FIVE TYPES OF ECONOMIC EFFICIENCY

Economics is all about efficiency. Most economic issues arise because of scarce resources.
Starting from there, we often have to find ways to use, produce and distribute those resources
in the best possible way (i.e. efficient). However, depending on the issue we are looking at,
there may be different factors that define whether a situation is considered efficient or not. In
other words, there are a number of different types of economic efficiency. We will look at
five of them in more detail below: allocative, productive, dynamic, social and X-efficiency.

Allocative Efficiency

Allocative efficiency occurs when all goods and services within an economy are distributed
according to consumer preferences. In this scenario price always equals marginal cost of
production. The reason for this is that the price consumers are willing to pay for a product or
service reflects the marginal utility they get from consuming the product. Hence, the optimal
outcome is achieved when marginal cost (MC) equals marginal benefit (MB). This is

illustrated in the graph below.

The optimal outcome in the illustration is marked by

point B (i.e. 240 units of output at a price of USD
120). This is at the intersection of the marginal cost
curve and the marginal benefit curve. By contrast,
point A does not represent an allocatively efficient
outcome, because marginal cost of production does
not equal marginal benefit at this point.

Allocative efficiency can be found in perfectly

competitive markets because firms in those markets
don’t have enough market power to increase prices.
To survive, they have to produce what society
values most, at the prices consumers are willing to
pay. By contrast, Monopolies are said to produce
allocatively inefficient levels of output, simply because they have enough market power to
affect prices and reduce consumer surplus by engaging in price discrimination.

Productive Efficiency

Productive efficiency occurs when the optimal combination of inputs results in the maximum
amount of output at minimal costs. This is the case when firms operate at the lowest point of
their average total cost curve (i.e. where marginal costs equal average costs). A productively
efficient economy always produces on its production possibility frontier. That means, it is

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impossible for that economy to produce more of one good or service without reducing the
production of another one.

The illustration above shows the production possibility

frontier (PPF) for two goods (A and B). If an economy
produces 600 units of good A and 450 units of good B, it
is not working at full capacity. More units of both goods
could be produced without reducing the production of
the other good. Thus, we have productive inefficiency.
However, if the same economy produces 800 units of
good A and 600 units of good B, it produces on the PPF,
which is productively efficient. Please note that all points
on the PPF represent a  productively efficient outcome.

Productive efficiency requires all firms to use the least

costly factors of production (e.g. land, labor), the best
processes and the most advanced technology available. In
addition wastage during production has to be reduced to a minimum and possible economies
of scale have to be realized. If those conditions are met, it won’t be possible for the firms to
produce more goods or services without more inputs.

Keep in mind that productive efficiency does not necessarily have to entail allocative
efficiency. For example, if society does not need 800 units of good A and 600 units of good
B, the illustration above does not describe an allocatively efficient outcome even though it is
productively efficient.

Dynamic Efficiency

Dynamic efficiency occurs over time, as innovation and new technologies reduce production

costs. In essence, it describes the productive efficiency of an economy (or firm) over
time. We speak of dynamic efficiency when an economy or firm manages to shift its average
cost curve (short and long run) down over time. This can be boosted by research and
development, investments in human capital or an increase
in competition within the market.  The graph below
illustrates dynamic efficiency.

As we can see, the first long-run average cost curve

(LRAC 1) lies above the second long-run average cost
curve (LRAC 2). In many cases, this is what happens
over time, as innovation helps to improve products and
processes and thus reduce costs. Lower average costs

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allow firms to sell at a lower price, which is why point A and the entire LRAC 1 shifts down
to point B (and LRAC 2) over time.

An economy with a high dynamic efficiency generally offers more choices of high-quality
goods for consumers. This is due to the fact that invention and innovation not only result in
better processes and lower cost, but also in higher quality goods and services for consumers.

Social Efficiency

Social Efficiency occurs when goods and services are

optimally distributed within an economy, also
taking externalities into account. This is the case when
marginal social cost of production equals social
benefit. This relationship can be illustrated as follows.

The graph shows two sets of curves. The intersection

of the marginal private cost curve (MPC) and the
marginal private benefit curve (MPB) represents an
allocatively efficient outcome (point A). However, if
we take externalities into account as well, we have
to look at the intersection of the marginal social
cost curve (MSC) and the marginal social benefit curve
(MSB) instead. Hence, the socially efficient outcome is
not reached at point A (18 units at a price of USD 100) but shifts up to point B (20 units at a
price of USD 120).

In a socially efficient economy, overall social welfare is maximized. However, in most cases,
this requires some form of taxation. In a free market, both consumers and producers don’t
take externalities into account. As a result, taxes (or subsidies) are required to internalize the
externalities and reach a socially efficient outcome (see also Positive and Negative
Externalities).

X-efficiency

X-efficiency occurs when a firm has an incentive to

produce maximum output with a given amount of
input. Hence, it is quite similar to productive
efficiency. The main difference between the two
is that X-efficiency depends on management
incentives whereas productive efficiency depends on
processes and technology.

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The illustration above shows an inefficient average total cost curve (ATC 1) and an efficient
total cost curve (ATC 2) of a firm. This looks quite similar to the illustration of dynamic
efficiency. However, in this case, the shift from point A to point B does not depend on
innovation but only on management incentives. That means, the firm has the ability to shift
its average total costs to ATC 2 from the beginning, however, it does not have any incentives
to do so.

We are most likely to encounter X-efficiency in highly competitive markets. In those

situations, the management has to produce as much output as possible (at the lowest possible
cost) to remain competitive. By contrast, in a monopoly, we will usually see a loss of X-
efficiency, because the monopolist is able to increase profits by not maximizing output.

In a Nutshell

Most economic issues arise because of scarce resources. Hence, it is critical to use, produce
and distribute those resources in an efficient manner. There are a number of different types of
economic efficiency. The five most relevant ones are allocative, productive, dynamic, social
and X-efficiency. Allocative efficiency occurs when goods and services are distributed
according to consumer preferences. Productive efficiency is a situation where the optimal
combination of inputs results in the maximum amount of output. Dynamic efficiency occurs
over time, as innovation reduces production costs. Social Efficiency happens when goods and
services are optimally distributed, also taking externalities into account. And last but not
least, X-efficiency occurs when a firm has an incentive to produce maximum output with a
given amount of input.