Cambridge International as and a level Economics Ebook

Figure 6.2
 
Productive eff iciency in an economy
Capital goods
Consumer goods
0
Y
X
0
Price
Quantity
q
p
Marginal cost
Average cost
Average
revenue
=
marginal
revenue
Figure 6.3
 
Productive eff iciency and perfect competition
Figure 6.1
 
Productive eff iciency for a firm
Costs
Output
Average costs
of production
0
P
q
x
131
Chapter 6: Basic economic ideas and resource allocation

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Allocative eff iciency
It is not enough for products to be produced at the lowest 
possible cost. Th
e right products must also be produced 
if there is to be economic effi
ciency. Allocative effi
ciency 
is all to do with allocating the right amount of scarce 
resources to the production of the right products. Th
is 
means producing the combination of products that 
will yield the greatest possible level of satisfaction of 
consumer wants.
As stated earlier, the point of allocative effi
ciency can 
be deemed to exist when the price of a product is equal 
to its marginal cost of production, the cost of producing 
one more unit of output. In this situation, the price paid 
by the consumer will represent the true economic cost of 
producing the last unit of the product. Th
is should ensure 
that precisely the right amount of the product is produced. 
Th
is idea can be shown through the simple example in 
Table 6.1.
For this product, an output of one unit would not be 
productively effi
cient. Here, the cost of producing the 
product is less than the value put on it by the consumer 
(as represented by the price that the consumer is willing 
to pay for that product). Th
e product should certainly 
be produced, but there is scope for further worthwhile 
production from this point. Th
is is also true when two or 
three units of the product are made. On the other hand, 
an output of seven units of the product should not be 
produced. Here, the seventh unit costs $8 to produce but 
is only valued at $5 by the consumer. Th
e same problem 
exists with output levels of fi ve and six. Th
us, there is only 
one ideal output level (that is, one output level that will 
yield allocative effi
ciency) and that is an output of four 
units where price is equal to the marginal cost.
It should be noted that, unlike productive effi
ciency, 
it is not possible to illustrate allocative effi
ciency on the 
production possibility frontier. Any point on the frontier 
could potentially be such a point provided price is equal to 
marginal cost at this point. Th
e exact location will depend 
upon consumer preferences and these are not part of 
this model.
A competitive market can lead to allocative effi
ciency. 
In such a market, fi rms are constrained to produce those 
products that consumers most desire relative to their cost 
of production. As with productive effi
ciency, there are two 
motivations. First, the desire to make the greatest possible 
profi t will drive fi rms to produce such products and will 
lead to the highest possible demand and hence the greatest 
revenue and profi ts. Second, fi rms in competitive markets 
will be forced to produce those products most demanded 
by consumers as other fi rms will certainly also do so. A 
failure to produce such products in this sort of market will 
force fi rms to close.
An alternative way to consider how a competitive 
market will achieve allocative efficiency is through 
the perfectly competitive diagram as shown earlier 
in 
Figure 6.3
. It can be seen that the point of 
equilibrium in this diagram (price 
p
and output 
q
) 
is a position at which price is equal to marginal cost. 
This is the requirement for allocative efficiency as 
explained above.
Th
e suggestion is thus made that in fully (or perfectly) 
competitive markets there will be economic effi
ciency. 
Both productive and allocative effi
ciency will exist. As will 
be shown in 
Chapter 7,
this is the only market structure 
where this is evidenced.