Definition: Allocative efficiency occurs when there is an optimal distribution of goods and services. This involves taking into account the preferences of consumers.
A more precise definition of allocative efficiency is at an output level where the price equals the Marginal Cost (MC) of production. This is because the price that consumer's are willing to pay is equivalent to the marginal utility that they get. Therefore the optimal distribution is achieved when the marginal utility of the good equals the marginal cost.
- Firms in perfect competition are said to produce at an allocatively efficient level (P=MC)
- Monopolies can increase price above the marginal cost of production and are allocatively inefficient.
Monopoly sets a price of Pm. This is allocatively inefficient because price is greater than MC.
Alloactive efficiency would occur at the point where the MC cuts the Demand curve so Price = MC.
- Note: Producing on the production possibility frontier is not necessarily allocatively efficient because a PPF is not concerned with distribution. This requires the addition of indifference curves
- Productive Efficiency
- Social Efficiency
- Consumer Choice Theory - more detailed examination of maximising total utility, looking at consumer equilibrium and marginal rate of substitution.
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