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.