Efficiency is achieved when scarce resources are utilised to produce the best outcomes for the economy. In other words, resources are used in such a way that wastage and welfare loss are prevented. There are two broad categories of efficiency, namely static efficiency and dynamic efficiency. Static efficiency relates to the use of resources to attain socially desirable outcomes at a particular point in time while dynamic efficiency can only occur over a period of time. Productive efficiency and allocative efficiency are the two types of static efficiency.
Here, available resources are used to produce more output or production is at the lowest possible cost. For an economy, maximum output can be obtained from its existing resources if it operates on the production possibility curve (point N in Figure 1 below). If it is on a point within the curve, less output is made from the economy’s resources or it is productively inefficient (point M in Figure 1 below). A firm is productively efficient if it produces at the lowest point on its average cost curve. In Figure 2 below, Q is the output level that ensures the firm is productively efficient as it corresponds to the lowest point on the average cost curve.
Figure 1: Diagram showing productive efficiency in an economy
Figure 2: Diagram showing productive efficiency for a firm
Allocative efficiency occurs when the price the consumers are willing to pay for a product is equal to the cost of producing an extra unit of the product. That is to say, the price is the same as the marginal cost of the product. When allocative efficiency is achieved in the market, consumers’ welfare (in terms of consumer surplus) is maximised because the firms produce the kinds of products consumers desire to have. In Figure 3 below, welfare is maximised at equilibrium and the quantity produced is the equilibrium quantity Qe while the price is Pe. If the firm decides to produce less than Qe, say Q1, there will be a loss of welfare as the price increases to P1 and quantity falls. The loss of welfare is known as deadweight loss and it is shown by the triangle ABE. The welfare loss (deadweight loss) is the sum of lost producer surplus and lost consumer surplus. Both consumers and producers experienced reduced welfare when firms do not produce the equilibrium quantity.
Figure 3: Diagram showing allocative efficiency
Dynamic efficiency is achieved when firms respond to changing conditions in the market over time. The business environment is not static as consumers’ tastes and needs may change rapidly. And the onus lies on the firm to adapt to these changes in order to remain competitive in the market. These changes require alterations to be made to the product itself and the production process; a completely new product may need to be invented. Though it may be costly initially, dynamic efficiency is capable of reducing the firm’s long-run average cost (see Figure 4 below), say from LRAC1 to LRAC2. The key drivers of dynamic efficiency are innovation, research and development, and technological advancement.
Figure 4: Diagram showing dynamic efficiency
What about X-efficiency?
This occurs when there is increased productivity due to the presence of incentives or competitive pressures. A monopoly, for instance, may be X-inefficient because there is no urge to increase productivity, improve its work processes or cut its costs due to lack of competition. X-inefficiency may also arise as a result of a lack of profit-motive or having an unmotivated workforce. The public sector may not be moved to improve productivity which makes it difficult for output to cover costs leading to rising unit cost. In addition, government workers usually show a negative attitude towards work due to the lack of profit motive, thereby making their productivity less than what it should be.