What this lesson teaches
I can judge how a firm's strategy affects efficiency, consumer welfare and other firms.
Syllabus 9570, 2.2.3(c). Firms' Decisions and Strategies: Impact of firms' decisions and strategies on:; efficiency (allocative, productive and dynamic efficiency); consumer welfare (consumer choice, product quality and consumer surplus); other firms (cost, revenue and profit)
Make a guess
A monopolist keeps its price well above marginal cost but spends its profits on research into better products. Is it efficient?
- Yes, because spending profit on research makes up for the high price.
- No, because a price above marginal cost means resources are wasted.
- In one way but not another: dynamically, not allocatively.
Show the answer
In one way but not another: dynamically, not allocatively.
Price above MC means society would value more output than is made, which is allocative inefficiency. Research can still improve products over time.
Productive efficiency means lowest cost, allocative efficiency means producing what society values most, and dynamic efficiency means improving over time.
Productive efficiency: producing at the lowest possible average cost, with no wasted resources.
Allocative efficiency: producing the combination of goods society values most. For a single market, this is where price equals marginal cost (P = MC), assuming no externalities.
Dynamic efficiency: improving products and processes over time through innovation and investment.
Market power can pull these apart. A firm with market power may produce less and charge above MC (allocative inefficiency), yet use its profits to fund research (dynamic efficiency). Competition tends to improve productive and allocative efficiency.
- Productive
- Lowest average cost.
- Allocative
- P = MC: producing what society values most.
- Dynamic
- Improvement over time.
Worked example: A large supplier's choices
A large supplier adopts a process that uses fewer inputs per unit, but restricts sales to keep its price high. It spends some of its profits on research.
- Fewer inputs per unit: more productively efficient.
- Restricting sales so that price is above MC: allocatively inefficient.
- Spending on research: may be dynamically efficient, if the research succeeds.
- Judge each type separately before reaching an overall view.
Watch out for this
Lower costs mean the firm is efficient in every way.
Lower costs show productive efficiency. A firm can still restrict output and charge above MC, which is allocatively inefficient.
Check your understanding
A monopolist uses its profits to develop a better product. Which type of efficiency does this show?
- Allocative efficiency.
- Productive efficiency.
- Dynamic efficiency.
Show the answer
Dynamic efficiency.
Right. Improving products over time is dynamic efficiency.