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Economic Efficiency in Markets and Introduc4on to Market Failure
Edexcel Economics 1.3.1
Economic Efficiency
• Efficiency is about a society making op4mal use of scarce resources to help sa:sfy changing wants & needs
• There are several meanings of efficiency but they all link to how well a market system allocates our scarce resources to sa:sfy consumers
• Normally the market mechanism is good at alloca:ng these inputs, but there are occasions when the market can fail
How well are scarce resources used? This is what is discussed when economists talk about economic efficiency
Alloca:ve Produc:ve
Dynamic Social
Alloca4ve Efficiency using a Price Theory Diagram
Economic efficiency means making op:mum use of scarce resources
Price
Quan:ty
Demand
Supply
P
Q
R
S
T O
Producer surplus
Consumer surplus
Alloca:ve efficiency is at an output which maximizes total consumer welfare
At the market equilibrium price, consumer and producer surplus is maximized – at this output, economic welfare is maximized.
Alloca4ve Efficiency • Alloca:ve efficiency is reached
when no one can be made beAer off without making someone else worse off. This is also known as Pareto efficiency
• Alloca:ve efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the factor resources used up in produc:on.
• The main condi:on required for alloca:ve efficiency in a given market is that market price = marginal cost of supply
A
B
C
Outputof Beer
Output of Cheese
X1
X2
X3
Y1 Y2 Y3
All points that lie on the PPF are alloca:vely efficient because we cannot produce more of one product without affec:ng the amount of all other products available.
Produc4ve Efficiency
• Produc:ve efficiency exists when producers minimize the wastage of resources
• Produc:ve efficiency also relates to when an economy is on their produc4on possibility fron4er
• An economy is produc:vely efficient if it can produce more of one good only by producing less of another.
A firm is produc:vely efficient when it is opera:ng at the lowest point on its average cost curve i.e. unit costs have been minimised
Cost Per Unit
Output
Produc:ve efficiency is achieved when the long run unit cost of produc:on is at a minimum
Average Cost
Social Efficiency
• The socially efficient level of output and/or consump:on occurs when marginal social benefit (MSB) = marginal social cost (MSC)
• The existence of nega4ve and posi4ve externali4es means that the private level of consump:on or produc:on differs from social op:mum
• The free market price mechanism does not always take into account social costs and benefits
Output
P1
Q1
MPC
MSC
MPB
MSB
P2
Q2
Costs, Benefits
Social op:mum output is where MSC = MSB
Dynamic Efficiency in Markets: Innova4on
Innova:on is pu_ng a new idea or approach into ac:on. Innova:on is 'the commercially successful exploita:on of ideas'
• Product innova4on • Small-‐scale and frequent
subtle changes to the characteris:cs and performance of a good or a service
• Process innova4on • Changes to the way in which
produc:on takes place or is organised
• Changes in business models and pricing strategies
• Innova:on has demand and supply-‐side effects in markets and the economy as a whole
Austrian economist Joseph Schumpeter (pictured) coined the term crea4ve destruc4on which refers to the upheaval of the established order in the pursuit of innova:on. Smaller disrup:ve businesses ocen challenge exis:ng firms!
What is Market Failure?
Market failure is when the price mechanism leads to an inefficient alloca:on of resources and a deadweight loss of economic welfare
Nega:ve externali:es
Posi:ve externali:es
Public goods Merit goods
De-‐merit goods Informa:on failures
Monopolies Immobility of factor inputs
Economic Efficiency in Markets and Introduc4on to Market Failure
EdExcel Economics 1.3.1