Economic Efficiency

Assessing the efficiency of firms is a powerful means of evaluating performance

of firms, and the performance of markets and whole economies. There are
several types of efficiency, including allocative and productive efficiency, KEY TAKEAWAYS
KEY TAKEAWAYS
technical efficiency, ‘X’ efficiency, dynamic efficiency and social efficiency.

What is Economic Efficiency? • Economic efficiency is when

Economic efficiency is when all goods and factors of production in an economy every scarce resource in an
are distributed or allocated to their most valuable uses and waste is eliminated economy is used and
or minimized. distributed among producers
and consumers in a way that
produces the most economic
CIE Suggested Definition output and benefit to
Economic efficiency: where scarce resources are used in the most efficient consumers.
way to produce maximum output. • Economic efficiency can involve
efficient production decisions
within firms and industries,
General Information of MARKET STRUCTURE
efficient consumption decisions
Perfect Competition and Imperfect competition
by individual consumers, and
efficient distribution of
consumer and producer goods
across individual consumers
and firms.
• Pareto efficiency is when every
economic good is optimally
allocated across production
and consumption so that no
change to the arrangement can
be made to make anyone
better off without making
someone else worse off.
Productive efficiency
Productive efficiency occurs when a firm is combining resources in such a way as to produce a given output at the
lowest possible average total cost. Costs will be minimized at the lowest point on a firm’s short run average total
cost curve.
This also means that ATC = MC, because MC always cuts ATC at the lowest point on the ATC curve.

#Productive efficiency for a Firm

Pe: Productive Efficiency

Note: Productive Efficiency is only achieved by Firms in Perfect Competition only, but in the LONG RUN (LR).

Productive efficiency:
This occurs when firms produce at the lowest possible cost. A firm is productively efficient when it is making the
best use of resources and producing at the lowest cost possible. For example, it can apply where a car assembly
plant is using the most UpToDate technology, minimizing the cost of producing each vehicle.
For productive efficiency to exist, goods and services must be made using the least possible resources and at the
minimum possible cost.

Why Y is Productive efficient point?

Look at the above highlighted text and take time to think, “using
least possible resources and at the minimum possible cost.”

#Productive efficiency for an ECONOMY

Look at the PPC diagram. Point X shows Productive inefficiency. This

is because the output is not optimum and there are still resources
left unused. Whereas, Point Y shows productive efficiency, as this is
the maximum output which can be achieved through the utilizing
all resources.

Allocative efficiency
It is not enough for products to be produced at the lowest possible cost. The right products must also be produced
if there is to be economic efficiency. Allocative efficiency is all to do with allocating the right amount of scarce
resources to the production of the right products. This means producing the combination of products that will yield
the greatest possible level of satisfaction of consumer wants. The point of allocative efficiency can be deemed to
exist when the price of a product is equal to its marginal cost of production, the cost of producing one more unit of
output. In this situation, the price paid by the consumer will represent the true economic cost of producing the last
unit of the product. Th is should ensure that precisely the right amount of the product is produced.

Therefore, when Price (P)=Marginal Cost (MC), then allocative efficiency for a firm exists.

Average Cost (AC)/$ Marginal Cost (MC)/$

Quantity/Units Price Total Cost (TC)/$ 𝑇𝐶 ∆𝑇𝐶
𝐴𝐶 = 𝑀𝐶 =
(P)/$ 𝑄 ∆𝑄

1 8 20 20 10
2 8 28 14 8
3 8 34 11.3 6
4 8 38 9.5 4
5 8 42 8.4 4
6 8 48 8 6
7 8 56 8 8
8 8 72 9 16

Look how Price (P)=Marginal Cost (MC). Therefore, at this point allocative
efficiency for firm exists.
Note: Allocative Efficiency is only achieved by Firms in Perfect Competition only.

Furthermore:

This occurs when goods and services are distributed according to consumer preferences. An economy could be
productively efficient but produce goods people don’t need this would be allocative inefficient.
Allocative efficiency occurs when the price of the good = the MC of production. This occurs at an output of 80, where
price $11 = MC.
At an output of 40, The price of £15 is much greater than MC of $6 – there is underconsumption.
Pareto optimality
Pareto optimality occurs when it is impossible to make someone better off without making someone else worse
off. It is an optimal situation, with resources allocated in the most efficient way.

CIE Suggested Definition

Pareto optimality: where it is impossible to make someone better off without making someone else worse off.

The concept can be simply applied using a production possibility curve (PPC) like that shown in Figure below. When
an economy is operating on its PPC, it is not possible to increase the output of capital goods without reducing the
output of consumer goods. In contrast, any point within the PPC, for example X, would be Pareto inefficient. This is
because it is possible to increase the output of either type of goods without reducing the output of the other.

If the allocation of resources is not Pareto efficient, then there is scope for improvement; this situation is one where
at least one person is made better off without making anyone else worse off. If there are welfare losses at a particular
point on the PPC, the reallocation of resources will lead to Pareto improvement. In reality, any improvement in
economic efficiency may require some form of compensation to be paid where individuals are worse off. A good
example is the case of a new road scheme designed to improve the efficiency of the flow of traffic. Users of the new
road benefit because their journey times are shorter and their travel costs are likely to be reduced. Others though,
for example those who might lose their homes, will be worse off unless they are paid appropriate compensation.
Those living close to the road will be adversely affected by additional noise and fumes and are unlikely to receive
compensation. There is, however, an overall efficiency gain.
Dynamic efficiency
Dynamic efficiency is a form of productive efficiency that benefits a firm over time. Resources are reallocated in such
a way that output increases relative to the increase in resources. It is achieved when a firm meets the changing
needs of its market by introducing new production processes in response to competitive pressures. It can be
particularly relevant when analyzing how monopolies and oligopolies seek to remain competitive. By using their
excess profits, such firms are able to engage in research, development and product innovation in order to protect
their market share. In turn, this can bring benefits to consumers in the form of new technologies and lower prices
while giving the firm a more efficient means of production. Dynamic efficiency is a longer-term phenomenon. To
achieve it requires investment sourced from within or outside of the firm. Initially, it can result in higher costs; the
payback comes later yet without investing, a firm may be destined to become less efficient and may be forced to
leave the market. Where a firm is dynamically efficient, its long-run average cost curve shifts downwards.