Is This Assertion About Productive Efficiency Correct?

Most of us have the understanding that Economics, as a subject taught in school, is ultimately theoretical, and we live with that (for the sake of exams).

As a tutor teaching Economics, I can live with having to explain the theoretical underpinnings of empirical observations, and pointing out their limitations. If anything, it helps students form good arguments especially in evaluative essays.

Occasionally though, I get flummoxed by questions posed by my students.

‘Chur I don’t understand.

What some students must have realised by now, is that the different JCs across Singapore often teach the same concepts differently. I can accept this to some extent by way that Economics, taught at the “entry-level” as a humanities subject, is not quite as deterministic as Math/Science subjects.

Unfortunately the side effect to this is confusion from students, especially when they do not understand their school’s materials, and resort to referencing other schools’ materials in the hope of getting alternative explanations.

I have to comment that reading some schools’ notes as a student is akin to using eyes only to read a barcode – you believe there is information behind it, but you can’t seem to see it.

Anyhow, I was motivated to write this post because of a particularly problematic concept that students often struggle to understand fully for such reasons.

And yes – it’s in the title.

Productive Efficiency is…

A situation where goods and/or services are produced with the least-cost factor combinations.

Which can also be re-stated as one where:

1. Producing an additional unit of a good or service cannot be achieved without reducing the production of another one; or
2. The maximum amount of goods and services is produced for the given quantity of resources.

This small list of possible permutations in the definition taught by schools is not exhaustive.

Cue potential confusion ahead. Fortunately, if you are a student, you can be assured that just sticking to whichever is taught to you in school works.

Illustrating Productive Efficiency.

In Economics at “A” levels, there is some obsession with using graphs everywhere. This case is no different. But ironically, that’s also where problems begin for this case.

When I was a student many years ago, I was taught that productive efficiency occurs at the minimum point of the LRAC (Long-Run Average Curve) curve. For the uninitiated, you may read more about what it is here.

The rationale for that is obvious – what can be more legit-ly minimal in cost than the minimum cost itself? And convinced I therefore was as a student.

Years later, as a tutor, I discovered that it is now mostly taught to students that any point on the LRAC curve is productively efficient.

Wait what?

What changed in the reasoning?

In the latest teachings, it is reasoned that since the LRAC is a cost curve enveloping all possible SRACs (each of which represents cost associated with 1 combination of fixed factor), all cost combinations on the LRAC itself must be efficient since they represent the respective lowest cost for all fixed factor combinations.

Ok, no arguments to that. But that means I was taught the “wrong” stuff years ago? There is already some confusion to that.

But then, one student tipped me off that her school taught the following:

• From the firm’s perspective, as long as it is producing on any point of the LRAC, it is productively efficient; but
• It may not be productively efficient from society’s perspective since it is not maximising long-term use of resources.

Of course given that the complexity in deciding something that should really be straightforward just got doubled suddenly, most of our first take would be: Wait wait don’t understand, let’s read again.

A superficial analysis might very well see this segregation of analysis to be a brilliant solution to reconciling what appeared to be 2 seemingly unproblematic perspectives (when viewed separately).

Unfortunately a closer look revealed at least 2 logical fallacies that mildly speaking, left me suspicious of what my students were being taught in their schools.

Who produces the wares?

In the simple model of society utilised at “A” level Economics, the 2-sector free market comprises only consumers and producers (firms) as economic agents, who consume and produce in their respective transactions.

It stands to reason that any yardstick utilised to measure the productive efficiency of producers in aggregate, must be the same as used for society. This is because producers are assumed to produce by definition (consumers do not contribute to production), and therefore wholly account for societal production.

Obviously this isn’t the case with the school’s approach, and the contradiction can be easily revealed.

Since the firms are productively efficient as long as they produce on their respective LRAC, the productively-efficient industry will too be producing on any point of the industry-aggregated LRAC.

Since society produces on the basis of producers’ efforts only (by definition), what applies to the industry must obviously apply to the society too. Except this didn’t happen in the school’s analysis.

Mixing key concepts up?

Productive efficiency at societal level refers to the maximisation of resource use in the production of all goods and services at the aggregate level.

It is therefore fundamentally different from productive efficiency at the industry level, since it considers the competing use of resources in the production of other goods and services.

All schools agree that, using a simple Production Possibility Curve (PPC) to illustrate, by definition, all points on the PPC represent productively efficient output combinations for society.

Unfortunately this contradicts the definition of societal productive efficiency taught by that particular school since it asserts that this only occurs at the lowest point of the industry LRAC (i.e. only 1 output level).

So how?

Quite frankly, unless I had seriously misunderstood something, I am not terribly convinced that the part about how firms are productively inefficient unless they produce at their respective LRACs will fly in the “A” levels.

In the spirit of leaving no stones unturned though (in case I am indeed wrong), but also to contribute my views, I plan to write to the school in question about what I had discussed here.

Before I do that though, I would like to see if my readers have comments to add, or even disagree with me. So please comment below if you like. You can also share this post of mine to others if you feel that they are in better position to advise.