Economic 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 economic 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.
The optimum combination of resources required to produce a given output at a given state of technology 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. As might be expected, productive efficiency can also be influenced by technological change, including changes in input performance.
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.
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 marginal 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.
The determinants of productive efficiency have application to business economics and to the theory of the firm, and the promotion of allocative efficiency is the principle objective of competition policy.