Allocative efficiency

Allocative efficiency occurs when an economy produces the mix of goods and services that maximizes social welfare, given its resources and preferences.

Marginal benefit: The additional benefit from consuming or producing one more unit of a good or service. The efficient mix equates the marginal value consumers place on output with its marginal cost.
Pareto efficiency: An allocation is Pareto efficient if no feasible change can make someone better off without making someone else worse off. Competitive equilibrium can satisfy this efficiency criterion, though it does not settle questions of fairness.
Productive efficiency: The production of a given output at the lowest feasible cost or with the fewest resources. An economy can produce goods cheaply yet still produce the wrong mix for social welfare.
Pigouvian tax: A tax set to reflect the external cost of an activity and bring private incentives closer to social costs. Pricing a negative externality can move production toward the socially efficient mix.
Marginal cost: The additional cost of producing one more unit of a good or service. Production should expand until the marginal cost of each good matches its marginal benefit.
Social welfare function: A rule that ranks social states by combining information about individuals’ well-being. The meaning of maximizing social welfare depends on how individual outcomes are evaluated collectively.
Dynamic efficiency: Efficiency achieved over time through innovation, investment, and improvements in productive capacity. Allocative efficiency concerns the current output mix, while dynamic efficiency concerns change over time.
Subsidy: A government payment or tax reduction that lowers the cost of an activity or increases its return. A subsidy can correct underproduction when private benefits omit social benefits.
Marginal rate of substitution: The rate at which a consumer will exchange one good for another while holding utility constant. Consumers’ trade-offs help determine which output combinations match their preferences.
Competitive equilibrium: A set of prices and choices at which markets clear and each participant optimizes given prices. Under ideal assumptions, competitive equilibrium yields an allocatively efficient allocation.

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