Introduction
Tour Itinerary
Destinations
Kitwe
Chingola
Mufulira
Issues
Theories
Supply Side
Dependency Ratio
Dependency Th.
Economic Effic.
Economic Growth
Models
Fisher Clark
Harrod-Domar
Lewis
Rostow
Demo. Trans.
Circular Flow
Neo-Classical
Popn Pyramids
Price Movts
Privatisation
Causes of Growth
Causes of Infl.
Multinationals
Externalities
Probs of Inflation
Worksheets
Resources

Home Field Trips Copper Tour Economic Efficiency

Theories

Economic Efficiency

Next theory - Economic Growth and the Production Possibility Frontier >>

One of the arguments in favour of privatisation is that it leads to improvements in efficiency. In economics we distinguish between two types of efficiency:

• Productive efficiency
• Allocative efficiency

When is a business productively efficient?

A productively efficient firm organises its factors of production in such a way that the average cost of production is at lowest point. In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has enjoyed all the possible benefits of specialisation and no further opportunities for increasing returns exist. This is at the minimum point in the diagram below.

In the long run, when all factors of production can be changed, the scale of the enterprise can be increased. In this case productive efficiency occurs at the optimum scale of output where all the possible economies of scale have been enjoyed and the firm is not large enough to experience diseconomies of scale. This occurs at output level Q2 in the diagram below.

Allocative efficiency

It is argued that increasing the amount of competition in the market will increase allocative efficiency. The need to compete will prevent firms from raising their prices excessively above their costs of production. The greater the competition, the closer the price the firm is able to charge will be to the marginal costs of the firm.

Allocative efficiency is where the countries' firms are producing a combination of goods that maximises the overall level of satisfaction or welfare of the population.

To understand this is important to realise that the factors of production a firm employs are scarce and thus have an opportunity cost. If a firm is able to produce one more unit of a good by utilising more factors of production, somewhere else in the economy a good must be foregone. There are insufficient resources to produce everything. Allocative efficiency occurs where a countries resources are allocated in such as way that it is impossible to reallocate factors of production and further increase welfare. If all the factors of production are being utilised efficiently the only way that someone can be made better off through the production and consumption of an extra good is if someone is worse off, because they are having to sacrifice a good. If it is possible to reorganise production and make someone better off without making someone equally worse off then clearly the welfare of society was not being maximised.

The condition where it is impossible to make one person better off without making someone else correspondingly worse off is called a Pareto optimal allocation of resources.

This begs two key questions for you to think about:

• How do we know when a firm is allocatively efficient?
• What type of market environment is likely to lead to the allocative efficiency?

The relationship between price and marginal cost

The price paid for a good or service is a measure of the benefit that a consumer derives from consumption of one more unit of that good or service. If you did not gain 50 pence worth of satisfaction from consuming a 50 pence can of Coke, you would not purchase it! One of the functions of money after all is a measure of value.

The marginal cost of production represents the costs of all the factors of production involved in producing one extra unit. As we have said all factors of production are scarce and have an opportunity cost. The marginal cost of producing a can of Coke represents the opportunity cost of the factors of production and crucially therefore a measure of the loss in welfare from someone who has had to forgo an alternative good produced using the resources.

If the price of a good is greater that the marginal cost of producing it then by producing and selling it the overall level of welfare in society has increased. A numerical example may help.

If the price of a good is 10 kwacha and the marginal cost 5 kwacha then the production and sale of the good will increase the consumer' welfare by 10 kwacha but decrease someone else's welfare by 5 kwacha. Overall there is a net gain of 5 kwacha.

If the price of a good is equal to that the marginal cost of producing it then by producing and selling it the overall level of welfare in society has not increased but only remained the same.

If the price is 10 kwacha and the marginal cost 10 kwacha then the production and sale of the good will increase the consumer' welfare by 10 kwacha but also decrease someone else's welfare by 10 kwacha. Overall there is no net gain to society. Consequently, there is a Pareto optimal allocation of resources and allocative efficiency.

This argument is put forward by those who advocate increased competition. In highly competitive markets the price will pushed down to a point where the marginal costs of production are covered. Deregulation and privatisation will, according to economists, increase the level of competition and facilitate this happening.

Next theory - Economic Growth and the Production Possibility Frontier >>

Related Glossary Items:
Marginal Cost
Pareto Optimal
Long run average cost curve
Productive efficiency
Allocative efficiency

Related Theories:
Economic Growth and the Production Possibility Frontier
The Arguments for Privatisation
The Causes of Economic Growth
Supply Side Approaches