Two Types of Efficiency
Definition
Productive efficiency: producing a given output at the lowest possible average cost, reached where marginal cost cuts average cost (MC = AC).
Allocative efficiency: producing the combination of goods consumers most value, reached where price = marginal cost (P = MC).
- Efficiency asks whether scarce resources are being used in the best possible way.
- Productive efficiency asks how cheaply a given output can be made.
- Allocative efficiency asks whether the right goods are made in the right quantities.
- A market can achieve one type while missing the other, so both must be tested separately.
Key Idea
- Productive efficiency is about least-cost production.
- Allocative efficiency is about producing the mix of goods society most wants.
Productive Efficiency
- A firm is productively efficient at the minimum point of its average cost (AC) curve, where MC = AC.
- At that point no rearrangement of inputs could lower average cost, so no resources are wasted per unit.
- For the whole economy, productive efficiency means producing on the production possibility curve (PPC); a point inside the PPC wastes resources and is productively inefficient.
Example
- Aldi stocks around 1,800 product lines against a large Tesco store's 30,000+, displays stock on pallets and runs tills with few staff, cutting inputs per £1 of sales.
- Fewer inputs per unit sold pull average cost below rivals', so Aldi operates near the minimum of its AC curve → productively efficient, which lets it price below the big four.
- A rival carrying surplus staff and unsold stock makes the same sales at a higher average cost, wasting resources → productively inefficient.
Allocative Efficiency
- Allocative efficiency is reached where price = marginal cost (P = MC).
- Price measures the value consumers place on the last unit, and marginal cost measures the resources used to make it.
- If P > MC the good is under-produced; if P < MC it is over-produced; only at P = MC is total welfare maximised.
Example
- A patented drug is sold at £12 a pack while the marginal cost of an extra pack is only £8, so P > MC.
- Consumers value the last pack (£12) above the resources used to make it (£8), so too few packs are produced and welfare is lost → allocatively inefficient.
- When the patent expires and competition drives price down towards £8, output expands until P = MC and the lost welfare is recovered.
A Point in Time
- Both are forms of static efficiency, judged at a single moment with technology held constant.
- Together they are the benchmark for judging how well a market structure uses resources.
- Perfect competition achieves both in long-run equilibrium, while monopoly typically achieves neither: though it depends, since a monopoly's scale can lower AC and its supernormal profit can fund innovation.
Exam technique
- Write price = marginal cost (P = MC) when defining allocative efficiency.
- Write lowest average cost (MC = AC), or production on the PPC, for productive efficiency.
Common Mistake
- Do not confuse the two conditions.
- Allocative efficiency is the right mix of output (P = MC), while productive efficiency is least-cost production (MC = AC).
Self review
- Define productive efficiency.
- Define allocative efficiency.
- At what price condition does allocative efficiency occur?
- Where on the cost curve is a firm productively efficient?
