What is Allocative efficiency Flashcards
(26 cards)
What is Allocative Efficiency?
Occurs when resources are allocated in such a way that they produce the combination of goods and services most wanted by society. It’s about producing the “right” goods in the “right” quantities.
Where does Allocative Efficiency occur in a Free Market Diagram?
At the point where the demand curve intersects the supply curve (equilibrium). However, for this to be truly allocatively efficient, there must be no externalities (social costs/benefits must equal private costs/benefits).
What does the Supply Curve represent in terms of Costs?
It represents the Marginal Private Cost (MPC) of production. This is the extra cost incurred by the producer for producing one more unit of the good. The upward slope reflects increasing marginal costs (due to diminishing marginal returns).
What is the Difference between Private Costs and Social Costs?
Private Costs (PC):** Costs incurred by the producer or consumer directly involved in the transaction (e.g., wages, raw materials for a firm; price paid for a good by a consumer).
* Social Costs (SC): The total cost to society as a whole. Social Costs = Private Costs + External Costs (costs imposed on third parties).
What are External Costs?
Costs imposed on third parties who are not directly involved in the production or consumption of a good or service (e.g., pollution from a factory affecting local residents, noise from a concert affecting neighbours).
Formula for Social Costs
Social Costs (SC) = Private Costs (PC) + External Costs (EC)
What does the Demand Curve represent in terms of Benefits?
It represents the Marginal Private Benefit (MPB) to the consumer. This is the extra satisfaction or utility a consumer gets from consuming one more unit of the good.
Why is the Demand Curve (MPB) Downward Sloping?
Due to the Law of Diminishing Marginal Utility. As a consumer consumes more units of a good, the extra satisfaction (marginal utility) they get from each additional unit tends to decrease. Therefore, they are only willing to pay a lower price for additional units.
What is the Difference between Private Benefits and Social Benefits?
Private Benefits (PB):** The benefits received by the consumer or producer directly involved in the transaction (e.g., the satisfaction a consumer gets from consuming a good).
* Social Benefits (SB): The total benefit to society as a whole. Social Benefits = Private Benefits + External Benefits (benefits conferred on third parties).
What are External Benefits?
Benefits conferred on third parties who are not directly involved in the production or consumption of a good or service (e.g., vaccination benefiting the wider community by reducing disease spread, a beautiful garden benefiting neighbours).
Formula for Social Benefits
Social Benefits (SB) = Private Benefits (PB) + External Benefits (EB)
External Costs vs. External Benefits
External Costs (Negative Externalities):** Harm or cost to third parties (SC > PC).
* External Benefits (Positive Externalities): Benefit to third parties (SB > PB).
Assumption for Allocative Efficiency in a Standard Free Market Diagram
We assume there are no externalities, meaning:
* Marginal Private Cost (MPC) = Marginal Social Cost (MSC)
* Marginal Private Benefit (MPB) = Marginal Social Benefit (MSB)
Why the Standard Supply Curve can be labelled S=MPC=MSC (in absence of externalities)
Because in a free market with no external costs, the extra cost to the producer (MPC) is the same as the extra cost to society as a whole (MSC).
Why the Standard Demand Curve can be labelled D=MPB=MSB (in absence of externalities)
Because in a free market with no external benefits, the extra satisfaction/benefit to the consumer (MPB) is the same as the extra benefit to society as a whole (MSB).
Condition for Allocative Efficiency (using MSC and MSB)
Allocative efficiency occurs where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).
Condition for Allocative Efficiency in a Free Market (in absence of externalities)
Since S=MSC and D=MSB (in absence of externalities), allocative efficiency occurs at the intersection of Demand and Supply, i.e., the free market equilibrium where D=S (or MPB=MPC).
Why Equilibrium (P*, Q*) Maximises Society’s Surplus (CS+PS)
At equilibrium, all trades where the benefit to the consumer (MPB/Demand) is greater than or equal to the cost to the producer (MPC/Supply) occur. Any quantity less than Q* leaves potential mutually beneficial trades unmade. Any quantity greater than Q* involves trades where cost exceeds benefit. Therefore, CS+PS is maximised at equilibrium.
Why Equilibrium (Q*) Maximises Net Social Benefit
Net social benefit is the total social benefit minus the total social cost. This is maximised where the extra social benefit (MSB) equals the extra social cost (MSC). At Q*, MSB=MSC. For quantities less than Q*, MSB > MSC, so producing more adds more to benefit than cost. For quantities greater than Q*, MSC > MSB, so producing more adds more to cost than benefit.
Third Condition for Allocative Efficiency (Relating to Supply and Demand)
Quantity Supplied (QS) = Quantity Demanded (QD). This means the market clears perfectly, with no excess supply (surplus) or excess demand (shortage).
Why QS=QD is a Condition for Allocative Efficiency
Because it means the exact quantity that consumers are willing and able to buy at the equilibrium price is being produced and sold, reflecting resources perfectly following consumer demand.
Key Assumptions for a Free Market Equilibrium to be Allocatively Efficient
Many buyers and sellers (perfect competition).
* Perfect information for both buyers and sellers.
* No barriers to entry or exit for firms.
* Firms aim to maximise profit.
* Consumers aim to maximise utility/satisfaction.
* No externalities (MPC=MSC and MPB=MSB).
What happens if the Assumptions for Allocative Efficiency are Broken?
If any of these assumptions are not met, the free market equilibrium (where Private Marginal Cost = Private Marginal Benefit, MPC=MPB) may not coincide with the Social Optimum (where Marginal Social Cost = Marginal Social Benefit, MSC=MSB).
The Relationship between Private Optimum and Social Optimum
Private Optimum:** The outcome determined by private costs and benefits (MPC=MPB), which is the free market equilibrium in standard models.
* Social Optimum: The outcome that maximises overall social welfare (MSC=MSB).
* In the absence of externalities and market imperfections, the Private Optimum = Social Optimum.
