Supplement (A Level only)

Basic Economic Ideas (A Levels Only)

1. Basic economic ideas (A Level only)

Efficient resource allocation

Concept of economic efficiency: productive and allocative
efficiency
Examples of other concepts and terms included:

Optimum resource allocation

Pareto optimality

Efficiency in general, describes the extent to which time, effort or cost is well used
for the intended task or purpose. It is often used with the specific purpose of relaying
the capability of a specific application of effort to produce a specific outcome
effectively with a minimum amount or quantity of waste, expense, or unnecessary
effort. "Efficiency" has widely varying meanings in different disciplines.
In economics, the term economic efficiency refers to the use of resources so as to
maximize the production of goods and services. A broad term that implies an
economic state in which every resources are optimally allocated to serve each
person in the best way while minimizing waste and inefficiency. When an
economy is economically efficient, any changes made to assist one person would
harm another.

An economic system is said to be more efficient than another (in relative terms) if it
can provide more goods and services for society without using more resources. In
absolute terms, a situation can be called economically efficient if:

No one can be made better off without making someone else worse off
(commonly referred to as Pareto efficiency).

No additional output can be obtained without increasing the amount of inputs.

Production proceeds at the lowest possible per-unit cost.

Productive Efficiency:
Productive efficiency refers to a firm's costs of production and can be applied both to
the short and long run. It is achieved when the output is produced at minimum
average total cost (AC). For example we might consider whether a business is
producing close to the low point of its long run average total cost curve. When this
happens the firm is exploiting most of the available economies of scale. Productive
efficiency exists when producers minimise the wastage of resources in their
production processes.
When production can be achieved with lower possible costs. Products must be made
with the least possible resources. There is a state of productive inefficiency if the
Production cost > Minimum possible costs. e.g a firm that produces 1000 units at a
cost of Rs. 100,000/- is said to be productive inefficient if it could have produced the
same number of units at a cost of Rs. 80,000/-.
Production Possibility Frontier
Productive efficiency is said to occur on the production possibility frontier. On the
PPF curve, it is impossible to produce more of one good without producing less of
another. In the diagram below. If you are at point A you cant produce more services
without foregoing goods.

Point C in graph is productively inefficient because you can produce more goods or
services without an opportunity cost.
Lowest Point on SRAC Curve
Productive efficiency also involves producing at the lowest point of the short run
average cost curve (where MC cuts the bottom of the SRAC curve).

Usually, productive efficiency refers to the short run (i.e. producing at lowest point of
SRAC curve) But if can also refer to producing at the lowest point on the Long Run
Average Cost curve LRAC i.e. benefiting from economies of scale
Existence of Productive efficiency is only possible with the existence of the technical
efficiency, where TECHNICAL EFFICIENCY is where the production can be carried
out with the minimum inputs. The concept of technical efficiency is also related to Xinefficiency. X-inefficiency is said to occur when a firm fails to be technically efficient
because of an absence of competitive pressures. e.g. a monopoly employs inefficient
working practises because it has no incentive to cut costs.
MARKET CONDITION: Competitive markets such as perfect competition need to
achieved productive efficiency as the firms need to produce at a minimum possible
cost (to enhance the profits).

Allocative efficiency :
The efficiency is not restricted to the condition of being produced at a minimum
possible cost, but the right type of product / service should be produced and provided
according to the nature of demand by the members of the economy. Allocative
efficiency is concerned with whether we are producing the goods and services that
match our changing needs and preferences and which we place the
greatest value on
So, the allocative efficiency in an economy is to do with the use of scarce resources
to produce a combination of the products that are required the most i.e to achieve the
maximum level of satisfaction amongst the consumers.

If the marginal cost was 10, and people were only willing to pay 5 for the good
(at output 5), this is allocatively inefficient. This is because the value people get
(2) is less than the cost of producing. The cost is greater than the benefit and it
is inefficient.

If the marginal cost of a good was 5, and the price was 10 . The price (MU) is
greater than marginal cost suggesting under-consumption. If output increased
and price fell, society would benefit from enjoying more of the good.
Allocative efficiency occurs at an output of 8.

Firms in perfect competition are said to produce at an allocative efficient level

because at Q1 P=MC

Monopolies allocatively inefficient

Monopolies can increase price above the marginal cost of production and
are allocatively inefficient. This is because monopolies have market power and
can increase price to reduce consumer surplus.

Monopoly sets a price

of Pm. This is allocatively inefficient because Price is greater than MC.

Alloactive efficiency would occur at the point where the MC cuts the Demand
curve so Price = MC.
Allocative efficiency is reached when no one can be made better off without making
someone else worse off. This is also known as Pareto efficiency
Using the production possibility frontier to show allocative efficiency
Pareto defined allocative efficiency as a position where no one could be made
better off without making someone else at least as worth off.
This can be illustrated using a production possibility frontier all points that lie on
the PPF are allocatively efficient because we cannot produce more of one product
without affecting the amount of all other products available

Allocative efficiency is achieved when the value consumers place on a good or

service (reflected in the price they are willing to pay) equals the cost of the resources
used up in production. Condition required is that price = marginal cost. When this
condition is satisfied, total economic welfare is maximised.

Pareto defined allocative efficiency as a situation where no one could be made better
off without making someone else at least as worth off.
Under monopoly, a business can keep price above marginal cost and increase total
revenue and profits as a result. Assuming that a monopolist and a competitive firm
have the same costs, the welfare loss under monopoly is shown by a deadweight
loss of consumer surplus compared to the competitive price and output. This is
shown in the diagram below.

Trade-offs between efficiency and equity

There is often a trade-off between economic efficiency and equity. Efficiency means
that all goods or services are allocated to someone (theres none left over). When a
market equilibrium is efficient, there is no way to reallocate the good or service
without hurting someone. Equity concerns the distribution of resources and is
inevitably linked with concepts of fairness and social justice. A market may have
achieved maximum efficiency but we may be concerned that the "benefits" from
market activity are unfairly shared out.