The three questions that have to be answered when trying to measure the efficiency of an economy are what?', how?', and for whom?'. The first question relates to the production of goods. We have scarce resources so to achieve maximum efficiency we must make sure those resources are being used to make things that people want. Otherwise, precious resources are being mis-allocated. The second factor of efficiency is the competence of the production method itself. Is output being maximised? The third question is for whom?'. This relates to financial inequalities which exist in our society. If everyone earned the same, then output could not be maximised because there would be no incentives to work hard.
I will be discussing the first two factors above. The first question links with allocative efficiency and the second one is associated with productive efficiency. Allocative efficiency can only be achieved if goods supplied match exactly with the wants and needs of society. For example, an economy that produces fruit and vegetables exists, and the population prefer fruit to vegetables, then for allocative efficiency to occur , more fruit must be produced than vegetables. This idea can be expressed on a PPC:.
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In the diagram above, both points are productively efficient because the resources are being used to make the maximum quantity of fruit and vegetables. However, only point A is allocatively efficient because it is the ratio of fruit to vegetables that the population wants. Point A could also be called economically efficient because it fulfils both of the factors. Point be can never be economically efficient because it only fulfils one factor.
If the market system is operating efficiently then the levels of fruit and vegetable production should adjust automatically. This is because if more vegetables are produced than demand dictates then a surplus will occur. This will result in a fall in vegetable prices which in turn will cause some producers to stop supplying it and switch to fruit production.