What’s it: Economic efficiency is the state in which resources are allocated to the economy’s highest value uses. It involves making the best possible use of resources and avoiding waste.
Under these conditions, no subsequent allocation of resources can further improve anyone’s welfare without making others worse off. It assumes the economy produces goods and services at minimum average costs and creates maximum total surpluses.
Why economic efficiency matters
We have limited resources. On the other hand, our needs and wants are limitless. It creates scarcity because resources cannot meet all our needs and wants. Finally, we have to make a choice.
Economic efficiency tells you that the choice to allocate resources must be made optimally and produce the goods and services we most want. These goods and services must provide maximum welfare for economic actors. In this case, economic actors consist only of consumers and producers and assume zero government intervention in resource allocation (free market).
In optimizing the use of resources, companies must operate at the most efficient level. They must minimize waste and inefficiencies and use the best production techniques and technology.
The total welfare in the economy is maximum if the extra satisfaction that consumers get from each additional product equals the extra costs that the producer bears in producing the extra product. Long story short, it is achieved when the market is in equilibrium under perfect competition.
Prerequisites for economic efficiency
In economics, economists associate efficiency with limited resources to meet our unlimited needs and wants. Economic efficiency implies the full use of available resources to produce goods and services that provide maximum welfare.
Economic efficiency, therefore, implies a combination of the following two types of efficiency:
- Allocative efficiency. We use our resources to produce a combination of goods and services we want most. It ultimately maximizes the total surplus in the economy (consumer surplus plus producer surplus).
- Productive efficiency. We use the most efficient production techniques to produce the goods and services we want. That way, production is at the minimum point of average cost.
The use of resources achieves allocative efficiency when price equals marginal cost. Price represents the additional benefit (satisfaction or utility) we get from each additional good we consume. If we plotted it on a graph, the marginal benefit curve would be the same as the demand curve.
Meanwhile, marginal cost equals the increase in costs when the producer adds one more unit of production. Its curve is represented by the supply curve, which shows the producers’ willingness to supply products at different prices. Companies are willing to produce more products only if prices are higher.
Allocative efficiency is achievable under perfect competition. The market equilibrium (price and quantity) represents the best outcomes for both producers and consumers, resulting in a maximum total surplus. It is achieved when the quantity supplied equals the quantity demanded the goods and services we most want.
Furthermore, when operating under perfect competition, firms can only charge prices at marginal cost levels in the long run. When setting a higher price, it will invite new players to enter. New players bring in new capacity and push prices down.
Conversely, some players may not be able to compete and exit the market. Market supply decreases and increases prices. Once again, because companies are free to enter and exit the market, prices will fall again as new players enter. Finally, long-run equilibrium is reached only when price equals marginal cost.
Conversely, in the imperfect competition, allocative efficiency will not be achievable. Firms have market power, enabling them to charge higher than those under perfect competition. Thus, prices are above marginal cost. Market power may come from product differentiation or supply control.
In theory, a monopoly market may result in allocative efficiency as long as it can implement first-degree price discrimination (perfect price discrimination). The monopolist sets the highest price that consumers are willing to pay (reservation price) for each consumer. In other words, the firm sets prices and sells output at every point of the demand curve.
Under perfect price discrimination, firms extract all consumer surplus into producer surplus. The total surplus in the economy is unchanged.
However, implementing it in the real world is nearly impossible because the company has to meet stringent requirements, such as:
- It has market power.
- It knows and sells at the reservation price of each consumer.
- It can prevent arbitrage, resale of products by customers to other customers.
The first requirement may still be done. However, the second and third requirements are challenging to implement. Also, the lost surplus hurts consumers by paying a higher price than when the market is operating competitively.
Productive efficiency is achieved at a price equal to the minimum average cost. In a graph, it occurs along the curved line of the production possibilities curve.
Productive efficiency occurs when markets operate under perfect competition. The long-run equilibrium price will be at the minimum point of the average total cost. Conversely, productive efficiency is not achieved under imperfect competition because market output will be less than the output at minimum average cost.
In some industries, natural monopolies require significant economies of scale to achieve efficient production. However, market power and the profit motive often discourage pricing at minimum average costs. Also, the problems of X-inefficiency and rent-seeking prevent productive efficiency from being achieved in a monopoly market.
In a natural monopoly market, the proportion of fixed costs to operating costs is highly significant. Thus, to produce efficient output, the company must operate at high economies of scale to produce minimum average costs.
Even after reaching the minimum average cost, the monopolist may be reluctant to set a price equal to the minimum average total cost. As a single producer, the monopolist rationally tries to maximize profits and set the selling price above the minimum average cost.
Furthermore, in most cases, it is difficult for the monopolist to produce at the least possible cost because there is no competitive pressure. They have no incentive to control costs and operate at a technically efficient level. As a result, the average cost is higher than it should be. Such inefficiency we call X-inefficiency.
Meanwhile, productive efficiency is unachievable because of rent-seeking. Monopolists seek to obtain or maintain monopoly privileges, which incurs substantial costs such as lobbying and legal fees.
What to read next
- Economic Problem: Definition and 3 Basic Questions
- Scarcity in Economics: Meaning and Explanation
- Economic Resources: Definition, Types
- Needs: Definition, Example, Type
- Wants: Definition and Examples
- Choices in economic: Meaning, Importance, Reasons
- Opportunity Cost: Meaning, Importance, Examples
- Economic Efficiency: Meaning, Prerequisites, Why It Matters
- How are Economic Resources Allocated?
- Why Are Economic Resources Scarce?
- Why is Money Not an Economic Resource?
- Does Scarcity Only Work For The Poor? What Causes Scarcity?
- What Are the Consequences of Scarcity in Economics?