Allocative efficiency

Last updated May 31, 2024

Allocative efficiency is a state of the economy in which production is aligned with the preferences of consumers and producers; in particular, the set of outputs is chosen so as to maximize the social welfare of society.^[1] This is achieved if every produced good or service has a marginal benefit equal to the marginal cost of production.

Description

In economics, allocative efficiency entails production at the point on the production possibilities frontier that is optimal for society.

In contract theory, allocative efficiency is achieved in a contract in which the skill demanded by the offering party and the skill of the agreeing party are the same.

Resource allocation efficiency includes two aspects:

At the macro aspect, it is the allocation efficiency of social resources, which is achieved through the economic system arrangements of the entire society.
The micro aspect is the efficient use of resources, which can be understood as the production efficiency of the organization, which can be improved through innovation and progress within the organizations.

Although there are different standards of evaluation for the concept of allocative efficiency, the basic principle asserts that in any economic system, choices in resource allocation produce both "winners" and "losers" relative to the choice being evaluated. The principles of rational choice, individual maximization, utilitarianism and market theory further suppose that the outcomes for winners and losers can be identified, compared, and measured. Under these basic premises, the goal of attaining allocative efficiency can be defined according to some principles where some allocations are subjectively better than others. For example, an economist might say that a policy change is an allocative improvement as long as those who benefit from the change (winners) gain more than the losers lose (see Kaldor–Hicks efficiency).

An allocatively efficient economy produces an "optimal mix" of commodities.^[2]^: 9 A firm is allocatively efficient when its price is equal to its marginal costs (that is, P = MC) in a perfect market. The demand curve coincides with the marginal utility curve, which measures the (private) benefit of the additional unit, while the supply curve coincides with the marginal cost curve, which measures the (private) cost of the additional unit. In a perfect market, there are no externalities, implying that the demand curve is also equal to the social benefit of the additional unit, while the supply curve measures the social cost of the additional unit. Therefore, the market equilibrium, where demand meets supply, is also where the marginal social benefit equals the marginal social costs. At this point, the net social benefit is maximized, meaning this is the allocative efficient outcome. When a market fails to allocate resources efficiently, there is said to be market failure. Market failure may occur because of imperfect knowledge, differentiated goods, concentrated market power (e.g., monopoly or oligopoly), or externalities.

In the single-price model, at the point of allocative efficiency price is equal to marginal cost.^[3]^[4] At this point the social surplus is maximized with no deadweight loss (the latter being the value society puts on that level of output produced minus the value of resources used to achieve that level). Allocative efficiency is the main tool of welfare analysis to measure the impact of markets and public policy upon society and subgroups being made better or worse off.

It is possible to have Pareto efficiency without allocative efficiency: in such a situation, it is impossible to reallocate resources in such a way that someone gains and no one loses (hence we have Pareto efficiency), yet it would be possible to reallocate in such a way that gainers gain more than losers lose (hence with such a reallocation, we do not have allocative efficiency).^[5]^: 397

Also, for an extensive discussion of various types of allocative efficiency in a production context and their estimations see Sickles and Zelenyuk (2019, Chapter 3, etc).^[6] In view of the Pareto efficiency measurement method, it is difficult to use in actual operation, including the use of human and material resources, which is hard to achieve a full range of efficiency allocation, and it is mainly to make judgments from the allocation of funds; therefore, analyzing the funds in the stock market. Allocation efficiency is used to determine the efficiency of resource allocation in the capital market.

In a perfectly competitive market, capital market resources should be allocated among capital markets under the principle of the highest marginal benefit. Therefore, the most important measurement standard in the capital market is to observe whether capital flows into the enterprise with the best operating efficiency. The most efficient companies should also get a large amount of capital investment, and the less efficient companies should get less capital investment. There are three conditions that come with Pareto efficiency

Best trade outcome: Even if you trade again, individuals cannot get greater benefits from it. At this time, for any two consumers, the marginal substitution rate of any two commodities is the same, and the utility of the two consumers is maximized at the same time.
Optimal production: This economy must be on the boundary of its own production possibilities. At this time, for any two producers who produce different products, the marginal technology substitution rate of the two production factors that need to be input is the same, and the output of the two consumers is maximized at the same time.
Optimal product mix: The combination of products produced by the economy must reflect consumer preferences. At this time, the marginal rate of substitution between any two commodities must be the same as the marginal product conversion rate of any producer between these two commodities.

Examples

A numerical example of allocative efficiency

Allocation efficiency occurs when there is an optimal distribution of goods and services, considering consumer's preference. When the price equals marginal cost of production, the allocation efficiency is at the output level. This is because the optimal distribution is achieved when the marginal utility of good equals the marginal cost. The price that consumer is willing to pay is same as the marginal utility of the consumer.

Allocative Efficiency example Allocative-efficiency-numbers.png — Allocative Efficiency example

From the graph we can see that at the output of 40, the marginal cost of good is $6 while the price that consumer is willing to pay is $15. It means the marginal utility of the consumer is higher than the marginal cost. The optimal level of the output is 70, where the marginal cost equals to marginal utility. At the output of 40, this product or service is under-consumed by the society. By increasing the output to 70, the price will fall to $11. Meanwhile, the society would benefit from consuming more of the good or service.

An example of allocation inefficiency

With the market power, the monopoly can increase the price to gain the super normal profit. The monopolies can set the price above the marginal cost of the production. In this case, the allocation is not efficient. It results in the dead weight welfare loss to the society as a whole. In real life, the government's intervention policy to monopoly enterprises will affect the allocation efficiency. Large-scale downstream companies with more efficient or better products are generally more competitive than other companies. The wholesale prices they get are much lower than those of their competitors. It is conducive to improving the efficiency of allocation. Ind erst and Shaffer (2009) found that banning prices would reduce allocation efficiency and lead to higher wholesale prices for all enterprises. More importantly, social welfare, industry profits, and consumer surplus will all be reduced.

Related Research Articles

Microeconomics is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, sectors, or industries as opposed to the national economy as a whole, which is studied in macroeconomics.

In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.

In welfare economics, a Pareto improvement formalizes the idea of an outcome being "better in every possible way". A change is called a Pareto improvement if it leaves everyone in a society better-off. A situation is called Pareto efficient or Pareto optimal if all possible Pareto improvements have already been made; in other words, there are no longer any ways left to make one person better-off, unless we are willing to make some other person worse-off.

<span class="mw-page-title-main">Deadweight loss</span> Measure of lost economic efficiency

In economics, deadweight loss is the loss of societal economic welfare due to production/consumption of a good at a quantity where marginal benefit does not equal marginal cost – in other words, there are either goods being produced despite the cost of doing so being larger than the benefit, or additional goods are not being produced despite the fact that the benefits of their production would be larger than the costs. The deadweight loss is the net benefit that is missed out on. While losses to one entity often lead to gains for another, deadweight loss represents the loss that is not regained by anyone else. This loss is therefore attributed to both producers and consumers.

This aims to be a complete article list of economics topics:

In microeconomics, economic efficiency, depending on the context, is usually one of the following two related concepts:

The following outline is provided as an overview of and topical guide to industrial organization:

X-inefficiency is a concept used in economics to describe instances where firms go through internal inefficiency resulting in higher production costs than required for a given output. This inefficiency is a result of various factors such as outdated technology, Inefficient production processes, poor management and lack of competition resulting in lower profits and higher prices for consumers. The concept of X-inefficiency was introduced by Harvey Leibenstein.

In microeconomics, a production–possibility frontier (PPF), production possibility curve (PPC), or production possibility boundary (PPB) is a graphical representation showing all the possible options of output for two goods that can be produced using all factors of production, where the given resources are fully and efficiently utilized per unit time. A PPF illustrates several economic concepts, such as allocative efficiency, economies of scale, opportunity cost, productive efficiency, and scarcity of resources.

Welfare economics is a field of economics that applies microeconomic techniques to evaluate the overall well-being (welfare) of a society. This evaluation is typically done at the economy-wide level, and attempts to assess the distribution of resources and opportunities among members of society.

There are two fundamental theorems of welfare economics. The first states that in economic equilibrium, a set of complete markets, with complete information, and in perfect competition, will be Pareto optimal. The requirements for perfect competition are these:

There are no externalities and each actor has perfect information.
Firms and consumers take prices as given.

Economic systems as a type of social system must confront and solve the three fundamental economic problems:

In microeconomic theory, productive efficiency is a situation in which the economy or an economic system operating within the constraints of current industrial technology cannot increase production of one good without sacrificing production of another good. In simple terms, the concept is illustrated on a production possibility frontier (PPF), where all points on the curve are points of productive efficiency. An equilibrium may be productively efficient without being allocatively efficient — i.e. it may result in a distribution of goods where social welfare is not maximized.

The Lange model is a neoclassical economic model for a hypothetical socialist economy based on public ownership of the means of production and a trial-and-error approach to determining output targets and achieving economic equilibrium and Pareto efficiency. In this model, the state owns non-labor factors of production, and markets allocate final goods and consumer goods. The Lange model states that if all production is performed by a public body such as the state, and there is a functioning price mechanism, this economy will be Pareto-efficient, like a hypothetical market economy under perfect competition. Unlike models of capitalism, the Lange model is based on direct allocation, by directing enterprise managers to set price equal to marginal cost in order to achieve Pareto efficiency. By contrast, in a capitalist economy, private owners seek to maximize profits, while competitive pressures are relied on to indirectly lower the price, this discourages production with high marginal cost and encourages economies of scale.

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<span class="mw-page-title-main">Utility–possibility frontier</span> Welfare economics concept

In welfare economics, a utility–possibility frontier, is a widely used concept analogous to the better-known production–possibility frontier. The graph shows the maximum amount of one person's utility given each level of utility attained by all others in society. The utility–possibility frontier (UPF) is the upper frontier of the utility possibilities set, which is the set of utility levels of agents possible for a given amount of output, and thus the utility levels possible in a given consumer Edgeworth box. The slope of the UPF is the trade-off of utilities between two individuals. The absolute value of the slope of the utility-possibility frontier showcases the utility gain of one individual at the expense of utility loss of another individual, through a marginal change in outputs. Therefore, it can be said that the frontier is the utility maximisation by consumers given an economies' endowment and technology. This means that points on the curve are, by definition, Pareto efficient, which are represented by E, F and G in the image to the right. Meanwhile the points that do not lie on this curve are not Pareto efficient, as shown by point H. The utility possibility frontier also represents a social optimum, as any point on the curve is a maximisation of the given social welfare function.

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Several theories of taxation exist in public economics. Governments at all levels need to raise revenue from a variety of sources to finance public-sector expenditures.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

References

↑ Anderson, D. (2019). Environmental Economics and Natural Resource Management, Routledge, New York.
↑ Kim, A., Decentralization and the Provision of Public Services: Framework and Implementation (Washington, D.C.: The World Bank, 2008), p. 9.
↑ Markovits, Richard (1998). Matters of Principle. New York: New York University Press. ISBN 978-0-8147-5513-6.
↑ Markovits, Richard (2008). Truth or Economics. New Haven: Yale University Press. ISBN 978-0-300-11459-1.
↑ Beardshaw, J., Economics: A Student's Guide (Upper Saddle River, NJ: FT Press, 1984), p. 397.
↑ Sickles, R., & Zelenyuk, V. (2019). Measurement of Productivity and Efficiency: Theory and Practice. Cambridge: Cambridge University Press. doi:10.1017/9781139565981

6. Inderst, Roman, and Greg Shaffer. "Market Power, Price Discrimination, and Allocative Efficiency in Intermediate-Goods Markets." The RAND Journal of Economics 40, no. 4 (2009): 658-72. Accessed April 27, 2021. http://www.jstor.org/stable/25593732

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[1] Anderson, D. (2019). Environmental Economics and Natural Resource Management, Routledge, New York.

[2] Kim, A., Decentralization and the Provision of Public Services: Framework and Implementation (Washington, D.C.: The World Bank, 2008), p. 9.

[3] Markovits, Richard (1998). Matters of Principle. New York: New York University Press. ISBN 978-0-8147-5513-6.

[4] Markovits, Richard (2008). Truth or Economics. New Haven: Yale University Press. ISBN 978-0-300-11459-1.

[5] Beardshaw, J., Economics: A Student's Guide (Upper Saddle River, NJ: FT Press, 1984), p. 397.

[6] Sickles, R., & Zelenyuk, V. (2019). Measurement of Productivity and Efficiency: Theory and Practice. Cambridge: Cambridge University Press. doi:10.1017/9781139565981

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