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. 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 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 (see the diagram on the tutorials subpage). 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.) 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.