7.3 Efficiency and Market Failure

7.3 Efficiency and Market Failure – Full Revision Notes

7.3.1 Definitions of Productive and Allocative Efficiency

Productive Efficiency

Productive efficiency occurs when an economy or firm produces the maximum output using the minimum input or resources. This means:

• All resources are fully employed.

• Production takes place at the lowest possible average total cost.

• Occurs at the lowest point of the average cost (AC) curve.

• Lies on the Production Possibility Frontier (PPF) – no additional output can be gained without reducing another.

Productive efficiency also aligns with technical efficiency, where the firm uses the most efficient mix of capital and labor. For example, a factory is productively efficient if it cannot produce more of one product without producing less of another.

Allocative Efficiency

Allocative efficiency refers to a state where resources are distributed according to consumer preferences and societal needs. It occurs when:

• Price (P) = Marginal Cost (MC).

• The value that consumers place on a good (reflected in the price) is equal to the cost of producing one additional unit.

• There is no over- or under-production of goods or services.

• Consumer satisfaction and welfare are maximized.

Allocative efficiency represents the socially optimal output level – where marginal social benefit equals marginal social cost.

7.3.2 Conditions for Productive and Allocative Efficiency

Conditions for Productive Efficiency:

• Operating on the PPF curve, not inside it.

• Using optimal combination of inputs (labor, capital).

• No idle resources; all factors of production are fully utilized.

• Minimum cost production – occurs at the lowest point on the Long-Run Average Cost (LRAC) curve.

• Firms are using best available technology.

Conditions for Allocative Efficiency:

• Price equals marginal cost: P = MC.

• Goods and services are produced based on what consumers most desire.

• There is no deadweight loss in the market.

• Occurs in perfect competition ideally.

• Requires well-informed consumers and producers.

7.3.3 Pareto Optimality

Pareto Optimality (or Pareto Efficiency) is a situation where it is impossible to make one individual better off without making another worse off. This concept:

• Is achieved when resources are allocated most efficiently.

• Lies on the PPF curve – every point on the frontier is Pareto efficient.

• Pareto Improvement happens when a change benefits at least one person without harming anyone else.

Example: Building a new airport may benefit the wider economy, but harm local residents due to noise. This is not Pareto efficient unless the locals are compensated to offset their loss.

Limitations:

• In practice, it is difficult to compensate losers.

• High administrative and social costs make Pareto optimality rarely achievable in reality.

7.3.4 Definition of Dynamic Efficiency

Dynamic efficiency refers to the ability of an economy or firm to improve its productive efficiency over time. It involves:

• Innovation, R&D, and technological advancement.

• Lowering costs over time by improving production processes.

• Movement of Short-Run Average Cost (SRAC) and Long-Run Average Cost (LRAC) curves downward.

A dynamically efficient firm:

• Continuously invests in new methods.

• Keeps up with changing consumer demand.

• Is responsive to long-term changes in the market.

Dynamic efficiency is important for sustained economic growth and competitiveness.

7.3.5 Definition of Market Failure

Market failure occurs when the free market fails to allocate resources efficiently, leading to a loss of economic and social welfare.

Key characteristics:

• Either productive or allocative efficiency is not achieved.

• Results in overproduction, underproduction, or missing markets.

• Leads to a situation where marginal social benefit ≠ marginal social cost.

Market failure justifies government intervention to correct the inefficiencies and promote welfare.

7.3.6 Reasons for Market Failure

1. Externalities

Externalities are third-party effects not reflected in market prices.

• Negative externality: Production or consumption imposes a cost on others (e.g., pollution).

• Positive externality: Benefits are enjoyed by others (e.g., education, vaccination).

Externalities distort prices and lead to over- or under-consumption.

2. Public Goods

Public goods are:

• Non-excludable – no one can be excluded from use.

• Non-rival – one person’s use does not reduce availability for others. Examples: street lighting, national defense.

These goods suffer from the free-rider problem, where people benefit without paying, leading to missing markets.

3. Information Failure

Occurs when consumers or producers do not have full or accurate information to make rational decisions.

• Leads to misallocation of resources.

• Example: Overconsumption of demerit goods like alcohol.

4. Market Power (Monopoly)

Monopolies and oligopolies:

• Restrict output and increase prices.

• Do not operate at allocative or productive efficiency.

• Create deadweight loss.

5. Immobility of Labor

Labor may be:

• Geographically immobile – cannot move to where jobs are.

• Occupationally immobile – lacks skills for certain jobs.

This prevents optimal allocation of labor, causing unemployment or underemployment.

6. Price Volatility

Markets such as agriculture or fuel may see sharp price changes, leading to:

• Unpredictable incomes for producers.

• Inefficient investment and output.

7. Merit and Demerit Goods

• Merit goods (e.g., education, healthcare) are under-consumed due to underestimation of benefits.

• Demerit goods (e.g., tobacco, alcohol) are over-consumed due to underestimation of harm.

Information failure and irrational behavior cause misallocation.

8. Missing Markets

Occurs when a good or service is not produced at all because:

• No one wants to pay for it.

• It is unprofitable for private firms.

Government may need to step in (e.g., vaccination campaigns, flood defense systems).

Social Costs and Benefits

Understanding social efficiency requires distinguishing:

• Private Marginal Benefit (PMB): Benefit to consumer.

• External Marginal Benefit (EMB): Spillover benefit to others.

• Social Marginal Benefit (SMB) = PMB + EMB.

Likewise for costs:

• Private Marginal Cost (PMC): Cost to producer.

• External Marginal Cost (EMC): Spillover cost to others.

• Social Marginal Cost (SMC) = PMC + EMC.

Social efficiency is achieved when: SMB = SMC