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Production Efficiency

One of the three conditions necessary for an economy to be economically efficient is that it be on its production-possibilities frontier. If it is not on the production-possibilities frontier, more could be produced with the given resources and technology. Because greater production would increase value, any position below the production-possibilities frontier is inefficient. Notice that a great many points satisfy this condition of production efficiency--every point on the production-possibilities frontier is production efficient.

Unemployed resources indicate that more goods and services could be produced, which means that the economy is not on the production-possibilities frontier. To be on the frontier, all resources must be used. In addition, resources must be used properly. A society that randomly assigns jobs to people or assigns jobs on the basis of political reliability will not produce as much as it could. It will require some people with little intellectual ability to perform jobs that require great intellectual ability, and it will require some people with little strength and endurance to perform jobs that demand much strength and endurance. If switching people among jobs can increase output, the original situation was not on the production-possibilities frontier and thus not economically efficient.

This requirement that resources must be used properly can be stated more technically. Production efficiency requires that an equimarginal principle be satisfied. It requires that the ratio of marginal products for any two resources be the same for all products. The table presents a case in which this condition is not met. Here the ratio of the two marginal products for the production of widgets is (5/5) or 1 and the ratio of the two marginal products for getwids is (6/4) or 1 1/2.

Production Inefficiency

Marginal product of capital is:

5 widgets or 6 getwids

Marginal product of labor is:

5 widgets or 4 getwids

To show that the situation in the table is not production-efficient, consider what happens if a getwid producer trades a unit of labor to a widget maker for one unit of capital. The widget maker will have no change in output as a result. Reducing capital by one unit cuts output by five, but this is offset by the five widgets the extra labor adds. However, there will be more getwids. The extra unit of capital adds 6 getwids, whereas the loss of a unit of labor subtracts 4 getwids. There is a net gain of two getwids. Because the amount of production after the exchange of resources was more than the original amount, the economy could not have been on the production-possibilities frontier originally. Further, because more output has more value to consumers, the original use of resources was less efficient than the use of resources after the trade.

As a result of the trade of resources, marginal products should change. Because more capital is being used in producing getwids, its marginal product in getwid production should drop (by the law of diminishing returns). Because more labor is being used in producing widgets, its marginal product in widget production should drop. Hence some exchange of resources should bring the ratios of marginal products to equality.

A second part of economic efficiency is exchange efficiency.

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Copyright Robert Schenk