Let’s move on and talk about the concept
of allocative efficiency.
We’ve talked about production possibilities
and how all points on the PPF are productively
efficient, but which point on the curve is
the “best” point?
This is what we will determine using the concept
of allocative efficiency.
The best point on the production possibilities
frontier is the point at which goods are produced
in quantities that provide the greatest possible
benefit.
I’ll expand a bit more on the concept of
benefit in just a bit.
Allocative efficiency is achieved when goods
are produced at the lowest possible cost and
in quantities that provide the greatest possible
benefit.
In order to understand the concept of allocative
efficiency fully, we’ll need to introduce
a few new concepts.
The first new concept is known as marginal
cost.
Marginal cost is the opportunity cost associated
with producing an additional unit of a good.
In the graph to the right, we are assuming
that we have an economy that produces only
cola and pizza.
The opportunity cost of producing more pizza
is different on every point on the frontier.
In fact, as we produce more pizza, we have
to give up more and more cola every time.
Let’s calculate the marginal cost of pizza
going from point B to point C.
We use the rise over run method to calculate
the slope of the PPF, which in turn gives
us the opportunity cost of producing an additional
unit of pizza.
The change in cola, which is on the y-axis
is negative two, and the change in pizza,
which is on the x-axis is one.
Negative two divided by one is equal to negative
two.
Thus, the marginal cost of producing pizza
at point B is two units of cola.
We are giving up two units of cola to produce
one unit of pizza.
We can do this calculation for every point
on the PPF, and we can graph all the values
we get for marginal cost.
As you can see on the graph on the left, marginal
cost is increasing.
This is based on the premise that we have
to give up more and more cola each time we
want to produce an additional unit of pizza.
I mentioned the word benefit before, and I
will now expand a little more on this concept.
Marginal benefit is defined as the benefit
received from consuming an additional unit
of a good.
“Benefit” is subjective because people’s
own personal preferences affect the benefit
they receive from consuming an additional
unit of a good.
The marginal benefit curve on the right shows
the relationship between the benefit received
per unit of pizza consumed, and the number
of units of pizza consumed.
It is clear that the benefit received from
consuming each additional unit of pizza is
decreasing.
We can thus say that the marginal benefit
of consuming pizza decreases.
This phenomenon is known as the law of decreasing
marginal benefit.
It applies to almost all goods in an economy.
The more we consume of a good, the less benefit
we gain from consuming even more.
Marginal benefit is measured by the maximum
amount of money that someone is willing to
pay for an additional unit of a good.
Let’s define allocative efficiency in concrete
terms by using the concepts of marginal benefit
and marginal cost.
The best point on the production possibilities
frontier is the point at which we cannot produce
more of one good without giving up some other
good that provides greater benefit.
The graph on the top is simply the production
possibilities frontier, and the graph on the
bottom is simply that of the marginal benefit
and marginal cost curves that we have just
seen.
In this first case, where we produce 1.5 units
of pizza, the marginal benefit of producing
pizza is greater than the marginal cost.
This means that someone values that pizza,
and is willing to pay for it, at a higher
price than it costs to produce.
We would get more value from our resources
if we were to produce more pizza and less
cola.
The second point, where we produce 2.5 units
of pizza, is the point at which we can say
we have achieved allocative efficiency.
Marginal cost is equal to marginal benefit,
thus we cannot produce more pizza without
giving up cola, which we now value more.
The third point, at which 3.5 million pizzas
are produced, is a point where the marginal
cost of producing pizzas exceeds the marginal
benefit.
Pizza production costs more than people are
actually willing to pay, so our resources
would be better used if we produced less pizza.
The point of this slide is to illustrate to
you that the best use of our resources is
at a point where the marginal cost of producing
a good is equal to the marginal benefit of
consuming that good.
That in turn leads us to the best point on
the production possibilities frontier for
our economy.
