OCR A Level Economics: Economic efficiency and the nature of market failure (H460) – Revision Notes

These notes condense the topics Productive and allocative efficiency, Market failure and Externalities from Component 1, Microeconomics, of the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. For full explanations read the study guide, then try the practice questions. Related pages: the OCR Economics hub, the checklist and the Microeconomics revision notes. Find weak spots with the free diagnostics. All figures are invented and illustrative.

Definitions

Term	Meaning	Test
Productive efficiency	Output produced at lowest possible average cost	MC = AC, the lowest point of AC; on the PPF
Allocative efficiency	Resources go to the goods society values most	P = MC; with externalities, MSB = MSC
Economic efficiency	Best use of scarce resources overall	Productive and allocative together
Static efficiency	Efficiency at one point in time	Given resources and technology
Dynamic efficiency	Efficiency over time through investment and innovation	Cost curves shift down
X-inefficiency	Cost above the lowest possible for the output	Actual AC above efficient AC
Market failure	Free market fails to allocate efficiently	MSB not equal to MSC

Method boxes

Find the productively efficient output

1. Write AC = TC ÷ Q for each output.
2. Find the lowest AC.
3. Check MC = AC there. MC is below AC while AC falls and above it while AC rises.

Find the allocatively efficient output

1. Set price (demand) equal to MC.
2. For a monopolist also set MR = MC, to find its actual output.
3. Welfare loss = ½ × (output difference) × (price minus MC at the monopoly output).

Solve an externality diagram

1. Market output: MPB = MPC.
2. Add the external element: MSC = MPC + MEC, or MSB = MPB + MEB.
3. Social output: MSB = MSC.
4. Welfare change = ½ × (output difference) × (gap between MSB and MSC at the market output).

Worked reminders

Productive and allocative efficiency together. A small firm in Country J (illustrative) has TC = 32 + 6Q + 2Q², with Q in thousands and TC in £ thousand. Then AC = 32/Q + 6 + 2Q and MC = 6 + 4Q.

Q	AC	MC
3	22.67	18
4	22.00	22
5	22.40	26
6	23.33	30

• Productive efficiency: lowest AC is £22 at Q = 4, where MC = AC.
• If the price is £30, P = MC gives 30 = 6 + 4Q, so Q = 6. The firm is allocatively efficient there.
• At Q = 6, AC = £23.33, so it is not productively efficient. Profit = (30 − 23.33) × 6 = £40 thousand supernormal.
• If entry pushes the price down to £22, Q = 4 and both conditions hold with zero supernormal profit.

X-inefficiency and dynamic efficiency. If the same firm’s actual unit cost at Q = 4 were £25 instead of £22, the excess is 3 ÷ 22 = 13.6% above the efficient level. Its cost curve sits above the efficient one. Dynamic efficiency would be an investment that moves the whole curve down in later years. For example, a firm in Country K (illustrative) spends £300,000 on new equipment, cutting unit cost from £12 to £10.50 on 80,000 units a year. Saving = 1.50 × 80,000 = £120,000 a year, so payback = 300,000 ÷ 120,000 = 2.5 years. The gain is real but arrives late and is uncertain, which is why dynamic efficiency is harder to weigh against a certain static loss.

Negative externality of consumption. In a market in Country G (illustrative), MPB = 66 − 2Q, MPC = 6 + 2Q and the external cost of each unit consumed is £12, so MSB = 54 − 2Q.

• Market: 66 − 2Q = 6 + 2Q, so Q = 15 and P = £36.
• Social: 54 − 2Q = 6 + 2Q, so Q = 12 and P = £30.
• At Q = 15, MSC = 36 and MSB = 24, a gap of 12. Welfare loss = ½ × 3 × 12 = £18 thousand.

The market over-consumes by 3 thousand units.

Positive externality of production. In Country H (illustrative), MPB = 64 − 2Q, MPC = 28 + 2Q and external benefit of production is £8 per unit, so MSC = 20 + 2Q.

• Market: 64 − 2Q = 28 + 2Q, so Q = 9 and P = £46.
• Social: 64 − 2Q = 20 + 2Q, so Q = 11 and P = £42.
• At Q = 9, MSB = 46 and MSC = 38, a gap of 8. Welfare gain = ½ × 2 × 8 = £8 thousand.

The market under-produces by 2 thousand units.

Four externality cases at a glance

Case	Curve shift	Market output	Examples
Negative, production	MSC above MPC	Too high	Factory noise or waste
Negative, consumption	MSB below MPB	Too high	Congestion, noise
Positive, consumption	MSB above MPB	Too low	Education, vaccination
Positive, production	MSC below MPC	Too low	Staff training that spreads

Market failure arises in each because price reflects only private costs and benefits.

Market failure: what to say

1. State what the market does: output is set where private benefit equals private cost.
2. State what is missing: a cost or benefit to a third party, or a missing market.
3. State the result: MSB differs from MSC, so output is too high or too low and resources are misallocated.
4. Name the consequence: a welfare loss, the triangle between MSB and MSC, which is allocative inefficiency.

Efficiency by market structure

Structure	Allocative	Productive
Perfect competition	Yes (P = MC)	Yes in the long run
Monopolistic competition	No	No in the long run
Oligopoly	Usually not	Depends on scale and rivalry
Monopoly	No	Often not, though scale economies may help

Evaluation hooks: perfect competition is a benchmark, not a description; scale economies can make a large firm more efficient; contestability disciplines price; dynamic gains may offset a static loss.

Must-know distinctions

• Productive and allocative: the first is about cost, the second is about what is produced.
• Static and dynamic: a point in time against change over time.
• X-inefficiency and allocative inefficiency: x-inefficiency is cost above the efficient curve; allocative inefficiency is price above MC.
• MPC, MEC, MSC: private, external, then their sum. The same for benefits.
• Over- and under-production: negative externalities give too much; positive give too little.

Effects on markets: chains of reasoning

• Education: skills benefit others, so MSB exceeds MPB. Individuals buy too little. Evaluate by size of the gap and how well benefits can be measured.
• Health: vaccination lowers infection risk for others, so there is under-consumption. Smoking harms others, so there is over-consumption.
• Transport: each driver slows others, so MSC exceeds MPC. Evaluate by timing, and by whether alternatives exist.
• Environment: firm pollution raises MSC above MPC. The damage may be long-run and hard to value.

For any of these, finish with a judgement. Say whether the externality is large or small, whether it is certain or uncertain, and whether it falls on many people or few. A large, certain and widespread externality supports a firm conclusion that the market fails badly. A small or uncertain one supports a more cautious view.

Quick self-test

1. A firm’s total cost for 10 units is £300. Calculate AC.
2. Total cost rises from £300 to £318 for one more unit. State MC.
3. MPC is £14 and MEC is £6. Calculate MSC.
4. MPB is £25 and MEB is £9. Calculate MSB.
5. In a market the price is £15 and MC is £11. State whether output is too high or too low, and why.
6. A firm has unit cost £26. An efficient rival has £20. Calculate the excess cost as a percentage of the efficient level.
7. MSC lies below MPC. Name the externality and state the market outcome.
8. A monopolist produces 8 units at price £40 where MC is £28. Allocative efficiency would be at 13 units. Calculate the welfare loss.
9. Classify as static or dynamic: a firm cuts its price to equal MC.
10. A market produces 14 units, the social optimum is 10 and the gap between MSC and MSB at 14 is £6. Calculate the welfare loss.

Answers

1. 300 ÷ 10 = £30.
2. 318 − 300 = £18.
3. 14 + 6 = £20.
4. 25 + 9 = £34.
5. P > MC, so buyers would pay more for another unit than it costs to make: output is too low.
6. (26 − 20) ÷ 20 × 100 = 30%.
7. A positive externality of production; the market under-produces.
8. ½ × (13 − 8) × (40 − 28) = ½ × 5 × 12 = £30.
9. Static: it concerns efficiency at a point in time.
10. ½ × 4 × 6 = £12.

Where marks are usually lost

• Saying “P = MC” for allocative efficiency when an externality is present. Use MSB = MSC.
• Defining productive efficiency as “low cost” without naming the lowest point of AC.
• Mixing up the curves: MSC is MPC plus MEC, so a negative externality of production puts MSC above MPC.
• Describing the welfare loss triangle without saying why it is a loss: units where MSC exceeds MSB are produced.
• Stating that externalities cause market failure with no chain: private decision, ignored third party, wrong output.
• Evaluation that lists points without a judgement or without weighing size, timing and measurement.
• Calling a monopoly inefficient with no mention of scale economies or dynamic gains.

Official syllabus

OCR, A Level Economics (H460), Version 3.0 (June 2026), for first assessment in 2021. Component 1 Microeconomics: Productive and allocative efficiency, Market failure and Externalities.