Economic Efficiency

Economic Efficiency Definition

Economic efficiency in microeconomics refers to the state that manifests optimum resource allocation, the minimum cost for producing goods and services, and maximum outcome. In other words, it also indicates the absence of overproduction or underproduction.

An efficient situation implies that it is impossible to make one entity better off without making another one worse off. In contrast, an inefficient scenario suggests that one entity can be better off without worsening another. Therefore, if the reallocation of resources can produce increased outcomes, inefficiency exists.

How Does Economic Efficiency Work?

The economic efficiency concept revolving around the optimal resource allocation process is primarily used in microeconomics. It reflects a collection of features as the production of goods and services without resource wastage, at the lowest possible cost, and inclining with the needs and wants of the consumers.

Technical and price efficiencyPrice EfficiencyPrice efficiency states that prices for the assets in a market, reflecting all information about the assets, is available to all market participants. It suggests that the market is efficient since all the information about the assets that could influence price is available in the public domainread more are essential for economic efficiency. Technical efficiency is the continuous production improvement aimed at producing larger output quantities from the same level of inputs. At the same time, price efficiency focus on profit maximization. Hence, technical and price efficiency contributes to economic efficiency.

There are various ways and types to measure efficiency in a society based on market performance, resource allocation, economic performance, etc. The measurement is typically shown using graphs based on frontier methods. Other measurement techniques include Bayesian techniques, bootstrapping, and duality theory. Furthermore, growth in total factor productivity points to economic efficiency.

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Types of Economic Efficiency

Let’s briefly describe significant types of economic efficiencies, such as allocative efficiency, productive efficiency, and dynamic efficiency.

Allocative Efficiency

Allocative or allocational efficiency occurs when products and services distribution streamlines with consumers’ requirements. Hence effective allocation of resources and consumer satisfaction happens. On the other hand, if the distributed goods and services do not meet consumer preferences, the situation will be termed as allocative inefficiency.

The above graph delineates the allocative efficiency at the equilibrium point demand-supply curve where demand matches the supply or price equals the marginal costMarginal CostMarginal costing in economics and managerial accounting refers to an increase or decrease in the total cost of production due to a change in the quantity of the desired output. It is variable, depending on the inclusion of resources required to produce or deliver additional unit(s) of a product or service.read more.

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Productive Efficiency

Productive or production efficiency results from minimization of production cost and obtaining maximum output at that point. Resources are believed to be allocated in the best possible way creating a cost-efficient product without compromising the quality. However, further production of additional units requires alteration of the production level of another item.

The lowest point (A) on the average cost curve (AC) represents the productive efficiency point where at the minimum cost (C), output (Q) is produced. Imagine an entity whose average production costProduction CostProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more is initially at a high level. As production increases, the average costAverage CostAverage cost refers to the per-unit cost of production, calculated by dividing the total production cost by the total number of units produced. In other words, it measures the amount of money that the business has to spend to produce each unit of output.read more decreases, and the entity can use economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. read more.

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Dynamic Efficiency

An entity exhibits dynamic efficiency if they escalate their production efficiency in the following years of their operation. The entities should adapt to changing business practices to bring down their cost curves.

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In the above graph, AC1 and AC2 are the average cost incurred to produce Q units in years one and two. It indicates that compared to year one, the entity reduced the cost of production in year two; that is the long-run average cost curve, LRAC₁ in year one is brought down in year two to LRAC₂. Hence, they obtained dynamic efficiency.

Practical Examples

For easy understanding, let us consider the example of economic efficiency and productivity in a fast-food outlet. First, it has to focus on effective resource allocation to ensure profitability. For instance, the effective allocation of labor reflects the minimum cost of laborCost Of LaborCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more for the entity. Another instance is that the entity can achieve allocative efficiency by making the supply of food products they sell match the demand by applying historical analysis or forecasting the number of customers per day, peak customer periods, and adequate staffing levels.

Let’s take a look at a farmland scenario. The sole owner of the big farmland chose to slice it into many leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more units. Now different units are operated by other farmers, which results in increased cost of production compared to the cost incurred when the single owner owned the entire farm area. Various studies have shown that large-scale farmers have higher economic efficiency than small-scale farmers due to factors like economies of scale.

Frequently Asked Questions (FAQs)

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