Assuming there’s not a market failure such as a monopoly or an externality, we assume that competitive markets are going to produce an efficient outcome. The economy is going to be efficient but what do we mean when we say efficient or efficiency? Well, there are three types of efficiency that we can think about in terms of the economy. There’s
- Efficiency in consumption
- Efficiency in production
- Product mix efficiency
All three of these types of efficiency are essential to have Pareto efficiency and with Pareto efficiency what we’re basically saying is, when we’re at an allocation that is Pareto efficient there’s no way we could make somebody in the economy better off without making at least one person worse off.
but let’s get back to our three types of efficiency I want to start by discussing the efficiency in consumption which will sometimes see referred to as exchange efficiency. So exchange efficiency just means that the goods that are produced in the economy end up in the hands of the people who value them the most.
Let’s say for example that I really like cookies and you really like cake. So let’s say there’s one cake and then there’s one plate of cookies in our economy and those are the only goods you should get the cake and I should get the cookies. Now if it started out where I actually had the cake and then you had the cookies we would just trade them. We would trade to the point where we have an efficient outcome and an outcome that’s efficient in consumption. Because I value cookies more and you value cake more we would just make a trade. When we are at an allocation that is efficient in consumption at that point there is no further sculpt for mutually beneficial trades because they’ve all been exhausted, we’ve already made the trades. So when we’re at the point where I have the plate of cookies and you have the cake we’d say that we are efficient in consumption. The economy’s efficient in consumption, the people who value the cookies and value the cake the most are the people who have them.
Now efficiency in production has to do with basically when you’re at a point at an allocation that is efficient in production you cannot produce any more of one good without producing less of another good. So let’s say that we had an economy with ice-cream cones and then we had slices of pizza. Let’s just think about those two specific types of goods and let’s say that if we just completely focused on producing ice-cream cones we’d produce 200 ice cream cones and 0 slices of pizza. Now if we just focused on slices of pizza we’d have 100 slices of pizza and 0 ice-cream cones. This is called the production possibilities frontier, any point along this curve is going to be efficient in production.
But I just want to focus on one point, let’s do an easy example. Let’s say we’re producing right here at the point “A”. Where there are 200 ice-cream cones are produced and then there are 0 slices of pizza. So if that’s the case, if we wanted to produce 1 slice of pizza or 2 slices of pizza whatever we want to increase and produce an additional slice of pizza go from 0 to 1 we’re going to have to decrease the number of ice-cream cones. We cannot produce any more than 0 slices of pizza without going from 200 to 198 ice-cream cones. We have to decrease the number of ice-cream cones at this point to be able to get some more slices of pizza. So all the points along the curve are efficient in production because they all those points you couldn’t get any more of one good without decreasing the amount of the other goods. So that’s efficient in production.
Now product mix efficiency is which is also called allocative efficiency has to do with people’s preferences in the economy. So basically the goods that are going to be produced are gonna go to the people who actually want or need them but it’s different than efficiency and consumption, I know it sounds similar but let me give an example of how it’s different. Let’s say we had an economy where we produce left shoes and right shoes. So if the economy just focuses specifically on left shoes and produces no right shoes at all just zero then we would have 50 left shoes and zero right shoes. Conversely, if we just focused on right shoes we’d have 50 right shoes and zero left shoes. Let’s just say that that’s the way the economy is.
Now it would be efficient in production, I’m not talking about allocative efficiency here we talked about efficiency in production. It would be efficient in production to produce 50 left shoes and zero right shoes. Why? Because at that point we could not increase any more or they couldn’t produce any right shoes or increase their production of right shoes without decreasing our production of left shoes. So that point would technically be efficient production but it wouldn’t be allocative efficient.
It wouldn’t have product mix efficiency because who wants an economy where there’s only left shoes? It doesn’t correspond to people’s preferences, the resources need to be allocated to their highest-value use. So the goods that are produced, can’t just be productive efficiency we need to say the goods being produced need to actually correspond to those that people prefer and people don’t want only left shoes they want pairs of shoes. They want a left shoe and a right shoe so actually if we were thinking about how would we decide this? Actually, we would map out the indifference curve and we can get into this another article. The point where the indifference curve is just assuming everybody in economies tastes were the same the point where the indifference curve meets the PPF is going to be the point where we want to produce.
So it might be just hypothetical numbers but let’s say you have 35 left shoes and then you have 35 right shoes. So that’d be a better example of allocative efficiency than just having an economy where we have entirely left shoes. 50 left shoes and zero right shoes might be efficient in production but it’s not allocative efficient because nobody wants to buy just left shoes you want to buy a pair of shoes.