YR 11 IB ECON, Wk 6
Economic efficiency broadly means making the best possible use of resources.
Economic efficiency consists of:
Productive Efficiency
Allocative Efficiency
PRODUCTIVE (or technical) EFFICIENCY: how to produce?
An economy achieves productive efficiency when it produces at the lowest possible
cost or when it produces using the fewest possible resources. The competitive
market induces (encourages) firms to produce at the lowest possible costs. If some
firms produce at a higher cost, they would have to charge a higher price in order
to cover their costs, however, consumers will prefer the lower price seller and the
higher price ones would go out of business.
When there is productive efficiency, the economy will be producing on its
Production Possibility Curve (PPC) and the “how to produce” question will be
answered since on the PPC there is no waste of resources.
ALLOCATIVE EFFICIENCY: what to produce?
An economy achieves allocative efficiency when it produces the combination of
goods that are mostly wanted by society and thus maximizes consumption for the
whole society. Allocative efficiency is reached when the economy produces at a
SPECIFIC point on the PPC because it specifies the combination of goods that
society mostly desires.
When there is allocative efficiency the “what to produce” question is answered in
the sense that the scarce resources are used to best satisfy consumers’ unlimited
wants.
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YR 11 IB ECON, Wk 6
Note that:
if an economy is achieving allocative efficiency, it must also be
achieving productive efficiency. Since allocative efficiency involves being at a point
on the PPC, productive efficiency must therefore also being achieved, otherwise
the economy will not be on the PPC.
When an economy achieves both productive and alloactive efficiency, the society is
said to have achieved ECONOMIC EFFICIENCY (also known as PARETO
EFFICIENCY or PARETO OPTIMALITY).
CONSUMER AND PRODUCER SURPLUS:
Consumer Surplus: is defined as the highest price consumers are willing to pay for
a good minus the price actually paid. It is shown diagrammatically as the shaded
area UNDER the demand curve (marginal benefit) and ABOVE the equilibrium price.
Consumer surplus indicates that whereas many consumers are willing to pay a
higher price to get a good they actually receive it for a lower price (at equilibrium).
For example:
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Consumers are willing to pay P2 to get Qa but actually pay Pe – the
difference between Pe and P2 is the consumer surplus for Qa.
Consumers are willing to pay P3 to get Qb but actually pay Pe – the
difference between Pe and P3 is the consumer surplus for Qb.
Producer Surplus: is defined as the price received by firms for selling their goods
minus the lowest price that they are willing to accept in order to produce the good.
The lowest price they are willing to accept represents the firms’ cost of producing
an extra unit of the good (marginal cost) and is shown by the supply curve.
Producer surplus is shown diagrammatically as the area ABOVE the supply curve
and BELOW the equilibrium price.
Firms were willing to accept P5 for Qa but actually received Pe – the
difference between Pe and P5 is the producer surplus for Qa.
Firms were willing to accept P4 for Qb but actually received Pe – the
difference between Pe and P4 is the producer surplus for Qb
The competitive market ensures that production of good occur at the point where
D= S or MB = MC which is also the point where the sum of consumer plus producer
surplus is maximum.
When MB = MC the market is achieving Economic Efficiency which includes both
(allocative and productive efficiency), thereby producing the quantity of the good
that is mostly desired by society at the lowest possible cost.
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YR 11 IB ECON, Wk 6
Test your Understanding:
Consider whether each of the following involves problems relating to productive
efficiency or allocative efficiency or both. What could be done in each case in
order to improve productive or allocative efficiency?
a) An economy produces mostly videotape players, whereas consumers mostly
prefer DVD players
b) An economy that has a large labour force (number of working-age people
who are working or looking for a job) and relatively small amounts of capital
decides to produce a variety of goods by using production methods that
require large amounts of capital and relatively small amounts of labour: (hint
think about how to produce basic question).
c) A farmer has just purchased a large modern tractor and uses it to drive
from the farm to the nearby town in order to buy seeds, fertilizer and
other agricultural inputs. (hint: the farmer making good use of the tractor,
which is an expensive piece of equipment, or does the tractor have better
uses on the farm?)
d) An economy with a temperate zone climate produces bananas, whereas it
could have been producing apples at a much lower cost.
e) Use a diagram to illustrate and explain consumer and producer surplus.
f) Distinguish between allocative, productive and economic efficiency.
g) Explain how the relationship between the PPC and economic efficiency.
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