Question

Efficiency in production (as part of allocative efficiency) is achieved if an economy's combination of goods (two goods produced with on resource) falls on its Production Possibilities Frontier. Yet allocative efficiency additionally requires optimality in consumption. Explain overall allocative efficiency (do not worry about the possibilities of international trade)-- its condition in the absence of market failures and why it does not hold in reality.

Answer 1

Allocative efficiency is the level of output where the price of a good or service is equal to the marginal cost of production. It can be achieved when goods and/or services have been distributed in an optimal manner, and when their marginal cost and marginal utility are equal.

The term refers to the degree of equality between the marginal benefits and marginal costs. The marginal cost is the cost of producing one additional item, and is used to pinpoint the optimal economy of scale. The marginal benefit is the greater enjoyment created by producing one additional item.

Allocative efficiency will occur when both consumers and producers have free access to information, allowing them both to make the most efficient possible decisions in purchasing and production. According to this principle, it is also necessary that consumer have free choice over the goods/services that maximize their individual satisfaction.

Operating in accordance with allocative efficiency ensures the correct resource allotment in terms of consumer needs and desires. Virtually all resources (i.e. factors of production) are limited; therefore, it’s important to make the right decisions regarding where to distribute resources in order to maximize value.

The aim is to achieve the ideal opportunity cost. The opportunity cost of a particular thing is the value that must be sacrificed in order to put resources of time, money, etc. toward that thing.

Economies of scale ensure that opportunity costs decrease as production levels increase, up to a point. Then, past certain levels of production, opportunity cost may begin to increase once again. Likewise, with higher supply, demand decreases.

The market equilibrium is the point at which value for society as a whole has been maximized, and allocative efficiency has been achieved. For these reasons, aiming to achieve allocative efficiency is valuable to both consumers and producers.

Market failure occurs when the price mechanism fails to account for all of the costs and benefits necessary to provide and consume a good.

Market failure occurs due to inefficiency in the allocation of goods and services. A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced.

In order to fully understand market failure, it is important to recognize the reasons why a market can fail. Due to the structure of markets, it is impossible for them to be perfect. As a result, most markets are not successful and require forms of intervention.

Reasons for market failure include:

• Positive and negative externalities: an externality is an effect on a third party that is caused by the consumption or production of a good or service. A positive externality is a positive spillover that results from the consumption or production of a good or service. For example, although public education may only directly affect students and schools, an educated population may provide positive effects on society as a whole. A negative externality is a negative spillover effect on third parties. For example, secondhand smoke may negatively impact the health of people, even if they do not directly engage in smoking.
• Environmental concerns: effects on the environment as important considerations as well as sustainable development.
• Lack of public goods: public goods are goods where the total cost of production does not increase with the number of consumers. As an example of a public good, a lighthouse has a fixed cost of production that is the same, whether one ship or one hundred ships use its light. Public goods can be underproduced; there is little incentive, from a private standpoint, to provide a lighthouse because one can wait for someone else to provide it, and then use its light without incurring a cost. This problem – someone benefiting from resources or goods and services without paying for the cost of the benefit – is known as the free rider problem.
• Underproduction of merit goods: a merit good is a private good that society believes is under consumed, often with positive externalities. For example, education, healthcare, and sports centers are considered merit goods.
• Overprovision of demerit goods: a demerit good is a private good that society believes is over consumed, often with negative externalities. For example, cigarettes, alcohol, and prostitution are considered demerit goods.
• Abuse of monopoly power: imperfect markets restrict output in an attempt to maximize profit.

Market failure occurs when the price mechanism fails to account for all of the costs and benefits necessary to provide and consume a good. The market will fail by not supplying the socially optimal amount of the good.

Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the marginal benefit of consumption. The imbalance causes allocative inefficiency, which is the over- or under-consumption of the good.

The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to inefficient producers, externalities, environmental concerns, and lack of public goods. An externality is an effect on a third party which is caused by the production or consumption of a good or service.

During market failures the government usually responds to varying degrees. Possible government responses include:

• legislation – enacting specific laws. For example, banning smoking in restaurants, or making high school attendance mandatory.
• direct provision of merit and public goods – governments control the supply of goods that have positive externalities. For example, by supplying high amounts of education, parks, or libraries.
• taxation – placing taxes on certain goods to discourage use and internalize external costs. For example, placing a ‘sin-tax’ on tobacco products, and subsequently increasing the cost of tobacco consumption.
• subsidies – reducing the price of a good based on the public benefit that is gained. For example, lowering college tuition because society benefits from more educated workers. Subsidies are most appropriate to encourage behavior that has positive externalities.