Allocative efficiency occurs when consumer demand is completely met by supply. In other words, businesses are providing the exact supply that consumers want.
For instance, a baker has 10 customers wanting an iced doughnut. The baker had made exactly 10 that morning – meaning there is allocative efficiency. Neither too few doughnuts were made, nor too many – which means no waste in terms of having to throw away doughnuts, nor unsatisfied customers wanting doughnuts.
Key Points
Allocative efficiency occurs from the producers side as well as the consumers side. This is when demand is fully met, and production is optimised until marginal costs = marginal revenue – therefore no more profits are made.
In economics, allocative efficiency occurs at the point where supply and demand intersect. This is also known as the equilibrium.
In order to achieve allocative efficiency, markets must be competitive and free of externalities, monopolies, and other market distortions. In such a market, prices serve as signals of relative scarcity, and producers respond to those signals by allocating resources efficiently.
The second component occurs when consumers pay the marginal cost of production. In other words, businesses stop producing when the cost is higher than the price they can sell for. Just think of the supermarket making a loaf of bread, costing it $2, and selling it at $1.50.
Quite simply, allocative efficiency occurs where there is efficiency both from the consumers point of view, but also for that of the producer. That means there are enough goods to satisfy consumer demand, but also enough demand to maximise business profits – also known as Marginal Cost = Marginal Revenue.
Producer Side
To expand, the first side of allocative efficiency comes from the producer. When the market is allocatively efficient, the producer will continue to produce more and more up till the point where marginal cost is equal to price. In other words, where it no longer makes a profit. This is where the cost to make an additional good is equal to the price that it sells that good for. This may be due to a number of factors which make the good more expensive to produce as production increases (also known as diseconomies of scale).
As we can tell from the chart below, the business will continue producing until the supply and demand curve intersect. In an allocatively efficient market, this would be where marginal cost equals marginal utility. This is also known as the equilibrium point – marked up as 2 below. If the producer produces at a lower quantity, there will be excess demand — meaning it is not allocatively efficient from the consumers side.
