Efficiency
55 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.
WJEC / Eduqas: Question 14 would be a 20-mark question on your papers.
Multiple choice online
The test
1A firm is productively efficient when it:
- A produces where price equals marginal cost
- B produces where marginal revenue equals marginal cost
- C produces at the lowest point on its average cost curve
- D earns only normal profit in the long run after all entry has taken place
2Allocative efficiency is achieved in a market when:
- A firms produce at the minimum of average cost
- B the market is dominated by a single large firm exploiting economies of scale
- C total revenue equals total cost
- D the price consumers pay equals the marginal cost of production
Use the information below for questions 3 to 4.
The table shows a firm's total costs at different outputs in the long run.
| Output (units) | 100 | 200 | 300 | 400 | 500 |
|---|---|---|---|---|---|
| Total cost (£) | 2,000 | 3,600 | 4,800 | 6,800 | 9,000 |
3The firm is productively efficient at an output of:
- A 400 units
- B 300 units
- C 500 units
- D 100 units
4The firm produces 500 units. A rival with the same technology can produce 500 units at an average cost of £16. The firm's X-inefficiency, measured as the excess of its total cost over the rival's, is:
- A £1,000
- B £500
- C £200
- D £2,000
5X-inefficiency is most likely to occur when:
- A a firm is too small to exploit economies of scale
- B a firm is forced by a regulator to produce at full capacity all year round
- C a firm faces little competition and lets costs drift above the minimum
- D a firm operates in a perfectly competitive market
6Dynamic efficiency refers to:
- A producing at the minimum of average cost at a point in time
- B lower costs and better products over time through investment and innovation
- C setting price equal to marginal cost
- D the elimination of waste from the production process
7In long-run equilibrium a firm in perfect competition is:
- A both productively and allocatively efficient
- B productively efficient but not allocatively efficient
- C allocatively efficient but not productively efficient
- D neither productively nor allocatively efficient
8A profit-maximising monopolist is usually allocatively inefficient because it:
- A sets price equal to marginal revenue
- B produces at the minimum point of its long-run average cost curve
- C earns only normal profit in the long run
- D sets a price above marginal cost, so output is too low
9A firm in monopolistic competition in the long run produces on the downward-sloping part of its average cost curve. This means it has:
- A excess capacity and is productively inefficient
- B achieved productive efficiency at the minimum of average cost
- C a perfectly elastic demand curve for its product
- D no barriers to entry into the industry
10An allocation of resources is Pareto efficient when:
- A every firm earns normal profit
- B total output is at its maximum
- C no one can be made better off without making someone else worse off
- D income and wealth are distributed equally between all households
11Which of the following is the strongest argument that a monopoly may be more dynamically efficient than a competitive industry?
- A a monopoly always produces at the minimum of average cost
- B abnormal profit provides the funds and the incentive to invest in research and development
- C a monopoly charges a lower price than competitive firms
- D a monopoly faces no threat of entry, so it has no reason to cut costs
12A supermarket chain introduces self-checkouts, cutting the staff hours needed for the same number of transactions. In the short run this most clearly improves its:
- A allocative efficiency, as price falls to marginal cost
- B X-efficiency of its rivals
- C Pareto efficiency, as no one is worse off
- D productive efficiency, as average cost falls
13Water and sewerage in England are supplied by regional monopolies, regulated by Ofwat, which sets the prices they may charge for five years at a time. In 2023 and 2024 the companies were criticised for record sewage spills, leaking pipes and years of low investment while paying large dividends. Ofwat allowed average bills to rise by around a third over 2025 to 2030 to fund new reservoirs and sewer upgrades, and fined several companies for missing targets. Table 1 shows an illustrative cost and demand schedule for one company.
| Output (million litres) | 100 | 200 | 300 | 400 | 500 |
|---|---|---|---|---|---|
| Average cost (£) | 1,800 | 1,500 | 1,400 | 1,450 | 1,600 |
| Marginal cost (£) | 1,400 | 1,200 | 1,200 | 1,600 | 2,200 |
| Price consumers would pay (£) | 2,400 | 2,100 | 1,800 | 1,600 | 1,400 |
(a)Using Table 1, identify the productively efficient output and the allocatively efficient output. [2]
(b)Explain why a regional water monopoly left to set its own prices is unlikely to produce at the allocatively efficient output. [4]
(c)With the aid of a diagram, explain why a monopoly is likely to be less efficient than a perfectly competitive industry in the long run, and one reason why it might be more efficient. [6]
(d)Explain two ways in which Ofwat's price limits and fines could affect the efficiency of the water companies. [6]
14Evaluate the view that perfectly competitive markets are always more efficient than markets dominated by one or a few large firms. [25]
Answers
Show the answers
AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.
| Answer | Why | |
|---|---|---|
| 1 | C | Productive efficiency means the output is produced at the lowest possible average cost, where MC cuts AC at its minimum. |
| 2 | D | At P = MC the value consumers place on the last unit equals the cost of the resources used to make it: no reallocation could raise welfare. |
| 3 | B | Average cost is £20, £18, £16, £17 and £18: lowest at 300 units. |
| 4 | A | Actual total cost £9,000 against 500 × £16 = £8,000: the £1,000 gap is X-inefficiency, cost above the minimum. |
| 5 | C | Without competitive pressure, managers can tolerate slack: overstaffing, generous perks and outdated methods raise costs above the AC curve. |
| 6 | B | Dynamic efficiency is about change over time: research, new technology and new products that shift cost curves down and raise quality. |
| 7 | A | Entry drives price to the minimum of AC (productive efficiency), and since P = MR = MC, price equals marginal cost (allocative efficiency). |
| 8 | D | Profit maximisation at MC = MR gives a price on the demand curve above MC; units worth more than their cost go unproduced, causing a welfare loss. |
| 9 | A | Output is below the minimum-AC level, so average cost could fall if the firm produced more: spare capacity and productive inefficiency. |
| 10 | C | Pareto efficiency is about the impossibility of a costless improvement; it says nothing about fairness or the size of output alone. |
| 11 | B | Retained profit finances R&D and barriers protect the returns from it; the last option is an argument against monopoly. |
| 12 | D | Fewer inputs for the same output lowers average cost; nothing in the question says price has changed, and the displaced staff are worse off. |
13 (a) Using Table 1, identify the productively efficient output and the allocatively efficient output. [2: AO2 2]
- AO2 (1) Productively efficient at 300 million litres, the minimum average cost of £1,400
- AO2 (1) Allocatively efficient at 400 million litres, where price (£1,600) equals marginal cost (£1,600)
13 (b) Explain why a regional water monopoly left to set its own prices is unlikely to produce at the allocatively efficient output. [4: AO1 1, AO2 1, AO3 2]
- AO1 (1) A profit-maximising firm produces where MC = MR, and for a monopoly MR lies below price because it must cut price on all units to sell more
- AO3 (1) So the profit-maximising output is below the level where P = MC and the price is above marginal cost; units that consumers value above their cost are not supplied
- AO3 (1) With no competitor to undercut it and no close substitute for mains water, nothing pushes the firm towards P = MC; the result is a deadweight welfare loss
- AO2 (1) Application: in Table 1 moving from 300 to 400 million litres adds units worth £1,600 at a marginal cost of £1,600 or less; without regulation the firm would stop short of that, which is why Ofwat sets price limits
13 (c) With the aid of a diagram, explain why a monopoly is likely to be less efficient than a perfectly competitive industry in the long run, and one reason why it might be more efficient. [6: AO1 2, AO2 1, AO3 3]
- AO1 (2) Diagram: AR, MR and a constant MC = AC; the monopoly output Qm where MC = MR and price Pm; the competitive outcome Pc = MC at Qc; the abnormal profit rectangle and the deadweight loss triangle between Qm and Qc
- AO3 (1) Allocative inefficiency: Pm is above MC, so output is restricted to Qm and the triangle of surplus between Qm and Qc is lost to everyone; in perfect competition entry pushes price down to MC
- AO3 (1) Productive and X-inefficiency: the monopoly need not produce at minimum AC and, protected from entry, can let costs drift up (leaking pipes left unrepaired), while competitive firms that do not minimise cost are driven out
- AO3 (1) Possible gain: a single network avoids duplicating pipes and treatment works (economies of scale, a natural monopoly), so the monopoly's AC may lie below what many small competitors could reach, and abnormal profit can fund long-term investment (dynamic efficiency)
- AO2 (1) Application: duplicating water mains would be wasteful, so the case rests on regulation forcing the monopoly towards the competitive price and investment rather than on breaking it up
Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram with the welfare loss explained; 5 to 6 for both allocative and productive or X-inefficiency explained and a counter-argument applied to water.
13 (d) Explain two ways in which Ofwat's price limits and fines could affect the efficiency of the water companies. [6: AO1 2, AO2 2, AO3 2]
- AO1+AO2+AO3 (3) A price cap below the profit-maximising price moves the firm towards P = MC (allocative efficiency) and, because the firm keeps any cost savings within the cap, gives it an incentive to cut X-inefficiency; the risk is that it cuts maintenance and investment to protect profit, which is what the sewage spills suggest happened
- AO1+AO2+AO3 (3) Allowing bills to rise to fund reservoirs and sewer upgrades, with fines for missed targets, aims at dynamic efficiency: investment now lowers costs and improves quality later; the risk is regulatory capture or that higher allowed prices simply raise profit if the spending is not enforced
- AO1+AO2+AO3 (3) Or: fines act like a cost on poor performance, pushing firms to repair leaks (productive efficiency); but if fines are small relative to profit they may be treated as a cost of doing business
Maximum 6: two effects, each linked to a named type of efficiency and applied to water.
14 Evaluate the view that perfectly competitive markets are always more efficient than markets dominated by one or a few large firms. [25: AO1, AO2 and AO3 16, AO4 9]
Knowledge and analysis (AO1 to AO3)
- Define productive, allocative, X- and dynamic efficiency, and the long-run equilibrium of perfect competition: many firms, homogeneous products and free entry drive price to the minimum of average cost with P = MC.
- Diagram: the competitive firm in long-run equilibrium at the bottom of AC with P = MC = AC; contrast the monopoly diagram, Pm above MC at Qm, with abnormal profit and a deadweight loss.
- Static case for competition: allocative efficiency (P = MC), productive efficiency (minimum AC), no X-inefficiency because firms that let costs rise make losses and exit; consumer surplus is maximised; opening airlines and telecoms to competition cut prices sharply.
- Against: where minimum efficient scale is large relative to the market (water, rail track, power grids) one firm's AC is below what many small firms could reach, a natural monopoly; large firms' economies of scale can mean lower prices even with a mark-up.
- Dynamic efficiency: competitive firms earn only normal profit, so they lack funds for R&D and cannot protect the returns from innovation; large firms with abnormal profit and patents invest heavily (pharmaceuticals, semiconductors); Schumpeter's creative destruction.
- Perfect competition is rare: most real markets are concentrated, so the useful comparison is between degrees of competition and contestability, not the textbook extremes.
Evaluation (AO4)
- It depends on the type of efficiency: competition wins on static allocative and productive efficiency; large firms can win on dynamic efficiency and economies of scale, and over the long run dynamic gains can dominate.
- It depends on the cost structure: where minimum efficient scale is small (cafés, hairdressers, farming) competition is more efficient; where it is large (networks) a regulated monopoly is more efficient than forced competition.
- Contestability matters more than the number of firms: a dominant firm facing a credible threat of entry may behave efficiently, while a protected industry of many firms (taxis with licences) may not.
- Large firms' dynamic efficiency is not guaranteed: without pressure, abnormal profit may go to dividends and X-inefficiency rather than investment, as the water companies show; the gains depend on regulation and the threat of entry.
- 'Always' fails on the evidence: welfare depends on the market, the time horizon and the regulatory framework.
Judgement
A supported judgement might conclude that perfectly competitive markets are more efficient in a static sense and in industries with low minimum efficient scale, but not always: where economies of scale are large or innovation matters, a few large firms under effective competition or regulation can deliver lower costs and faster progress, so the view holds for some markets and some kinds of efficiency rather than in general.
Marking
Levels, out of 25 (Edexcel splits them as knowledge, application and analysis 16, evaluation 9; AQA marks the whole answer against one set of levels). Top level (21 to 25): a range of points developed in full chains of reasoning, supported by accurate diagrams and real examples, with evaluation that weighs the arguments against each other and reaches a judgement that depends on stated conditions. Middle level (11 to 20): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom level (1 to 10): points listed or described, little use of theory or examples, judgement missing or unsupported. WJEC: a 20-mark question with AO1 6, AO3 6 and AO4 8.