Economic Efficiency

Definition of efficiency

Efficiency is concerned with the optimal production and distribution of scarce

resources.

Different types of efficiency

 Productive – producing for the lowest cost.

 Allocative – distributing resources according to consumer preference
P=MC
 Dynamic – Efficiency over time.
 X-efficiency – incentives to cut costs.
 Efficiency of scale – taking advantage of economies of scale.
 Social efficiency – taking into account external costs/benefits.
1. Productive efficiency

This occurs when the maximum number of goods and services are produced with
a given amount of inputs. This will occur on the production possibility frontier. On
the curve, it is impossible to produce more goods without producing fewer
services. Productive efficiency will also occur at the lowest point on the firm’s
average costs curve. (Q1)
See: Productive Efficiency
2. Allocative efficiency

This occurs when goods and services are distributed according to consumer
preferences. An economy could be productively efficient but produce goods
people don’t need this would be allocative inefficient.

Allocative efficiency occurs when the price of the good = the MC of production.
This occurs at an output of 80, where price £11 = MC.

At an output of 40, The price of £15 is much greater than MC of £6 – there is

underconsumption.

See: Allocative Efficiency
3. X inefficiency
This occurs when firms do not have incentives to cut costs, for example, a
monopoly which makes supernormal profits may have little incentive to get rid of
surplus labour.
If a firm’s average costs are higher than potential – then we are x-inefficient.
See: X Inefficiency
4. Efficiency of scale

This occurs when the firms produce on the lowest point of its long-run average
cost (Q2) and therefore benefits fully from economies of scale
5. Dynamic efficiency
This refers to efficiency over time, for example, a Ford factory in 2010 may be
very efficient for the time period, but by 2017, it could have lost this relative
advantage and by comparison, would now be inefficient. Dynamic efficiency
involves the introduction of new technology and working practices to reduce
costs over time.

 Dynamic efficiency
 Static efficiency – efficiency at a particular point in time.
6. Social efficiency
This occurs when externalities are taken into consideration and occurs at an
output where the social cost of production (SMC) = the social benefit (SMB)
Social efficiency occurs at an output of 16 – where SMB = SMC

See: Social efficiency
7. Technical efficiency
This requires the optimum combination of factor inputs to produce a good: it is
related to productive efficiency.

See: Technical efficiency
8. Pareto efficiency
A situation where resources are distributed in the most efficient way. It is defined
as a situation where it is not possible to make one party better off without making
another party worse off.

See: Pareto efficiency
9. Distributive efficiency
Concerned with allocating goods and services according to who needs them
most. Therefore, requires an equitable distribution.

Distributive Efficiency Definition

Distributive efficiency occurs when goods and services are consumed by those
who need them most.

Distributive efficiency is concerned with an equitable distribution of resources

because of the law of diminishing marginal returns.
The Law of diminishing marginal returns states that as consumption of a good
increase we tend to get diminishing marginal utility.

For example, if a millionaire already has three cars, but gets a fourth car – this
fourth car will only increase his net utility by a small amount.

If by contrast, someone on a low income can get their first car, the marginal utility
will be much higher.

Therefore, to be distributively efficient, society will need to ensure an equitable

distribution of resources.

A monopoly could lead to distributive inefficiency. A monopoly is able to use its

market power to set high prices and make super-normal profits. Thus a monopoly
owner can gain a higher share of national output, but consumers face higher
prices and a decline in consumer surplus.

Conflict Between Distributive Efficiency and Economic Efficiency

Ensuring an equitable distribution of resources may cause economic

disincentives. For example, if people on high incomes see very high rates of
marginal tax, they may stop working or work in another country. Therefore,
society may see less output.

There is a trade-off between increasing equity and causing disincentives to work

and take risks.

Generally, there is an assumption that a free market needs a degree of inequality

to create some incentives for entrepreneurship etc.

Production possibility frontier and distributive efficiency

A move from A to B is still productively efficient but it can lead to a decline in
distributive efficiency.

Definition of efficiency

Efficiency is concerned with the optimal production and distribution of scarce

resources.

Different types of efficiency

 Productive – producing for the lowest cost.

 Allocative – distributing resources according to consumer preference
P=MC
 Dynamic – Efficiency over time.
 X-efficiency – incentives to cut costs.
 Efficiency of scale – taking advantage of economies of scale.
 Social efficiency – taking into account external costs/benefits.
1. Productive efficiency

This occurs when the maximum number of goods and services are produced with
a given amount of inputs. This will occur on the production possibility frontier. On
the curve, it is impossible to produce more goods without producing fewer
services. Productive efficiency will also occur at the lowest point on the firm’s
average costs curve. (Q1)

Efficiency vs Equity
30 November 2019 by Tejvan Pettinger
A big issue in economics is the tradeoff between efficiency and equity.

 Efficiency is concerned with the optimal production and allocation of

resources given existing factors of production. For example, producing at
the lowest cost. See: Different types of efficiency
 Equity is concerned with how resources are distributed throughout society.
1. Vertical equity is concerned with the relative income and welfare of the
whole population e.g. relative poverty when people have less than 50% of
average income. Vertical equity is concerned with how equitably resources
are distributed and may imply higher tax rates for high-income earners.
2. Horizontal equity is treating everyone in the same situation the same. e.g.
everyone earning £15,000 should pay the same tax rates.

Efficiency may lead to less equity

The poll tax

The Community Charge (Poll tax) was a tax on every individual. Each individual
paid the same amount – regardless of their income. It was considered to be
economically efficient because a poll tax doesn’t distort economic behaviour. It
has no impact on incentives to work because if you earn more, the tax you pay
remains the same. However, by making a millionaire pay the same tax as a poor
pensioner, it was considered to be unfair.

Cigarette taxes

A tax on cigarettes can be said to increase social efficiency. Cigarettes have

negative externalities causing the social cost to be higher than personal cost.
The cigarette tax makes people pay the full social cost of smoking and increases
social efficiency. However, a cigarette tax is also highly regressive. It takes a
bigger percentage of income from low-income earners.
Pareto efficiency
Pareto efficiency is concerned with creating a situation where we cannot make
one party better off without making another party worse off. For example, a
country may devote 60% of GDP to the manufacture of armaments. In doing this,
they may achieve technical and productive efficiency and produce on their
production possibility frontier. Therefore from this perspective, they are efficient.
But, such an economy may have a great deal of inequality, with large portions of
the population struggling to have enough to eat.
Pareto efficiency is a point on the PPF curve, but there is no guarantee this will
lead to an efficient outcome.
Bank bailouts and equity

From one perspective we may say bailing out banks is an economic necessity as
it prevents a collapse in confidence in the banking system. By bailing out banks,
we enable a more productively efficient economy.

However, from another perspective, it seems unfair that the government enables
bankers to retain high paying jobs whilst they implement cuts for workers on
lower-income.

Increased inequality and increased growth

Sometimes, economic policies create a situation where everyone becomes better

off (rising real incomes across the population). However, those on high incomes
gain a bigger percentage rise in real incomes. The result is that everyone
becomes better off, but there is also greater income inequality. Therefore, some
people may feel that relatively they appear worse off compared to others in
society.

This is a pareto improvement in economic welfare but also an increase in

inequality.
It is like the ‘trickle-down effect‘ – where the poorest only gain a small increase in
their income. Whilst the rich gain a big percentage and bigger absolute increase
in income. There is increased economic efficiency but increased inequality.
Is it good to have increased efficiency but increased inequality?

Yes
 Reduction in absolute poverty.
 Increase in real incomes – everyone is better off.
 Some feel that inequality creates incentives to work harder.
No
 People value happiness in terms of ‘fairness’ and relative perspectives. If
the rich gain a bigger share of national income, it may create resentment.
 Diminishing marginal utility of income. Rich struggle to spend their
increased income on goods which increase utility.
The final point is that there doesn’t have to be a trade-off between equality and
efficiency. An improvement in efficiency should generally make the economy
better off. There is no reason why improved efficiency has to lead to inequality. It
is compatible to improve both efficiency and equity within society.

2. Allocative efficiency
This occurs when goods and services are distributed according to consumer
preferences. An economy could be productively efficient but produce goods
people don’t need this would be allocative inefficient.

Allocative efficiency occurs when the price of the good = the MC of production.
This occurs at an output of 80, where price £11 = MC.

At an output of 40, The price of £15 is much greater than MC of £6 – there is

underconsumption.

See: Allocative Efficiency
3. X inefficiency
This occurs when firms do not have incentives to cut costs, for example, a
monopoly which makes supernormal profits may have little incentive to get rid of
surplus labour.

If a firm’s average costs are higher than potential – then we are x-inefficient.

See: X Inefficiency
4. Efficiency of scale

This occurs when the firms produce on the lowest point of its long-run average
cost (Q2) and therefore benefits fully from economies of scale
5. Dynamic efficiency
This refers to efficiency over time, for example, a Ford factory in 2010 may be
very efficient for the time period, but by 2017, it could have lost this relative
advantage and by comparison, would now be inefficient. Dynamic efficiency
involves the introduction of new technology and working practices to reduce
costs over time.
  Dynamic efficiency
 Static efficiency – efficiency at a particular point in time.
6. Social efficiency
This occurs when externalities are taken into consideration and occurs at an
output where the social cost of production (SMC) = the social benefit (SMB)

Social efficiency occurs at an output of 16 – where SMB = SMC

See: Social efficiency
7. Technical efficiency
This requires the optimum combination of factor inputs to produce a good: it is
related to productive efficiency.

8. Pareto efficiency
A situation where resources are distributed in the most efficient way. It is defined
as a situation where it is not possible to make one party better off without making
another party worse off.

See: Pareto efficiency
9. Distributive efficiency
Concerned with allocating goods and services according to who needs them
most. Therefore, requires an equitable distribution.