Allocative efficiency is concerned with whether we are producing the goods and services that match our changing needs and preferences and which we place the greatest value on
Allocative efficiency is reached when no one can be made better off without making someone else worse off. This situation is also known as Pareto efficiency
Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production.
The condition required for allocative efficiency is that price = marginal cost of supply.
Pareto defined allocative efficiency as a position “where no one could be made better off without making someone else at least as worth off.”
This can be illustrated using a production possibility curve – all points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available
If an economy is operating within the PPF there will be an under-utilisation of resources causing output of goods and services to be lower than is feasible.
- Productive efficiency is achieved when the output is produced at minimum average total cost
- Productive efficiency exists when producers minimise the wastage of resources in their production processes.
- There is no unemployment (not being used) or underemployment (not being used to full capacity) of resources
Dynamic efficiency occurs over time and it focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available. This is done by innovation.
This is the time dimension of allocative and productive efficiencies:
Dynamic Allocative Efficiency
This is producing the products people will want in the future, as well as the present. The development of a new, or substantially different, product.
Dynamic Productive Efficiency
This is better methods of producing things, reducing resources needed to produce a product. This causes a rightward shift of the PPC over time.
The socially efficient level of output and or consumption occurs when marginal social benefit = marginal social cost. At this point we have maximized social welfare.
The existence of negative and positive externalities means that the private optimum level of consumption or production often differs from the social optimum leading to some form of market failure and a loss of social welfare.
The price mechanism does not always take into account social costs and benefits of production
Market failure occurs whenever markets fail to deliver an efficient allocation of resources and the result is a loss of economic and social welfare.
Market failure exists when the competitive outcome of markets is not satisfactory from the point of view of society. What is satisfactory nearly always involves value judgments.
Complete and partial market failure
- Complete market failure occurs when the market simply does not supply products at all - we see “missing markets”
- Partial market failure occurs when the market does actually function but it produces either the wrong quantity of a product or at the wrong price.
When there is market failure, there is an inefficient use of scarce resources.
Reasons for Market Failure
Markets can fail for lots of reasons:
Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost
Positive externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit
Imperfect information or information failure means that merit goods are under-produced while demerit goods are over-produced or over-consumed
The private sector in a free-markets cannot profitably supply to consumers pure public goods and quasi-public goods that are needed to meet people’s needs and wants
Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition, causing consumer welfare to be damaged
Factor immobility causes unemployment and a loss of productive efficiency
Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and consequent social exclusion which the government may choose to change
Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid.
Externalities occur outside of the market i.e. they affect people not directly involved in the production and/or consumption of a good or service. They are also known as spill-over effects.
Economic activity creates spill over benefits and spill over costs – with negative externalities we focus on the spill over costs
Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid, for example passive smoking and air pollution from cars.
When negative production externalities exist, social costs exceed private cost. This leads to over-production if producers do not take into account the externalities.
Social costs are the total costs incurred by society from an economic action – they include private and external costs
From a social welfare viewpoint, we want less output from activities that create an “economic-bad” such as pollution.
We have not eliminated the externalities – but at least the market has recognised them and priced them into the price of the product.
Types of External Cost
External costs from production
Production externalities are generated and received in supplying goods and services - examples include noise and atmospheric pollution from factories.
External costs from consumption
- Consumption externalities are generated and received in consumption - examples include pollution from driving cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution created by loud music being played in built-up areas.
- Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit.
Social and Private Costs
The existence of externalities creates a divergence between private and social costs of production and the private and social benefits of consumption.
Social Cost = Private Cost + External Cost
Social Benefit = Private Benefit + External Benefit
Marginal cost or marginal benefit is the change in total cost or benefits that results from an increase in production or consumption by one unit
There are many occasions when the production and/or consumption of a good or a service creates external benefits which boost social welfare, such as:
- External benefits from development of renewable energy sources such as wind power
- External benefits from vaccination / immunisation programmes
- Social benefits from providing milk to young schoolchildren
- Social benefits from the maintenance of a post-office network
Positive externalities and market failure
Where positive externalities exist, the good or service may be under-consumed or under-provided since the free market may fail to value them correctly or take them into account when pricing the product. In other words, the level of output is below the level that maximises social welfare.
Positive Externalities 2
Positive externalities exist when either:
- Marginal Private Cost is greater than Marginal Social Cost, or
- Marginal Social Benefit is greater than Marginal Private Benefit
Positive externalities also lead to market failure because the market is not producing at the most efficient point, there is allocative inefficiency.