Efficiency and market failure

Economics A2 · The price system and the microeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Efficiency is about using scarce resources as well as possible. Productive efficiency means output is made at the lowest possible average cost. Allocative efficiency means resources make the goods that consumers want most, so the price people pay equals the cost of the last unit made.

When no one can be made better off without making someone else worse off, the allocation is Pareto optimal. Dynamic efficiency is efficiency over time: firms invest, innovate and improve products and methods.

Market failure happens when the free market does not give an efficient allocation of resources. Too much or too little of a good is produced, so welfare is lost.

Rules to remember

Productive efficiency: production at the lowest point of the average total cost curve, where MC = ATC. For an economy: any point on the production possibility curve.
Allocative efficiency: price = marginal cost (P = MC).
Pareto optimality: no one can be made better off without making someone else worse off.
Dynamic efficiency: lower costs and better products over time through investment, research and innovation.
Market failure: the free market fails to allocate resources efficiently.
Reasons for market failure: externalities, public goods, merit and demerit goods, information failure, market power (monopoly), immobility of factors of production.

Common mistake

Students mix up the two conditions. P = MC is allocative efficiency. MC = ATC (lowest average cost) is productive efficiency. A firm can meet one without the other.

Worked example

At its present output a firm sells its product at $25. Its marginal cost is $25 and its average total cost is $28. Is the firm allocatively efficient, productively efficient, both or neither?

Price ($25) equals marginal cost ($25), so the firm is allocatively efficient.
Marginal cost ($25) is below average total cost ($28), so average total cost is still falling.
The firm is not at the lowest point of its average total cost curve, so it is not productively efficient.

Answer: The firm is allocatively efficient but not productively efficient.

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