Friday, December 5, 2014

Is Allocative Efficiency and Social Efficiency the Same?

Allocative efficiency
It is when scarce resources are being combined in such a way to produce the highest number of output using the least cost method and these products are actually what the consumers desire the most as reflected by the value they place on it. Therefore, this relationship can also be written as P = MC or MB = MC or AR = MC (P = AR = MB)

Social efficiency
The condition for social efficiency is stricter and harder to be achieved. It is when scarce resources are combined in such a way to produce the maximum number of output using the cheapest possible method of production and these goods are what people value the most, taking into account both negative and positive externalities. The condition for social efficiency is when MSB = MSC

Relating all together
As can be seen, allocative efficiency may or may not be the same as social efficiency, depending on the case studies that we use. In practice, as observed, they are unlikely to be the same. In fact it is quite impossible for the relationship between the two to be identical

To simplify our analysis, consider merit goods like alcohol and cigarettes. A firm is said to be productively efficient if these cigarettes are produced using the most cost efficient method. In other words, the company itself is operating where MC = AC

The same firm can also become allocatively efficient if the cigarettes that they manufacture are actually what the smokers desire the most as reflected by the price that they are willing and able to pay. Therefore the condition of P = MC is met

However, cigarettes are demerit goods and smoking is always associated with negative externalities. In a pure market economy, firms will only take into account their own PB and PC during the production process. Therefore, cigarettes are manufactured up to the point where MPB = MPC. The same can be said with consumers. As they smoke, they only consider their own MPB and MPC and so will smoke up to the point where MPB = MPC. However, from the society’s point of view, smoking is harmful and its production or consumption should be reduced up to the point where MSB = MSC. The overproduction and overconsumption of cigarettes have resulted in the case of market failure

In conclusion, even if a firm is both productively and allocatively efficient, it is not necessarily socially efficient. Yes, they produce goods and services that consumers value the most and therefore in theory, allocation of resources should be efficient. However, the firm does not meet the last condition. Not everyone concurs that cigarettes are ‘beneficial’ and in most cases, societies (majority of the population which is non-smoker) often object their existence. Therefore, allocatively efficient and socially efficient are not the same

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