All four types marked on one set of cost curves: the lowest point of ATC, P = MC, costs above the curve and costs falling over time.
Octopus Energy built its own customer and billing system, Kraken, in 2017. Older suppliers were running customers through many separate systems; firms that later moved to Kraken replaced anywhere from 15 to 200 of them. In 2020 E.ON and npower licensed it for about 10 million customers, and E.ON said the move would give it the lowest costs in the industry and add about £100 million a year to its earnings by 2023. EDF followed in 2021 with about five million customers.
The older suppliers were already producing. In what sense were they inefficient? And what kind of efficiency did Octopus create?
Sources: New Power (E.ON and npower move to Kraken); Wikipedia, Kraken Technologies (licensees and systems replaced).
Efficiency means getting the most out of scarce resources. Economists separate it into four kinds:
The first three are static: they are about one moment. The fourth is about change. Always name the type you mean: examiners do not credit “efficient” on its own.
Two firms make the same product at the same output.
Firm A uses old software and pays its staff to rekey the same data three times. Firm B does each job once. Both are producing where their average cost curve is at its lowest.
Which statement is right?
The lowest point of a cost curve only tells you the best a firm could do with its methods. Firm A’s real costs are above what they need to be at that output. That waste is called X-inefficiency, and it is one of four types of efficiency in this lesson.
Start with the costs. MC goes in first: the Nike tick. It falls at first, then rises as diminishing returns set in.
Then ATC, a flatter U, with the rising part of MC cutting it at ATC’s lowest point. This is the make-or-break detail: while MC is below ATC, each extra unit pulls the average down. The moment MC crosses ATC, each extra unit pulls the average up, so ATC turns upwards exactly there.
Productive efficiency is at the lowest point of ATC, output Qp, where MC = ATC. Each unit is made at the lowest average cost the firm’s methods allow.
Check: Where is the firm productively efficient?
Productive efficiency is producing at the lowest possible average cost. That is the bottom of ATC, which is also where MC cuts it. The bottom of MC is a common wrong answer.
Now add demand. The demand curve shows what consumers are willing to pay for each unit: the value they put on it. MC is the firm’s supply side, so where the two meet is where demand meets supply.
Allocative efficiency is where demand meets MC, at Q*: price equals marginal cost. Do not just state P = MC; explain it. Price is what consumers think the last unit is worth. MC is the value of the resources used to make it. Below Q*, P > MC, so more output would add more value than it costs. Beyond Q*, P < MC, so the last units cost more than they are worth.
Teacher tip: Allocative efficiency is where demand (AR) crosses MC, not where MR crosses MC. MC = MR is profit maximisation, a different point for any firm with market power.
Check: At an output where price is above MC, what is true?
Price measures the value of the last unit to consumers. MC measures the value of the resources used to make it. If P > MC, one more unit adds more value than it uses up, so society gains from more output.
The two can differ. Here Q* is beyond Qp, so at Q* average cost is rising. A firm can be productively efficient without being allocatively efficient, and the other way round. In perfect competition in the long run, P = MC = lowest ATC, so both hold at once.
X-inefficiency is any point above the ATC curve. At this output the firm could produce for less, but its real costs are higher: overstaffing, paying suppliers too much, or rekeying data across old systems, as the older energy suppliers were doing. Slack builds up where nothing forces costs down: a firm with few rivals, or a public body with no profit motive.
Check: A firm finds a new production method that cuts the materials and labour needed for every unit. How would you show this on its cost diagram?
Less material and labour per unit lowers the variable cost of every unit, so both MC and ATC shift down.
Dynamic efficiency shifts the curves themselves. A process innovation, like Kraken, lowers the cost of every unit, so MC and ATC both shift down, to MC2 and ATC2. Do not confuse this with economies of scale: those are a movement along the long-run average cost curve as a firm grows. Dynamic efficiency is a new, lower curve.
Check: Which is an example of dynamic efficiency?
Dynamic efficiency is about change over time: a new process shifts the cost curves down. Bulk buying is an economy of scale: a movement along the long-run average cost curve as the firm grows, not a new way of producing.
They marked the lowest point of MC. Productive efficiency is the lowest point of average cost, ATC, which is where MC cuts it on its way up.
Explain the difference between productive efficiency and allocative efficiency.
Productive efficiency means producing at the lowest point of the average cost curve, where marginal cost cuts average cost. Each unit is made at the lowest cost per unit the firm’s methods allow.
Allocative efficiency means producing the output where price equals marginal cost. Price is the value consumers put on the last unit; marginal cost is the value of the resources used to make it. If price is above MC, one more unit would add more to welfare than it costs, so output is too low. If price is below MC, the last units cost more than they are worth. Welfare is greatest where P = MC.
The two need not coincide. A monopolist producing where MC = MR is usually neither: price is above MC and average cost is above its minimum. In the long run in perfect competition, firms produce where P = MC = lowest ATC, so both hold at once.
**Evaluation:** both are static measures. A firm with market power may be inefficient in both senses today, yet use its profit to cut costs over time, which is dynamic efficiency.
Kraken: Octopus Energy Group and its licensees, as reported by New Power and summarised on Wikipedia (Kraken Technologies). Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed. Your answers are saved only on this device.