MARKET STRUCTURE, STATIC EFFICIENCY, DYNAMIC EFFICIENCY AND RESOURCE ALLOCATION: AQA Economics Specification Topic 4.1

Topic 4.1 - Individuals, firms, markets and market failure

Snapshot of the AQA syllabus topic area we’ll be covering in this post.

MARKET STRUCTURE, STATIC EFFICIENCY, DYNAMIC EFFICIENCY AND RESOURCE ALLOCATION: Perfect competition, imperfectly competitive markets and monopoly

AQA students must understand the following content [taken from the syllabus]

• The difference between static efficiency and dynamic efficiency.

• The conditions required for productive efficiency (minimising average total costs) and allocative efficiency (price = marginal cost).

• Dynamic efficiency is influenced by, for example, research and development, investment in human and non-human capital and technological change.

INFORMATION YOU NEED TO KNOW

[NOTE: supporting diagrams and questions at the end]

Introduction:

A fundamental idea in economics, efficiency, includes several aspects of production and resource allocation. Static efficiency and dynamic efficiency are two crucial facets of efficiency that will be covered here. We will also go over the prerequisites for productive efficiency and allocative efficiency, as well as how variables like R&D, investments in human and non-human capital, and technological advancement affect dynamic efficiency.

Static Efficiency: Optimal resource allocation and utilisation at any one moment in time are referred to as static efficiency. It emphasises using resources in a way which maximises measured social welfare at a point in time.

• Productive Efficiency: Productive efficiency, a form of static efficiency, happens when businesses create goods and services at the lowest average total cost. Utilising effective production methods, taking use of economies of scale, and reducing resource waste are necessary to achieve productive efficiency.

  • Competitive firms are more likely to be productively efficient. This is because long-run competition requires you to produce at the lowest possible cost - this occurs at the lowest point of a firm’s ATC curve.

  • Monopoly powers, on the other hand, are less likely to be productively efficient. This is because monopolies tend to restrict output and raise prices. Lower levels of output mean higher costs per unit on a firm’s ATC curve.

• Allocative Efficiency: Allocative efficiency, another form of static efficiency, occurs when resources are allocated in a way which best reflects its value to society.

  • Allocative efficiency is achieved when the price of a good or service is equal to its marginal cost of production (P=MC). This means the selling price is equal to the cost of the final unit produced.

  • Allocative efficiency means that resources are allocated in a way where the marginal benefit to consumers is equal to the marginal cost of production, resulting in an optimal level of output.

  • If fewer units were made than at the point P=MC, producing another unit would benefit consumers more than additional cost to consumers.

  • If you surpass the point P=MC and produce even more units, then the cost of producing those units would outweigh the additional benefit consumers receive from those units.

  • Competitive firms are more likely to achieve allocative efficiency. This is because in a competitive market, firms can only accept the market price as due to them being price takers. This means a competitive firm’s pricing and output is a better reflection of consumer wants and needs.

  • Monopolistic firms are less likely to achieve allocative efficiency. This is because a monopolist is able to maximise their own welfare without worrying about the threat of competition. The fact that a monopolist is a price maker, means that a profit maximising firm can generate supernormal profits. This entails producing at lower levels of output and raising prices to the point where P>MC. Society would benefit more if the monopolist reduced prices and raised their output, but doing that would mean a sacrifice of profitability for the firm - so the final outcome is supernormal profits for the monopoly at the expense of societal welfare.

Dynamic Efficiency: Dynamic efficiency is concerned with how quickly an economy may evolve thanks to new ideas, technical developments, and expenditures on research and development (R&D). It places emphasis on the prospect for sustainable economic growth as well as long-term increases in productivity. An economy with dynamic efficiency can respond to shifting conditions and grab new possibilities.

• It’s worth noting that dynamic efficiency depends heavily on investment such as investment into human capital or non-human capital like machinery.

• It’s also worth noting that dynamic efficiency depends on greater levels of funding, because business investment doesn’t come cheap.

• This means that more profitable businesses can create dynamic efficiency throughout society and drive economic progress.

X-Inefficiency: When a company uses its resources and technology inefficiently and fails to reduce expenses, this is referred to as X-inefficiency. When a company does not achieve the optimum level of productive efficiency, it leads to waste and unnecessary costs. Organisational inefficiencies, managerial incompetence, and a lack of competition are some of the causes of X-inefficiency. Resources are not used to their full potential in x-inefficient firms, which raises expenses, lowers productivity, and lowers profitability.

• Competitive firms are less likely to be x-inefficient due to the cutthroat nature of a competitive market. Competitive firms always have the incentive to find new ways of reducing costs to gain an advantage over rivals, therefore they are likely to minimise waste and raise the efficiency of their production lines.

• Monopolies and large government organisations are more likely to be x-inefficient. Larger firms typically have more complex production lines, a greater level of human labour input, and less of an incentive to cut costs due to high barriers to entry.

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diagram to illustrate static efficiency in a competitive market - this is a perfectly competitive market because AR=MR and normal profits are being made (price = cost per unit) - notice that at this level of output, P=MC which means the market is allocatively efficient - also notice that MC=AC which is the lowest cost per unit possible - this means the firm is productively efficient

diagram to illustrate productive effiency - productive efficiency occurs when a firm maximises their output with respect to minimising the cost per unit - this occurs at the point where MC=AC

diagram to illustrate x-inefficiency - this occurs in larger organisations protected from competition - the company’s ATC 1 curve is higher than the more efficient ATC 2 curve - this is because their production lines are not optimised for reducing costs - the distance between ATC1 and ATC2 is the level of x-inefficiency

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SUPPORTING QUESTIONS

Question 1: What is the condition required for allocative efficiency to be achieved in a perfectly competitive market?

Answer:

Allocative efficiency is achieved in a perfectly competitive market when the price of a good or service is equal to its marginal cost (P=MC). In other words, the quantity produced and consumed in the market is such that the last unit produced provides a benefit equal to its cost of production. This means, in the absence of other market failures such as externalities, a perfectly competitive firm behaves in a way that maximises measured societal welfare

Question 2: Explain why a competitive firm might not be dynamically efficient compared to a monopolistic firm.

Answer:

Dynamic efficiency refers to a kind of effiency achieved over time as a result of the research, development, innovation and invention that benefits society over the long term. This requires a high degree of investment outlay which is not always achievable for a competitive firm. This is because in the long-run, a competitive firm only produces normal profits. Normal profits are defined as the level of profit required for a business to stay operational. Normal profitability does not allow for high degrees of frivolous spending into R&D, which means competitive firms are only often statically efficient.

Monopolies, on the other hand, can produce supernormal levels of profit. These supernormal profits can be reinvested into producing new and better products that come with the benefit of economic progress. This is why larger firms are more likely to be dynamically efficient.

An example of dynamic efficiency in action would be the case of Uber, the global taxi firm. Before the advent of Uber, taxi firms were typically competitive businesses making normal levels of profit. This is because the barriers to entry and exit were relatively low in that industry.

A typical competitive taxi firm would not have the level of funding necessary to develop a new revolutionary app and market it all around the world. A very large firm with millions of dollars of start-up funding such as Uber had to come along and change the market for taxi hire.