Basic Economic Ideas

A2 Unit 1
 Syllabus Coverage

Bamford: Chapter 6
Anderton: Chapters 14-16, 52, 58
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 An A2-Economics Theme
1. Markets may not always be efficient.
• When does the market achieve efficiency?
• When does it not?
• What can government do to fix markets?
• When is government inefficient?
2. There is a trade-off between efficiency and equity.
• Is it better for society to have more stuff, or less stuff
that is more evenly distributed?
• Which policies can increase equity at a minimum cost
to efficiency?

• This idea is a major component of A2 Econ (as

well as economics in general).
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 Time Dimension
We will see most of these definitions again later.

• Short Run (SR) – period of time when only some inputs are
variable (usually labor).

• Long Run (LR) – period of time when all factors of production

are variable (capital, firm size, market entry & exit).

• Very Long Run – period of time when all factors and other key
inputs are variable (technology, government regulations,
social considerations).

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a) Efficient resource allocation

Anderton Chapter 56
Bamford Chapter 6
 Efficiency
• Economic efficiency – when scarce resources are used in the most
efficient way to produce maximum output; economic efficiency
includes productive, allocative, and dynamic.

• Productive efficiency – efficiency that exists when a firm produces at

the lowest possible cost; normally this means competition among
firms in markets forces the firms to produce goods at the lowest cost.

• Allocative efficiency – efficiency that exists when firms are producing

the goods and services desired most by consumers. Things are
produced up to the point where the last unit provides MB to society
equal to MC of producing it.

• Dynamic efficiency – efficiency from the improvement of technology

in production methods over time; this allows firms to produce more
output at cheaper cost.
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 Efficiency
• Sustainability – using resources in a way that does not reduce
their quantity or quality over time.
• Pareto optimal (Pareto efficiency) – a situation where it is
impossible to make someone better off without making someone
else worse off.
• Equity – the “fair” distribution of economic benefits. Fairness is
usually subjective and thus a normative concept. Economics does
try to measure equality positively but equality and equity –
though related in many people’s minds – are different things.

Note there is often a trade-off between efficiency and equity.

• Raising income taxes on people with higher incomes or
increasing subsidies to the unemployed would both increase
equity but will likely lower work incentives and efficiency.
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 Productive Efficiency
• This is a move from a point within the PPC to a point on the PPC.

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 Allocative Efficiency
• Producing output where price is equal to marginal cost.
– A theme of microeconomics is examining which market
structures can coexist with allocative efficiency.

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 Allocative Efficiency
• All points on the PPC can be
Capital
allocatively efficient because it is Goods
possible that any specific point is
the combination of goods and
services most desired by society. It A
follows that only one point at a
time on the PPC is allocatively
efficient.
• Every point is productively
C B
efficient because production is
maximized.
• So points A and B are both
allocatively and productively
Consumer
efficient; point C is not allocatively Goods
or productively efficient.
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 Pareto Optimality
• Pareto optimality is a minimum standard of efficiency, a baseline
for analysis; what is Pareto optimal is not necessary the best
choice for a society – i.e. not necessarily equitable.

• A society where everyone has $1 million could be Pareto

optimal, but so could a society where 99% have $1 and 1% have
all the rest of the money.

• The point is that all the existing resources are being used, not
that the use is equitable.

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 Dynamic Efficiency
• This is a type of productive efficiency which exists over time as a
business undertakes research and development in order to
establish new methods of production.

• Creative destruction – a term from famous Austrian economist

Joseph Schumpeter, this is the death of older inefficient firms or
production methods (destruction) and their replacement by
newer more efficient firms or production methods (creation).
The economy advances in spurts of creative destruction.

• In the LRAC diagram – dynamic efficiency is shown by a

noninflationary expansion of output (next slide).

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 Dynamic Efficiency
Total Cost
Average

LRAC1
LRAC2

C1

C2

Q1 Output

• In the Long-Run Average Cost (LRAC) diagram this is shown by a

noninflationary expansion of output; in other words the LRAC
curve shifts downwards, lowering costs (usually also prices)
and/or increasing output.
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