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As you know, economic resources are scarce and economics studies how to allocate these resources efficiently. But, how do you measure economic efficiency? What makes an economy efficient? This explanation will help you understand what we talk about when we say economic efficiency and the different types of economic efficiency
The focus of an economy is the allocation of scarce resources. When resources are allocated optimally we have economic efficiency. Economic efficiency is a result of scarcity. Since resources are limited, they must be used optimally. In an efficient economy, it is impossible to increase the benefit of one party without hurting another.
Economic efficiency is ensuring that all resources available in an economy are utilised optimally while minimising inefficiency.
Economic efficiency is important because it allows businesses to reduce their costs and increase output. For consumers, economic efficiency leads to lower prices for goods and services. For the government, more efficient firms and higher levels of productivity and economic activity increase economic growth.
There are various types of efficiency. Let’s take a look at some of them.
The different types of economic efficiency are:
This term refers to when output is maximised from the available inputs. It occurs when an optimal combination of goods and services produces maximum output while achieving minimum cost. In simpler terms, it is the point where producing more of one good would reduce the production of another.
Productive efficiency occurs when output is fully maximised from the available inputs. Productive efficiency occurs when it is impossible to produce more of one good without producing less of another. For a firm, productive efficiency occurs when the average total cost of production is minimised.
A production possibility frontier (PPF) can be used to further explain productive efficiency. It shows how much an economy can produce given existing resources. It highlights the different options an economy has for resource allocation.
Figure 1. The Production Possibility Frontier - StudySmarter.
Figure 1 shows a production possibility frontier (PPF). It shows the maximum level of output from available inputs at every point on the curve. The curve aids in explaining the points of productive efficiency and productive inefficiency.
Points A and B are considered points of productive efficiency because the firm can achieve maximum output given the combination of goods. Points D and C are considered points of productive inefficiency and thus wasteful.
If you would like to learn more about PPF curves check out our Production Possibility Curve explanation!
Productive efficiency can also be illustrated with another graph shown in Figure 2 below.
Figure 2. Productive efficiency with AC and MC curves - StudySmarter.
Productive efficiency is achieved when a firm is producing at the lowest point on the short-run average cost curve (SRAC). I.e where marginal cost (MC) meets average cost (AC) on the graph.
We can illustrate dynamic efficiency through an example of a t-shirt printing business.
A printing business starts out by using a single printer with a capacity of printing 100 t-shirts in 2 days. However, over time, the business is able to grow and improve its production by using a big scale printer. They now produce 500 printed t-shirts a day, thereby reducing cost and increasing productivity.
This business has improved its production process while reducing its costs over time.
Dynamic efficiency explains the productive efficiency of firms over a long period of time. It occurs when firms reduce their cost by implementing new processes of production. Dynamic efficiency aids in reducing long-run average cost (LRAC).
Some factors that affect dynamic efficiency are:
As the name implies, this is concerned with efficiency at a particular point in time. This is a type of economic efficiency focused on the best combination of existing resources at a particular time. It is producing at the lowest point on the short-run average cost (SRAC).
Dynamic efficiency is concerned with allocative efficiency and with efficiency over a period of time. For example, it examines whether investing into technological development and research over a period of time will help a firm be more efficient.
Static efficiency is concerned with productive and allocative efficiency and efficiency at a particular time. For example, it examines whether a firm can produce 10,000 units a year cheaper by using more labour and less capital. It is concerned with producing outputs at a specific time by allocating resources differently.
This is a situation where goods and services are distributed satisfactorily according to consumers' preferences and willingness to pay a price equivalent to the marginal cost. This point is also known as the allocative efficient point.
Allocative efficiency is a type of efficiency focused on the optimum distribution of goods and services taking into consideration consumers’ preference. Allocative efficiency occurs when the price of a good is equivalent to the marginal cost, or in a shortened version, with the formula P = MC.
Everyone in society needs a public good such as healthcare. The government provides this healthcare service in the market to ensure allocative efficiency.
In the UK, this is done through the National Healthcare Service (the NHS). However, the queues for the NHS are long and the toll on the service may be currently so high that it means that this merit good is under-provided and not allocated to maximise economic welfare.
Figure 3 illustrates allocative efficiency on a firm/individual level, and the market as a whole.
Figure 3. Allocative efficiency - StudySmarter.
For firms, allocative efficiency occurs when P=MC. For the whole market, allocative efficiency occurs when supply (S) = demand (D).
Social efficiency occurs when resources are optimally distributed in a society and the benefit derived by an individual doesn't make another person worse off. Social efficiency occurs when the benefit of production is not greater than its negative effect. It subsists when all benefits and costs are considered in producing an extra unit.
Externalities occur when the production or consumption of a good causes a benefit or cost impact on a third party that doesn’t have a direct relation to the transaction. Externalities can be positive or negative.
Positive externalities occur when the third party gets benefits from the good production or consumption. Social efficiency occurs when a good has a positive externality.
Negative externalities occur when the third party gets a cost from the good production or consumption. Social inefficiency occurs when a good has a negative externality.
The government introduces a taxation policy that helps reduce the environmental footprint and make firms more sustainable thereby protecting acommunity from a polluted environment.
This policy also helps other communities by ensuring other firms and start-ups do not pollute the environment. This policy has brought about a positive externality and social efficiency has occurred.
Interestingly, we can see how efficiency is promoted through one market in particular: the financial market.
Financial markets play a key role in the growth, development, stability, and efficiency of an economy. The financial market is a market where traders buy and sell assets such as stocks, which exist to ensure the flow of money in the economy. It is a market that promotes the transfer of excess available funds to areas experiencing a scarcity of funds.
Furthermore, financial markets promote economic efficiency as they give the market participants (consumers and businesses) an idea of the return on investments and how to direct their funds.
The financial market provides an opportunity for participants to meet their needs of borrowing and lending by matching products to borrowers at varying interest rates and risks while giving lenders a variety of opportunities to lend funds.
This promotes efficiency as it provides a good mix of products required by society. It directs funds from savers to investors.
Economic efficiency is a state where resources are allocated optimally.
The following are examples of economic efficiency:
- Productive efficiency
- Allocative efficiency
- Social efficiency
- Dynamic efficiency
Financial markets promote economic efficiency by promoting the transfer of excess funds to areas of shortage. It is a form of allocative efficiency whereby the needs of lenders are met in the market which provides borrowers.
The government promotes economic efficiency by implementing policies that aid in redistribution of wealth to encourage production.
Economic efficiency is important because it allows for businesses to reduce their costs and increase output. For consumers, this leads to lower prices for goods and services. For the government, more efficient firms and higher levels of productivity and economic activity increases economic growth.
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