EFFICIENCY

 Economic efficiency is whereby scarce resources are used in the most effective way to
produce maximum output.
 Efficiency is concerned with how well resources, such as time, talents or materials, are used
to produce an end result.
 This means the greatest level of infinite wants is being met by the available resources e.g. in
agriculture it is where the maximum crop yields are obtained from a given piece of land.
 In manufacturing it is where the greatest possible output is obtained from a given set of
inputs.
 Efficiency can either be static or dynamic.

Static efficiency

 This type of efficiency is measured at a given point in time. Examples of static efficiency are
productive and allocative efficiency.

Dynamic efficiency

 Dynamic efficiency results from improvements in allocative and productive efficiency over
time.
 It is concerned with how resources are allocated over a given period of time e.g. new
products, new methods of producing old products and new methods of management.
 Dynamic efficiency can increase with innovations, inventions, research and development as
well as investments in human capital.

Types of efficiency

i. Productive efficiency
 Productive efficiency occurs when the firm operates at minimum average total cost and
choosing an appropriate combination of inputs and producing the maximum possible output
from these inputs.
 In micro terms productive efficiency occurs when a firm produces on the lowest point of the
long run average cost curve whereas in macro terms productive efficiency occurs when the
economy is producing along the PPC.
 There are two aspects of productive efficiency which are:

Cost efficiency

 This is when any size of output is produced at the lowest possible cost or least cost e.g. a
firm which produces 1000 units at a cost of $10000 would be productively inefficient if it
could have produced that output at a cost of $8000.
 A firm is productively efficient when it is operating at the lowest point of the long run
average cost curve.
 Along the PPC there is productive efficiency because the economy will be producing the
highest possible output given the available resources.

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 However, inside the PPC there is productive inefficiency since the economy could produce
more with the available resources.
 In the long run equilibrium for perfectly competitive markets productive efficiency is
attained where marginal cost is equal to average cost (M. C=A.C)

 Productive efficiency ensures that firms spend as little as possible to produce any given
output.

 Productive efficiency is desirable to society since resource wastages are avoided during
production.

 Firms are motivated to be productively efficient because it allows them to minimize

production costs and make highest possible profits.

Technical efficiency

 This involves attaining the maximum possible output from a given set of inputs or
alternatively producing the greatest possible output with the least amount of inputs e.g.
instead of producing 1000 units with 10 workers a technically efficient firm would use 9
workers.

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  For a firm to be technically efficient it must operate at the lowest point of the lowest
ATC as shown below:

ii. Allocative efficiency

 It is when the right amount of scarce resources is allocated to the production of the right
products demanded by the people at the right time.
 This means producing the combination of goods yielding the greatest possible level of
satisfaction wanted by the consumers.
 It is achieved when society produces the appropriate bundle of goods relative to consumer
tastes and preferences and the output mix will be the most valued by consumers.
 The condition for allocative efficiency is that social marginal cost (SMC) should be equal to
social marginal benefit (SMB).

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 SMB is the extra benefit enjoyed by the consumer from consuming an extra unit hence is
also the marginal utility curve or the demand curve which is downward sloping due to the
law of diminishing marginal utility.
 SMB also represents the price for different quantities purchased hence the condition for
allocative efficiency can also be expressed as follows: P=SMC.
 M.C is the additional cost of producing an extra unit.
 If SMB is greater than SMC society would gain by producing an extra unit since an extra unit
produced would add more to benefits than costs.
 However, if SMC is greater than SMB the society would benefit by producing less of the good
because an extra unit produced would add more to costs than to benefits.
 It is only when SMB=SMC that allocative efficiency will be attained. This because at the point
community surplus will also be maximized.
 In the long run equilibrium for perfectly competitive markets allocative efficiency is attained
where P=M.C as shown below:

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  Output Q is also allocatively efficient because it is being produced at the point where P=M.C
 Unlike productive efficiency, allocative efficiency cannot be shown on the PPC.
 Any point on the PPC can be a point of allocative efficiency, however, this will depend upon
consumer tastes and preferences which cannot be illustrated on the PPC.
 A competitive market leads to allocative efficiency as firms are forced to produce goods
desired by consumers.
 Also, competition leads to productive efficiency because for firms to make profits they have
to produce at the lowest possible cost since they cannot charge high prices due to
competition.
 Therefore, in perfectly competitive markets there will be economic efficiency (both
productive and allocative efficiency)

iii. X efficiency
 This occurs when a firm is operating at any point along its long run average cost curve as
shown below:

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  Points A, B and C are x efficient sine the firm is operating along its LRAC. In this case the firm
is not incurring unnecessarily high costs of production.
 However, at point D there is X inefficiency also known as organizational slack because the
firm is now incurring unnecessary high costs of production.
 The same output Q could be produced at a lower cost of production, C instead of C 1.
 X inefficiency occurs when the firm buys its raw materials from expensive sources, the firm
pays its management unnecessarily high salaries not linked to productivity and a monopoly
employs inefficient methods of production.
 At a point like A the firm is x efficient but not productive efficient.
 At point B the firm is both X and productively efficient.

iv. Pareto efficiency/ pareto optimality

 It is a situation where it is impossible to change the existing allocation of resources in such a
way that someone is made better off without making another person worse-off.
 Any point along the PPC is pareto efficient or pareto optimum. The point represents an
optimal allocation of resources.
 If an economy is operating along the PPC, it is not possible to increase the quantity of one
the goods without reducing the quantity of the other.
 Pareto efficiency does not, however, mean that there will be an equal distribution of
resources.
 Pareto Efficiency= Productive Efficiency + Allocative efficiency.

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 At points B and C, there is pareto efficiency because for the economy to increase the
production of capital goods it has to reduce the production of consumer goods.
 However, inside the PPC, e.g. at point A, there is pareto inefficiency since an economy can
increase the production of one of the two goods without reducing the production of the
other.

Pareto improvement

 This is a situation whereby reallocating the available resources results in at least one
individual is made better off without making any individual worse off.
 There is room for potential pareto improvement inside the PPC.