A2 Level Economics – Productive and Allocative Efficiency and Pareto Optimum

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For an Economy

  • Productive Efficiency

For an economy, productive efficiency occurs when it is operating on the PPC since productive efficiency is concerned with fully utilizing scarce resources and this happens on PPC.

Figure 1.1 PPC of an ecoomy

 

 In figure 1.1 a PPC of an economy can be seen. Any point on the curve (points A, B and C) are productive efficient since economy is fully utilizing all its available factors of production and is producing maximum output possible with the available resources. However, any point under the curve (point D) is not productive efficient since resources are under-utilized and more output could be produced.

  • Allocative Efficiency

Allocative efficiency is concerned with the production of the right combination of goods (in this case combination of capital and consumer goods). We know that all the points on PPC in figure 1.1 are productively efficient but only one point on PPC is allocative efficient. That point depends on consumer preferences. It is not possible to identify the point without any more information. However it can be anywhere on PPC even other than points A, B and C.

 So productive efficient is concerned with producing at any point on PPC while allocative efficiency is concerned with producing the right combination of goods. The common thing about them is that both points (productive and allocative efficient) will be on PPC.

 

  • Pareto Optimum

Pareto optimum is a situation where resources can no longer be reallocated to increase the output of one good without decreasing output of another. All the points on PPC are Pareto optimum. If an economy is operating on point B and wishes to increase output of capital goods (from Qx to Qz) by moving towards point A, it will have to sacrifice consumer goods output (output reduced from Qb to Qa). Similarly at point B if it chooses to increase the output of consumer goods (from Qb to Qc) it will have to decrease the output of capital goods (from Qx to Qy)

 All the points under the curve are not Pareto optimum because it is possible to increase the output of both goods by reallocating resources. For eg at point D, this can be done by moving to Point B.

 

For a firm

  • Productive Efficiency

For a firm, it means to produce output at the lowest possible cost. This point can be identified on a firms SRAC (short-run average cost) curve. This curve is a U shaped and shows the cost of the firm for producing output. This curve will be studied in later topics.

Figure 1.2

Figure 1.2 shows a firm’s SRAC curve. The productively efficient will be on the curve where the cost is lowest. So the productive efficient point will b point X since the cost (the y-axis) is lowest at this point.

 

 

 

 

  • Allocative Efficiency

Since allocative efficiency is concerned with the right combination of goods so for a firm it means producing the right output of the good. So the question for the firm is how much output should be produced.

 For identifying this point we would need a supply and demand diagram of the good’s market.

Figure 1.3

 It is also considered as cost and benefit diagram of good’s market. This diagram is a separate topic like SRAC curve but to understand allocative efficiency look at figure 1.3 showing a cost and benefit diagram of a good. To understand why thy labelling of demand curve, supply curve and the y-axis is changed read more.

Consider a market of an individual good. There is a supply curve (S) and Demand curve (D) with an equilibrium point E. The x-axis is the output of that good in the market. Y-axis is price for that good but also the cost and benefit for society; for firms and consumers.
To understand the cost and benefits for both firms and consumers, let’s take the example of the sandwich market. For firms, the cost will be the cost of bread, labour, rent etc. The benefit will be the revenue generated by selling these sandwiches in the market. For the consumers cost will be the price paid for the sandwich and the benefits will be reduced hunger, increased satisfaction from consuming the sandwich.Note that we are talking about marginal cost/benefit, not total cost/benefit. Marginal is cost/benefit for each additional unit while total is for all the output. This is because the decision for producing and consuming another unit is based on the cost incurred due to additional units (2/3 slices of bread for each additional sandwich) and benefit gained from each additional unit (satisfaction and decreased hunger).
So the supply curve (S) is also Marginal Cost (MC) curve and the demand curve (D) is also Marginal Benefit (MB) curve and the y-axis is also measuring cost and benefit.

 So we were on the question ‘How much output should the firm produce?’ The answer is that firms will be producing the quantity of the equilibrium point that is where the marginal cost will be equal to marginal benefit (MC=MB). In the figure, this quantity will be Qe. So at the point E firm will be allocative efficient.

If the MC cost is higher than MB, firms will leave the market due to higher costs, but if MB is higher than MC more firms will enter the market until the market reaches the equilibrium point.

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