Allocative Efficiency

Allocative efficiency is the level of output where the price of a good or service is equal to the marginal cost of production. It can be achieved when goods and/or services have been distributed in an optimal manner, and when their marginal cost and marginal utility are equal.

What is Allocative Efficiency?

The term refers to the degree of equality between the marginal benefits and marginal costs. The marginal cost is the cost of producing one additional item, and is used to pinpoint the optimal economy of scale. The marginal benefit is the greater enjoyment created by producing one additional item.

Allocative efficiency will occur when both consumers and producers have free access to information, allowing them both to make the most efficient possible decisions in purchasing and production. According to this principle, it is also necessary that consumer have free choice over the goods/services that maximize their individual satisfaction.

Why does Allocative Efficiency matter?

Operating in accordance with allocative efficiency ensures the correct resource allotment in terms of consumer needs and desires. Virtually all resources (i.e. factors of production) are limited; therefore, it’s important to make the right decisions regarding where to distribute resources in order to maximize value.

The aim is to achieve the ideal opportunity cost. The opportunity cost of a particular thing is the value that must be sacrificed in order to put resources of time, money, etc. toward that thing.

Economies of scale ensure that opportunity costs decrease as production levels increase, up to a point. Then, past certain levels of production, opportunity cost may begin to increase once again. Likewise, with higher supply, demand decreases.

The market equilibrium is the point at which value for society as a whole has been maximized, and allocative efficiency has been achieved. For these reasons, aiming to achieve allocative efficiency is valuable to both consumers and producers.

Example of Allocative Efficiency

Let’s say someone decides to buy a new suit, and goes to a clothing shop. The shop is going to have the cuts and colors of suits that are most in-demand. They’re much more likely to have the standard navy blue suits available for sale than something with much lower demand like a bright green suit, even if there are a few consumers who’d love a more unusual color.

This reality is in line with allocative efficiency: the suits that are available are limited because car retailers’ resources are not infinite, and they need to put their energy into the styles that are in the highest demand. Putting resources toward the items in highest demand helps them achieve higher profits.

In this case, the marginal benefit of the person in this example who is going to the clothing shop is near equal to the clothing shop’s marginal cost: the amount they will pay for more suits. Even though some consumers might want a bright green suit, the majority will prefer navy blue, so clothing manufacturers will put their resources (advertising and production dollars) toward navy blue suits.

Allocative vs. Productive Efficiency

Productive efficiency centers around producing goods at the lowest possible cost. This is based on the method of production, in contrast to the allocative efficiency, which is the amount that is produced.

Productive efficiency and allocative efficiency are two ideas that are very different, although they are certainly connected.

If you produce unwanted amounts of goods in a highly efficient manner, you have achieved high productive efficiency, but low allocative efficiency. It is important that both allocative and productive efficiency be reached in order to maximize satisfaction for as many people as possible, and thus benefit society as a whole.

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