always set price equal to marginal cost. Thus, these other competitive
situations will not produce productive and allocative efficiency.

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