Bahir Dar University

College of Agriculture and Environmental Sciences

Department of Agricultural Economics

Program: M.Sc.

Course Title: Production Economics and Farm Management

Course Code: AgEc6021

A review on Production Efficiency vs Allocation Efficiency, how we derive them? And their
Implications?

Group Participants

Name Id

1. Badmaw Minuye 1401288

2. Amarech Yitayih 1401285
3. Meseret Kefale 1300588
4. Sisay Terefe 1401293

Bahir Dar University, Ethiopia

February 17, 2022 Submitted to: Dr Zemen Ayalew (P.hD)

Table of Contents
Lists of figure..................................................................................................................................................................ii
1. Introduction................................................................................................................................................................1
1.1. Objectives............................................................................................................................................................1
2. Productive efficiency vs Allocative efficiency..............................................................................................................2
3. Approaches of Measuring Efficiency...........................................................................................................................2
3.1. Output oriented measure in production scenario...............................................................................................2
3.2. Output oriented measure in service provision scenario......................................................................................3
3.2.1. Implications of Productive and allocative efficiency.....................................................................................5
3.3 Input oriented measure........................................................................................................................................7
References......................................................................................................................................................................9

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Lists of figure
Figure1: Output oriented measures for technical efficiency

Figure 2: Productive and Allocative Efficiency.

Figure 3: Brazil and U.S. PPFs

Figure 4: Allocative efficiency & technically efficient

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1. Introduction
In economics, technical efficiency and allocative efficiency are the two components of economic efficiency.
Allocative efficiency relates to the ability to create at a given level of output utilizing the cost-minimizing
input ratios, whereas technical efficiency refers to the ability to produce on the frontier isoquant.

Michael Farrell established a technique in 1957 for measuring and decomposing the efficiency of a
production activity into technical and allocative components. Farrell's efficiency criteria were the frontier
unit isoquant, a concept that evolved into today's production and cost frontiers. To be clear from the start,
productive efficiency is defined as a production organization's ability to generate a well-defined output at
the lowest possible cost(Kopp, 1981).

Productive efficiency has two components namely technical efficiency and allocative efficiency. The
technical efficiency component refers to ability to minimize wastages by producing as much output by given
level of inputs or by using as little input to produce given level of output. Thus, the technical efficiency can
be explained based on two alternative arguments; an output augmenting and an input orientation. The
allocative (price component) is defined as the ability to combine resources and outputs in optimal
proportions(National & Pillars, n.d.).

The number of inputs and outputs can be used to calculate technical efficiency without the need for prices
for these inputs and outputs. To be economically efficient, however, a company must first be technically
efficient. To be technically efficient, a company should create the most output possible given the level of
inputs used, and to be allocativelly efficient, it should use the right mix of inputs based on the relative price
of each input.

1.1. Objectives
The overall objective is differentiating productive efficiency and allocative efficiency, their derivation and
implications. Specifically

 To differentiate productive and allocative efficiency.

 To derive productive and allocative efficiency.
 To describe their implications.

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2. Productive efficiency vs Allocative efficiency
There are two parts to productivity efficiency. The strictly technical, or physical, component relates to the
ability to reduce waste by creating as much output as input allows, or by consuming as little input as output
allows. As a result, technical efficiency study can be oriented toward increasing output or preserving input.
The ability to combine inputs and outputs in optimal proportions based on current pricing is referred to as
the allocative, or price, component(Lovell, 1993).

The allocative (price component) is defined as the ability to combine resources and outputs in optimal
proportions. Many researchers have paid their attention to define the concept of efficiency and its
components. According to Debreu (1951) and Farrel (1957) introduced a measure of technical efficiency.

Based on Farrel (1957), measure of technical efficiency can be obtained by using input and output quantity
without introducing prices of these inputs and outputs. Technical efficiency can be decomposed into three
components such as scale efficiency, congestion and pure technical efficiency. Technical efficiency is just
one component of overall economic efficiency. However, a firm must first be technically efficient in order
to be economically efficient. A firm should produce maximum output given the level of inputs employed in
order to be technically efficient and should use the right mix of inputs in light of the relative price of each
input in order to be allocativelly efficient according to (Kumbhaker and Lovell 2000). However, there are
many examples in literature which show the difference between allocative efficiency and technical
efficiency by using Isoquant curve(National & Pillars, n.d.).

3. Approaches of Measuring Efficiency

According to (Coelli and Battese, 2005), efficiency can be measured in two ways: input-oriented and
output-oriented. The output-oriented approach is concerned with the question of "how much output can be
increased from a given level of input?" Alternatively, "by how much may input quantities be proportionally
lowered without changing the output quantity produced?" could be posed as a question. This is an efficiency
metric that is based on inputs. Both measures will, however, be consistent when the technology
demonstrates constant returns to scale, but they will likely differ otherwise.(Wassie, 2014).

3.1. Output oriented measure in production scenario

In the output oriented perspective, efficiency is evaluated keeping inputs constant. According to Farrell
(1957), output oriented measures can be illustrated by considering the case where production involves two

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outputs (Y1 and Y2) and a single input (L). If the input quantity is held fixed at a particular level, the
technology can be represented by a production possibility curve in two dimensions as follows:

Figure 1 Output oriented measures for technical efficiency

The production possibility curve is represented by the curve AB in Figure 1, which represents technically
efficient combinations of production of outputs Y1/L and Y2/L. Given same level of input (L), it is not
efficient to produce at point Q. considering a firm situated at point Q, the TE can be calculated as OQ/OG.
Alternatively, all farmers producing along the production possibility curve are 100 percent technically
efficient.

3.2. Output oriented measure in service provision scenario

The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and
allocative efficiency.

Figure 2, below, illustrates these ideas using a production possibilities frontier between health care and
education.

Figure 2. Productive and Allocative Efficiency.

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Productive efficiency means that, given the available inputs and technology, it’s impossible to produce
more of one good without decreasing the quantity of another good that’s produced. All choices along the
PPF in Figure 2, such as points A, B, C, D, and F, display productive efficiency. As a firm moves from any
one of these choices to any other, either health care increases and education decreases or vice versa.
However, any choice inside the production possibilities frontier is productively inefficient and wasteful
because it’s possible to produce more of one good, the other good, or some combination of both goods.

For example, point R is productively inefficient because it is possible at choice C to have more of both
goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and health
care on the vertical axis is also higher at point C than point R (H2 is greater than H1).

Any time a society is producing a combination of goods that falls along the PPF, it is achieving productive
efficiency. When the combination of goods produced falls inside the PPF, then the society is productively
inefficient.

Allocative efficiency means that the particular mix of goods a society produces represents the combination
that society most desires. For example, often a society with a younger population has a preference for
production of education, over production of health care. If the society is producing the quantity or level of
education that the society demands, then the society is achieving allocative efficiency. Determining “what a
society desires” can be a controversial question and is often discussed in political science, sociology, and
philosophy classes, as well as in economics.

At the most basic level, allocative efficiency means that producers supply the quantity of each product that
consumers demand. Only one of the productively efficient choices will be the allocative efficient choice for
society as a whole. For example, in order to achieve allocative efficiency, a society with a young population
will invest more in education. As the population ages, the society will shift resources toward health care
because the older population requires more health care than education.

In the graph (Figure 2) above, a society with a younger population might achieve allocative efficiency at
point D, while a society with an older population that required more health care might achieve allocative
efficiency at point B.

However, improvements in productive efficiency take time to discover and implement, and economic
growth happens only gradually. So, a society must choose between trades-offs in the present—as opposed to

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years down the road. For government, this process often involves trying to identify where additional
spending could do the most good and where reductions in spending would do the least harm.

At the individual and firm level, the market economy coordinates a process in which firms seek to produce
goods and services in the quantity, quality, and price that people want. But for both the government and the
market economy, in the short term, increases in production of one good typically mean offsetting decreases
somewhere else in the economy.

3.2.1. Implications of Productive and allocative efficiency

The PPF and Comparative Advantage
While every society must choose how much of each good it should produce, it doesn’t need to produce
every single good it consumes. Often, how much of a good a country decides to produce depends on how
expensive it is to produce it versus buying it from a different country. As we saw earlier, the curve of a
country’s PPF gives us information about the trade-off between devoting resources to producing one good
versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in
the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of
producing a specific good, either because of different climates, geography, technology, or skills.

Suppose two countries, the U.S. and Brazil, need to decide how much they will produce of two crops: sugar
cane and wheat. Due to its climate, Brazil can produce a lot of sugar cane per acre but not much wheat.
Conversely, the U.S. can produce a lot of wheat per acre, but not much sugar cane. Clearly, Brazil has a
lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true;
the U.S. has a lower opportunity cost of producing wheat than Brazil. This can be illustrated by the PPF of
each country, shown in Figure 3, below.

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Figure 3. Brazil and U.S. PPFs

Comparative graphs showing the production possibilities curve for wheat and sugar cane in both Brazil and
the United States.

When a country can produce a good at a lower opportunity cost than another country, we say that this
country has a comparative advantage in that good. In our example, Brazil has a comparative advantage in
sugar cane, and the U.S. has a comparative advantage in wheat. One can easily see this with a simple
observation of the extreme production points in the PPFs. If Brazil devoted all of its resources to producing
wheat, it would be producing at point A. If, however, it devoted all of its resources to producing sugar cane
instead, it would be producing a much larger amount, at point B. By moving from point A to point B, Brazil
would give up a relatively small quantity in wheat production to obtain a large production in sugar cane.
The opposite is true for the U.S. If the U.S. moved from point A to B and produced only sugar cane, this
would result in a large opportunity cost in terms of foregone wheat production.

The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is
not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S.,
and therefore the opportunity cost of wheat is generally higher in Brazil. In the module on International
Trade we have learned that countries’ differences in comparative advantage determine which goods they
will choose to produce and trade. When countries engage in trade, they specialize in the production of the
goods in which they have comparative advantage and trade part of that production for goods in which they
don’t have comparative advantage in. With trade, goods are produced where the opportunity cost is lowest,
so total production increases, benefiting both trading parties.

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The Production Possibility Frontier/Production Possibility Curve however, is often criticized for being
oversimplified and unrealistic. In general, using a PPF assumes certain constants that wants of people are
unlimited that the resources involved are limited but have alternatives.

Only two commodities are being compared, which does not facto the effect of other commodities in the
overall economy (which in reality any commodity would have an effect, however small) that the economy is
constant and stable it does not take into consideration any advancements in the economy which realistically
would have a significant impact on the production particularly if the period of time used is in years).

Factors of production (i.e. land, labor, and capital goods) are constant and always available and finally that
the entire economic environment is unchanging (which as we all know is unrealistic as it can shift at any
time). Despite these criticisms, PPF/PPC models are commonly used for getting rough estimates on what
commodities are needed how much should be produced what needs to be adjusted with the allocation of
resources potential economic growth and such.

3.3 Input oriented measure

As we have discussed before Productive efficiency has two components namely technical efficiency and
allocative efficiency. The technical efficiency component refers to ability to minimize wastages by
producing as much output by given level of inputs (production on PPF) or by using as little input to produce
given level of output (production on Isoquant).

However, there are many examples in literature which show the difference between allocative efficiency
and technical efficiency by using Isoquant curve.

In Figure 4 below, observation A utilizes two input factors to produce a single output. SS/ is the efficient
isoquant curve estimated with an available technique. Point B on the isoquant represents the efficient
reference of the observation A. The technical efficiency of a production unit operating at A is most
commonly measured by the ratio TE = OB/OA, which is equal to one minus BA/OB. It will take a value
between zero and one, and hence an indicator of the degree of technical inefficiency of the production unit.
A value of one indicates that the firm is fully technically efficient, for instance, the point B is technically
efficient because it lies on the efficient isoquant.

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Allocative efficiency can be calculated if the input price ratio represented by the slope of the isocost line,
WW/ in Figure 4, is known, the allocative efficiency (AE) of a production unit operating at A is defined to
be the ratio of AE = OC/OB.

Since the distance CB represents the reduction in production costs that would occur if production were to
occur at the allocativelly and technically efficient point E, instead of the technically efficient, but
allocativelly inefficient point B. The total economic efficiency (EE) is defined to be the ratio of EE =
OC/OA where the distance CA can also be interpreted in terms of a cost reduction. Note that the product of
technical efficiency and allocative efficiency measures provides the measure of overall economic efficiency.

X2

X1

Figure 4: Allocative efficiency technically efficient

Economic efficiency is divided into two parts: technical efficiency and allocative efficiency in economics.
Allocative efficiency refers to a company's capacity to produce a certain amount of production while
keeping costs to a minimum. Productive efficiency, on the other hand, refers to a company's ability to
provide a specific output at the lowest possible cost. Because it is feasible to create more of one thing, or
combination of both, any option within the production possibilities frontier (PPF) is productively inefficient
and wasteful. Determining "what a society desires" is a contentious topic that is frequently debated in
classes.Increases in the production of one good usually result in declines elsewhere in the economy in the
short term. The Productive and Allocative Efficiency (PPF) curve of a country tells us how productive and
efficient it is

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References
Kopp, R. J. (1981). The measurement of productive efficiency: A reconsideration. Quarterly
Journal of Economics, 96(3), 477–503. https://doi.org/10.2307/1882683
Lovell, C. A. K. (1993). Production Frontiers and Productive Efficiency. Measurement of
Productive Efficiency: Techniques and Applications, April, 3–67.
National, G., & Pillars, H. (n.d.). No 主観的健康感を中心とした在宅高齢者における 健
康関連指標に関する共分散構造分析 Title. 56–68.
Wassie, S. B. (2014). Technical Efficiency of major crops in Ethiopia: Stochastic frontier
model. Academia Journal of Agricultural Research, 2(6), 147–153.
https://doi.org/10.13140/RG.2.2.25688.34569
Read more: Difference between PPF and PPC | Difference Between
http://www.differencebetween.net/business/economics-business/difference-between-
ppf-and-ppc/#ixzz7KskhiVeI