Economic Efficiency

Section 10.4

Production and Efficiency

AS Economics

Economic Efficiency

• Efficiency relates to how well a market or economy allocates scarce resources to satisfy unlimited wants.

• Efficiency occurs when society is using its scare resources to produce the highest possible amount of goods and services that consumers most want to buy (produces on PPF)

• Efficiencies fall into two types:

Static & Dynamic Efficiency

1.Static Efficiency– How efficient a firm/economy is at a certain point in

time– All the efficiencies we’re looking at are static

efficiencies.

2. Dynamic Efficiency– This looks at improvements in technical, allocative

and productive efficiency over time.– Improvements in dynamic efficiency occur due to

improvements in competition, technology, innovation and invention.

Allocative Efficiency

• Allocative efficiency occurs when the value that consumers place on a good or service equals the cost of the resources used up in production

• The technical condition required for allocative efficiency is that price = marginal cost (same as D=S in a perfect market)

• When this happens, total economic welfare is maximized• When the goods produced are actually what the

consumer wants (not like USSR and shoes).• In other words it occurs when no-one could be better off

without making someone else worse off (Pareto).

Showing allocative efficiencyCosts

Revenues

Output (Q)

Demand

Supply

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

Consumer Surplus (CS)

Producer Surplus (CS)

A loss of allocative efficiency if output is too low and price too high

CostsRevenues

Output (Q)

Demand

Supply

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

P2

Q2

Price level P2 and output Q2 leads to a higher level of producer surplus but a lower level of consumer surplus

Deadweight loss of welfareCosts

Revenues

Output (Q)

Demand

Supply

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

P2

Q2

Loss of economic welfare from output being below the optimal level

A loss of allocative efficiency if output is too high and price too low

CostsRevenues

Output (Q)

Demand

Supply

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

P2

Q3

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 (MES)

• Productive efficiency exists when producers minimize the wastage of resources in their production processes.

• Any point lying on the production possibility boundary is productively efficient

The long run average cost curve

Costs

Output (Q)

SRAC1

SRAC2SRAC3

Q1 Q2 Q3

AC1

AC2

AC3

LRAC

Productive efficiency in the long run is achieved when output is produced at the bottom of the long run average cost curve

Productive and allocative efficiency

• There is little point in producing items at lowest cost if they are not the products most valued by consumers.

• Productive efficiency is a necessary but insufficient condition for an optimal allocation of resources.

• Allocative efficiency is also required.

X-inefficiency

• Tendency for costs to rise in a firm with few or no competitors to incentivise cost-cutting.

• X-inefficiency tends to occur in monopoly situations.

• Although X-inefficiency can also be caused by a firm simply being too inefficient.

Pareto efficiency (optimality)

• Pareto efficiency occurs when resources cannot be reallocated to make one consumer better off without making someone worse off.

• Pareto efficiency can be illustrated using a production possibility frontier (PPF)

• Any point within the PPF is inefficient. Using idle resources to increase output means some consumers gain while no consumers lose.