I N S T R U C T I O N A L M AT E R I A L F O R P U B L I C E C O N O M I C S

PART B
ECONOMIC EFFICIENCY AND THE COMPETITIVE
PRICE SYSTEM

Learning Outcomes
This chapter will discuss the concept of pareto optimality and efficiency of competitive market which
includes exchange efficiency, productions efficiency, and overall efficiency. At the end of the chapter, the
students will be able to understand the concepts of economic efficiency and econolic losses, discuss the
different types of externalities and explain how both the government and private sectors make decisions
in order to achieve optimal efficiency and minimize negative externalities.

Economic Efficiency be shown in the next discussion under 2.2). The

In the market economy, competition exist among intuitive case for this is based on the fact that
firms with limited resources aimed at using them prices reflect economic values in a competitive
at their optimum efficiency to maximize profit. market. If a unit of goods or services could
There are two major categories of competition: produce more or bring greater satisfaction in some
perfect competition and imperfect competition. activity other than its present use, someone would
Firms in perfect competition are price takers of have been willing to bid up its price, and it would
what is being dictated by the market. On the other have been attracted to the new use.
hand, firms under imperfect competition set their
price at levels that will miximize profit using limited When this price system is in equilibrium, the
resources at optimal economic efficiency. marginal revenue product, the opportunity cost,
and the price of a resource or asset will all be
Economic efficiency is a situation where every equal. Each unit of every good and service is in its
resource is allocated optimally so that each person most productive use or best consumption use. No
is served in the best possible way and inefficiency transfer of resources could result in greater output
and waste are minimized. Other factors that show or satisfaction.
economic efficiency:
1. Production of goods is at its lowest cost. This can be examined more formally in terms of
2. One person cannot be helped, by means of three criteria that have to be met for a market
reallocating the goods, without making another equilibrium to result in Pareto Optimality. These
person worse off. are that there should be: exchange efficiency,
3. It indicates that there has been a balance production efficiency and output efficiency.
between loss and benefit.
a. Exchange efficiency
Pareto Principle
Pareto efficiency is an economic situation where Exchange efficiency occurs when, for any given
resources cannot be reallocated to make one bundle of goods, it is not possible to redistribute
individual better off without making at least one them such that the utility (welfare) of one
individual worse off. Pareto efficiency implies that consumer is raised without reducing the utility
resources are allocated in the most economically (welfare) of another consumer.
efficient manner, but does not imply equality or
fairness. An economy is said to be in a Pareto A simple example of this is where there are two
optimum state when no economic changes can individuals, one with a loaf of bread, the other with
make one individual better off without making at a block of cheese. Both can be made better off by
least one other individual worse off. exchanging bread for cheese. An efficient exchange
system will allow exchange of bread and cheese to
You may immediately recognise that this is the take place until neither party can be made better
socially optimal outcome achieved by a perfectly off without one of them becoming worse off.
competitive market. An economy will be Pareto
Optimal when the economy is perfectly competitive Exchange efficiency alone does not necessarily
and in a state of static general equilibrium (will result in Pareto Optimality. This is because it

12
 D E V E L O P E D B Y : P U P C S S D D E PA R T M E N T O F E C O N O M I C S

relates only to a specific bundle of goods. It may

be possible to make one or more individuals even c. Output efficiency
better off - without making any one else worse
off - by altering the bundle of goods produced in Output efficiency occurs where the combination
the economy. This could involve raising the total of products actually produced is such that there is
volume of goods produced, as well as altering the no alternative combination of products that would
combination of goods produced. raise the welfare of one consumer without reducing
the welfare of another.
b. Production efficiency
Both the exchange efficiency and the production
Production efficiency occurs when the available efficiency criteria must hold in order for this
factors of production are allocated between criterion to be met. The combination of outputs
products in such a way that it is not possible to produced according to this criterion is distributed
reallocate the production factors so as to raise the between consumers according to the exchange
output of one product without reducing the output efficiency criterion, and the economy is operating
of another product. with production efficiency.

This is similar to technical or production efficiency Pareto Optimality is the result of rational economic
at the level of the firm. What is being said here behaviorr on the part of producers, consumers,
is that there are many situations in which it is and owners of factors of production in a perfectly
possible to raise the total output in an economy competitive economy. It is important to realize
by simply reallocating factors of production at that, whilst Pareto Optimality is the outcome in an
no additional cost. This is because factors of economy that meets each of the three efficiency
production are more productive in some uses criteria listed earlier, this does not mean that there
than they are in others. In a competitive economy, is only one ‘optimal’ allocation of resources.
producers bid for factors of production until they
are reallocated to their most productive use. A Pareto efficient economy results in the
maximization of aggregate economic welfare
For example, if there is a lot of unproductive, for a given distribution of income and a specific
low-wage labour employed in the agricultural set of consumer preferences. A shift in income
sector and labour shortages in the industrial distribution changes the incomes of individual
sector where labour productivity is potentially consumers. As their incomes change, so too
high, factory owners will bid up the price of labour will their preferences, as their demand curves
and draw labour from the agricultural sector into for various products shift to the left or right.
the industrial sector. This could significantly raise This will result in a different equilibrium point in
output in the industrial sector without having the various markets that make up the economy.
a negative impact on output in the agricultural Every alternative distribution of income or set of
sector. So long as factors of production can be preferences is characterized by a different Pareto
redistributed in a way that increases the output of Optimum. Thus, since there is an infinite number of
one product without reducing the output of others, different ways in which income can be distributed,
the economy is operating sub-optimally in terms of there is also an infinite number of different Pareto
production efficiency. Optimal equilibriums.

13