Efficiency And Market Failure (Copy)
7.3 Efficiency and Market Failure
7.3.1 Definitions of Productive Efficiency and Allocative Efficiency
- Productive Efficiency: Producing goods/services at the lowest possible average cost (using resources fully and efficiently).
- Allocative Efficiency: Producing the combination of goods/services that maximises society’s welfare — where P = MC (price equals marginal cost).
Table – Productive vs. Allocative Efficiency:
| Efficiency Type | Definition | Key Condition | Outcome |
|---|---|---|---|
| Productive | Lowest cost production | Producing on PPF / lowest point of AC curve | Maximum output from given inputs |
| Allocative | Right mix of goods | P = MC | Resources allocated to goods most valued by society |
7.3.2 Conditions for Productive Efficiency and Allocative Efficiency
- Productive Efficiency Conditions:
- Firms produce on the production possibility frontier (PPF).
- Firms operate at lowest point on average cost curve in long run.
- No waste of resources.
- Allocative Efficiency Conditions:
- P = MC.
- Marginal benefit to society equals marginal cost.
- Goods distributed to those who value them most.
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7.3.3 Pareto Optimality
- A situation where it is impossible to make someone better off without making someone else worse off.
- At Pareto optimality → resources are efficiently allocated.
- All points on PPF are Pareto efficient; points inside PPF are not.
7.3.4 Definition of Dynamic Efficiency
- Efficiency over time — occurs when firms improve products/processes through innovation and investment.
- Links to technological progress, R&D spending, and long-run competitiveness.
7.3.5 Definition of Market Failure
- Occurs when the market fails to allocate resources efficiently, leading to a loss of economic welfare.
- Exists when equilibrium output ≠socially optimal output.
7.3.6 Reasons for Market Failure
Table – Major Causes of Market Failure:
| Cause | Explanation | Example |
|---|---|---|
| Public goods | Non-excludable, non-rival → no profit incentive for private provision | Street lighting |
| Externalities | Costs/benefits on third parties not reflected in prices | Pollution |
| Information failure | Buyers/sellers lack perfect information | Second-hand cars |
| Monopoly power | Firms restrict output and raise prices | Utility companies |
| Factor immobility | Labour/capital cannot move freely | Regional unemployment |
| Inequality | Resources unfairly distributed | Wealth gap |
| Missing markets | No market exists for certain goods | National defence |