Understanding Economic Efficiency

Economic Efficiency

• Economic efficiency is achieved when scarce resources are utilized in the most effective way to satisfy the wants with limited resources.
• It is desired as it offers the best solution to the economic problem.
• Production takes place at the lowest possible average cost under productive efficiency.
• Firms produce the combination of goods/services most desired by consumers with the fewest resources under allocative efficiency.
• No waste occurs, and consumer and producer satisfaction is met.
• The prices consumers are willing to pay reflect preferences and benefits derived from consumption.
• Marginal costs measure the opportunity cost to produce one more unit; when Price = Marginal Cost, consumers are prepared to pay.
• A requirement for allocative efficiency is where Price = MC.
• When productive and allocative efficiency coexist, the best use of scarce resources is being made, leading to efficient resource allocation = economic efficiency.

Productive Efficiency

• Achieved with the fewest resources and at minimal costs, shown by average costs (AC) curve (y-axis) and output (x-axis).
• Possible when an economy produces right on the boundary of its Production Possibility Frontier (PPF)
• PPF shows the best possible combination of two products given the resource amount.
• Competition serves as a healthy catalyst.

Allocative Efficiency

• The correct products must be produced to align consumer and producer interests.
• Involves allocating the right amount of resources to the right products (demand).
• Production should yield maximum consumer satisfaction.
• Allocative efficiency isn't directly illustrated on a PPC like productive efficiency; any point on the PPF can be allocatively efficient if P=MC.

Market Efficiency Concerns

• Competitive markets lead to allocative efficiency as firms produce highly consumer-desired products.
• Two motivations for firms:
  • Desire to maximize profit by meeting high demand.
  • Competitive pressure to produce needed products or risk market failure.
• Productive efficiency is concerned with producing goods at the minimum cost.
• Allocative efficiency optimizes the distribution of goods/services to satisfy consumer desires.

Pareto Optimality: Resource Perfection

• States that resources are so perfect that one person could better off making others worse off.
• Resources cannot be reallocated in a more efficient way.

Economic Efficiencies

• Efficiency and Inefficiency stem from PPC

Dynamic Efficiency

• Benefits firms over time.
• Requires initial investment (costs) with later payoffs.
• Output increases relative to the increase in resources when resources are reallocated.
• Results from new production processes, technological improvements, and innovation.
• Represented by long-run average cost (LR-AC) curve.

X-Inefficiency

• Occurs if the actual LR-AC is higher than potentially possible due to organizational slack and low competition.

Market Failure: Failures in Optimal Resource Allocation

• Occurs when market mechanisms fail to allocate resources optimally, hindering productive and/or allocative resource allocation.
• Reasons for market failure:
  • Externalities (effects on a 3rd party not involved in the transaction)
  • Merit or demerit goods
  • Public and quasi-public goods
  • Information failure
  • Adverse selection and moral hazards
  • Abuse of monopoly power

Externalities: Decision and Transaction Effects

• Economic decisions require suppliers and consumers who are influenced by externalities.
• If a transaction affects another party, an externality arises.
• Side or spillover effects occur on parties not part of the transaction.

Positive Externalities

• Benefits third parties.
• Production: When production activities lead to medical research and reduce disease incidence.
• Key for governments to provide merit goods as it relates to Consumption
• Secondary education offers employment, reduced unemployment, and improves economic prospects.

Negative Externalities: Unexpected Costs

• Impacts and detriment to third parties
• Production: Production activities may cause pollution, leading to additional community costs.
• Consumption:
  • Passive smoking.
  • CO2 emissions cause global warming.

Externalities: Private, External, and Social Costs

• Refers to the divergence between private and social action costs of an action.
• Private: Paid for by the producer of a good or service.
• Social: Total cost to society from producing a good or service.
• With no externality, there is no difference in allocation relative to cost.
• Externality shifts the cost to third parties as external costs.
• Social costs equal private costs plus external costs.
• Private and social costs align, indicating no externalities.

Social Benefits

• Private benefits plus external benefits.
• Private and should benefits align in order to outweigh the private gains.

Externalities: The Core Problem

• Presents an inappropriate resource allocation, causing too little goods or services that free markets produce that leads to inefficiency.
• Production impacts a chemical firm as an example
• Private costs paid by the decision-maker
  • Raw material, labor, energy and distribution costs and part of any social costs are factored in by the firm.
• Further costs are negative externalities
  • Chemical waste clean up, atmospheric and road contamination due to transportation.

Cost Benefit Analysis

• Aids with decision making in the economy
• Evaluates large-scale investment projects, which considers prospective benefits and costs associated with the project(s).

Why Use Cost Benefit Analysis?

• Conventional financial appraisals for corporate usage regarding the cost and benefits might not be appropriate when considering external factors.
• CBA is all encompassing view that assess decisions
• Considers long, wide, and overall impacts and views.
• Attempts to quantify possible outcomes
• Used when no market price available for a certain cost/benefit imputes a shadow price.