21 Productive Efficiency and Allocative Efficiency (17/108) -- Macroeconomics

21 Productive Efficiency and Allocative Efficiency Learning Objectives - Use the production possibilities frontier to identify productive and allocative efficiency Efficiency In a market-oriented economy with a democratic government, the choice of what combination of goods and services to produce, and thus where to operate along the production possibilities curve, will involve a mixture of decisions by individuals, firms, and government, expressing supplies and demands. However, economics can point out that some choices are unambiguously better than others. This observation is based on the idea of efficiency. In everyday parlance, efficiency refers to lack of waste. An inefficient washing machine operates at high cost, while an efficient washing machine operates at lower cost, because it’s not wasting water or energy. An inefficient organization operates with long delays and high costs, while an efficient organization is focused, meets deadlines, and performs within budget. The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency. Figure 2, below, illustrates these ideas using a production possibilities frontier between health care and education. Productive efficiency means that, given the available inputs and technology, it’s impossible to produce more of one good without decreasing the quantity of another good that’s produced. All choices along the PPF in Figure 2, such as points A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either health care increases and education decreases or vice versa. This makes sense if you remember the definition of the PPF as showing the maximum amounts of goods a society can produce, given the resources it has. Thus, producing efficiently leads to maximum production, which is what the PPF shows. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it’s possible to produce more of one good, the other good, or some combination of both goods. Wasting scarce resources means the society is not producing as well or as much as it could, so it is not operating on the PPF. For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and health care on the vertical axis is also higher at point C than point R (H2 is greater than H1). Any time a society is producing a combination of goods that falls along the PPF, it is achieving productive efficiency. When the combination of goods produced falls inside the PPF, then the society is productively inefficient. Allocative efficiency means that the particular mix of goods a society produces represents the combination that society most desires. For example, often a society with a younger population has a preference for production of education, over produ