Allocative Efficiency and the Production Possibilities Frontier

Because resources are scarce, a society must decide how to use those resources for its maximum benefit. When resources are used to produce one good or service, those resources become unavailable for any other purpose. Therefore, to understand how an economy allocates resources, it is best to look at a simplified economy that produces only 2 goods. In this simple economy, a production possibilities frontier, or model, can be constructed that shows every combination of the production of the 2 goods. Because economic resources are scarce, society must decide what those resources will be used to produce, since any resources used to produce one good reduces the resources available to produce the other good.

To better understand the allocation of resources, there are several assumptions for this simplified economy:

The purpose of the assumptions is to show how the production possibilities of an economy changes with the allocation of its resources, so we must assume that nothing else changes — as economists like to say, ceteris paribus, meaning all other factors remaining the same. So if employment was less than full employment or productive efficiency was less than the maximum, then that introduces other production possibilities, such as increasing productive efficiency or increasing employment. Thus, making these assumptions simplifies the analysis. Consider the production possibilities between bread and guns.

Any movement along the curve indicates the reallocation of resources from one good to the other, from guns to bread or vice versa. Production outside of the curve is unattainable, and production below the curve is attainable but without using all resources, which violates the assumptions and reduces the aggregate wealth of society.

A diagram of the production possibility frontier between bread and guns, and how the opportunity cost of producing each changes as one moves along the curve.

Increasing Opportunity Cost

Every specific allocation of resources has an opportunity cost, which is what is given up to produce a specific product. Sacrificing the production of guns to make one more unit of bread is the opportunity cost of bread in our simplified economy, which is the number of guns that must be given up to make one more unit of bread.

Generally, as more resources are allocated to produce one good, the cost of an additional unit of the good usually increases after a certain point. The reason is because when only a few units of the goods are produced, then the most suitable factors of production are used, which lowers the cost of producing the good. But as the number and quantity of goods increases, then other factors of production must be used that will not be as efficient. For example, if a factory is already operating near capacity, then to increase its output, it must hire more labor, train new workers, and utilize space that was devoted to other resources. In our bread example, farmers would first use the best land to grow the grains necessary to produce bread, but if our simplified economy wanted to produce mostly bread, it would have to grow grains on less suitable land and in less suitable climate. Irrigation may even have to be provided. This is sometimes referred to as the law of diminishing returns.

Allocative Efficiency

Because the opportunity cost of producing extra units of goods increases after a certain point, then there is a point for which the cost of producing the good is less than its benefit to society. Because of economies of scale, opportunity costs at first decline in the production of goods. However, when the production exceeds a certain amount, then the opportunity cost starts to increase. Furthermore, as the supply of one good increases, the demand for the good decreases — in other words, society wants it less. Hence, because the opportunity cost of producing one good increases with the amount produced and society's aggregate desire for the product decreases, then there is a certain amount of each individual good or service that provides the maximum satisfaction to society. This is the market equilibrium.

How well economic resources are allocated to satisfy economic wants is known as allocative efficiency, which is the production of those goods and services that are most desired by society in the quantity that they desire.

Because the opportunity cost of producing goods or services and the benefit of the output to society depends on how much of each good or service is produced, then how does an individual producer know how much to produce? Since the producers' costs are variable, then it makes sense to ask if an additional unit should be produced.

Because of economies of scale, the cost of producing an additional unit, known as the marginal cost, continually declines until it reaches a minimum. On the other hand, the marginal benefit, which is the benefit to society of the last unit, also declines with increasing quantity. Since the amount that consumers are willing to pay for a particular product depends on the marginal benefit of the last unit produced, a producer can maximize profit by producing more units until the marginal cost of producing the last unit is equal to the marginal benefit of that unit to society.

Note that, in economics, economic cost also includes the profit that would satisfy the producer. Therefore, we can derive a simple formula for maximizing allocative efficiency. Allocative efficiency is maximized when the marginal benefit equals the marginal cost of producing one extra unit.

Marginal Benefit = Marginal Cost

If the marginal benefit exceeds the marginal cost, then people will be willing to pay a higher price than the economic cost of production, which therefore allows the manufacturer to increase profits by producing more. When allocative efficiency is maximized with respect to the good, then the manufacturer is producing the good in the exact quantities that society desires. On the other hand, if the manufacturer produces more goods than what society desires, then the price they are willing to pay will be less than the economic cost of production, and will cause profits to drop.

Expanding the Production Possibilities Frontier

The assumptions of the production possibility frontier simplify the analysis of the effect of allocating resources differently. Over time, however, the production possibility frontier can be expanded.

Increases in the production possibility frontier will be made possible by increased resources, such as population growth, advances in technology, and also by the application of technology, such as developing irrigation systems so that more arid land can be used for farming. However, the largest expansion of the production possibility frontier of any economy will probably result from advances in technology, especially computer, network, robotics, and artificial intelligence technology. Not only do computers reduce the need for resources, but robotics will increasingly reduce the need for human labor. With the aid of computers, networks, and robotics, each person will be able to do more and more, thereby greatly increasing the productivity of each individual. Furthermore, the Internet can quickly distribute information and knowledge to anyone who wants it, improving productivity.

Consider the simple elimination of paper. The Internet, computers, e-readers, and other portable devices allow the creation, distribution, and consumption of information and knowledge in an electronic format. Content can be created on computers, distributed by the Internet to anywhere in the world for virtually no cost, then read on portable devices. This reduces the need for the many trees required to manufacture paper, the need for delivery vehicles and their requirement for fuel and other maintenance, the need of publishing houses and distribution centers, such as bookstores, and their associated land and labor.

Note that economic growth will always be uneven, that the production of some goods can become more cost-effective faster than other goods. However, when the cost of producing a good decreases, it also frees economic resources for the production of other goods or services.

An economy's choice of how much to invest in capital and consumer goods will determine how fast future growth will be. A greater investment in capital goods over consumer goods will usually result in faster future growth but at the expense of current consumption.

International trade also allows a nation to benefit from the comparative advantage of other countries. Thus, by using the cheaper labor in China and India, United States manufacturers and service providers can lower their production costs, which benefits American consumers.

The production possibility frontier can also be expanded by eliminating anything that causes unemployment, such as discrimination based on race, sex, or any other quality and by eliminating unnecessary bureaucracies and laws. For instance, by greatly simplifying the tax code, people would be able to do their own taxes, eliminating the need for tax preparers, and many accountants and tax lawyers. It would also minimize the many economic distortions created by a complicated tax code.

So why are not the laws changed to maximize economic efficiency? Because politicians serve special interests and because most of them do not know economics. Hence, we all suffer!