Allocative efficiency is a state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing. In the single-price model, at the point of allocative efficiency, price is equal to marginal cost. At this point the social surplus is maximized with no deadweight loss, or the value society puts on that level of output produced minus the value of resources used to achieve that level, yet can be applied to other things such as level of pollution. Allocative efficiency is the main tool of welfare analysis to measure the impact of markets and public policy upon society and subgroups being made better or worse off.
Although there are different standards of evaluation for the concept of allocative efficiency, the basic principle asserts that in any economic system, choices in resource allocation produce both "winners" and "losers" relative to the choice being evaluated. The principles of rational choice, individual maximization, utilitarianism and market theory further suppose that the outcomes for winners and losers can be identified, compared and measured.
Under these basic premises, the goal of maximizing allocative efficiency can be defined according to some neutral principle where some allocations are objectively better than others. For example, an economist might say that a change in policy increases allocative efficiency as long as those who benefit from the change (winners) gain more than the losers lose (see Kaldor–Hicks efficiency).
It is possible to have Pareto efficiency without allocative efficiency: in such a situation, it is impossible to reallocate resources in such a way that someone gains and no one loses (hence we have Pareto efficiency), yet it would be possible to reallocate in such a way that gainers gain more than losers lose (hence without such a reallocation, we do not have allocative efficiency).
When a market fails to allocate resources efficiently, there is said to be market failure. Market failure may occur because of imperfect knowledge, differentiated goods, concentrated market power (e.g., monopoly or oligopoly), or externalities.
In contract theory
In contract theory, allocative efficiency reflects a contract in which the skill demanded by the offering party and the skill of the agreeing party are the same.
- Pareto efficiency
- Production-possibility frontier
- Productive efficiency
- Financial market efficiency
- Markovits, Richard (1998). Matters of Principle. New York: New York University Press. ISBN 978-0-8147-5513-6.
- Markovits, Richard (2008). Truth or Economics. New Haven: Yale University Press. ISBN 978-0-300-11459-1.
- Beardshaw, J., Economics: A Student's Guide (Upper Saddle River, NJ: FT Press, 1984), p. 397.