PRODUCTIVE AND ALLOCATIVE EFFICIENCY



PRODUCTIVE AND ALLOCATIVE EFFICIENCY

Productive efficiency has two aspects:

1) Productive efficiency within each firm

• Productive efficiency for the firm requires the firm to be producing its output at the lowest possible cost.

• Productive efficiency of the industry requires that the marginal cost of production be the same for each firm.

• See example on age 281 of note.

If firms are producing on their production possibilities boundary, the they are producing efficiently because every point on the production possibilities boundary is efficient. Is there some point on the PPB that is better than others. This brings us to the concept of allocative efficiency.

2) Allocation of production among the firms in the industry.

• The economy is allocatively efficient when, for each good produced, its marginal cost of production is equal to its price.

• People will continue to consume a product as long as the value they get from consuming an additional unit is greater than or equal to the price.

• Once price exceeds the value of the additional unit (marginal value), people will stop consuming.

Since people consume when MV = P and allocative efficiency occurs where MC = P, then allocative efficiency occurs where MC = MV

See Figure 12-3 on page 284.

EFFICIENT MARKET STRUCTURES.

Productive efficiency - all firms must be minimizing their costs and marginal cost should be the same for all firms in any one industry.

Allocative efficiency - marginal cost should be equal to price in each industry.

Perfect Competition

As we already discovered, in the long-run under perfect competition, each firm produces at the lowest point on its long-run average cost curve. Therefore, no one firm could reduce its costs by altering its own production. Every firm in perfect competition is therefore productively efficient.

We have already seen that perfectly competitive firms maximize their profits by choosing an output level such that marginal cost equals market price. Thus, when perfect competition is the market structure for the whole economy, price is equal to marginal cost in each industry, resulting in allocative efficiency.

Monopoly

Monopolists have an incentive to be productively efficient because their profits will be maximized when they adopt the lowest-cost production method. Hence, profit maximizing monopolists will operate on their LRAC curves and thus be productively efficient.

A monopolist will choose and output at which the price charged is greater than the marginal cost. Such a choice violates the conditions for allocative efficiency because price, and hence the marginal value to consumers, exceeds the marginal cost of production.

Therefore, monopoly is not allocatively efficient because the monopolist’s price always exceeds its marginal cost.

Other Market Structures

The allocative inefficiency of monopoly extends to other imperfectly competitive markets such as oligopoly or monopolistic.

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