12.1 Productive and Allocative Efficiency
Efficiency requires that factors of production are fully employed.
Three examples of inefficiency in the use of fully employed resources:
o If firms do not use the least-cost method of producing their chosen
outputs, they are being inefficient.
I.e. producing shoes at a resource cost of $400 when you can
produce them at $300 ($100 of resources can be reallocated to
other productive uses).
o If the marginal cost of production is not the same for every firm in an
industry, the industry is being inefficient.
I.e. Industry where TC = $1000 but firm1’s MC = $50 and
firm2’s MC = $40, reducing output at firm1 will reduce TC by
$50 and increasing output at firm2 will increase TC by $40
(ΔTC = -$10).
o If too much of one product and too little of another product are
produced, the economy’s resources are being used inefficiently.
I.e. consumer places $0 on one extra unit of DVD players but
places $600 on one extra unit of T.V.’s, consumers are better off
if resources are reallocated from DVD player production to T.V.
Productive efficiency for the firm requires the firm to be producing its output
at the lowest possible cost (example 1).
o In the long-run the firm must be operating on its LRAC curve.
Productive efficiency for the industry: when the industry is producing a given
level of output at the lowest possible cost. This requires that MC be equated
across all firms in the industry (example 2).
If firms and industries are productively efficient, the economy will be on,
rather than inside, the production possibilities boundary.
The economy is allocatively efficient when, for each good produced, its
marginal cost of production is equal to its price
o In other words, when marginal cost (supply curve) is equal to
marginal value (demand curve).
o When the combination of goods produced is allocatively efficient,
economists say the economy is Pareto efficient.
Which market structures are efficient?
Perfectly competitive industries are productively efficient. If an economy
could be made up of perfectly competitive industries, the economy would be
o Since perfect competition only exists in some industries in modern
economies, modern economies are neither perfectly competitive nor
allocatively efficient. Monopolists have an incentive to be productively efficient because their
profits will be maximized when they adopt the lowest-cost production
method (they will operate on their LRAC curves and thus will be productively
Monopoly is not allocatively efficient because the monopolist’s price always
exceeds its marginal cost.
o In perfect price discrimination, however, the monopolist is
allocatively efficient as it will be operating where MC=MV.
The efficient point on the production possibilities boundary depends on the
distribution of income.
Allocative efficiency can also be expressed as the point where the sum of the
consumer and producer surplus is maximized.
The sum of producer and consumer surplus is maximized only at the
perfectly competitive level of output. This is the only level of output that is
The loss of surplus resulting from a monopolistic market is called the
deadweight loss of monopoly.
One of the most important issues in public policy is whether, and under what
circumstances, government action can increase the allocative efficiency of
12.2 Economic Regulation to Promote Efficiency
Monopoly practices: monopolies, cartels, price-fixing agreements among
oligopolists, and other non-competitive practices.
Competition policy: made up of the laws and other instruments that are used
to encourage competitive behaviour and discourage monopoly practices.
Canadian competition policy has sought to:
o Create more competitive market structures where possible
o Discourage monopolistic practices
o Encourage competitive behaviour where competitive market
structures cannot be established
Economic regulation: prescribe the rules under which firms can do business
and in some cases determine the prices that businesses can charge for their
Competition policy is used to promote allocative efficiency by increasing
competition in the marketplace.
Where competitive behaviour is not possible (i.e. natural monopolies), public
ownership or economic regulation of privately owned firms can be used as a
substitute for competition.
Responses to a natural monopoly:
o The government assumes control of the single firm and then it
becomes a Crown corporation.
o To allow private ownership but to regulate the monopolist’s
behaviour. I.e. the industry’s pricing policy is determined by the
Government intervention in a natural monopoly encounters problems in the:
o Short-Run (Price and Output)
There are three general types of pricing policies:
o The government dictates that the natural
monopoly set a price where the market demand
curve and the firm’s MC curve intersect.
o When a natural monopoly with falling average
costs sets a price equal to MC, it will suffer
o Customers pay one price to gain access to the
product and a second price for each unit
I.e. hook-up fee for new T.V. subscribers.
o The firm produces the level of output at which
the demand curve intersects the ATC curve.
o For a natural monopoly with falling average
costs, a policy of average-cost pricing will not
result in allocative efficiency because price will
not equal marginal cost.
o Long-Run (Investment)
Average-cost pricing generally leads to inefficient long-run