Economic Efficiency

Types of economic efficiency

The different types of economic efficiency are:

1. Productive efficiency - this occurs when a firm produces goods and services at the lowest possible cost, given the current technology and resources.
2. Allocative efficiency, also referred to as Pareto efficiency, occurs when resources are allocated to their most valuable use, such that no one can be made better off without making someone else worse off.
3. Dynamic efficiency occurs when a firm is able to improve its productive efficiency over time through innovation and learning.
4. Static efficiency occurs when a firm produces goods and services at the lowest possible cost, given the current technology and resources, without any improvement over time.
5. Social efficiency occurs when the benefits of economic activity are greater than its costs to society as a whole.
6. X-efficiency refers to the ability of a company to use its resources in the best way possible to produce the most output from a given level of inputs. This is more likely to occur when a company operates in a highly competitive market where managers are motivated to produce as much as they can. However, when a market is less competitive, such as in a monopoly or oligopoly, there is a risk of losing X-efficiency, due to a lack of motivation for managers.

Productive efficiency

This term refers to when output is maximised from the available inputs. It occurs when an optimal combination of goods and services produces maximum output while achieving minimum cost. In simpler terms, it is the point where producing more of one good would reduce the production of another.

The production possibility frontier (PPF)

A production possibility frontier (PPF) can be used to further explain productive efficiency. It shows how much an economy can produce given existing resources. It highlights the different options an economy has for resource allocation.

Figure 1 shows a production possibility frontier (PPF). It shows the maximum level of output from available inputs at every point on the curve. The curve aids in explaining the points of productive efficiency and productive inefficiency.

Points A and B are considered points of productive efficiency because the firm can achieve maximum output given the combination of goods. Points D and C are considered points of productive inefficiency and thus wasteful.

Productive efficiency can also be illustrated with another graph shown in Figure 2 below.

Productive efficiency is achieved when a firm is producing at the lowest point on the short-run average cost curve (SRAC). I.e where marginal cost (MC) meets average cost (AC) on the graph.

Dynamic Efficiency

Dynamic efficiency is about a firm's ability to improve its production efficiency over time by adopting new technologies, processes, and products. We can illustrate dynamic efficiency through an example of a t-shirt printing business.

Economic Efficiency: Factors affecting dynamic efficiency

Some factors that affect dynamic efficiency are:

1. Investment. Investing in technology and more capital can lower future costs.
2. Technology. Improved technology in a firm can help reduce costs.
3. Finance. Accessibility to finance will aid a firm in investing more capital to improve production, which will enable cost reduction.
4. Motivating the workforce. Encouraging and motivating workers and managers can enable a firm to reduce costs.

Static efficiency

Static efficiency is concerned with efficiency at a particular point in time, given the current state of technology and resources. This is a type of economic efficiency focused on the best combination of existing resources at a particular time. It is producing at the lowest point on the short-run average cost (SRAC).

Economic Efficiency: Difference between dynamic and static efficiency

Dynamic efficiency is concerned with allocative efficiency and with efficiency over a period of time. For example, it examines whether investing in technological development and research over a period of time will help a firm be more efficient.

Static efficiency is concerned with productive and allocative efficiency and efficiency at a particular time. For example, it examines whether a firm can produce 10,000 units a year cheaper by using more labour and less capital. It is concerned with producing outputs at a specific time by allocating resources differently.

Allocative efficiency

This is a situation where goods and services are distributed satisfactorily according to consumers' preferences and willingness to pay a price equivalent to the marginal cost. This point is also known as the allocative efficient point.

Figure 3 illustrates allocative efficiency on a firm/individual level and the market as a whole.

For firms, allocative efficiency occurs when P=MC. For the whole market, allocative efficiency occurs when supply (S) = demand (D).

Social efficiency

Social efficiency occurs when resources are optimally distributed in a society and the benefit derived by an individual doesn't make another person worse off. Social efficiency occurs when the benefit of production is not greater than its negative effect. It subsists when all benefits and costs are considered in producing an extra unit.

Economic Efficiency and Externalities

Externalities occur when the production or consumption of a good causes a benefit or cost impact on a third party that doesn’t have a direct relation to the transaction. Externalities can be positive or negative.

Positive externalities occur when the third party gets benefits from the good production or consumption. Social efficiency occurs when a good has a positive externality.

Negative externalities occur when the third party gets a cost from the good production or consumption. Social inefficiency occurs when a good has a negative externality.

Economic efficiency examples

Here are examples of economic efficiency for different economic efficiency types: