Dynamic Efficiency
Definition
Dynamic efficiency: the improvement in efficiency over time as firms invest in research, innovation and new technology to lower costs and improve products.
Static efficiency: efficiency judged at a single point in time, covering productive efficiency (MC = AC) and allocative efficiency (P = MC).
- Dynamic efficiency is driven by reinvesting profit into research, innovation and new technology.
- Its gains appear only over time, as a lower average cost curve and better products.
- So it can justify a short-run static welfare loss if long-run innovation follows.
Key Idea
- Supernormal profit, a static welfare loss, can be the fund that pays for dynamic gains.
- Weigh a static loss today against dynamic gains over time when judging market structures.
What Drives It
- Spending on research and development (R&D) discovers cheaper methods and better products.
- Investment in physical and human capital raises productivity over time.
- Technological change shifts the average cost curve downwards and widens consumer choice.
Example
- AstraZeneca reinvests a large share of its profit into R&D, spending several billion pounds a year on new medicines and production methods.
- A new process it develops cuts average cost from £20 to £15 a unit and its new drugs widen the range of treatments available.
- The lower cost curve is dynamic efficiency, even though the profit that funded it looked like a static welfare loss to consumers.
Use in Evaluation
- A monopoly may be statically inefficient because price > marginal cost (P > MC).
- Yet its supernormal profit can fund R&D that a small, low-profit firm could not afford.
- So the static loss must be weighed against the possible dynamic gains.
- It depends on whether the firm actually reinvests: a sheltered monopoly may grow complacent and X-inefficient, delivering neither static nor dynamic efficiency.
Exam technique
- Set static welfare losses against possible dynamic gains when evaluating market structures.
- Link supernormal profit explicitly to the funds available for research and development.
Common Mistake
- Do not treat efficiency as purely static.
- Ignoring long-run innovation misses the dynamic efficiency argument entirely.
Self review
- Define dynamic efficiency.
- How does it differ from static efficiency?
- Name two drivers of dynamic efficiency.
- Why can supernormal profit support dynamic efficiency?
