Efficiency And Market Failure Flashcards
Productive efficiency
Firm is producing at the lowest possible cost (minimum cost).
- Resources are fully utilised and using least possible resources.
- Producing at lowest cost.
- Not possible to produce anymore.
Graph of productive efficiency for a firm
X-axis: Output
Y-axis: Costs
Downward C-curve
Indicate AC1 AC2
Lowest curve is the best
Graph of productive efficiency in an economy
X-axis: Consumer goods
Y-axis: Capital goods
Draw a PPC
Point on PPC curve is productive efficiency
Average cost
The cost occurs to the firm when producing goods.
Formula: total cost ➗ quantity
Formula: fixed cost ➕variable cost
Competition can lead to productive efficiency
- Firms have the incentive for profit.
- The lower the costs, the higher the profits.
- When there is competition, rivals will produce at lowest possible cost, firms that are unable to produce at lower cost will result in higher price.
- This leads to lower demand and subsequent lower profits.
Evaluation for productive efficiency
- Long run
> Perfectly competitive firms are given by price p and quantity q.
> At this point, productive efficiency is achieved.
> Firms are producing at the lowest point on its average cost curve.
> Competition will constrain firms to always produce at lowest possible cost.
> Therefore at this point, allocative efficiency is also achieved. - It happens in short term.
Graph for productive efficiency and perfect competition
X-axis: Quantity
Y-axis: Price
AC curve
Marginal Cost (MC) curve
p - average revenue= marginal revenue
q - optimum output
Point of intersection of these curves and line is the lowest cost
Allocative efficiency
Firms are producing goods and services most wanted by consumers.
> producing the combination of products that yield the greatest possible level of satisfaction of consumer wants
Exist when price of a product 🟰 marginal cost of production
> P = MC
> price paid by the consumer will represent the true economic cost of producing the last unit of product
> to ensure the right amount of product is produced
Why allocative efficiency cannot be illustrated on PPC
- PPC cannot show P=MC
- The exact location will depend upon consumer preference and is not indicated in the PPC model
Competition can lead to allocative efficiency
- In perfect competition, firms are constrained to produce products that consumers most desire relative to their cost of production.
- If firms want to meet requirements of consumers but ignore minimum cost, output of allocative efficiency will be different from productive efficiency.
- No waste in resources and satisfied consumer’s infinite wants.
Two motivations under allocative efficiency
- The desire to make the greatest possible profit will drive firms to produce such products, and lead to highest possible demand therefore greater revenue and profits.
- Firms in competitive markets are forced to produce those products most demanded by consumers, as other firms are doing so.
Graph of allocative efficiency and perfect competition
Same as Graph of productive efficiency and perfect competition
X-axis: Quantity
Y-axis: Price
AC curve
Marginal Cost (MC) curve
p - average revenue= marginal revenue
q - optimum output
Point of intersection of these curves and line is the lowest cost
Evaluation for allocative efficiency
- Long run
> Perfectly competitive firms are given by price p and quantity q.
> At this point, productive efficiency is achieved.
> Competition will constrain firms to always produce at lowest possible cost.
> Therefore, at this point, allocative efficiency is also achieved.
> In a perfect competitive market, both productive and allocative efficiency will exist.
Pareto optimality / Pareto efficiency
Not possible to make someone better off without making someone else worse off.
Graph of Pareto optimality
Occur on a production possibility frontier (PPF)
X-axis: Consumer goods
Y-axis: Capital goods
Resources are allocated in the most efficient way.
When an economy is operating on a PPF, it is not possible to increase output of capital goods without reducing output of consumer goods.
Point inside the PPF,
> Pareto inefficient
> There is scope for improvement where at least one person is made better off without making someone else worse off.
> Any improvement in economic efficiency may require some form of compensation to be paid to those that are worse off.
> Example, new roads designed to improve the traffic flow, users of the road benefited as their journey times shortened. However, those staying close to the road will be affected by the noise and pollution.
Dynamic efficiency
A form of productive efficiency that benefits a firm over time.
Can be achieved when a firm meets the changing needs of its market by introducing new production processes or innovation in response to competitive pressures.
> Example, firms can use their excess profits to engage in R&D and other investments to bring benefits to consumers in the form of new technologies and lower prices, while giving firms a more efficient production process.
Evaluation for dynamic efficiency
- Long term phenomenon
> Obtain an investment fund from dividends or borrowing.
> Results to higher costs in the short run before the payback comes years later after investing.
> Only get benefit when reaches maturity level (minimum point of AC curve).
> If the firm does not invest, it may become inefficient and may be forced to leave the market as it cannot compete with other firms. - May involve opportunity cost
Graph for dynamic efficiency
X-axis: Output
Y-axis: Costs
LRAC1 LRAC2
C1 Q1
C2 Q2
When a firm is dynamically efficient, it’s long run average cost curve (LRAC) shifts downwards.
> LRAC1 to LRAC2, cost reduced while output increased.
> This can be done by buying new capital goods to reduce cost of production in the long run.
Industry that constantly facing dynamic efficiency
Motor vehicle manufacturing
- Growing intensity of competition to be more fuel efficient, less pollution etc.
- Extensive investment and innovation on products and processes resulted in highly efficient, automated production plants.
- Computer-aided techniques and robots rather than human labour has contributed to increase efficiency and lower production costs per vehicle.
Market failure
A free market, left to its own devices and totally free from any form of government intervention, fails to make the best use of scarce resources.
Inefficient allocation of resources.
Free markets fail to allocate resources efficiently
- Interaction of demand and supply in a market does not lead to productive and or allocative efficiency.
- There is no efficient allocation of resources.
- Lead to wastage of resources.
- Deals with price mechanism.
- Only those who are able to afford the good will have the good.
Consequences or reasons of market failure
- Information failure
> Asymmetric information (one party has more information than another party)
> Might lead to overconsumption or underconsumption of demerit or merit goods.
> Might not be aware of the benefit of merit goods. - Externalities in the market.
- Provision of public and quasi-public goods.
- Provision of merit and demerit goods.
- Adverse selection or moral hazard.
- Abuse of monopoly power in the market.
> Firms set higher prices for the goods, making it more difficult for the consumers to buy.
