Efficiency

Efficiency refers to the extent to which scarce economic resources are used successfully to satisfy wants. If we could increase the satisfaction of wants from available resources, then resources are not being used efficiently. There is a number of different ways of looking at efficiency:

Static and Dynamic Efficiency

Static Efficiency is concerned with efficiency at a particular point in time. For instance, a country producing within its production possibility frontier has some unemployed resources. It is therefore not allocating resources efficiently at the present time (it is allocatively inefficient). A firm that made its product using an expensive material when an equally good cheaper alternative exists would not be productively efficient at the present time, since it could produce at a lower cost.

Allocative and productive efficiency are therefore both examples of static efficiency, and are discussed further in this section.

Dynamic Efficiency looks at how well resources are used over a period of time. For instance, it is sometimes argued that mergers and takeovers may increase efficiency by creating bigger firms that have more resources to invest in new technologies. Perhaps a reduction in taxes on company profits might stimulate investment, leading to higher growth. This would lead to an outward shift of the production possibility frontier over a number of years.

Allocative Efficiency

Allocative Efficiency refers to the extent to which resources are allocated to their most valued use.

Allocative efficiency exists when the production of a good is at a level where price equals marginal cost (P=MC).

Price is a measure of how much consumers are willing to pay for an extra (or marginal) unit of output, in other words its value to them. Because of diminishing marginal utility (see notes on 1.2.2) consumers are willing to pay lower prices the more they consume of a good.

Marginal Cost is a measure of the value of resources used up in making an additional unit.

It follows from this that if P>MC, the good is being under-produced, since consumers place a higher value on having an additional unit, compared to the cost of producing it.

If MC>P, the good is being over-produced, since the cost of the last unit exceeds its value to consumers.

Both under and over-production result in allocative inefficiency.

__NB: __Under conditions of perfect competition (see notes on 3.4.2) firms will always produce at an output where P=MC, an are therefore allocatively efficient. Perfect competition is the only market structure that is allocatively efficient.

Allocative efficiency can only be achieved if there are no externalities. Positive externalities will result in under-production and negative externalities will result in over-production.

Productive Efficiency

Productive Efficiency is achieved if a given level of output is produced at the lowest possible cost, given the current state of technology and knowledge.

In the short-run productive efficiency is achieved if a firm in producing at the lowest point on its short-run average cost curve. In the long-run, a firm is productively efficient if it is producing at the lowest point on its long-run average cost curve (between minimum efficient scale and disconomies of scale)

Short-run productive efficiency is shown in Fig 1 below:

Q1 is the most productively efficient output, corresponding to an average total cost of C1 per unit. X is the lowest point on the ATC curve.

Any lower, or higher output results in higher ATC. For example, at point Y, output is at Q2 and cost per unit is C2.

Productive efficiency can only be achieved if a firm is also technically efficient. This means that a firm must be producing a given output with the least possible quantity of inputs (resources). For instance, at point Z, the firm is producing output Q2 at a cost of C3 per unit, when a technically efficient firm could produce this output at a cost of C2 per unit.
Even if a firm is technically efficient (such as at point Y) it is not productively efficient unless it is also at the lowest point on the AT curve (ie at point X)
Under conditions of perfect competition all firms will produce where both short and long run average total cost are at the lowest point, so they are productively efficient. All other market structures result in productive inefficiency, since ATC is not at a minimum.
X-inefficiency is a particular kind of productive inefficiency, also known as organisational slack. It is likely to be found in firms that have substantial monopoly power (see notes on 3.4.5). X-inefficiency can arise because the absence of competition allows management to avoid having to focus on reducing costs. For instance, a firm may not always seek to find the cheapest supplier or introduce more efficient working methods. This may avoid conflict with suppliers or the workforce, enabling managers to enjoy a ‘quiet life’. X-inefficiency can also be shown in Fig 1 by a point such as Z, where the firm is operating within its cost boundary (ie above the ATC curve).

Production Possibility Frontier and Efficiency

We can show different kinds of efficiency in a PPF diagram, as in Fig 2 below:

Assume initially the PPF is at PPF1. At any point inside the PPF (eg at U), there is allocative inefficiency, since there are unemployed resources.

Points S,T and V are all on the PPF, so the economy as a whole is productively efficient (it can only produce more of one type of goods by producing less of the other).

But there is only one point that is both productively and allocatively efficient. This is determined by the preferences of households for a particular balance between consumer goods and capital goods. This could be, for instance, at point T.

Dynamic efficiency is shown by the outward movement of the PP to PPF2. It is then possible for the economy to move to point W, still in keeping with households’ desired balance between consumer an capital goods.

The long term pattern of output is shown by the growth path that connects the points showing consumers preferences on particular PPFs. To push the PPF out at a faster rate (increasing dynamic efficiency) would require a change in preferences towards producing more capital goods (ie more investment). This would result in higher output in the long run, but fewer consumer goods in the present.

Explain in a paragraph why externalities may result in allocative inefficiency.: Your answer should include: negative externalities / external costs / positive externalities / external benefits / price / marginal cost / under-production / under-produced / over-production / over-produced