Question

Efficiency in production (as part of allocative efficiency) is achieved if an economy's combination of goods (two goods produced with one 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 conditions in the absence of market failures and why it does not hold in reality.

Answer 1

We know that allocative efficiency is reached when no one can be made better off without making someone else worse off . This situation is also known as Pareto efficiency .

The value that consumers place on a particular good or service is shown by their reservation price for the product . At allocative efficiency this value should be equal to the cost of factors used in production . Market price should be equal to marginal cost of supply .

Now comes the technical difference between allocative and productive efficiency . In productive efficiency products are being produced in the least cost way . This is any point on the Production Possibility curve from where production of one good in extra is not possible without reducing production of another good .

In allocative efficiency the products being produced should be the ones that are desired by the consumers . So this is an optimal point on the PPC but this point also matches desires of society , hence allocative eficiency additionally requires optimality in consumption or maximization of utility .

It does not hold in reality because an economy does not produce just two goods , resources are often under utilized , it is difficult to assess consumer desires .