So far, we have assumed full employment and productive efficiency, both of which are necessary to realize any point on an economy’s production possibilities frontier. We now turn to allocative efficiency, which requires that the economy produce at the most valued, or optimal, point on the production possibilities curve. Of all the attainable combinations of goods which is best? That is, what specific quantities of resources should be allocated to good “A” and what quantity to good B in order to maximize satisfaction?
Our discussion of the economic perspective before puts us on the right track. Recall that economic decisions centre on comparisons of marginal benefits and marginal costs. Any economic activity—for example, production or consumption— should be expanded as long as marginal benefit exceeds marginal cost and should be reduced if marginal cost exceeds marginal benefit. The optimal amount of the activity occurs where MB = MC.
We already know from the law of increasing opportunity costs that the marginal cost (MC) of additional units of good “A” will rise as more units are produced. This can be shown by an upsloping MC curve. We also know that we obtain extra or marginal benefits (MB) from additional units of good “A”. However, although material wants in the aggregate are insatiable, studies reveal that the second unit of a particular product yields less additional benefit to a person than the first. And a third provides even less MB than the second. So it is for society as a whole. We therefore can portray the marginal benefits from pizzas with a downsloping MB curve. Although total benefits rise when society consumes more good “A”, marginal benefits decline.
The optimal quantity of good “A” production is indicated by the intersection of the MB and MC curves. Why is this the optimal quantity? If less good “A” was produced, the marginal benefit of it would exceed its marginal cost. . This suggests that society would be underallocating resources to good “A” production and that more of it should be produced.
When MB = MC, the benefits of producing good “A” or alternative products with the available resources are equal. Allocative efficiency is achieved where MB = MC. The production more good “A” would represent an overallocation of resources to its production.
Generalization: Resources are being efficiently allocated to any product when the marginal benefit and marginal cost of its output are equal (MB = MC).