What is allocative efficiency? (With benefits and examples)

By Indeed Editorial Team

Published 5 July 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Allocative efficiency enables companies to understand ideal market pricing. Businesses can apply this knowledge when making decisions regarding the manufacture and sale of products. By learning about this economic concept, you can help the company you work for understand the best way to produce and distribute its goods and services. In this article, we discuss what allocative efficiency is, list its benefits, show you how to calculate it and review some examples to help you understand the concept.

What is allocative efficiency?

Allocative efficiency, or allocational efficiency, describes an efficient market where the distribution of goods and services is optimally beneficial to both consumers and the economy. It occurs when a product or service's supply curve and demand curve intersect. To achieve this efficiency, businesses can use available market data to decide how to optimally utilise their resources.

The demand curve represents the amount that consumers want to pay for a product. This typically decreases as the supply of the product increases. The supply curve portrays the cost of production, which typically increases as a company produces more units of a product. Equilibrium is the price at which the supply and demand for a product are equal. When a company identifies the point of equilibrium, its product is likely to sell well at that price point.

Market efficiency

A market is typically naturally efficient before it's possible to achieve allocational efficiency. For this to occur, it's beneficial for all necessary data to be available to market participants and reflected in market prices. For a market to be totally efficient, it's important that it's both informationally efficient and operationally, or transactional, efficient. Below are the definitions of these two terms:

  • Informational efficiency: Informational efficiency occurs when the necessary information about a particular market is accessible to all parties in that market, so no party has an advantage over another based on data.

  • Operational/transactional efficiency: A market is transactionally efficient when all transactions are fair to all parties in the market. This ensures that no party spends more than the other on the same product or service.

Related: What is operation costing? (And how to calculate it)

Benefits of allocational efficiency

Below are some benefits of calculating the allocational efficiency of a product:

  • It helps a company optimise its resources. Improving a company's projections for maximum production ensures that it uses the available resources to their full potential. Once the company achieves optimum output by calculating the efficiency of its market, it may reallocate its resources to other projects.

  • It helps a company understand the market. Various factors influence conditions in the market, and allocational efficiency may help a business understand how certain factors affect the market. Factors such as prices, the number of product units and customer preferences all influence the market.

  • It benefits society. Determining the price point of a product using allocational efficiency allows a company and its consumers to save money. The company benefits from selling at a price higher than the marginal cost, and consumers benefit because they spend less than what they may pay if fewer products were available.

Related: How to calculate marginal benefit (and why its useful)?

How to calculate allocational efficiency

If the company you work for produces a new product or re-evaluates an existing one, you can use this economic concept to determine an ideal price point. The following steps detail how to calculate the allocational efficiency of a product:

1. Determine the cost of production

This is the first step to take when calculating allocational efficiency. To create a correct supply curve and find the point of equilibrium, determine the exact amount required to produce the product or service. Also, consider how the price may increase or decrease based on how many units the company makes.

Certain costs, such as rent, may remain constant throughout the various production steps. Other costs may vary in direct proportion to the units a company produces. This means that the cost increases as the units increase and decrease as the units decrease. The more accurately you understand the production costs, the more effectively you can record the marginal costs and identify allocational efficiency.

Related: Production process: definition, types and considerations

2. Analyse demand

The next essential factor to analyse is the demand for the product or service in the marketplace. Marginal demand describes the amount a customer might pay for a specific unit of product. If the product or service solves a particular problem, people may show more interest and be willing to purchase it.

Analysing the product or service's market demand helps to ensure accurate allocational efficiency. As a company produces more units of a product, it relies on less enthusiastic customers to purchase it to be able to sell all of its units. In this situation, the company may reduce the price of its products to enable it to appeal to more customers and maximise sales.

3. Chart the curves

After identifying the marginal supply and marginal demand curve, plot them on a single graph. This allows you to easily visualise both curves in the same space using a similar scale. An analysis of these curves enables you to determine the allocational efficiency of a market.

Aside from helping you determine the point of equilibrium, these curves also show you how the market changes in response to variations in production. Usually, excessive production causes prices to decrease because it's challenging for a company to sell all of its units at the initial price. In contrast, under-production may cause the company to miss out on potential profits. Understanding these curves may help you make more profitable production choices for the business you work for.

Related: Supply and demand diagram (definition, types and examples)

4. Find the point of intersection

You can easily determine the allocational efficiency of a product on a graph with a marginal supply and demand curve. To determine the allocational efficiency of a product, locate the exact point at which the marginal demand curve crosses over the marginal supply curve. If the calculations for both curves are correct, the value you get specifies the price at which the company can sell all units of its product without incurring a loss.

By producing the optimal number of units, the company can optimise its profits. Determining allocational efficiency ensures that the supply of its products, services and finances results in the most profitable outcome. Calculating and analysing supply and demand data may ensure that the company makes better decisions.

Productive vs. allocative efficiency

Productive efficiency, or production efficiency, occurs when a company or business produces its goods or services at the lowest possible cost. In contrast, allocative efficiency ensures the efficient distribution of company goods and services. Productive efficiency allows a company to minimise waste and manage available resources to produce the best possible product. This means that it can maintain the quality of its products at a minimal cost.

Effectively lowering the cost of production is not equivalent to achieving allocational efficiency. A company may successfully produce units of its product at a low cost and offer it at a low price, showing that it has productive efficiency, but if the products do not sell, the company lacks allocational efficiency. It's possible to achieve one without the other, so it's beneficial to differentiate between the two terms.

Examples of allocational efficiency

Below are two examples of allocational efficiency:

Example 1

Here's an example of a toy manufacturing company:

A company that produces toys for children may make both black and blue toy cars. Analysing the demand and supply curve of the toy cars may reveal that customers prefer the black car over the blue one, so when the company produces equal units of both, they sell all the black cars but not all the blue cars. Instead of producing 50% of each car, they may decide to produce 70% black cars and 30% blue cars using the equilibrium point. This may cause all products to sell, satisfying both the customer requirements and the company.

Example 2

Here's an example from a national economy:

A developing country with a large population receives an international grant for health and education. The government finds it challenging to decide on the most impactful way to allocate the funds. The government reaches the point of allocational efficiency when they utilise the limited resources so that a maximum amount of individuals benefit from new healthcare and educational facilities.

Related:

  • Productivity vs efficiency: differences, examples and tips


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