bulletLearning Objectives
bulletKey Terms
bulletExercises

Learning Objectives

bulletUnderstand the relationship between allocative and productive efficiency
bulletExplain the how allocative efficiency is defined in terms of marginal benefit and marginal cost

     We are only concerned with the first section of this chapter on efficiency. Consumer surplus and producer surplus, covered in subsequent sections, are important concepts in economics, but they probably are not going to come up in the MBA program.

     Efficiency is another term that we use in everyday language that takes on special meanings in economics. Economist are concerned with both productive efficiency and allocative efficiency. If we want to do the best that we can with given resources then an economy must achieve both productive efficiency and allocative proficiency.

     Productive efficiency, termed economic efficiency in Chapter 10, occurs when the cost of producing a given output is as low as possible. Productive efficiency encompasses technological efficiency. If we produce the maximum output given the present set of inputs we have achieved technological efficiency.  This is the type of efficiency that engineers are most often interested in. Productive efficiency, however, also requires that we are using a least-cost combination of inputs in order to produce the existing output.

     For example, a given amount of grain may be produced with a lot of labor and a small amount of capital, or it may be produced with a lot of capital and a small amount of labor. As long as we are producing the maximum amount of output given either set of inputs, then both processes would be technologically efficient. However, given the relative prices of labor and capital, only one of the processes may exhibit productive efficiency. In high labor cost regions like the U.S., it is likely that the capital intensive process would be productively efficient.  It is possible, however,  that technologies that are inefficient in one country may be productively efficient in another country. Low labor cost regions like the third world may find the labor intensive process more productively efficient.

     We have allocative efficiency when we produce the "right" basket of goods. The "right" combination of goods is the market basket that maximizes society's welfare.  Like in "Goldilocks and the Three Bears" we are searching for the level of output for each and every good  that is "just right." This is the concept of efficiency that is emphasized in this chapter. Remember, in a full-employment economy more of one good must mean less of another. Therefore, if we are producing the wrong amount of one good, it must create a distortion in the production of at least one other good.

     It is possible to have productive efficiency without also achieving allocative efficiency.  A firm may be producing its current level of output with the best technology and a least-cost combination of inputs; i.e., it has achieved both technological efficiency and productive efficiency. This doesn't mean, however, that the firm is maximizing profits. It may be producing a level of output that either to small or to large relative to what will be optimally demanded in the market.

     Allocative efficiency can be defined in terms of marginal benefits and marginal cost. Marginal benefit may be thought of as the additional or incremental benefit we derive from having an additional unit of a good. It is not the total benefit we receive from consumption of the good, only the benefit attached to the marginally consumed unit. Since the days of Jeremy Bentham (see his auto-icon) , economists have typically assumed that marginal benefit declines as we consume more of an item. The next unit of a good provides less satisfaction than the previous unit of the good.

      Marginal cost is the additional or incremental cost attached to the production of an additional unit of the good. It is not the total cost of producing the good, only the costs attached to the marginally produced unit. Economists generally assume that marginal cost increases as we produce more of a good. At some point it costs more to produce the next unit than it cost to produce the previous unit.

     The important point is that we can judge whether or not we are at the level of output that maximizes welfare by observing what is happening at the margin. When marginal benefit exceeds marginal cost (MB>MC), the excess of marginal benefit over marginal cost represents a net benefit for society. We could be better off if we produced more of this good. This means we are not   producing an optimal amount of this good. There is too little of the good produced and there is inefficient underproduction of the good.

     When marginal cost exceeds marginal benefit (MC>MB), then it costs us more to produce the last unit than the benefits we derive from that last unit. This means we could be better off if we reduced production. Too much of he good is produced and there is inefficient overproduction of the good.

MB > MC

More production of the good would increase welfare.
(underproduction)

MB = MC

"Just Right!"
(optimal production)

MB < MC

Less production of the good would decrease welfare.
(overproduction)

 

Key Terms

bulletallocative efficiency
bulletefficiency
bulletmarginal benefit
bulletmarginal cost
bulletproductive efficiency
bullettechnical efficiency

Exercises

bullet5.1 Optimal Pollution
bullet5.2 Price Ceiling

 

Tutorial

Internet Links

bulletJeremy Bentham - Short Excerpts

  09/25/07

                           


All rights reserved
Ralph R. Frasca, Ph.D. 2007