Economic efficiency

Economic efficiency is regarded by many students as a dry topic which is difficult to relate to the real world. But it is worth getting to grips with because once you understand the ideas, you can use them to good advantage when discussing – for example – the effects of government intervention.

• Are markets working well in allocating resource optimally?
• Are businesses producing close to the lowest possible unit cost and with minimum waste?
• In a given industry, is there sufficient dynamic efficiency driven by research and innovation?
• Does a market take into account external costs and benefits to reach a position of social efficiency?

These are the main questions in this section. 

Key Definitions

1. Allocative efficiency: Occurs when the price is equal to the marginal cost (AR=MC or P=MC)
2. Productive efficiency: Occurs when output is supplied at minimum unit (average) cost either in the short or the long run
3. Dynamic efficiency: Dynamic efficiency focuses on changes in the choice available in a market together with the quality/performance of products that we buy. Economists often link dynamic efficiency with the pace of innovation in a market

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Productive efficiency (again)

It is important that a business makes effective use of its assets. The investment in production capacity is often significant. Think about how much it costs to set up a factory; the production line with all its machinery and technology. One way to look at how efficiently a business operates is to look at "productivity".
 

Productivity measures the relationship between inputs into the production process and the resultant outputs. Productivity can be measured in several ways: e.g.

• Output per worker or hour of labour
• Output per hour / day / week
• Output per machine
• Unit costs (total costs divided by total output)

The unit cost measure is particularly important. A falling ratio would indicate that efficiency was improving.

Why is achieving high productivity important?

• Most importantly, a more efficient business will produce lower cost goods than competitors. That means the business can either make a higher profit per unit sold (assuming that the product is sold for the same price as a competitor) or the business can offer customers a lower price than competitors (and still make a good profit/
• Investing in production assets (e.g. equipment, factory buildings) is expensive – a business needs to maximise the return it makes on these assets

There are various ways in which a business can try to improve its productivity:

• Training – e.g. on-the-job training that allows an employee to improve skills required to work more productively
• Improved motivation – more motivated employees tend to produce greater output for the same effort than de-motivated ones
• More or better capital equipment (this links with the topic of automation)
• Better quality raw materials (reduces amount of time wasted on rejected products)
• Improved organisation of production – e.g. less wastage

Productive Efficiency

Definition of Productive efficiency

Productive efficiency is concerned with producing goods and services with the optimal combination of inputs to produce maximum output for the minimum cost.
To be productively efficient means the economy must be producing on its production possibility frontier. (i.e. it is impossible to produce more of one good without producing less of another).

• Points A and B are productively efficient.
• Point C is inefficient because you could produce more goods or services with no opportunity cost

A firm is said to be productively efficient when it is producing at the lowest point on the average cost curve (where Marginal cost meets average cost).

Productive efficiency is closely related to the concept of Technical Efficiency. A firm is technically efficient when it combines the optimal combination of labour and capital to produce a good. i.e. cannot produce more of a good, without more inputs.

Note: An economy can be productively efficient but have very poor allocative efficiency.
Allocative efficiency is concerned with the optimal distribution of resources. For example, if you devoted 90% of GDP to defence, you could be productively efficient, but, this would be a very unbalanced economy.