In every day language, the term ‘efficiency’ refers to some activity done accurately, with minimum or no waste.
In economics, however, the term has very specific and technical meanings, depending on the context in which it is being used.
Importantly, efficiency concepts are used to appraise market performance under the ‘Structure-Conduct-Performance’ (SCP) model. Essentially there are three kinds of efficiency we need to be aware of: productive, allocative and dynamic efficiencies.
Productive efficiency means that long-run average costs are minimised. Diagrammatically, this is seen as the lowest point on the AC curve, where the curve is neither rising nor falling. Of course at this point, long-run marginal cost is equal to long-run average cost (AC = MC).
To reach a state of productive efficiency, the firm will have attained its optimum scale of output. Namely, it will have grown large enough to gain the benefits of bulk-purchase discounts, marketing economies, technical economies, etc. But not so large as to have these cost reductions totally offset by the inevitable rise in bureaucracy. Hence the firm is said to be efficient in terms of its average cost of production.
Productive efficiency is important for two reasons:
- Firstly, the basic economic problem tells us that there are unlimited wants but finite resources. Firms and industries which attain productive efficiency are using minimal resources per unit of output to produce their goods and services. Accordingly, there is no waste and more resources are freed up to produce other goods and services. This helps to satisfy more of our wants and therefore addresses the basic economic problem of scarcity.
- Secondly, operating at minimum average cost means the firm has greater scope for price reductions. This is of course a direct benefit to consumers, as it leaves them with more money to purchase even more of their wants.
Allocative efficiency is where society gets the optimum mix of goods and services in the highest possible quantities. This is said to occur at the level of output where P = MC (or AR = MC).
The price reflects consumers’ valuation of the usefulness (i.e. utility) of the product, while the marginal cost reflects the additional cost to society of allocating resources to its production. It would therefore be allocatively inefficient if the price consumers were having to pay was less or more than the additional cost to society of the resources used up in the production process.
Consider the quantity that would be produced and sold if price did not equal marginal cost. To illustrate, we shall use the example of tennis balls and tennis rackets – two complementary goods that should be provided in the right quantities if society is to get the most out of them.
If P > MC, demand will be lower than the allocatively efficient level of output. At such a high price of P1, fewer units of the good (in this case, tennis balls) would be bought and sold, hence it would be undersupplied. In other words, some consumers who are willing to pay at least the marginal cost of production (MC1) are being ‘priced out of the market’, thus not being allocated the tennis balls they require. In such a case, it would be better if we allocated more resources (land, labour and capital) to the production of this good.
Conversely, a situation of P < MC will mean demand is greater than the allocatively efficient level of output. At such a low price of P2, the product (in this case, tennis rackets) is clearly being oversupplied. More units of the good are being produced and sold than is actually efficient, given the marginal cost of production. It would be better for society if some of the resources that are allocated to the production of tennis rackets were redirected elsewhere – to the production of goods that are currently undersupplied, like tennis balls. In addition, at P < MC the firm is making a loss on the last tennis racket produced. Thus it is not being allocated its fair share of society’s rewards, so again this would be allocatively inefficient.
It should now be fairly obvious why P = MC will deliver the optimum mix of goods and services in the highest possible quantities. Only when price has been set at this level for each and every good will we see an appropriate level of output and, therefore, the right level of factor inputs allocated to the production of each good. In other words, at P = MC, society allocates its resources such that it gets both tennis rackets and tennis balls in the right quantities.
Both productive and allocative efficiency are examples of static efficiency – that is, efficiency at a point in time. By contrast, dynamic efficiency concerns the efficient allocation of resources over a period of time. Essentially, this means that firms engage in research and development as well as capital investment to bring about new products and new production processes.
Hence the aim of dynamic efficiency is two-fold. Firstly, to boost future productivity and growth, hence getting closer to productive efficiency over time. One famous example of this is in the car manufacturing industry, where firms have been investing in ever more advanced robotics to drive down average costs. Secondly, dynamically efficient policies aim to bring about new and innovative products, such that consumers get what they want and we move closer to allocative efficiency. A good example of this is in the pharmaceutical industry, where firms like Pfizer and Merck frequently develop life-saving drugs that are highly valued by society.
However, there are inevitable tradeoffs here. In order to be dynamically efficient, the firm will probably have to set price at P > MC. Without the additional (monopoly) profits, it is unlikely that the risky and expensive process of investment and R&D would ever take place. Take the pharmaceutical industry for instance. The marginal cost of a life-saving cancer drug may be less than £1 per pill, yet that same pill may be sold for more than £100. Without such large profits, it would be difficult, if not impossible for these firms to invest the US$1 billion and 15 years of R&D required to develop and commercialise such drugs. So a measure of common sense and a broader outlook is required when judging market performance, especially in high-tech industries.
© Anforme Limited
Business Economics : Microeconomics for A2
To see this new book by Chief Examiner Robert Nutter, which covers the whole of the A2 Micro Course Click here
The volume of world trade has plummeted with the global crisis. This column says that high-quality imports are more responsive to income changes than low-quality imports. This explains why world trade value fell faster during the crisis than world trade volume, which fell faster than GDP.
The volume of world trade plummeted between the last quarter of 2008 and the first quarter of 2009. Recent forecasts by the IMF (2009) predict a reduction of world trade volume by 11% (and value by 23%) for the year 2009. This is by far larger than the 1.3% contraction of the world GDP. The CEPR book edited by Simon Evenett and Richard Baldwin suggests that the availability of trade finance, the increase of protection, and the contraction of inventories contribute to explain the disconnection world trade volumes and the world GDP during the crisis this year. Caroline Freund (2009) also argues that world trade volume is more responsive to GDP variations during global downturns, suggesting that all the above-mentioned hurdles may be specific to bad times.
Another surprising pattern is the decrease of import price indices, associated with the disconnection between import volumes and import values. Joseph Francois and Julia Woerz (2009) argue that part of the decrease in import prices can be explained by the reduction of world commodity prices. But the contraction of markups and individual prices or the selection of varieties according to their price may have also contributed to the decrease of import price indices. Indeed, tougher competition following the contraction of income and demand may lead firms to reduce their profit margins. Also, consumers may shift their demand to low-price varieties in times of recession. Hence, the price evolution within each individual variety and the selection between varieties is responsible for aggregate price variations.
In an upcoming paper, we test whether variations of income can affect differently the imports of varieties differentiated by their price, therefore contributing to the disconnection between volumes and values when income falls. Theoretical models by Bils and Klenow (2001) and Fajgelbaum et al. (2009) indeed suggest that variations of income are not only associated with variations in the quantity of goods consumed but also variations in the quality of those goods. Households prefer more expensive varieties as they become richer. This implies that a global recession is expected to decrease the demand for high-quality varieties.
Empirically, price differentiation within detailed product categories is usually considered a proxy for quality differentiation (Baldwin and Harrigan 2009, Fontagné et al. 2008, Schott 2008, amongst others). Accordingly, we use international trade data with the greatest level of product disaggregation, provided by the UN, to classify varieties as low or high quality.2 More precisely, on each individual market, varieties with an import price above the average import price observed on the market are classified as high-quality varieties, and those varieties with below-average import prices are classified as low quality.
We use this classification to compute the recent evolution of low and high quality import quantities for the EU (15). The monthly data are by Eurostat Comext are highly disaggregated, yielding some 8,000 product categories.3 Figure 1 reports the evolution of the import quantities for high- and low-quality varieties. The curves show that the decrease of the quantity imported has been larger for high-quality varieties (-23%) than low-quality varieties (-17%), between March 2008 and March 2009. The disconnection between high- and low-quality varieties was more pronounced during the fourth quarter of 2008. This helps explain why import values have decreased more than import volumes or quantity – demand shifted away from more expensive varieties more.
Figure 1. Evolution of import quantity by quality in the EU15
We complete the analysis by estimating the elasticity of import quantity with respect to variations of the GDP for low- and high-quality ladders. We use import quantity and unit values from the BACI database (CEPII) that covers the period 1995-2007. GDP and nominal exchange rates are provided by the World Development Indicators database. Import demand equations are estimated separately for each HS4 level of product disaggregation for 184 exporting and importing countries. We report the median of income elasticities in Figure 2, considering all coefficients.
The results show that a decrease in aggregate income (measured by GDP) reduces the quantity of goods imported (positive elasticity). However, the income elasticity differs significantly across low- and high-quality varieties. The income elasticity is almost 60% higher for high-quality varieties. These results are obtained by considering all countries, but they remain qualitatively similar when the elasticity is estimated for only OECD destinations or emerging economies destinations.
Figure 2. Median estimated income elasticity
The median income elasticity is always above unity for both high-quality (expensive) varieties and low-quality (cheap) varieties. This implies that variations in import quantity are always larger than variations in GDP. This matches recent experience, as trade volume fell much more (-11%) than world production (-1.3%) during the crisis. Applying our estimated elasticity to this decrease in world production, we find that the predicted contraction of world GDP in 2009 should lead to a 1.6% decrease of the import quantity for low-quality varieties, and a 2.6% decrease of import quantity for high-quality varieties.
Figure 2 reports that the income elasticity is larger for OECD destinations compared to emerging markets. The recession has also been worse for advanced economies. Taken together, these facts explain the recent collapse of world trade – countries with more elastic import demand have had the largest recessions. The example of Japan is suggestive. The IMF predicts a -6.2% recession for Japan in 2009, one of the most severe reductions of GDP among advanced economies (IMF 2009). Using the quality distribution of exports for each exporter on the Japanese market and the income elasticity for OECD destinations, we can predict the variation of imports from each country. Results are reported in Figure 3 for a selection of exporters. These predictions show that, due to quality differentiation, the difference between the reaction of Chinese export quantities and export quantities from the most advanced economies may reach more than 2%. The difference in the reaction of export quantity between countries specialised in low and high quality products can explain the decrease of import prices during the crisis.
Figure 3. Predicted change in exports following a 6.2% GDP decrease in Japan, by destination
We show that high-quality imports are more responsive to GDP variations than low-quality imports. This empirical pattern can explain the behaviour of world trade volume, world trade value, and import prices during the last crisis. Our findings also imply that high-quality imports should benefit more from the recovery, due to their larger income elasticity. In other words, countries specialised in high quality exports are expected to suffer more in times of crises but should also recover faster. This has important implications regarding policies in rich countries that promote specialisation in higher-quality product ladders. While this form of specialisation can isolate part of domestic production from competition from the South, it also implies greater volatility, as such exports are more responsive to the world business cycle.
1 This is what we find using the CPB Netherlands Bureau for Economic Policy Analysis
2 We used tariff-line data provided by the UN for the year 2005. In these data, product disaggregation varies according to the market that is considered (between HS6 and HS10 categories).
3 Eurostat uses a Combined Nomenclature at 8 digits.
Baldwin, Richard and James Harrigan (2009), “Zeros, Quality and Space: Trade theory and trade evidence”, mimeo.
Berthou, Antoine and Charlotte Emlinger (2009), “Crisis, trade collapse, and the decrease of import prices”, mimeo.
Bils, Mark and Peter Klenow (2001), “Quantifying quality growth”, The American Economic Review 91 (4): 1006-1030.
Evenett, Simon and Richard Baldwin, “The collapse of global trade, murky protectionism, and the crisis: Recommendations for the G20”, CEPR, 2009.
Fajgelbaum, Pablo, Gene M. Grossman and Elhanan Helpman, “Income distribution, product quality and international trade”, mimeo.
Fontagné, Lionel, Guillaume Gaulier and Soledad Zignago (2008), “Specialization Across Varieties and North–South Competition”, Economic Policy, 23 (53): 51-91.
Francois, Joseph and Julia Woerz (2009), “The big drop: Trade and the Great Recession”, VoxEU.org, 2 May.
Freund, Caroline (2008), “Demystifying the collapse in trade”, VoxEU.org, 3 July.
IMF (2009), World Economic Outlook, April.
Schott, Peter (2008), “The Relative Sophistication of Chinese Exports” Economic Policy 53:5-49.
To see a full range of our economics books, posters and other resources go to: www.anforme.com
To see previous ezines and blogs just go to our home page and click on the appropriate buttons at www.anforme.com
Copyright Anforme Limited