Productive, Allocative and Dynamic Efficiency: Trade-offs
A commonly known saying is that there's no such thing as a free lunch. Another familiar proverb is that you can't have your cake and eat it. Such is the state of things when it comes to efficiency in economics.
Economists often divide economic efficiency into three types: productive, allocative, and dynamic. According to most economists, it is difficult, if not impossible, to achieve all three of these efficiencies at the same time. Rather, one must choose between them.
The reason for these is the different market structures in existence. One of the most well-known is the perfectly competitive market structure, where there is perfect knowledge, goods are not differentiated (i.e. branded), and generally, where there are a whole lot of other totally unrealistic things.
A more realistic market structure is monopolistic competition. Under this structure, there is imperfect knowledge and goods are branded, but firms do not have enough power to control the market because they compete against each other.
Oligopolies and monopolies are less common, but certainly more prevalent than perfectly competitive markets. Under oligopolies and monopolies, a few firms (in the case of a monopoly, exactly one firm) control the market, and thus have a lot of power over the market.
The amount of each profit a firm makes roughly corresponds with its power. Under perfectly competitive and monopolistically competitive markets, firms can make profits in the short run, but because in the long run new firms enter the market to take advantage of the potential profits to be made, the profit drops to zero.
On the other hand, oligopolies and monopolies often make huge profits, thanks to their immense power. So where does efficiency come in?
As might be expected, productive and allocative efficiency are achieved in perfectly competitive markets. Productive efficiency — where the goods and services are produced at the lowest cost possible — is only attainable under a perfectly competitive market structure, but fortunately one can come close to it in a monopolistically competitive market.
Allocative efficiency can also be achieved in a perfectly competitive market — the right combination of goods will be produced because the perfect knowledge of firms and consumers creates the right confluence of market signals. Thus, the economy will optimise its allocation of resources.
Surprisingly, dynamic efficiency is virtually impossible to achieve in a perfectly competitive market. Why? Because in the long run, firms have no profits. Thus, they have no money to innovate and develop new technology. Moreover, the perfect knowledge of the other firms and consumers ensures that any new development will be copied by others, and the competitive edge gained from it will be lost.
It has been suggested that monopolies and oligopolies, although terribly inefficient when it comes to achieving productive efficiency — they don't produce enough to achieve sufficient economies of scale and thus produce at the lowest average cost possible, because they find they can restrict output and make greater profits — as well as allocative efficiency (monolithic institutions are rarely conducive to the operation of market signals for allocating resources), can be excellent when it comes to dynamic efficiency.
The reason for this is that the immense profits these firms make allow them to devote more time and energy to research, thus benefiting society in the long run. There is reason to be skeptical of this explanation, since the market will not necessarily create an incentive to innovate (why would a monopolist want to spend his profits on research when he has no competition?). But there may be a ring of truth to it, since even notorious monopolies like Microsoft do innovate from time to time.
Under the most common market structure, monopolistic competition, no particular effiency is achieved. One might even argue this is particularly inefficient since, unlike with monopolies, firms in such a market have to spend money on essentially useless advertising. But this market structure also represents a compromise between the three different types of efficiency — and thank God for that, since a world without any dynamic efficiency would be just as dreadful as one without any productive or allocative efficiency.