Allocative Efficiency: Definition, Examples & Productive Efficiency
Allocative Efficiency Definition
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.
- 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.
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.
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.
From the consumer’s perspective, a market is allocatively efficient when the price reflects the maximum they are willing to pay. In other words, allocative efficiency is where the consumers satisfaction is maximized in relation to cost. For instance, the consumer may be willing to spend a maximum of $5 on a bagel. This is the price at which maximizes the consumer’s utility, but also the price paid to the producer.
As the price increases, the level of utility or satisfaction decreases. For instance, few would enjoy a croissant if they had to pay $50 for it. So allocative efficiency is where consumers maximize their utility, but also the price they pay.
Allocative Efficiency Expanded
We have looked at the producer and consumer side of allocative efficiency. So let us now define this in more detail.
In order to be allocatively efficient, the market must meet two criteria. The first is from the producer side. The producer must supply the market up until it is no longer profitable to produce another good. However, this must also fit in line with the second factor. This must also be at the price which maximises marginal utility. As we can see in the graph below, the two points must intersect to classify as allocatively efficient.
So in short, allocative efficiency applies when producers continue production up until a point where its marginal costs align to the maximum utility and price a consumer would be willing to pay.
Example of Allocative Efficiency
There is a business that manufactures cars called Michaels Motors. Each car that they manufacture is sold at a price of $20,000. In 2019, the firm manufactured 100 cars in the year. At the same time, they had 100 orders come in – allowing them to sell all the stock they had. This is allocatively efficient from the consumer side as there is no excess demand for the product. In other words, no customer is going without.
So what stopped Michaels Motors from producing even more cars in the year? Well at 99 cars, it was still costing them less than $20,000 to make an additional unit. The 100th car they made cost them $20,000 to make – meaning they would not make any profit on it. Therefore, at this point, we see allocative efficiency from the producer’s perspective.
Allocative Efficiency vs Productive Efficiency
Productive efficiency occurs when a business focuses on producing a good at the lowest possible cost. By contrast, allocative efficiency looks to optimize how the goods are distributed.
To explain, a business could produce 10 million units of Product A for $2. This would suggest that it has productive efficiency. However, it does not mean it has allocative efficiency. For instance, nobody may want Product A, which means it is highly inefficient. Nobody benefits from the lower costs nor do they receive any utility.
Allocative Efficiency in Perfect Competition
Under perfect competition, businesses are said to be allocatively efficient as they produce to a paint where price = marginal cost.
True allocative efficiency can only exist under perfect competition. This is because perfectly competitive firms are profit maximizers. They must operate under strong competition which brings marginal revenue in line with marginal costs. In turn, this creates an environment that maximizes the consumer’s utility. However, in reality, neither allocative efficiency nor perfect competition exists.
With that said, the theories themselves are used as an ideal to aim for.
One example is where a bakery makes baked goods. It produces 100 loaves of bread for customers. In the same day that those loaves are made, there are exactly 100 customers that come in looking for a loaf of bread. The baker has supplied 100 loaves, and equally, 100 loaves have been purchased – resulting in allocative efficiency.
It is where demand is fully met by supply, with no excess. In other words, the amount supplied to market equals exactly the amount that is demanded.
Allocative efficiency comes as a result of the supplier knowing exactly how many goods they need to provide to the market. That way, the supplier can reduce any excess waste and capacity and the consumer is always able to get the goods they want.
Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.