Productivity and efficiency

Efficiency gives an indication of whether firms are able to use the existing technology in the best way.2 It has three components: scale efficiency, technical efficiency and allocative efficiency. The first two, mentioned above, are components of productivity and refer to physical notions, theoretically independent of input and output prices.

The third component of efficiency, the allocative efficiency of a firm (also called its price efficiency), reflects its ability to use inputs in their optimal proportions given their respective prices, or to produce an optimal combination of outputs given their respective prices. A firm is allocatively efficient if its outputs and inputs maximise its profit (or minimise its costs) at given prices. Allocative efficiency implies technical efficiency, as in order to maximise its profits, the firm must firstly lie on the production frontier. However, technical efficiency does not necessarily imply allocative efficiency, since the combination of outputs and inputs can be optimal with respect to the production possibilities, but not be profit maximising.

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