Allocative and productive efficiency will be explained on the basis of the graph below:
Let’s assume we have a farmer who produces two types of food (X and Y) and consumes them. He does not trade with anybody, so basically he can consume only the goods he can produce.
How much he can produce? This is represented with red curves, which we call the Production possibilities curve.
The production possibilities curve is a curve that shows all combinations of output that can be produced given the farmer’s resources and technologies. When a farmer gets better resources and technologies, he can move on the red curve on the right, i.e. he can produce more units of X and more units of Y simultaneously.
However, when he gets on the right red curve, he cannot increase the output of one good without decreasing the output of the second one.
The production possibilities curve explains productive efficiency. Each combination of output on the furthest curve on the graph (looked from left to right) is a combination of maximum productive efficiency.
Now let’s explain blue curves. They are called Indifference curves. These curves represent combinations of consumption that bring the same utility to our farmer. The farmer will prefer to go the furthest curve (looked from left to right), since on it are combinations of the maximum utility of consumption. The farmer’s goal to go to the furthest indifference curve represents allocative efficiency: goods are distributed in a manner that brings maximum utility to a farmer.
What is the best option for a farmer, considering both productive efficiency and allocative efficiency?
It is pointed A in which the furthest production possibilities curve and the furthest indifference curve meet each other. At that point, he produces as much as he can (productive efficiency) which is also the most attractive option from his perspective as a consumer (allocative efficiency).
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