Allocational Efficiency

What is Allocational Efficiency?

Allocational Efficiency (or Allocative Efficiency) is a concept used in microeconomics where goods and services are distributed in an economy in a manner that is optimal and beneficial to all parties (consumers and producers). The concept is a characteristic of an efficient market, and the point of allocative efficiency is where the demand (marginal utility) is equal to the supply (marginal cost). The diagrammatic explanation of allocational efficiency is shown below:

Understanding Allocational Efficiency

Allocational efficiency can be viewed from the point of view of an organization and also from a broader view.

Organizational Perspective

From an organizational perspective, the demand and supply curves above represent the demand and supply for the company’s product/service, respectively. In such a situation, if the company is operating in an efficient market, the aim should be to produce as much as is represented by consumer preferences.

To be specific, the company should produce each good/service to the point where the marginal benefit of that good/service to consumers is equal to the marginal cost of production. It is the point of allocational efficiency, also represented by the intersection of the demand and supply curves of that good/service. In such a scenario, both the consumers and producers are getting maximum utility out of the purchase and production, respectively.

Broader Perspective

Now, if we look at the concept of allocational efficiency from a broader perspective for a country, we can see that there are many more players in a country’s economy, such as consumers, investors, government, suppliers, and retailers. In such a case, allocational efficiency will be realized when all the country’s resources are allocated in a manner such that it provides the maximum possible benefit to all market participants.

Projects with the highest profitability will receive funding. Capital will be allocated efficiently to all economic activities, and production will be in accordance with consumer preferences. The entire economy’s resources will be positioned in a way such that everyone gets the maximum benefit when the market is in equilibrium.

Efficient Markets

For allocational efficiency to hold, a market must operate efficiently. A market that is efficient demonstrates clear transparency of all data to all market participants. It means that everyone can access all readily available information, and the information is accurately represented in market prices. It is called informational efficiency.

Another characteristic of an efficient market is that there are little or no transaction costs. It allows all parties to participate equally in transactions, and capital will flow where maximum utility is recognized. The phenomenon is referred to as transactional efficiency.

The concept of efficient markets is mostly hypothetical and assumes a perfect world. In the real world, there are several variables that restrict the free movement of information and results in inefficiencies related to the optimal distribution of capital and resources.

Consumer and Producer Surplus

Allocational efficiency consists of two components. The first one is efficiency in consumption, which demonstrates the fact that consumers with receive incomes and a rational consumer will allocate his income such that he achieves the maximum utility out of it.

The second is efficiency in specialization and exchange. In a perfect world, each market participant with a certain specialization (companies produce and consumers buy). Due to such specializations, there is the potential of exchange between different players, which stimulates the economy.

If the state of allocational efficiency is not achieved, it leads to a consumer surplus or a producer surplus. In an imperfect world, there is normally a difference between the price that a consumer is willing to pay for a good/service versus what he actually pays.

Consumer Surplus Example

For example, in the apple market, a consumer is willing to pay $1.50 for an apple, but the market price is $1.00, the consumer is benefitting by $0.50. The $0.50 is the consumer surplus, which can also be explained by the fact that the marginal utility of the apple is greater than the price.

Producer Surplus Example

The concept of producer surplus is similar, whereby in imperfect markets, there is a difference between the cost of production of a good/service relative to the price it is eventually sold at. If the producer is able to sell at a price that is higher than his cost of production, producer surplus is created.

Going back to the apple market example, it costs the producer $0.70 to pick and sell the apple (marginal cost), whereas the price charged to the consumer is $1.00. The difference of $0.30 is the producer surplus.

Consumer and Producer Surplus Diagram

The diagram below shows the graphical representation of the producer and consumer surplus relative to a state of allocational efficiency. The consumer surplus is the area between the market price and the segment of the demand curve above the equilibrium. The producer surplus is the area between the market price and the segment of the supply curve below the equilibrium. Both of these combined are referred to as economic surplus.

Application of Allocational Efficiency

In the real world, it is fairly difficult to find examples for the concept of allocational efficiency as markets are generally imperfect with high transaction costs and asymmetrical informational sharing. However, most countries strive to operate at a point where they utilize their resources in the most efficient manner possible.

Looking at a developing country with a large population comprising of children and the elderly, the education and healthcare sectors are fairly important from the development point of view. If the country’s government gets a grant from an international aid agency, the biggest challenge would be to allocate the funds between the education and healthcare sectors.

The point of allocational efficiency would be reached when the government utilizes restricted resources such that the maximum number of people residing in that country benefit from the new education and healthcare facilities.

Additional Resources

CFI offers the Capital Markets & Securities Analyst (CMSA®) certification program for those looking to take their careers to the next level. To keep learning and advance your career, the following resources will be helpful:

• Aggregate Supply and Demand
• Allocative Efficiency
• Consumer Surplus
• Asymmetric Information
• Efficient Markets Hypothesis
• See all economics resources