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32 Efficiency & Market Failure

Chapter 32: Efficiency & Market Failure

Efficiency

  • Efficiency — using scarce resources well and minimising waste.

  • Economic efficiency — using scarce resources in the best possible way to maximize output, consumer utility, or social benefit.

  • Optimum / optimality — the greatest possible satisfaction of wants that can be achieved with scarce resources.

  • Productive efficiency — producing a given level of output at the lowest possible unit or average cost. For a firm, this occurs at minimum average cost.

  • Cost efficiency — choosing the least-cost combination of factor inputs for a given output.

  • Technical efficiency — producing the maximum possible output from a given combination of inputs.

  • Allocative efficiency — allocating resources to produce the combination of goods and services most valued by consumers. The key condition is P = MC; in a competitive market, P = MB, so MB = MC.

  • Marginal cost (MC) — the addition to total cost caused by producing one extra unit of output.

  • Pareto optimality / Pareto efficiency — a situation in which it is impossible to make one person better off without making someone else worse off.

  • Pareto improvement — a change that makes at least one person better off without making anyone else worse off.

  • Dynamic efficiency — the efficient allocation of resources over time, usually through innovation, research and development, new production methods, and investment that meet changing needs and raise future output or productivity. It is a long-run concept.

  • Static efficiency — the best allocation of scarce resources at a given point in time. Productive and allocative efficiency are static concepts.

  • Market failure — a situation in which a free market, without government intervention, fails to make the best use of scarce resources, so the market outcome is not productively and/or allocatively efficient.

  • Externality — a cost or benefit of production or consumption imposed on, or received by, a third party and not reflected in the market price.

  • Negative externality — a harmful external effect that imposes an external cost on third parties. Because this cost is not fully included in the market price, the market may overproduce and underprice the good.

  • Positive externality — a beneficial external effect received by third parties without full payment through the market.

  • Information failure — a situation in which consumers or producers lack complete, accurate, or relevant information, leading to choices and resource allocation that may be inefficient.

  • Merit good — a good that creates positive externalities and is likely to be underconsumed in a free market, often because consumers underestimate its benefits.

  • Demerit good — a good that creates negative externalities or wider harm and is likely to be overconsumed in a free market.

  • Public good — a good that is non-rival in consumption and non-excludable, so private markets may underprovide it.

  • Moral hazard — a situation in which an economic agent has an incentive to take more risks because they do not bear the full costs of those risks.

  • Adverse selection — a situation in which asymmetric information causes high-quality goods or high-quality consumers to be excluded from transactions because their quality cannot be demonstrated.

  • Economic myopia — a failure to give sufficient weight to long-term costs and benefits, meaning that an economic agent discounts the future too heavily.

Distinctions to Memorize

  • Productive vs allocative efficiency: productive efficiency concerns the cost of producing a given output; allocative efficiency concerns whether the right goods are produced in the right quantities for consumers.
  • Pareto efficiency vs productive efficiency: a point can be productively efficient without being Pareto efficient if the allocation of output does not reflect consumer preferences.
  • Static vs dynamic efficiency: static efficiency concerns the best use of resources now; dynamic efficiency concerns improvement and innovation over time.
  • Private cost vs external cost: private cost is borne by the producer or consumer making the decision; external cost falls on third parties.
  • Market failure vs market disequilibrium: market failure is an inefficient allocation of resources; it is not simply a temporary shortage or surplus.

Diagram-Linked AO1 Terms

  • Marginal benefit (MB) — the additional benefit to consumers from consuming one more unit.
  • Total surplus — the sum of consumer surplus and producer surplus.
  • Deadweight loss (DWL) — the loss of total surplus caused by output being away from the allocatively efficient level.

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