A Level. Economic Efficiency and Market Failure

Introductory Task


We know that price can act as a signal to enable a market to reach an equilibrium. Society though, is made up of many different markets. We will now consider how price works in this context.

We also know about consumer surplus, which is a measure of the benefit that consumers receive from consuming a good, calculated as the difference between what they would be willing to pay for it and what they actually pay. Similarly we know about producer surplus, the amount earned by firms beyond the minimum amount that would have kept them in the market.


To tackle the fundamental economic problem of scarcity, a society must find how to use its limited resources as effectively as possible. Economists consider two aspects of efficiency that societies seek to achieve.

Below is a production possibility curve (PPC) for a country regarding production of agricultural or manufactured goods:

As we know, at point A the economy is not using its resources fully, however it is more difficult to compare points B and C. Both are on the curve, so both represent resources being fully used.

Hence the first aspect of efficiency is whether or not society is operating on the PPC (known as productive efficiency) and the second aspect of efficiency is where on the PPC it is operating (allocative efficiency), i.e. whether it is producing the balance of goods that consumers wish to consume. Any point that is on the PPC is called a Pareto optimum, which means that it is impossible to make someone better off without making someone else worse off, as resources are already being allocated in the most efficient way. It is important to distinguish allocative efficiency, which is when firms are producing the goods and services most wanted by consumers (as indicated by their price being equal to their marginal cost).


Productive efficiency is achieved when a firm operates at minimum average total cost (total cost divided by quantity produced), choosing an appropriate combination of inputs (cost efficiency) and producing the maximum possible output from them (technical efficiency). To help achieve this, firms will often try to get economies of scale, whereby an increase in the amount of production leads to a lower long-run average cost.

The appropriate technique of production (and the balance between factors of production, e.g. capital and labour) will depend upon the level of output that the firm wishes to produce.

  • So there are three steps in a firm’s decision making:
    1. Decide quantity of output to produce;
    2. Choose appropriate combination of factors of production for this quantity;
    3. Produce as much output as possible given the chosen inputs

Task – Reducing Costs

Task – Productive Efficiency

Explain the difference between productive efficiency in a firm and productive efficiency in an economy.

Allocative Efficiency

Allocative efficiency is achieved when a society is producing an appropriate bundle of goods relative to consumer preferences. Market forces tend towards a position where from the consumers’ perspective the price is equal to the marginal benefit received from consuming the good and from the firms’ perspective the price is equal to the marginal cost of producing the good. We need to consider for each market though, whether this situation is always achieved.

Task – Allocative Efficiency 1

Task – Allocative Efficiency 2

Dynamic Efficiency

In the early 20th Century, Joseph Schumpeter emphasised the importance of considering Dynamic Efficiency, which is a view of efficiency that takes into account the effect of innovation and technical progress on productive and allocative efficiency in the long run. i.e. production can become more efficient in the future due to research and development carried out in the present. Also, as new products are developed this can mean that a different bundle of goods will better serve consumers. When a firm is dynamically efficient, its long-run average cost curve (LRAC) shifts downwards, as shown below:

Task – Brief Discussion then Article

Number of Flights

Will people fly less in the future?

Not according to the latest forecasts of the global aircraft fleet in 2038. It is projected that the global aircraft fleet will almost double to over 50,000 aircraft in 2038. The largest increase, 146%, is expected in the Asia-Pacific region, with large increases also expected in Europe and North America, 77% and 45% respectively.

Around 2.5% of global carbon dioxide emissions come from aviation. This may not seem much compared with other sources, but there is growing pressure for individuals to cut back on the number of times that they fly and to use alternative forms of transport, such as rail, which are far more efficient in terms of emissions and fuel used.

Interestingly, in addition to environmental groups, two of Europe’s biggest airlines, KLM and Lufthansa, have launched campaigns to get people to think more about whether they need to fly. The head of Lufthansa has criticised low-cost airlines for flying too many people to too many destinations and thus damaging the environment.

  • Consider the arguments for flying less;
  • Discuss the likely economic and social impact of fewer people flying for business and leisure reasons;
  • Think about the impact that fewer aircraft would have on global supply chains
  • Write an article with the the title The Economic impact of a reduction in number of flights

How a market economy works

One way to understand how a market economy works is using the concept of opportunity cost. If a company chooses to produce cheap mobile phones, then it is not using its resources to produce top-end smartphones. This represents an opportunity cost and if the profitability of top-end smartphones becomes much higher than the profitability of cheap mobile phones the company can find that they are not covering their opportunity costs and so they will transfer production from the cheap mobile phone market to the top-end smartphone market.

This process of resource allocation is called capitalism, a situation in which individuals own the means of production and can pursue whichever activities they prefer (within the law). A government in this system is responsible for providing a basic framework of property rights and a basic legal framework, but they do not intervene directly in the production process. Consumers are then left to try to maximise the satisfaction they gain from consuming a range of products and firms are left to try to maximise their profits by responding to customer demand through the medium of price signals.

Adam Smith referred to this process of capitalism as allowing effective allocation of resources by the operation of an invisible hand, meaning that whilst individuals are pursuing their self-interest, the overall effect at society level is positive. He also warned however that many factors interfered with the free market system and that there was a risk of cartels and so some government intervention would be necessary to support the operation of free markets.

Task – Market Economy

Task – Improved Allocation of Resources

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