Economic Efficiency

Economic efficiency is the property of an allocation of resources in which no further improvement can be made without making someone worse off. Efficiency is a central criterion in welfare economics, and it is distinct from equity, which concerns the distribution of welfare.

Concepts

Several concepts of efficiency are distinguished. Allocative efficiency, or Pareto efficiency, obtains when resources are allocated so that no reallocation can make one person better off without making another worse off. Productive efficiency obtains when goods are produced at the lowest possible cost. Dynamic efficiency concerns the allocation of resources over time, including investment in innovation.

The concepts are related but distinct. An allocation may be productively efficient within each firm while being allocatively inefficient overall, because the composition of output does not match the preferences of consumers.

Conditions

The conditions for allocative efficiency in a competitive market are that the marginal rate of substitution between any two goods is the same for all consumers, and that it equals the marginal rate of transformation in production. These conditions imply that price equals marginal cost for each good, so that the value that consumers place on an additional unit equals the cost of producing it.

The conditions for productive efficiency are that firms combine inputs so that the marginal rate of technical substitution is the same across firms, and that each firm operates at the minimum of its average cost curve in the long run.

Market Failure

Efficiency is not achieved automatically in all circumstances. Market failures, including externalities, public goods, market power, and imperfect information, cause the conditions for efficiency to fail. In such cases, the market outcome is not allocatively efficient, and there may be a role for policy.

Externalities arise when the actions of one party affect the welfare of others without being reflected in prices. Public goods are non-rival and non-excludable, so that markets undersupply them. Market power leads to prices above marginal cost and to output below the efficient level.

Equity and Efficiency

Efficiency is distinct from equity, and the two can conflict. An allocation may be efficient but highly unequal, and a redistribution of resources may improve equity at the cost of efficiency. The trade-off between the two is central to the design of policy.

The analysis of the trade-off is complicated by the fact that the instruments of redistribution may themselves create distortions. Taxes and transfers can reduce the incentive to work and to invest, so that redistribution involves a cost in terms of efficiency. The optimal design of policy balances the gains from redistribution against these costs.

Measurement

Measuring efficiency requires the specification of a benchmark, and the choice of benchmark affects the results. The efficiency of a firm can be assessed relative to the best practice in the industry, or relative to a theoretical frontier. The two approaches give different answers, and they are used for different purposes.

Measures of efficiency are used in the regulation of utilities, in the assessment of the performance of firms, and in the analysis of the effects of policy. The measurement is subject to the usual problems of data and of specification, and the results are often sensitive to the method used.

Efficiency in General Equilibrium

The analysis of efficiency in general equilibrium extends the partial equilibrium analysis to the economy as a whole. The first fundamental theorem of welfare economics states that a competitive equilibrium is Pareto efficient, provided that markets are complete and that there are no externalities or market power.

The second fundamental theorem states that any Pareto-efficient allocation can be achieved as a competitive equilibrium with an appropriate redistribution of endowments. The theorem separates the questions of efficiency and of distribution, since it implies that the two can be addressed independently.

The theorems are subject to restrictive assumptions. They require complete markets, perfect competition, and the absence of externalities. When these assumptions fail, the competitive equilibrium is not efficient, and there may be a role for policy.

Efficiency and Information

The analysis of efficiency under imperfect information extends the standard framework. When information is asymmetric, so that one party knows more than the other, markets may fail to allocate resources efficiently. Adverse selection and moral hazard are the classic examples.

Adverse selection arises when the quality of a good is not observable, so that buyers are unwilling to pay a price that reflects the average quality, driving high-quality sellers out of the market. Moral hazard arises when one party can take actions that affect the outcome but are not observed by the other.

The analysis of these problems has led to the design of mechanisms that mitigate them, including signalling, screening, and the design of contracts. These mechanisms can improve efficiency, but they also involve costs, and they do not fully restore the first-best outcome.

Efficiency in Public Economics

The analysis of efficiency is central to public economics, where it informs the design of taxation and of public expenditure. The optimal taxation literature analyses the trade-off between efficiency and equity, and it derives conditions for the design of taxes that minimise the efficiency cost for a given redistribution.

The analysis of public goods extends the efficiency framework to goods that are non-rival and non-excludable. The efficient provision of such goods requires that the sum of the marginal rates of substitution across consumers equals the marginal cost of provision, which cannot be achieved through private markets.

The analysis of externalities extends the framework to cases where private decisions affect others without being reflected in prices. The efficient outcome requires that the marginal social cost equals the marginal social benefit, which may require taxes, subsidies, or regulation.

Summary

Economic efficiency is a central concept in welfare economics, and its analysis extends from partial equilibrium to general equilibrium and to the economics of information. Its application requires attention to the assumptions under which the theorems hold and to the trade-offs with other objectives.

See also

• Market Failure Theory
• Profit Maximization
• Economic Surplus