Efficiency, X inefficiency and the effects of firm size

Overview

Allocative efficiency, productive efficiency and dynamic efficiency.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is allocative efficiency, and what condition must hold for it?

   Model answer

   Allocative efficiency is achieved when resources are used to produce the combination of goods that consumers most value, so that no reallocation could make anyone better off without making someone worse off. The condition is that price equals marginal cost, because price measures the value consumers place on an extra unit and marginal cost measures the value of the resources used to make it. Where price exceeds marginal cost, too little is produced, and where price is below marginal cost, too much is.

2. 2

   A firm sells at 12 pounds per unit while its marginal cost is 8 pounds. Explain whether allocative efficiency is achieved and what should happen.

   Model answer

   Price exceeds marginal cost by 4 pounds, so consumers value an extra unit at 12 pounds while the resources needed to produce it are worth only 8 pounds elsewhere. Society would gain 4 pounds of net benefit from that extra unit, so output is below the allocatively efficient level. Expanding output would raise welfare until the gap closes and price equals marginal cost.

3. 3

   What is productive efficiency, and where does it occur on a cost diagram?

   Model answer

   Productive efficiency is achieved when output is produced at the lowest possible average total cost, so no resources are wasted in making the chosen quantity. On a diagram with output on the horizontal axis and cost per unit on the vertical axis, it is the minimum point of the average total cost curve, which is also where the rising marginal cost curve cuts it. For an economy as a whole it corresponds to producing on the production possibility frontier rather than inside it.

4. 4

   A firm has average total costs of 100.00, 62.00, 46.00, 39.00, 38.00 and 41.00 pounds at outputs of one to six units. Identify the productively efficient output and calculate the cost penalty per unit of instead operating at six units.

   Model answer

   Productive efficiency occurs at the minimum of average total cost, which is 38.00 pounds at five units. At six units average total cost is 41.00 pounds, so each unit costs 41.00 - 38.00 = 3.00 pounds more than the lowest attainable figure. Across six units that is a penalty of 3.00 multiplied by 6 = 18 pounds, since total cost is 246 pounds rather than the 228 pounds those units would cost at 38 pounds each.

5. 5

   What is dynamic efficiency, and why is it described as a property of a firm over time rather than at a point in time?

   Model answer

   Dynamic efficiency is improvement in the way a firm produces, achieved through investment in research, new technology, better processes and new products, so that its costs fall or its products improve over successive years. It cannot be read off a single diagram, because any one diagram shows the cost curves the firm faces now; a dynamically efficient firm is one whose whole long-run average cost curve is lower this year than it was five years ago. Judging a firm only by its current costs therefore misses dynamic efficiency entirely, and can mislead: a firm spending heavily on research looks worse today than a rival that spends nothing, yet it is the one whose costs will be lower later.

6. 6

   A firm's minimum long-run average cost is 30 pounds at 4,000 units. After five years of research it falls to 24 pounds at the same output. Calculate the improvement and identify the type of efficiency gained.

   Model answer

   The fall is 30 - 24 = 6 pounds per unit, a reduction of 6 divided by 30 multiplied by 100 = 20 per cent. On 4,000 units this saves 6 multiplied by 4,000 = 24,000 pounds a week. This is a gain in dynamic efficiency, since the entire long-run average cost curve has shifted downward over time rather than the firm merely moving to a better point on an unchanged curve.

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