Chapter 6: Basic economic ideas and resource allocation


Economic efficiency is said to exist where scarce resources are used in the most efficient way to produce maximum output.

Economic efficiency consists of:

  1. Productive efficiency
  2. Allocative efficiency
  3. Pareto optimality
  4. Dynamic efficiency
  1. Productive Efficiency

Productive efficiency occurs when firms produce at the lowest possible average cost. To achieve this, firms must exploit economies of scale and minimize wastage of resources. Productive efficiency can only exist when an economy is producing right on the boundary of its production possibility frontier. If the goods are not produced using least possible resources then it is productive inefficiency.

  1. Allocative Efficiency

Allocative efficiency is achieved when products are made in the correct quantities to best satisfy consumer wants and needs. This occurs when the marginal cost of an item is equal to the market price. Allocative efficiency is all to do with allocating the right amount of scarce resources to the production of the right products. A competitive market can lead to allocative efficiency.

  1. Pareto Optimality

Pareto optimality occurs when it is impossible to make someone better off without making someone else worse off. If the allocation of resource is not Pareto efficient, then there is scope for improvement.

  1. Dynamic efficiency

Dynamic efficiency is the form of productive efficiency that benefits a firm over time. Dynamic efficiency is a longer-term phenomenon. To achieve it requires investment from within or from outside the firm.

Market Failure

Market failure occurs when the price mechanism fails to produce the goods consumers want. The Pareto optimum is not achieved. There is no productive or allocative efficiency. Simply, it is when a market fails. The reasons for market failure to occur are:

  • Information failure
  • Abuse of monopoly power in market
  • Where there are externalities present in market
  • Provision of merit and demerit goods


Externality is where the actions of producers or consumers give rise to side effects on third parties who are not involved in the action; sometimes referred to as spillover effects. Externalities can be internalized by bringing the cost home to the producer or consumer so that they have to pay for clean-up.

Externalities cause market failure of the cost/benefit to third parties is not taken into account.

  • Negative Externalities
  • Positive Externalities

Negative Externalities

Negative externalities

Negative externalities occur when the production or consumption of a good cause cost to a third party. Example; passive smoking causes health problems for people who do not consume cigarettes themselves.

Positive Externalities

Positive externalities provide benefits to people not directly concerned with the reduction or consumption of the good. Example of positive externalities include public transport, vaccinations and education.

Externalities and inefficient resource allocation

Private, external and social cost

Social Cost is the total costs of a particular action

Private Cost are those costs that are incurable by an individual who produces services and goods.

External costs are those costs incurred and paid for by third party not involved in the action.

Social Cost= Private costs + External costs

Private, external and social benefits

Social benefits is the total benefits arising from a particular action.

Private benefits are those benefits that accrue solely to individual making action.

External benefits is that benefit that are received by the third party not involved in the action.

Social Benefit= Private benefits + External Benefits

Cost Benefit Analysis

Cost benefit analysis (CBA) is widely practiced method for assessing the desirability of a project taking into account the costs and benefits involved. CBA genuinely attempts to quantify the opportunity cost to society of various possible outcomes or sources of action.

Framework of Cost Benefit Analysis

Stages in cost benefit analysis is given below: