Production and Allocative Efficiency

Production and Allocative Efficiency

Productive Efficiency

• For the firm, productive efficiency is producing on it’s LRATC (Long Run Average Total Cost), which is at the lowest cost for each output
• For the industry cost to be minimized, marginal cost (MC) must be equal for every firm. Just because each firm is being efficient does not mean the whole industry is producing at minimum cost. Example: Marginal cost for firm A is $30 and for firm B is $40. If B makes one less book and A makes one more book, the output would be the same but the industry saves $10.

Allocative Efficiency

• A market has allocative efficiency when the Price (Marginal Value/Benefit) = MC
• When the market has allocative efficiency the total surplus (Consumer Surplus + Producer Surplus) is maximized.
• In the diagram below, allocative efficiency occurs where demand intersects with the marginal cost, which occurs at an output of

  20

  ---

  and price of

  $15

  ---

  .
• Anywhere on the left of 20 the marginal value is

  greater

  ---

  than marginal cost so

  more

  ---

  units should be produced and consumed.
• Anywhere on the right of 20 the marginal value is

  less

  ---

  than marginal cost so

  less

  ---

  units should be produced and consumed

Efficiency in Different Types of Markets

• Monopoly is productively efficient (no other firm in the market so industry has the same MC). It does not have allocative efficiency because P > MC.
• The only exception to this rule is a monopoly with perfect price discrimination that will charge every consumer the maximum that they are willing to pay. In this case allocative efficiency will be achieved because they will produce till the point where Price = MC.

Example: Production and Allocative Efficiency

Example: Efficiency with Different Market Structures