Economic efficiency

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.

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

Definitions of efficiency

Pareto efficiency

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 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. (If such compensation actually took place, the outcome would be an increase in Pareto efficiency because the action in question would then have benefited its gainers without harming its losers.) This is the criterion that is used in cost/benefit analysis, but its application is valid only if the willingness to make and accept the hypothetical compensation is validly inferred from experiments or from observations of market behaviour. This is sometimes referred to as the compensation principle.

The components of 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.

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.

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.

Limitations and applications

Limitations

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.)