Economics is a science of efficiency in the use of scarce resources. Efficiency requires full employment of available resources and full production. Full employment means all available resources should be employed. Full production means that employed resources are providing maximum satisfaction for our material wants. Full production implies two kinds of efficiency:
1. Allocative efficiency means that resources are used for producing the combination of goods and services most wanted by society. For example, producing computers with word processors rather than producing manual typewriters.
2. Productive efficiency means that least costly production techniques are used to produce wanted goods and services.
Full efficiency means producing the "right" (Allocative efficiency) amount in the "right "way (productive efficiency).
Productive efficiency occurs where price is equal to minimum average total cost (min ATC); at this point firms must use the lease-cost technology or they won’t survive. Under pure competition, this outcome will be achieved, as the long run equilibrium price of pure competitive firms would be at the min ATC
Allocative efficiency occurs where price is equal to marginal cost ( P=MC), because price is society’s measure of relative worth of a product at the margin or its marginal benefit. And the marginal cost of producing product X measures the relative worth of the other goods that the resources used in producing an extra unit of X could otherwise have produced. In short, price measures the benefit that society gets from additional units of good X, and the marginal cost of this unit of X measures the sacrifice or cost to society of other goods given up to produce more of X. Under pure competition, this outcome will be achieved. Dynamic adjustments will occur automatically in pure competition when changes in demand or in resources supply, or in technology occur. Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P=MC occurs.
Price of non-perfect competitive firms will exceed marginal cost, because price exceeds marginal revenue and the firms produce where marginal revenue (MR) and marginal cost are equal. Then the firms can charge the price that consumers will pay for that output level. Allocative efficiency is not achieved because price (what product is worth to consumers) is above marginal cost (opportunity cost of product). Ideally, output should expand to a level where P=MC, but this will occur only under pure competitive conditions where P = MR.
Productive efficiency is not achieved because the firms’ output is less than the output at which average total cost is minimum.
Economies of scale (natural monopoly) may make monopoly the most efficient market model in some industries. X-inefficiency, the inefficiency that occurs in the absence of fear of entry and rivalry, may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs. Rent-seeking behavior often occurs as monopolies seek to acquire or maintain government –granted monopoly privileges. Such rent-seeking may entail substantial cost (lobbying, legal fees, public relations advertising etc.) which are inefficient.
There are several policy options available when monopoly creates substantial economic inefficiency:
1. Antitrust laws could be used to break up the monopoly if the monopoly’s inefficiency appears to be long-lasting.
2. Society may choose to regulate its prices and operations if it is a natural monopoly.
3. Society may simply ignore it if the monopoly appears to be short-lived because of changing conditions or technology.
Efficiency Vs technological advances:
Allocative efficiency is improved when technological advance involves a new product that increases the utility consumers can obtain from their limited income. Process innovation can lower production cost and improve productive efficiency. Innovation can create monopoly power through patents or the advantages of being first, reducing the benefit to society from the innovation. Innovation can also reduce or even disintegrate existing monopoly power by providing competition where there was none. In this case economic efficiency is enhanced because the competition drives prices down closer to marginal cost and minimum average total cost.