Dynamic efficiency

Dynamic efficiency relates to the efficiency gains made by firms in the long run as a result of investing in new technology, or improving production processes. Employing new technology enables production costs to fall, which can have two key benefits - lower prices benefit consumers and increased profits benefit producers.

Dynamic and static efficiency

Static efficiency

In contrast to dynamic efficiency, static efficiency refers to efficiency in the short run where it is assumed that there is investment in technology and no 'technological progress'.

Firms are productively efficient when average production costs are at their lowest. This can be seen in the following diagram.

Firms are allocatively efficient when the price they charge for a good or service is equal to the marginal cost of producing that good or service, as shown above:

The P=MC rule for allocative efficiency

The reason why allocative efficiency concerns the relationship between price and marginal cost is that an efficient allocation of goods and services arises when what a consumer is prepared to pay - which indicates the expected utility from consumption - equals the price a producer is prepared to accept in order to cover its marginal cost of producing.

This concept can be confusing if we look at it from a simple accounting perspective - surely, if price is equal to marginal cost then no profit is being made!

However, normal profits are being made when P=MC because marginal cost INCLUDES the cost to the firm of using all its scarce factors of production, including the reward to the entrepreneur. For example, assume a firm produces a £10 product, and the cost of labour and raw materials is £5.50, the repayment of any loans and for rents is £2, and £2.50 is the reward to he entrepreneur to cover opportunity cost. If this firm charges £10 for its products, all marginal costs have been covered, including a reward to the entrepreneur.

Assessing the level of static efficiency considers two key elements in the supply of goods. It starts with an assessment of how well scarce resources are used (productive efficiency), and ends with an assessment of how well resources are allocated to consumers (allocative efficiency). Optimal short run efficiency will exist when both productive and allocative efficiency have been reached.

In terms of traditional theory of the firm, the greater the level of competition the closer the firm will move towards optimal efficiency, with 'perfect competition' achieving maximum efficiency.

Dynamic efficiency

Dynamic efficiency considers how firms can use technology and knowledge to reduce long run average cost. In order to do so, supernormal profits made in the short run can be allocated towards investment in new technology.

This alters how we view the role of supernormal profits in enabling investment. If perfectly competitive firms in the short run are only making normal profits, it is not possible to allocate funds to investment as, in simple terms, investment would be an additional cost that would possibly force the firm into making a loss and leaving the market.

Hence, it can be argued that dynamic efficiency can only be achieved as a result of supernormal profits being derived in the short run, which must mean marginal revenue is greater than marginal cost. This is most likely to occur with less than perfectly competitive firms, including monopolies and oligopolies.

For example, a monopolist may produce at an output where price is greater than marginal cost (and therefore is allocatively inefficient) and where average costs are not at their lowest (productively inefficient) and derive supernormal profits.

It is then possible that, over time, improvements in technology (through innovation and invention) can reduce production costs, which may then be passed-on in terms of lower prices to consumers. While a monopolist may operate at an inefficient level of output at one point in time, it may reduce average costs as it expands and uses new technology and becomes more efficient in the long run.

This, of course, could also be the case with firms operating under conditions of monopolistic competition and oligopoly.

Dynamic efficiency is, therefore, more associated with monopolies and oligopolies, and can be used in their 'defense'.  Making supernormal profits in the long run can provide funds for investment, which can improve efficiency in the long run.

The importance of technology

Technological progress will decrease average and marginal cost in the long run, and clearly increase productive efficiency. This will benefit consumers in terms of lower prices with the possibility that supernormal profits increase if (as in the above diagram) marginal costs fall at a faster rate than marginal revenue.

This highlights the significance of technological advances in generating important benefits for both consumers and producers.