Efficiency And Market Failure (Copy)
7.3.1 Definitions of Productive Efficiency and Allocative Efficiency
- Productive Efficiency
- Occurs when a firm or economy produces goods and services at the lowest possible cost.
- All resources are fully utilised and no waste occurs.
- It is achieved when production is on the lowest point of the average cost (AC) curve.
- Implication: Maximum output is produced from given inputs.
- Allocative Efficiency
- Occurs when resources are allocated to produce the combination of goods and services most desired by consumers.
- The value consumers place on a good equals the cost of resources used to produce it.
- Achieved when Price (P) = Marginal Cost (MC).
- Implication: The mix of goods produced matches consumer preferences perfectly.
7.3.2 Conditions for Productive Efficiency and Allocative Efficiency
| Efficiency Type | Condition | Explanation |
|---|---|---|
| Productive Efficiency | Produce at lowest average cost: AC is minimum | No resources wasted; cost per unit minimized |
| Allocative Efficiency | Price equals marginal cost: P = MC | Value to consumers equals cost of production |
- Graphical Representation:
- Productive efficiency at minimum of AC curve.
- Allocative efficiency at output where P = MC on the supply curve.
7.3.3 Pareto Optimality
- Definition:
- A state of resource allocation where no one can be made better off without making someone else worse off.
- It is a condition for economic efficiency.
- Implies an allocation is efficient but not necessarily equitable.
- Application:
- All points on the contract curve (between indifference curves and production possibility frontier) are Pareto efficient.
- Limitations:
- Does not account for fairness or distribution of wealth.
7.3.4 Definition of Dynamic Efficiency
- Dynamic Efficiency:
- Efficiency over time in adapting to changing conditions, such as new technologies, innovation, and improvements in production processes.
- Firms invest in research and development (R&D), improving productivity and consumer choice in the future.
- Markets are dynamically efficient if they promote long-term growth and innovation.
7.3.5 Definition of Market Failure
- Market Failure:
- Occurs when the free market fails to allocate resources efficiently, leading to a loss of economic and social welfare.
- The market outcome is not Pareto efficient.
- Causes include externalities, public goods, information asymmetry, monopoly power, and common access resources.
7.3.6 Reasons for Market Failure
| Reason | Explanation |
|---|---|
| Externalities | Costs or benefits affecting third parties not reflected in market prices (e.g., pollution) |
| Public Goods | Goods that are non-excludable and non-rivalrous; free-rider problem prevents private provision |
| Information Asymmetry | When one party has more or better information than the other, causing inefficient outcomes |
| Monopoly Power | Firms with market power can restrict output and raise prices above competitive levels |
| Common Access Resources | Resources like fisheries or forests subject to overuse and depletion (tragedy of the commons) |
- These failures justify government intervention to improve outcomes.
Diagrams
Diagram 1: Productive Efficiency (Minimum AC)
Cost
↑
| AC
| /
| /
| / ______
| /
|____/____________________→ Output (Q)
- Productive efficiency at minimum point of AC.
Diagram 2: Allocative Efficiency (P = MC)
Price/Cost
↑
| S=MC
| /
| /
|____/________________________ Demand
| /
| /
| /
|_/_____________________________→ Output (Q)
- Allocative efficiency where P = MC.
Diagram 3: Pareto Optimality Concept
Utility Person A
↑ Pareto Frontier
| * *
| * *
| * *
|_____________________________→ Utility Person B
- No movement possible without making one worse off.
Diagram 4: Market Failure Example — Negative Externality
Price/Cost
↑
| MSC (Marginal Social Cost)
| /
| /
| /
| /
| /
|/____________________________ MPC (Marginal Private Cost)
|
|
| Demand
|
|_____________________________→ Output (Q)
- MSC > MPC due to external costs (e.g., pollution).
- Market produces Qm > Q* (social optimum).