Eco Article - Efficiency Drivers

TECHNICAL | FECB

Efficiency drivers Adrian Sims Reviewing a few key areas of economics and the relationships between them could gain you extra marks in the computer-based assessment and objective test papers

he “economic problem” concerns the need to allocate scarce resources to satisfy potentially unlimited wants. This situation of scarcity gives rise to the need for an economic system to resolve three fundamental questions: l What should we produce, and how much? l How should we produce it? l Who should receive the output? Because resources are scarce relative to the competing demands upon them, it’s in society’s interests that they are used efficiently. Economists distinguish between two aspects of efficiency. Technical efficiency takes its lead from the fundamental economic question of “how?” It relates to the amount of factors of production consumed to make units of the product. Allocative efficiency picks up on the key questions of “what?” and “who?” It concerns whether the system is making what people want, and on what terms they can get it. Technical efficiency can be defined as the point at which it’s impossible to make more units of one product without foregoing units of another product. Allocative efficiency can be defined as the point at which it’s impossible to make one consumer better off without making another consumer worse off. These definitions are sometimes called the Pareto

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1 Production possibility frontier

A

Bread

Y

B X C Circuses

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CIMA Insider March 2004

2 Perfectly competitive market £

Marginal cost Average total cost

Demand = average revenue = marginal revenue

QE

efficiency conditions, after the Italian economist and social theorist Vilfredo Pareto. Consider diagram 1: any point on the frontier – say A, B or C – is a point of technical efficiency. Shifting from B to C means society has more circuses but less bread. The curve is steep here, denoting that society will sacrifice a lot of bread to get a few extra circuses. It reflects the fact that resources are being transferred from making bread to providing circuses, and that the productivity of the transferred resources is falling – perhaps bakers don’t make good clowns. This is the effect of the law of (eventually) diminishing marginal returns. If this law didn’t apply, the frontier would instead be the dotted diagonal line on the diagram. A point inside the frontier – X, for example – is technically inefficient because, as the arrows show, the resources of the economy could produce more bread and circuses using the resources available. Point Y is unattainable within the present resource and technological constraints of the economy. The production possibility frontier cannot display allocative efficiency, though. It shows what combination of goods society can make, but it doesn’t tell us whether society wants them or not. The market

Output

mechanism is one system for resolving the economic problem. The price, cost and output solutions derived by different market structures form a major part of the microeconomics section of the syllabus. Let’s consider them from an efficiency perspective. Technical efficiency requires that the firm produces at lowest average total cost – ie, where marginal cost equals the average total cost. Producing at lowest average total cost means that the fewest resources possible are being used to make the level of output. Allocative efficiency requires that the price (sometimes called the average revenue) equals the marginal cost. This second definition can be tough to understand, so let’s unpack it a bit. The key is to remember that economists analyse decisions in terms of opportunity costs. For the consumer, the cost of buying one product is the satisfaction they forego by not having consumed their next most preferred alternative. Say the price of music CDs falls: as the consumer increases their consumption of CDs the added satisfaction they receive from having an extra CD in their collection declines – ie, the law of diminishing marginal utility applies. This predicts that they will demand more CDs up to the point at which the

TECHNICAL | FECB

satisfaction per pound spent on CDs equals the satisfaction per pound available from the next most preferred alternative – say, film DVDs. The market price of a product therefore represents the satisfaction foregone by buying the marginal product. For the firm, the opportunity cost of providing music CDs at the market price is the revenue it could have received from using the same resources to make the next most valuable product – say, video games. This cost is reflected in the firm’s marginal cost curve. As the firm increases production of music CDs in the short run, it transfers units of the variable factor of production from video games and therefore foregoes sales of these games. The marginal cost rises because productivity is subject to the law of diminishing marginal returns. Let’s put both halves of this explanation together and consider what the allocative efficiency condition (price equals marginal cost) means. First, remember that the money spent on the marginal product equals the satisfaction that the consumer gets from it. Second, remember also that marginal cost is the revenue foregone from not making the next most valuable product. Suppose the firm produces music CDs to the point where the marginal cost is greater than the price. This would mean that the consumer of the marginal CD is paying less for the CD than the satisfaction another consumer could have received (reflected in the marginal cost), had the same resources been used to make the alternative product instead. If the firm produces more CDs here, the CD buyer will be better off at the expense of another consumer. This violates the Pareto concept of allocative efficiency. Fortunately, the firm will stop producing CDs at this point – otherwise it wouldn’t be maximising its profits. It will settle at the output level at which the marginal cost equals the marginal revenue. For allocative efficiency to exist, the marginal revenue must therefore equal the price. In theory, the only market that can assure both allocative and technical efficiency is a perfectly competitive market, as shown in diagram 2. Like all businesses, the perfectly competitive firm produces at the profit-maximising point where the marginal cost equals the marginal revenue. But this market structure is unique because it is the only one where the average revenue equals the marginal revenue. It’s also a market in which competition will force prices down to the minimum average total cost. Let’s recall the reasons for this: l The average revenue equals the marginal revenue because, as a small firm in a

3 Monopoly (short term) £ Marginal cost

P Average total cost

C

Demand = average revenue Q

Marginal revenue

4 Monopoly (long term) £ Marginal cost

Average total cost P=C F

Demand = average revenue

Q

large market, it can increase its output without reducing the market price. It’s a price-taker. Other market forms (monopolies, oligopolies etc) have to cut the price so that the marginal revenue is less than the average revenue. l The absence of barriers to entry means that profits will be forced down to a “normal” level in the long run (average total cost equals average revenue equals marginal cost). Compare this situation with that of the firm operating in a monopoly and we can see the impact (see diagram 3). Here, the marginal revenue is less than the average revenue because, as a price-maker, the firm must endure lower prices in order to sell higher outputs. It profit-maximises at Q,

G

E

Marginal revenue

where the marginal cost equals the marginal revenue. Its technical efficiency is sacrificed, since it produces at an output lower than the minimum average total cost. Its allocative efficiency is also sacrificed because the average revenue is greater than the marginal cost. A secondary effect is the excess of average revenue over average cost shown by the supernormal profit per unit between P and C, which shifts welfare from the consumer to the monopolist. In the long run, the situation changes to that shown in diagram 4. This again is doubly inefficient. Technical inefficiency occurs because the firm is not producing at output E in the diagram (minimum average total cost). The shortfall of output between E and March 2004 CIMA Insider

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TECHNICAL | FECB/IORG

Q is called excess capacity. Allocative inefficiency occurs because the average revenue exceeds the marginal cost. It would need to produce at G to achieve allocative efficiency, but it still wouldn’t be technically efficient. So overall economic efficiency requires the following condition to be satisfied: the average revenue equals the marginal cost equals the average total cost. But the costs and revenues expressed by this equation are private, conveying only the opportunity costs and benefits to the consumer and the firm trading in the market. They overlook externalities and therefore underestimate the social costs and benefits. Externalities are the costs and benefits of a transaction that affects individuals beyond the initial trading parties. Social costs are the total welfare costs to society of using resources in a given way. Social benefits are the total welfare benefits from using resources in a given way. The consumption decision can lead to allocative inefficiency. If the private benefit is less than the social benefit, this will lead to an underconsumption of the product or service. If the private benefit is greater than the social benefit, this will lead to an overconsumption of the product or service. Consider your decision to pursue the CIMA qualification as an example. l Private benefit: the increased income that you or your employer (assuming that it sponsors you) obtain from your improved knowledge and skills. l Externalities: your organisation gets a more able employee; clients and suppliers receive a better service; the shareholders’ investments will be better managed; and society may prosper from getting a world-class business. l Social benefit: your increased salary, plus the externalities. According to microeconomic theory, you will pay for the CIMA qualification up to the point where the marginal benefit per pound spent equals that available from the next best alternative. But suppose you calculate that getting qualified would be too costly to justify relative to the extra salary you’d gain. You would spend your money elsewhere and therefore deprive society of all the positive externalities. This would be an underconsumption market failure. In the production decision, technical inefficiencies occur as follows: l If the private revenues are less than the social benefits, the company will not generate enough of the product or service to maximise social welfare – an underproduction problem.

l If the private revenues are less than the private costs, there will be an underproduction problem and the firm will make losses. l If the private costs are less than the social costs, the firm will overproduce. On the production side, the private benefits to CIMA of your decision to take the qualification are the revenues it will bring in from your student and exam fees, and your future spending as a member. But there are external social benefits too, such as the employer and branch networks CIMA supports; the research it funds; and the contribution to the development of management accountancy resulting from the existence of a dedicated professional body. If you decide not to qualify for CIMA, your decision to underconsume will have a knock-on effect that leads to the underproduction of CIMA’s services. If the fees it charges do not cover its costs, the institute will go out of business if left to a free market. In either event, the scarce resources of CIMA would be dissipated and social welfare would be reduced as the resources are used for a less socially beneficial purpose. To help correct the potential for market failures as a result of externalities, the

government seeks to adjust private values to reflect social values in five ways: l Raising private costs to equal social costs through taxation. This discourages consumption of the product (eg, excise duty on cigarettes); production of harmful products (eg, pollution taxes); or the use of socially expensive processes (eg, taxes on commercial waste dumping). l Reducing private costs to encourage firms to make more socially desirable products that would otherwise be lossmaking (eg, subsidies to the arts). l Reducing the private costs of consuming “merit goods” (eg, free health and education provision; subsidies for public transport; legal regulation of maximum charges for personal pensions). l Increasing the private costs of consuming “demerit goods” (eg, traffic congestion charges or higher taxes for company cars with high CO2 emissions). l Increasing the private benefits of consuming merit goods (eg, tax relief on charitable and pension contributions). n Adrian Sims teaches for BPP Professional Education in Luton and Milton Keynes

Body building The examiner for Organisational Management The subject of organisational development (OD) has featured in the intermediate level syllabus for years, but the questions in this field are rarely well answered

he term “organisational development” (OD) dates back to the early 1960s, when Richard Beckhard and Douglas McGregor used it to describe a consulting programme that focused on the conflicting interests of organisations and their members. By 1969 Warren Bennis had defined OD as “a complex educational strategy intended to change the beliefs, attitudes, values and structure of organisations so that they can better adapt to new technologies, markets

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and challenges – and the dizzying rate of change itself ”. More recently, Cecil Bell and Wendell French defined it as “a planned, systematic process in which applied behavioural science principles and practices are introduced into ongoing organisations toward the goal of increasing individual and organisational effectiveness”. Given the references to “change” and “beliefs, attitudes and values” in these definitions, it’s clear that OD has close links with topics such as change management March 2004 CIMA Insider

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