I will be discussing the first two factors above. The first question links with allocative efficiency and the second one is associated with productive efficiency. Allocative efficiency can only be achieved if goods supplied match exactly with the wants and needs of society. For example, an economy that produces fruit and vegetables exists, and the population prefer fruit to vegetables, then for allocative efficiency to occur , more fruit must be produced than vegetables. This idea can be expressed on a PPC:
In the diagram above, both points are productively efficient because the resources are being used to make the maximum quantity of fruit and vegetables. However, only point A is allocatively efficient because it is the ratio of fruit to vegetables that the population wants. Point A could also be called economically efficient because it fulfils both of the factors. Point be can never be economically efficient because it only fulfils one factor.
If the market system is operating efficiently then the levels of fruit and vegetable production should adjust automatically. This is because if more vegetables are produced than demand dictates then a surplus will occur. This will result in a fall in vegetable prices which in turn will cause some producers to stop supplying it and switch to fruit production.
Efficiency under competition is different. When a product is in demand, its price will rise. Naturally, suppliers will increase production, but by how much should they increase it?
The market price of this good is £10, so, in other words, people value this product at £10. Simply, the manufacturer should increase production until his marginal costs reach £10. Over £10 it would be unwise to increase production. To conclude, allocative efficiency exists where P=MC.
Productive efficiency is where a firm is using all resources to produce goods at the lowest possible cost. To put it another way, if a firm is producing on the lowest point of the average cost curve, it is productively efficient. q* is the level of output associated with productive efficiency.
In a situation where perfect competition existed, then both productive and allocative efficiency could exist. However, in the real world, they can only be set as targets. The market will never produce things in exactly the right quantities to meet peoples requirements, as is shown by food mountains and bargain bins. Productive efficiency is nearer to being achieved, but until workers are pushed to their maximum potential and machines developed which use their resources 100% efficiently, it cannot be reached. However, if we do reach it this sentence will still apply: ‘it is impossible to make one person better off without making another person worse off’.
