Short Questions

Q1) What is meant by economic inefficiency?

A1) Economic inefficiency occurs when the resources are not allocated in
the most efficient way possible, or at the socially optimum output.
Inefficiency can occur in several ways like an imbalance between the
market forces of demand and supply or failure to account for negative
externalities such as pollution during decision making

Q2) How is productive inefficiency illustrated on a production possibility

curve diagram?
A2) A production possibility curve (PPC) diagram shows productive
inefficiency as a point that is inside the curve, showing that an economy
has the capacity to produce more goods or services than it is currently
producing.

Q3) Explain why a market would be inefficient if output is where price is

below marginal cost. ​
A3) A market is inefficient if output is set where price is lower than
marginal cost, since this shows that the market is overproducing the good
or service, which causes an oversupply of a good or service. For
producers, this situation can lead to shortage of inventory. They may also
face an inefficient allocation of resources, as producers are unable to cover
their production expenses, which could lead to a loss in economic
inefficiency. ​
​
Q4) Will achieving economic efficiency solve the economic problem?
A4) No, achieving economic efficiency will not solve the economic problem
as there will always be unlimited wants and limited resources. However, it
may improve the situation because of more efficient allocation of resources. ​
​
Q5) What does the existence of long run shortages in a market indicate
about the efficiency of a market?
A5) The existence of long-run shortages in a market indicates that the
market is not perfectly competitive and that it may be inefficient. It implies
that there is an excess demand for the product, and firms are earning
higher profits, further leading to an inefficient allocation of resources and
prices that may be higher than the socially optimal level. ​
​
Q6) Explain why international trade may promote economic efficiency. ​
A6) International trade would require firms to stay internationally
competitive. This would promote allocative and productive efficiency in
order to reduce costs and increase profits. Additionally, domestic firms
would be pressured to improve efficiency as foreign firms could take market
share with lower prices. ​
​
Q7) What does the existence of unemployment indicate about the efficiency
of an economy?
A7) The existence of unemployment indicates that there is an inefficient
allocation of labor in the economy. It suggests that there are idle resources
in the economy that are not being utilized, which means that the country is
producing inside its production possibility curve (PPC). ​
​
Q8) Explain what type of efficiency is not achieved in the case of merit
goods.
A8) In the case of merit goods, allocative efficiency is not achieved
because the market forces fail to account for the positive externalities
associated with consuming these goods. This is because the consumers do
not appreciate how useful or positively impactful they are for them. Hence,
causing them to produced and consumed below the socially optimum level. ​
​
Q9) Why might the composition of a tax on a demerit good reduce
efficiency?​
A9) The composition of a tax on a demerit good might reduce efficiency if
the tax discourages consumption of the good without addressing the social
costs associated with its production and consumption such as pollution.
This can lead to a misallocation of resources and a failure to account for
the negative externalities, resulting in a loss of economic efficiency.
Q10) Why is it difficult to achieve allocative efficiency in the case of public
goods?​
A10) Since there is no efficient market mechanism for allocating public
goods, it is challenging to achieve allocative efficiency in this situation.
Determining the socially optimal level of production and consumption is
difficult since public goods are non-excludable and non-rivalrous.
Practice Questions ​
​

Q1) Decide whether the following would affect allocative or productive efficiency and
whether they would increase or reduce efficiency.

a) A reduction in unemployment
Ans) Increase productive efficiency

b) A shift of resources from producing demerit goods to producing merit goods ​

Ans) Increase allocative efficiency

c) A reduction in surpluses​
Ans) Increase allocative efficiency ​

d) A reduction in labour productivity​

Ans) Decrease productive efficiency

e) A switch from producing less popular to more popular products​

Ans) Increase allocative efficiency

f) A reduction in organisational slack.​

Ans) Increase productive efficiency

Q2) Explain whether the following statements about allocative and productive efficiency
are true or false.

a) A shift to the right of a production possibility curve indicates an increase in productive

efficiency. ​
Ans) False. A shift of the production possibility curve to the right indicates an increase in
the productive potential of the economy. ​
​
b) If average revenue is above marginal cost resources are being used inefficiently. ​
Ans) True. If average revenue is above marginal cost, it indicates that resources are
being used inefficiently as the price consumers are willing to pay exceeds the cost of
production.
c) When allocative efficiency is achieved there is no welfare loss.​
Ans) True. Allocative efficiency ensures maximum social welfare and hence, there is no
welfare loss. ​
​
d) For economic efficiency to be achieved marginal social cost has to be at a minimum
for all products​
Ans) False. For economic efficiency to be achieved, marginal social cost has to be
equal to marginal social benefit. ​
​
e) Information failure can result in allocative inefficiency.​
Ans) True. Information failure can result in allocative inefficiency as it can lead to a
misallocation of resources due to a lack of accurate information.
Multiple Choice Questions (MCQ)

1.​ D
2.​ B
3.​ B
4.​ C
5.​ D
6.​ C
7.​ A
8.​ A
9.​ C
10.​ C
11.​ A
12.​ C
Essay Question

Climate change is currently one of the most important worldwide problems

today and has precipitated a lot of debate concerning our utilisation of our
economic resources. In economics, efficient use of resources involves
utilising limited resources in such a manner as to bring about a maximum
overall benefit to society.

In many cases, markets fail to allocate resources efficiently, especially

when there are externalities. Externalities are the negative impact that a
third party faces. For example, a factory that produces goods might also
cause air pollution, which harms the health of the people who live nearby.
Because the factory does not pay for the pollution it causes, it has a
negative impact on the socially optimum level of production. In a diagram,
this can be shown with two cost curves: the Marginal Private Cost (MPC),
which is what the firm pays, and the Marginal Social Cost (MSC), which
includes the cost to society. The market equilibrium happens where the
demand curve (Marginal Private Benefit) meets MPC, but the socially
efficient level is where it meets MSC. This shows that the market on its own
leads to overproduction and inefficiency.

Negative production externalities can be illustrated as:

When MPC equals MPB, the real output Q1 is generated. This indicates
that production is higher than ideal. The factory releases an excessive
amount of harmful waste as a result of this overproduction. The deadweight
welfare loss resulting from this overproduction is represented by the
triangle xyz.​
​
Governments can help fix this problem in several ways. For example, they
can introduce a tax on pollution. This tax increases the firm’s cost and shifts
the supply curve up to match the MSC, bringing production closer to the
efficient level. In this case, government intervention is necessary because
the market doesn’t take into account the external cost.

There are goods such as education and healthcare which generate positive
externalities. These are called merit goods. They are underproduced and
under consumed if left to the market forces in a free market economy.
Marginal social benefit MSB is more than marginal private benefit MPB
because of the positive externalities mentioned above. Therefore, MSB
curve will be higher than the MPB curve. Difference between them is
the marginal external benefit, MEB. Assuming there are no positive
production externalities, the output level Q1 is below the social
optimum of Q. There is underconsumption of secondary education and
free healthcare. The deadweight welfare loss is the triangle xyz.

It is also important to understand that government intervention is not

always perfect. Governments may face problems like poor information,
political pressure, or inefficient use of money. For example, if the
government provides a merit good, it may be underprovided by the
government. ​
 ​

Diagram 2 illustrates the under-provision of a public good. The market,

driven by individual willingness to pay, will provide a lower quantity than the
socially optimal quantity where the social benefit equals the marginal cost

In conclusion, while it is possible for markets to contribute to the efficient

use of resources, they often fail to do so in the case of externalities,
especially related to climate change. Government intervention is usually
necessary to correct these failures and ensure that the benefits and costs
of resource use are shared fairly across society. However, this does not
mean that the private sector has no role. The best results are usually
achieved when governments and markets work together. A mixed
approach, combining government regulation with market incentives, is often
the most effective way to achieve efficiency and tackle climate change.