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

T
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 effi-
ciently. Economists distinguish between
two aspects of efficiency. Technical effi-
ciency takes its lead from the fundamental
economic question of “how?” It relates to
the amount of factors of production con-
sumed 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 impossi-
ble to make one consumer better off without
making another consumer worse off. These
definitions are sometimes called the Pareto
1 Production possibility frontier
A
Bread
Y arrows show, the resources of the economy
B logical constraints of the economy.
X The production possibility frontier can-
C
Circuses
2 Perfectly competitive market
£ Marginal cost
Demand = average revenue = marginal revenue
QE
efficiency conditions, after the Italian econ-
omist and social theorist Vilfredo Pareto.
Consider diagram 1: any point on the
frontier – say A, B or C – is a point of techni-
cal 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 cir-
cuses. It reflects the fact that resources are
being transferred from making bread to pro-
viding 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 diago-
nal line on the diagram.
A point inside the frontier – X, for example
– is technically inefficient because, as the
could produce more bread and circuses using
the resources available. Point Y is unattain-
able within the present resource and techno-
not 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
Average total cost
Output
mechanism is one system for resolving the
economic problem. The price, cost and out-
put solutions derived by different market
structures form a major part of the micro-
economics section of the syllabus. Let’s con-
sider 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 rev-
enue) 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

18 CIMA Insider March 2004

 TECHNICAL | FECB

satisfaction per pound spent on CDs equals

3 Monopoly (short term)
the satisfaction per pound available from
the next most preferred alternative – say,
£
film DVDs. The market price of a product
therefore represents the satisfaction fore- Marginal cost
gone by buying the marginal product.
For the firm, the opportunity cost of pro-
P
viding music CDs at the market price is the
Average total cost
revenue it could have received from using
the same resources to make the next most
valuable product – say, video games. This C
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 Demand =
average revenue
of the variable factor of production from
video games and therefore foregoes sales of
Q
these games. The marginal cost rises Marginal revenue
because productivity is subject to the law of
diminishing marginal returns.
Let’s put both halves of this explanation 4 Monopoly (long term)
together and consider what the allocative
efficiency condition (price equals marginal £
cost) means. First, remember that the Marginal cost
money spent on the marginal product
equals the satisfaction that the consumer
gets from it. Second, remember also that Average total cost
P=C
marginal cost is the revenue foregone from
not making the next most valuable product. F
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
Demand =
for the CD than the satisfaction another average revenue
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 Q G E Marginal revenue
CDs at this point – otherwise it wouldn’t be
maximising its profits. It will settle at the
output level at which the marginal cost large market, it can increase its output where the marginal cost equals the mar-
equals the marginal revenue. For allocative without reducing the market price. It’s a ginal revenue.
efficiency to exist, the marginal revenue price-taker. Other market forms (mono- Its technical efficiency is sacrificed, since
must therefore equal the price. In theory, polies, oligopolies etc) have to cut the it produces at an output lower than the
the only market that can assure both alloca- price so that the marginal revenue is less minimum average total cost. Its allocative
tive and technical efficiency is a perfectly than the average revenue. efficiency is also sacrificed because the aver-
competitive market, as shown in diagram 2. l The absence of barriers to entry means age revenue is greater than the marginal
Like all businesses, the perfectly competi- that profits will be forced down to a cost. A secondary effect is the excess of aver-
tive firm produces at the profit-maximising “normal” level in the long run (average age revenue over average cost shown by the
point where the marginal cost equals the total cost equals average revenue equals supernormal profit per unit between P and
marginal revenue. But this market structure marginal cost). C, which shifts welfare from the consumer
is unique because it is the only one where the Compare this situation with that of the to the monopolist.
average revenue equals the marginal rev- firm operating in a monopoly and we can In the long run, the situation changes to
enue. It’s also a market in which competition see the impact (see diagram 3). Here, the that shown in diagram 4. This again is dou-
will force prices down to the minimum aver- marginal revenue is less than the average bly inefficient. Technical inefficiency occurs
age total cost. Let’s recall the reasons for this: revenue because, as a price-maker, the firm because the firm is not producing at output
l The average revenue equals the marginal must endure lower prices in order to sell E in the diagram (minimum average total
revenue because, as a small firm in a higher outputs. It profit-maximises at Q, cost). The shortfall of output between E and

March 2004 CIMA Insider 19


Q is called excess capacity. Allocative ineffi-
ciency 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 bene-
fits 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 over-
consumption 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 sup-
pliers receive a better service; the share-
holders’ investments will be better man-
aged; 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 undercon-
sumption 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 under-
production problem.
l If the private revenues are less than the
private costs, there will be an under-
production 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 bene-
fits 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 sup-
ports; the research it funds; and the contri-
bution 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 underpro-
duction 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 wel-
fare 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
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 develop-
T ment” (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
TECHNICAL | FECB/IORG
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 con-
sumption 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 loss-
making (eg, subsidies to the arts).
l Reducing the private costs of consuming
“merit goods” (eg, free health and educa-
tion provision; subsidies for public trans-
port; 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 consum-
ing merit goods (eg, tax relief on charita-
ble and pension contributions). n
Adrian Sims teaches for BPP
Professional Education in Luton
and Milton Keynes
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 behav-
ioural 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 21