Allocative Efficiency

 

By Cyril Morong (cyrilmorong@grandecom.net)

 

Question: If the government pays for a Public Good like defense, how much defense should we have? How many submarines should we have?

 

This is where Allocative Efficiency comes.

 

Allocative Efficiency-We have this when the quantity produced of a good makes the marginal benefit equal to the marginal cost.

 

Marginal benefit-The additional benefit received by consuming one more unit of a good.

 

Marginal cost-The additional cost of producing one more unit of a good.

 

Suppose that the graph below shows the marginal benefit and marginal cost of submarines. The best or optimal amount would be 14, where marginal benefit and marginal cost cross.

 

Why is this the best quantity?  SEE THE GRAPH BELOW. Suppose that we currently have 11 submarines. If we build a 12th, the cost will be 12 and the benefit will be 16. This makes sense, to spend $12 to get $16 in benefits. It makes sense to keep building submarines as long as MB > MC. We keep improving our Social Welfare (SW), or total net benefit from a good, as we get closer to 14. It would be a mistake to move beyond 14, since we would be made worse off. We would spend $15 to build the 15th submarine while it only brought in $13 in benefits. This would make us $2 worse off (YOU SHOULD BE ABLE TO READ THESE NUMBER FROM THE GRAPH).

 

(MC slopes upward since that is consistent with the Law of Increasing Opportunity Cost. MB slopes downward since every time you consume one more of something, your marginal or additional benefit falls, like when the first slice of pizza is better than the second and the second is better than the third, etc.)

 

WARNING: In the real world, cost-benefit is very hard to do and we can never be sure if the optimal quantity of public goods has been produced.