CHAPTER 6 : BASIC ECONOMIC IDEA AND RESOURCE ALLOCATION
6.1 EFFICIENT RESOURCE ALLOCATION
● productive and allocative efficiency
● Pareto optimality
● dynamic efficiency
TERMS DEFINITION / FORMULA
Economic efficiency - The optimal use of scarce inputs to produce the
largest possible output
Optimality / optimum - The best situation than can be attained in particular
circumstances
Productive efficiency - The most efficient use of scarce resources whereby
the maximum output is produced with the minimum
of resources
Technical efficiency - The situation in a firm where production is at the
lowest point on the average total cost curve
Allocative efficiency - The quantity of output produced with scarce
resources that leads to the best satisfaction for
consumers
Pareto optimality - Situation when it is not possible to make one
person better off without making someone else
worse off as a result of reallocating resources
Pareto improvement - Changes in production or consumption can make
someone else better off without making anyone
worse off
Dynamic efficiency - The greater efficiency that results from
improvements in technical or productive efficiency
over a period of time
● Efficiency (Static vs Dynamic)
- Static : exist at a point in time → productive and allocative
- Dynamic : over a period of time → long term future development
,● Productive efficiency (in a firm)
- Products are made with the least possible use of scarce resources
- Technical efficiency → least possible resources
- Cost efficiency → least cost
- MC = AC
● Productive efficiency (in an economy)
- Point on PPC → B, D, C
● Maximum use of resource → no wastage → Productively efficient
- Point inside PPC → A
● Wastage exists → Productively inefficient
- Point outside PPC → X
● Unattainable
● Ways to achieve → discovery of new resources, increases in population
● Allocative efficiency
- Producing right products at right quantity
- Producing combination of goods that yields max satisfaction of consumers’ want
- Price = preferences and benefits derived from consumption
- Price = true economic cost of producing the last unit of the good
- P = MC
,● Pareto optimality
- Inputs are used in the most efficient way (productive efficiency) and yields
maximum possible satisfaction to consumer (allocative efficiency)
- Both productive and allocative efficiency are achieved
- Where MSB ≠ MSC → Pareto improvement will be made until pareto optimality is
achieved
- Pareto improvement : D → A , D → B
● Dynamic efficiency
- Output increases relative to the increases in resources
- Innovation → to meet changing demand
- Enjoyed by big firms → use excess profits to engage in R&D
- Consumer → lower price, new technologies
- Long-term phenomenon
- LRAC shifts downward
, 6.2 EXTERNALITIES AND MARKET FAILURE
● reasons for market failure
● positive and negative externalities for both consumers and firms
● inefficient resource allocation
TERMS DEFINITION / FORMULA
Market failure - Market fails at delivering economic efficiency
Externality - Transaction between consumers and producers
affects someone else who is not the party of the
economic decision (third party)
Private cost - Cost of an activity to an individual economic unit
such as a consumer or a firm
Private benefit - Benefits received by an individual consumer or a
firm
● Market failure
- Free market is left on its own → fail to make the optimum use of scarce
resources
- Interaction between demand and supply does not lead to productive and
allocative efficiency
● Reasons for market failure
- Externalities
- Missing market → no provision of public goods
- Existence of monopoly
- Factor immobility
- Income inequality
● Externalities
- Difference exists between private costs and benefits and social costs and
benefits
- Negative externality → external cost
- Positive externality → external benefit
6.1 EFFICIENT RESOURCE ALLOCATION
● productive and allocative efficiency
● Pareto optimality
● dynamic efficiency
TERMS DEFINITION / FORMULA
Economic efficiency - The optimal use of scarce inputs to produce the
largest possible output
Optimality / optimum - The best situation than can be attained in particular
circumstances
Productive efficiency - The most efficient use of scarce resources whereby
the maximum output is produced with the minimum
of resources
Technical efficiency - The situation in a firm where production is at the
lowest point on the average total cost curve
Allocative efficiency - The quantity of output produced with scarce
resources that leads to the best satisfaction for
consumers
Pareto optimality - Situation when it is not possible to make one
person better off without making someone else
worse off as a result of reallocating resources
Pareto improvement - Changes in production or consumption can make
someone else better off without making anyone
worse off
Dynamic efficiency - The greater efficiency that results from
improvements in technical or productive efficiency
over a period of time
● Efficiency (Static vs Dynamic)
- Static : exist at a point in time → productive and allocative
- Dynamic : over a period of time → long term future development
,● Productive efficiency (in a firm)
- Products are made with the least possible use of scarce resources
- Technical efficiency → least possible resources
- Cost efficiency → least cost
- MC = AC
● Productive efficiency (in an economy)
- Point on PPC → B, D, C
● Maximum use of resource → no wastage → Productively efficient
- Point inside PPC → A
● Wastage exists → Productively inefficient
- Point outside PPC → X
● Unattainable
● Ways to achieve → discovery of new resources, increases in population
● Allocative efficiency
- Producing right products at right quantity
- Producing combination of goods that yields max satisfaction of consumers’ want
- Price = preferences and benefits derived from consumption
- Price = true economic cost of producing the last unit of the good
- P = MC
,● Pareto optimality
- Inputs are used in the most efficient way (productive efficiency) and yields
maximum possible satisfaction to consumer (allocative efficiency)
- Both productive and allocative efficiency are achieved
- Where MSB ≠ MSC → Pareto improvement will be made until pareto optimality is
achieved
- Pareto improvement : D → A , D → B
● Dynamic efficiency
- Output increases relative to the increases in resources
- Innovation → to meet changing demand
- Enjoyed by big firms → use excess profits to engage in R&D
- Consumer → lower price, new technologies
- Long-term phenomenon
- LRAC shifts downward
, 6.2 EXTERNALITIES AND MARKET FAILURE
● reasons for market failure
● positive and negative externalities for both consumers and firms
● inefficient resource allocation
TERMS DEFINITION / FORMULA
Market failure - Market fails at delivering economic efficiency
Externality - Transaction between consumers and producers
affects someone else who is not the party of the
economic decision (third party)
Private cost - Cost of an activity to an individual economic unit
such as a consumer or a firm
Private benefit - Benefits received by an individual consumer or a
firm
● Market failure
- Free market is left on its own → fail to make the optimum use of scarce
resources
- Interaction between demand and supply does not lead to productive and
allocative efficiency
● Reasons for market failure
- Externalities
- Missing market → no provision of public goods
- Existence of monopoly
- Factor immobility
- Income inequality
● Externalities
- Difference exists between private costs and benefits and social costs and
benefits
- Negative externality → external cost
- Positive externality → external benefit
