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 social utility, and the input required is some combination of the productive resources of land, labour and capital. The concept of 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 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.

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 margin 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

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.

Applications

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.