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Efficiency is normally defined as a ratio of the quantity of some measure of  output to the quantity of  input required to bring it about. In economic theory, the desired output of economic activity is  taken to be an increase in individual welfare, and the input required is some combination of the productive resources of land, labour and capital. The economic efficiency of an action is thus taken refer to the ratio of the aggregate increase in welfare that it produces to the aggregate quantity of resources that it requires.
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'''Economic efficiency''' is normally defined as a ratio of the quantity of some measure of  output to the quantity of  input required to bring it about. In economic theory, the desired output of economic activity is  taken to be an increase in social [[utility]], and the input required is some combination of the productive resources of land, labour and capital. The concept of economic efficiency is a product of the theory of [[welfare economics]] and is subject to the limitations noted in the article on that topic.
 


The concept of economic efficiency is central to the theorems of [[welfare economics]] and to the practice of [[cost/benefit analysis]]


==Definitions of efficiency==
==Definitions of efficiency==
In principle, the economic efficiency of an action is  taken refer to the ratio of the  increase in social utility (or total consumer satisfaction)  that it produces to the  quantity of the community's resources that it requires. The difficulty about that definition is that  the effect on social utility of actions that result in losses as well as gains cannot be assessed without making subjective judgments about the best distribution of income among individuals. The "''Pareto criterion''" evades that difficulty by the proposition that:
:''- an action is Pareto efficient only if it makes somebody better off without making anybody worse off.''
Since most actions do make some people worse off, the Pareto criterion is too restrictive to be generally useful, and it is often replaced by the  Kaldor-Hicks criterion, which requires that:
:''- an action is Kaldor-Hicks efficient only if it can  benefit those who gain from it after they have compensated those who lose from it.''


===Pareto efficiency===
That way of adapting of the Pareto criterion is known as ''compensation principle'', and it is not strictly valid unless the compensation is actually paid.  
The aggregate increase in welfare resulting from an action cannot be quantified because interpersonal comparisons of welfare are conceptually impossible. However, it is possible to determine whether an activity increases or  decreases an individual's economic welfare. One way of overcoming the conceptual barrier is to deem that an activity will increase efficiency only if it makes somebody better off without making anybody worse off. Efficiency so defined is termed ''Pareto efficiency'' in honour of the economist, Vilfredo Pareto, who first put that definition forward.  In a somewhat different sense, the terms ''Pareto efficent'' and ''Pareto optimum '' are used to describe an ideal state of affairs from which it is impossible to make a change which would make anybody better off without making somebody else worse off.


===Kaldor-Hicks efficiency===
The three categories of choice that determine economic efficiency are those that affect ''productive efficiency'' by choosing among  alternative resources that are to be applied to the production of an output; those that determine  ''allocative efficiency'' by choosing among the alternative  outputs to which resources are to be applied, and those that determine ''distributive efficiency'' by the choosing among  alternative recipients for the outputs that are produced. The practical application of the following definitions of those three categories  of economic efficiency may require the imputation of value judgments in order to give meaning to the concepts of social utility and social product which they employ.  
The Pareto criterion is too restrictive to be generally useful so for practical purposes it is normally replaced by the criterion that efficiency is deemed to be increased if those who gain as the result of an action would benefit from it after compensating those who lose from it. This is the criterion that is used in cost/benefit analysis, but its application is strictly valid only if the compensation is actually paid. This is sometimes referred to as the ''compensation principle''.


==The components of efficiency==
===Productive efficiency===
===Productive efficiency===
Productive efficiency can be defined as the ratio of the quantity of  output of a product to the quantity of resources used to produce it.  Where the same resources can be used to produce more than one product, their optimum product  combinations form a ''production possibilities frontier'' (represented in the text book in the two-product case as a curve with the output of one product diminishing as the output of the other is  increased). A loss of productive efficiency is definitionally the result of any  change that results in a non-optimal product combination. The productive efficiency of an economy  can be increased  by an expansion of the production possibilities frontier as a result of  scale economies or  of an increase in the availability or the productivity of the factors of production.
The optimum combination of resources required to produce a given output at a given state of technology is that at which the ratio of their marginal products to their marginal costs are equal, because otherwise output could be increased at a given level of cost by increasing one input and reducing another. As might be expected, productive efficiency can also be influenced by technological change, including changes in input performance.


=== Allocative efficiency===
=== Allocative efficiency===
An economy achieves optimum allocative efficiency when it produces that combination of products which makes for the greatest consumer satisfaction – so that consumers would not wish to spend their money in any other way.  An increase in allocative efficiency using the Kaldor/Hicks criterion would occur if welfare gains from a change in the combination of goods produced would outweigh any resulting losses.
Where the same resources can be used to produce more than one product, their possible product  combinations at a given level of  productive efficiency form a ''production possibilities frontier'' (shown graphically on the tutorials subpage). An economy achieves a definitionaly optimum allocation of resources between outputs  when it produces that combination which makes for the greatest social utility. Stated more precisely, resources are allocated optimally between two outputs when the ratios of their marginal social utilities to their marginal social costs are equal - because  social utility could otherwise be increased by switching resources from one output to the other. The usefulness of this definition may be  limited, however, because unknown differences in the preferences for alternative outputs among individual consumers may  make the marginal social utilities of those outputs hard to assess.


===Distributional  efficiency===
===Distributional  efficiency===
Distributional efficiency is increased if the way that consumption is shared among households is changed in  such a way as to increase aggregate welfare.
By definition, economic efficiency is increased if the way that outputs are distributed among consumers is changed in  such a way as to increase social utility. The optimum distribution of two products between two consumers is achieved when each consumer's [[marginal rate of substitution]] of one product for the other is the same as that of the other consumer; that is to say when the ratio of the  marginal utilities of the two products is the same for the two consumers, because otherwise they could gain from a swap. This is a restricted definition of the optimum, however, because it is concerned only  about the relative amounts and says nothing about the total amounts of the outputs  that are  to be received by either consumer.
 
==Limitations and applications==


===Limitations===
==Applications==
The above definitions and classifications provide one of a number of conceptually possible frameworks for analysing economic activity, but they do not contribute directly to its understanding. Their contribution depends indirectly upon the uses to which they can be put, and those uses are subject to several limitations. Foremost is the fact that, because  the welfare referred to is the welfare of the individuals affected ''as each of them perceives it'', it cannot be aggregated. Secondly, the possibility of interactions within an economic system  means that an improvement in one category of efficiency  may not be reflected as an improvement in their combination.  (For  example, the merger of two large firms could lead both to a loss of  allocative efficiency because of their gain in market power,  and to a gain in  productive efficiency  because of scale economies. Similarly an increase in income support could lead both to an increase in distributional efficiency because of the diminishing marginal utility of wealth, and to a loss of productive efficiency because of the resulting change in recipients' relative preferences for work and leisure.) Thirdly, practical considerations often limit the possibility balancing of gains to one category of efficiency against the losses to another to cases where the balance is judgementally obvious. That difficulty can be so acute where distributional efficiency is involved that refuge has to be taken in the presumption that distributional welfare gains and losses are a matter that can be put aside to be dealt with , if necessary, by redistributive taxes and benefits.
The determinants of productive efficiency have application to [[business economics]] and to the [[theory of the firm]], and the promotion of allocative efficiency is the principle objective of [[competition policy]].


===Applications===
==References==
Despite those  limitations, the concept of efficiency underlies much of the work of practising economists. The practice of ''[[cost/benefit analysis]]'' embodies the assumption that the  welfare  of an individual is increased  by  the free  exchange of a particular good for claims upon alternative goods (ie money) - and that the benefit  thereby  gained is measurable by the price that he is willing to pay for it. By extension, that implies that an economy's allocative efficiency is increased if the total benefits so defined exceed the cost of provision of the good.  The existing states of productive and distributive efficiency are normally assumed to be unaffected . The operation of  [[competition policy]]  depends upon the presumption  that a reduction in a company’s market power  or the removal of a barrier to competition will result in an increase in allocative efficiency (a presumption and its rebuttal according to the ''theory of the second best'' are explained in the article on [[competition]]).  The adoption of  a ''per se'' prohibition (based upon the form of a business practice) ignores the possibility of a consequent reduction in productive efficiency  whereas an effects-based ''rule of reason''  prohibition can take account of that possibility.
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Economic efficiency is normally defined as a ratio of the quantity of some measure of output to the quantity of input required to bring it about. In economic theory, the desired output of economic activity is taken to be an increase in social utility, and the input required is some combination of the productive resources of land, labour and capital. The concept of economic efficiency is a product of the theory of welfare economics and is subject to the limitations noted in the article on that topic.


Definitions of efficiency

In principle, the economic efficiency of an action is taken refer to the ratio of the increase in social utility (or total consumer satisfaction) that it produces to the quantity of the community's resources that it requires. The difficulty about that definition is that the effect on social utility of actions that result in losses as well as gains cannot be assessed without making subjective judgments about the best distribution of income among individuals. The "Pareto criterion" evades that difficulty by the proposition that:

- an action is Pareto efficient only if it makes somebody better off without making anybody worse off.

Since most actions do make some people worse off, the Pareto criterion is too restrictive to be generally useful, and it is often replaced by the Kaldor-Hicks criterion, which requires that:

- an action is Kaldor-Hicks efficient only if it can benefit those who gain from it after they have compensated those who lose from it.

That way of adapting of the Pareto criterion is known as compensation principle, and it is not strictly valid unless the compensation is actually paid.

The three categories of choice that determine economic efficiency are those that affect productive efficiency by choosing among alternative resources that are to be applied to the production of an output; those that determine allocative efficiency by choosing among the alternative outputs to which resources are to be applied, and those that determine distributive efficiency by the choosing among alternative recipients for the outputs that are produced. The practical application of the following definitions of those three categories of economic efficiency may require the imputation of value judgments in order to give meaning to the concepts of social utility and social product which they employ.

Productive efficiency

The optimum combination of resources required to produce a given output at a given state of technology is that at which the ratio of their marginal products to their marginal costs are equal, because otherwise output could be increased at a given level of cost by increasing one input and reducing another. As might be expected, productive efficiency can also be influenced by technological change, including changes in input performance.

Allocative efficiency

Where the same resources can be used to produce more than one product, their possible product combinations at a given level of productive efficiency form a production possibilities frontier (shown graphically on the tutorials subpage). An economy achieves a definitionaly optimum allocation of resources between outputs when it produces that combination which makes for the greatest social utility. Stated more precisely, resources are allocated optimally between two outputs when the ratios of their marginal social utilities to their marginal social costs are equal - because social utility could otherwise be increased by switching resources from one output to the other. The usefulness of this definition may be limited, however, because unknown differences in the preferences for alternative outputs among individual consumers may make the marginal social utilities of those outputs hard to assess.

Distributional efficiency

By definition, economic efficiency is increased if the way that outputs are distributed among consumers is changed in such a way as to increase social utility. The optimum distribution of two products between two consumers is achieved when each consumer's marginal rate of substitution of one product for the other is the same as that of the other consumer; that is to say when the ratio of the marginal utilities of the two products is the same for the two consumers, because otherwise they could gain from a swap. This is a restricted definition of the optimum, however, because it is concerned only about the relative amounts and says nothing about the total amounts of the outputs that are to be received by either consumer.

Applications

The determinants of productive efficiency have application to business economics and to the theory of the firm, and the promotion of allocative efficiency is the principle objective of competition policy.

References

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