Economics Lecture Notes

Economic Efficiency

One of the most important terms in economics is economic efficiency.

• Economic efficiency is the situation where both allocative and productive efficiency are achieved.

Allocative Efficiency

• Allocative efficiency is a situation where production matches consumer preferences, represented by the supply and demand curve.
• S = MC (Supply equals Marginal Cost)
• D = MU (Demand equals Marginal Utility)
• S = Supply
• D = Demand
• MC = Marginal Cost
• MU = Marginal Utility
• Equilibrium is allocatively efficient when the price reflects the marginal utility (satisfaction) of the additional consumer.
• Achieved when price is equal to the marginal cost of production.
• Marginal utility of a good equals the marginal cost of that good.
• Note: The demand curve has no externalities or impact on third parties (e.g., pollution).
• Example:
  • At an output of 70, the price is £10, which is also the marginal cost.
  • At an output of 40, the price is £15, which is greater than the marginal cost of £6, indicating under consumption.
  • At an output of 110, the price people are willing to pay is £7, but the marginal cost is £17, which is much greater than the marginal benefit, indicating over consumption.

Incentives and Production

• Government incentives, such as subsidies, can increase the amount of money a business uses in materials and capital, increasing production.
• Subsidies can be connected to the number of bicycles produced.
• Example: A firm receives £x on producing every 100th bike after the first 2000.
• Benefit: Lower unit costs, potentially leading to a fall in the price of bikes and encouraging a rise in demand.

Productive Efficiency

• Productive efficiency is a situation where all resources are utilized in the economy to produce as much as possible, as represented by the Production Possibility Frontier (PPF) / Production Possibility Curve (PPC).
• Concerned with producing goods and services with the optimal combination of inputs to produce maximum output for minimum cost
• To be productively efficient, the economy must be producing on its PPC.
• At this point, it is impossible to produce more of one good without producing less of another

Productive Efficiency and Short Run Average Cost

• A firm is said to be productively efficient when producing at the lowest point of the short-run cost curve.
• This occurs at the point where Marginal Cost (MC) equals Average Cost (AC).
• AC = \frac{Total Production Cost}{Total Units Produced}
• When the firm benefits from all available economies of scale (as output increases, average cost falls).
• Example: Purchasing economies through bulk buying resources, resulting in discounts and a reduction in average cost.
• Key Diagram: Economies of scale

Economies and Diseconomies of Scale

• With productive efficiency, the firm is benefiting from all available economies of scale (as a firm's output increases, their average cost falls).
• Example: Purchasing economies, bulk buying resources resulting in discounts and a reduction in average costs.

Important point:

A firm can be productively efficient but produce goods that society does not need and is allocatively inefficient.