As you know, economic resources are scarce and economics studies how to allocate these resources efficiently. But, how do you measure economic efficiency? What makes an economy efficient? This explanation will help you understand what we talk about when we say economic efficiency and the different types of economic efficiency
Economic efficiency definition
The fundamental economic problem that must be solved efficiently is the problem of scarcity. Scarcity exists because there are limited resources, such as natural resources, labor, and capital, but unlimited wants and needs. Therefore, the challenge is to allocate these resources in the most efficient way possible to satisfy as many wants and needs as possible.
Economic efficiency refers to a state where resources are allocated in a way that maximizes the production of goods and services. This means that the available resources are used in the most efficient manner possible, and there is no waste.
Economic efficiency is achieved when the allocation of resources maximizes the production of goods and services, and all waste is eliminated.
Economic efficiency is important because it allows businesses to reduce their costs and increase output. For consumers, economic efficiency leads to lower prices for goods and services. For the government, more efficient firms and higher levels of productivity and economic activity increase economic growth.
Types of economic efficiency
The different types of economic efficiency are:
- Productive efficiency - this occurs when a firm produces goods and services at the lowest possible cost, given the current technology and resources.
- Allocative efficiency, also referred to as Pareto efficiency, occurs when resources are allocated to their most valuable use, such that no one can be made better off without making someone else worse off.
- Dynamic efficiency occurs when a firm is able to improve its productive efficiency over time through innovation and learning.
- Static efficiency occurs when a firm produces goods and services at the lowest possible cost, given the current technology and resources, without any improvement over time.
- Social efficiency occurs when the benefits of economic activity are greater than its costs to society as a whole.
- X-efficiency refers to the ability of a company to use its resources in the best way possible to produce the most output from a given level of inputs. This is more likely to occur when a company operates in a highly competitive market where managers are motivated to produce as much as they can. However, when a market is less competitive, such as in a monopoly or oligopoly, there is a risk of losing X-efficiency, due to a lack of motivation for managers.
Productive efficiency
This term refers to when output is maximised from the available inputs. It occurs when an optimal combination of goods and services produces maximum output while achieving minimum cost. In simpler terms, it is the point where producing more of one good would reduce the production of another.
Productive efficiency occurs when output is fully maximised from the available inputs. Productive efficiency occurs when it is impossible to produce more of one good without producing less of another. For a firm, productive efficiency occurs when the average total cost of production is minimised.
The production possibility frontier (PPF)
A production possibility frontier (PPF) can be used to further explain productive efficiency. It shows how much an economy can produce given existing resources. It highlights the different options an economy has for resource allocation.
Fig. 1 - The Production Possibility Frontier
Figure 1 shows a production possibility frontier (PPF). It shows the maximum level of output from available inputs at every point on the curve. The curve aids in explaining the points of productive efficiency and productive inefficiency.
Points A and B are considered points of productive efficiency because the firm can achieve maximum output given the combination of goods. Points D and C are considered points of productive inefficiency and thus wasteful.
If you would like to learn more about PPF curves check out our Production Possibility Curve explanation!
Productive efficiency can also be illustrated with another graph shown in Figure 2 below.
Fig. 2 - Productive efficiency with AC and MC curves
Productive efficiency is achieved when a firm is producing at the lowest point on the short-run average cost curve (SRAC). I.e where marginal cost (MC) meets average cost (AC) on the graph.
Dynamic Efficiency
Dynamic efficiency is about a firm's ability to improve its production efficiency over time by adopting new technologies, processes, and products. We can illustrate dynamic efficiency through an example of a t-shirt printing business.
A printing business starts out by using a single printer with a capacity of printing 100 t-shirts in 2 days. However, over time, the business is able to grow and improve its production by using a big scale printer. They now produce 500 printed t-shirts a day, thereby reducing cost and increasing productivity.
This business has improved its production process while reducing its costs over time.
Dynamic efficiency occurs when a firm is able to lower its long-run average costs through innovation and learning.
Economic Efficiency: Factors affecting dynamic efficiency
Some factors that affect dynamic efficiency are:
- Investment. Investing in technology and more capital can lower future costs.
- Technology. Improved technology in a firm can help reduce costs.
- Finance. Accessibility to finance will aid a firm in investing more capital to improve production, which will enable cost reduction.
- Motivating the workforce. Encouraging and motivating workers and managers can enable a firm to reduce costs.
Static efficiency
Static efficiency is concerned with efficiency at a particular point in time, given the current state of technology and resources. This is a type of economic efficiency focused on the best combination of existing resources at a particular time. It is producing at the lowest point on the short-run average cost (SRAC).
Economic Efficiency: Difference between dynamic and static efficiency
Dynamic efficiency is concerned with allocative efficiency and with efficiency over a period of time. For example, it examines whether investing in technological development and research over a period of time will help a firm be more efficient.
Static efficiency is concerned with productive and allocative efficiency and efficiency at a particular time. For example, it examines whether a firm can produce 10,000 units a year cheaper by using more labour and less capital. It is concerned with producing outputs at a specific time by allocating resources differently.
Allocative efficiency
This is a situation where goods and services are distributed satisfactorily according to consumers' preferences and willingness to pay a price equivalent to the marginal cost. This point is also known as the allocative efficient point.
Allocative efficiency is a type of efficiency focused on the optimum distribution of goods and services, taking into consideration consumers’ preferences. Allocative efficiency occurs when the price of a good is equivalent to the marginal cost, or in a shortened version, with the formula P = MC.
Everyone in society needs a public good such as healthcare. The government provides this healthcare service in the market to ensure allocative efficiency.
In the UK, this is done through the National Healthcare Service (the NHS). However, the queues for the NHS are long, and the toll on the service may be currently so high that it means that this merit good is under-provided and not allocated to maximise economic welfare.
Figure 3 illustrates allocative efficiency on a firm/individual level and the market as a whole.
Fig. 3 - Allocative efficiency
For firms, allocative efficiency occurs when P=MC. For the whole market, allocative efficiency occurs when supply (S) = demand (D).
Social efficiency
Social efficiency occurs when resources are optimally distributed in a society and the benefit derived by an individual doesn't make another person worse off. Social efficiency occurs when the benefit of production is not greater than its negative effect. It subsists when all benefits and costs are considered in producing an extra unit.
Economic Efficiency and Externalities
Externalities occur when the production or consumption of a good causes a benefit or cost impact on a third party that doesn’t have a direct relation to the transaction. Externalities can be positive or negative.
Positive externalities occur when the third party gets benefits from the good production or consumption. Social efficiency occurs when a good has a positive externality.
Negative externalities occur when the third party gets a cost from the good production or consumption. Social inefficiency occurs when a good has a negative externality.
The government introduces a taxation policy that helps reduce the environmental footprint and make firms more sustainable, thereby protecting the community from a polluted environment.
This policy also helps other communities by ensuring other firms and start-ups do not pollute the environment. This policy has brought about a positive externality and social efficiency has occurred.
Interestingly, we can see how efficiency is promoted through one market in particular: the financial market.
Financial markets play a key role in the growth, development, stability, and efficiency of an economy. The financial market is a market where traders buy and sell assets such as stocks, which exist to ensure the flow of money in the economy. It is a market that promotes the transfer of excess available funds to areas experiencing a scarcity of funds.
Furthermore, financial markets promote economic efficiency as they give the market participants (consumers and businesses) an idea of the return on investments and how to direct their funds.
The financial market provides an opportunity for participants to meet their needs of borrowing and lending by matching products to borrowers at varying interest rates and risks while giving lenders a variety of opportunities to lend funds.
This promotes efficiency as it provides a good mix of products required by society. It directs funds from savers to investors.
Economic efficiency examples
Here are examples of economic efficiency for different economic efficiency types:
| Type of efficiency | Examples of economic efficiency |
| Productive efficiency | A manufacturing company producing the maximum number of units of a product possible using the least amount of resources, such as raw materials and labor. |
| Allocative efficiency | A government allocating resources to the most beneficial projects, such as investing in infrastructure that will provide the greatest benefit to society as a whole. |
| Dynamic efficiency | A technology company constantly innovates and developing new products to stay competitive in the market and improve its efficiency over time. |
| Social efficiency | A renewable energy company producing clean energy that benefits both the environment and the economy, reducing the costs associated with pollution and health impacts while providing jobs and economic growth. |
Economic Efficiency - Key takeaways
- Economic efficiency is achieved when the allocation of resources maximizes the production of goods and services, and all waste is eliminated.
- Economic efficiency can be improved by reducing waste or inefficiency in the production process. This can be achieved in various ways, such as by adopting more efficient production technologies, reducing unnecessary inputs, improving management practices, or better utilizing existing resources.
- Productive, allocative, dynamic, social, and static are types of economic efficiency.
- Productive efficiency occurs when a firm produces goods and services at the lowest possible cost, given the current technology and resources.
- Allocative efficiency ccurs when resources are allocated to their most valuable use, such that no one can be made better off without making someone else worse off.
- Dynamic efficiency is efficiency over a period of time, for example, the long run.
- Static efficiency is efficiency at a particular time, for example, the short run.
- The roduction possibility frontier is used to show output maximisation given the available inputs.
- Social efficiency occurs when the production or consumption of a good brings about benefits to third parties.
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