ALLOCATIVE EFFICIENCY AND COMPARATIVE ADVANTAGE

Allocative Efficiency  

Definition: Allocative efficiency occurs when there is an optimal distribution of goods and services. This involves taking into account consumer's preferences.

A more precise definition of allocative efficiency is at an output level where the price equals the Marginal Cost (MC) of production. This is because the price that consumer's are willing to pay is equivalent to the marginal utility that they get. Therefore the optimal distribution is achieved when the marginal utility of the good equals the marginal cost.

• Firms in Perfect competition are said to produce at an allocatively efficient level
• Monopolies can increase price above the marginal cost of production and are Allocatively inefficient.

Monopoly sets a price of Pm. This is allocatively inefficient because Price is greater than MC.

Alloactive efficiency would occur at the point where the MC cuts the Demand curve so Price = MC. 

• Note: Producing on the production possibility frontier is not necessarily allocatively efficient because a PPF is not concerned with distribution. This requires the addition of indifference curves

Worked example of comparative advantage

Consider two countries producing two products – digital cameras and vacuum cleaners. With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below.

Working out the comparative advantage

To identify which country should specialise in a particular product we need to analyse the internal opportunity costs for each country. For example, were the UK to shift more resources into higher output of vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television. For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners.

If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still one vacuum cleaner. But for the United States the opportunity cost is only 5/12ths of a vacuum cleaner. Thus the United States has a comparative advantage in producing digital cameras because its opportunity cost is lowest.

Output after Specialisation

• The UK specializes totally in producing vacuum cleaners – doubling its output to 1200
• The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners
• As a result of specialisation according to the principle of comparative advantage, output of both products has increased - representing a gain in economic welfare.

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another.

There are gains from trade between the two countries. If the two countries trade at a rate of exchange of 2 digital cameras for one vacuum cleaner, the post-trade position will be as follows:

• The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
• The USA exports 840 digital cameras and imports 420 vacuum cleaners

Post trade output / consumption

Compared with the pre-specialisation output levels, consumers in both countries now have an increased supply of both goods to choose from.