Efficiency (economics)

Efficiency (economics)

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In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services. An economic system
Economic system
An economic system is the combination of the various agencies, entities that provide the economic structure that defines the social community. These agencies are joined by lines of trade and exchange along which goods, money etc. are continuously flowing. An example of such a system for a closed...

 is said to be more efficient than another (in relative terms) if it can provide more goods and services
Goods and services
In economics, economic output is divided into physical goods and intangible services. Consumption of goods and services is assumed to produce utility. It is often used when referring to a Goods and Services Tax....

 for society
Society
A society, or a human society, is a group of people related to each other through persistent relations, or a large social grouping sharing the same geographical or virtual territory, subject to the same political authority and dominant cultural expectations...

 without using more resources. In absolute terms, a situation can be called economically efficient if:
  • No one can be made better off without making someone else worse off.
  • No additional output can be obtained without increasing the amount of inputs.
  • Production proceeds at the lowest possible per-unit cost.

These definitions of efficiency are not exactly equivalent, but they are all encompassed by the idea that a system is efficient if nothing more can be achieved given the resources available.

Theory


There are two main strains in economic thought on economic efficiency, which respectively emphasize the distortions created by governments (and reduced by decreasing government involvement) and the distortions created by markets (and reduced by increasing government involvement). These are at times competing, at times complementary – either debating the overall level of government involvement, or the effects of specific government involvement. Broadly speaking, this dialog is referred to as Economic liberalism
Economic liberalism
Economic liberalism is the ideological belief in giving all people economic freedom, and as such granting people with more basis to control their own lives and make their own mistakes. It is an economic philosophy that supports and promotes individual liberty and choice in economic matters and...

 or neoliberalism
Neoliberalism
Neoliberalism is a market-driven approach to economic and social policy based on neoclassical theories of economics that emphasizes the efficiency of private enterprise, liberalized trade and relatively open markets, and therefore seeks to maximize the role of the private sector in determining the...

, though these terms are also used more narrowly to refer to particular views, especially advocating laissez faire.

Further, there are differences in views on microeconomic versus macroeconomic efficiency, some advocating a greater role for government in one sphere or the other.

Mainstream views


The mainstream view is that market economies
Market economy
A market economy is an economy in which the prices of goods and services are determined in a free price system. This is often contrasted with a state-directed or planned economy. Market economies can range from hypothetically pure laissez-faire variants to an assortment of real-world mixed...

 are generally believed to be more efficient than other known alternatives and that government involvement is necessary at the macroeconomic level (via fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

 and monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

) to counteract the economic cycle – following Keynesian economics. At the microeconomic level there is debate about how to maximize efficiency, with some advocating laissez faire, to remove government distortions, while others advocate regulation, to reduce market failures and imperfections, particularly via internalizing externalities.

The first fundamental welfare theorem
Fundamental theorems of welfare economics
There are two fundamental theorems of welfare economics. The first states that any competitive equilibrium or Walrasian equilibrium leads to a Pareto efficient allocation of resources. The second states the converse, that any efficient allocation can be sustainable by a competitive equilibrium...

 provides some basis for the belief in efficiency of market economies, as it states that any perfectly competitive market equilibrium is Pareto efficient
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

. Strictly speaking, however, this result is only valid in the absence of market imperfections, which are significant in real markets.
Furthermore, Pareto efficiency is a minimal notion of optimality and does not necessarily result in a socially desirable distribution of resources, as it makes no statement about equality or the overall well-being of a society.

Schools of thought


Advocates of limited government
Limited government
Limited government is a government which anything more than minimal governmental intervention in personal liberties and the economy is generally disallowed by law, usually in a written constitution. It is written in the United States Constitution in Article 1, Section 8...

, in the form laissez faire (little or no government role in the economy) follow from the 19th century philosophical tradition classical liberalism
Classical liberalism
Classical liberalism is the philosophy committed to the ideal of limited government, constitutionalism, rule of law, due process, and liberty of individuals including freedom of religion, speech, press, assembly, and free markets....

, and are particularly associated with the mainstream
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...

 economic schools of classical economics
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....

 (through the 1870s) and neoclassical economics
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...

 (from the 1870s onwards), and with the heterodox
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...

 Austrian school
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

.

Advocates of an expanded government role follow instead in alternative streams of liberalism; in the Anglosphere
Anglosphere
Anglosphere is a neologism which refers to those nations with English as the most common language. The term can be used more specifically to refer to those nations which share certain characteristics within their cultures based on a linguistic heritage, through being former British colonies...

 (English-speaking countries, notably the United States, United Kingdom, Canada, Australia and New Zealand) this is associated with Institutional economics
Institutional economics
Institutional economics focuses on understanding the role of the evolutionary process and the role of institutions in shaping economic behaviour. Its original focus lay in Thorstein Veblen's instinct-oriented dichotomy between technology on the one side and the "ceremonial" sphere of society on the...

 and, at the macroeconomic level, with Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

. In Germany the guiding philosophy is Ordoliberalism
Ordoliberalism
Ordoliberalism is a school of liberalism that emphasised the need for the state to ensure that the free market produces results close to its theoretical potential . The theory was developed by German economists and legal scholars such as Walter Eucken, Franz Böhm, Hans Grossmann-Doerth and Leonhard...

, in the Freiburg School
Freiburg School
The Freiburg School is a school of economic thought founded in the 1930s at the University of Freiburg.It builds somewhat on the earlier Historical school of economics but stresses that only some forms of competition are good, while others may require oversight. This is considered a lawful and...

 of economics.

Microeconomic


Microeconomic reform
Microeconomic reform
The term microeconomic reform refers to policies directed to achieve improvements in economic efficiency, either by eliminating or reducing distortions in individual sectors of the economy or by reforming economy-wide policies such as tax policy and competition policy with an emphasis on economic...

are policies that aim to reduce economic distortions
Market distortion
In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and...

 via deregulation
Deregulation
Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or...

, and increase economic efficiency. However, there is no clear theoretical basis for the belief that removing a market distortion
Market distortion
In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and...

 will always increase economic efficiency. The Theory of the Second Best
Theory of the Second Best
In welfare economics, the theory of the second best concerns what happens when one or more optimality conditions cannot be satisfied. Canadian economist Richard Lipsey and Australian economist Kelvin Lancaster showed in a 1956 paper that if one optimality condition in an economic model cannot be...

 states that if there is some unavoidable market distortion in one sector, a move toward greater market perfection in another sector may actually decrease efficiency.

Criteria


There are several alternate criteria for economic efficiency, these include:
  • Pareto efficiency
    Pareto efficiency
    Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

  • Kaldor-Hicks efficiency
    Kaldor-Hicks efficiency
    Kaldor–Hicks efficiency, named for Nicholas Kaldor and John Hicks, also known as Kaldor–Hicks criterion, is a measure of economic efficiency that captures some of the intuitive appeal of Pareto efficiency, but has less stringent criteria and is hence applicable to more circumstances...

  • X-efficiency
  • Allocative efficiency
    Allocative efficiency
    Allocative efficiency is a theoretical measure of the benefit or utility derived from a proposed or actual selection in the allocation or allotment of resources....

  • Distributive efficiency
    Distributive efficiency
    In welfare economics, distributive efficiency occurs when goods and services are received by those who have the greatest need for them. Abba Lerner first proposed the idea of distributive efficiency in his 1944 book The Economics of Control....

  • Dynamic efficiency
    Dynamic efficiency
    Dynamic efficiency is a term in economics, which refers to an economy that appropriately balances short run concerns with concerns in the long run . Through dynamic efficiency, such an economy is able to further improve efficiency over time...

  • Productive efficiency
    Productive efficiency
    Productive efficiency occurs when the economy is utilizing all of its resources efficiently, producing most output from least input. The concept is illustrated on a production possibility frontier where all points on the curve are points of maximum productive efficiency...

  • Optimisation of a social welfare function
    Social welfare function
    In economics, a social welfare function is a real-valued function that ranks conceivable social states from lowest to highest. Inputs of the function include any variables considered to affect the economic welfare of a society...

  • Utility maximization

For applications of these principles see:
  • Efficient market hypothesis
    Efficient market hypothesis
    In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...

  • Welfare economics
    Welfare economics
    Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

  • Production theory basics
    Production theory basics
    Production refers to the economic process of converting of inputs into outputs. Production uses resources to create a good or service that is suitable for use, gift-giving in a gift economy, or exchange in a market economy. This can include manufacturing, storing, shipping, and packaging. Some...

  • Microeconomic reform
    Microeconomic reform
    The term microeconomic reform refers to policies directed to achieve improvements in economic efficiency, either by eliminating or reducing distortions in individual sectors of the economy or by reforming economy-wide policies such as tax policy and competition policy with an emphasis on economic...


Competing goals



Efficiency is but one of many vying goals in an economic system, and different notions of efficiency may be complementary or may be at odds. Most commonly, efficiency is contrasted or paired with morality, particularly liberty
Liberty
Liberty is a moral and political principle, or Right, that identifies the condition in which human beings are able to govern themselves, to behave according to their own free will, and take responsibility for their actions...

 and justice
Justice
Justice is a concept of moral rightness based on ethics, rationality, law, natural law, religion, or equity, along with the punishment of the breach of said ethics; justice is the act of being just and/or fair.-Concept of justice:...

. Some economic policies may be seen as increasing efficiency, but at the cost to liberty or justice, while others may be argued to both increase efficiency and be more free or just. There is debate on what effects specific policies have, which goals should be pursued, the relative weights that should be placed on different goals, and which trade-offs should be made.

For example, some advocates of laissez faire (such as classical liberalism
Classical liberalism
Classical liberalism is the philosophy committed to the ideal of limited government, constitutionalism, rule of law, due process, and liberty of individuals including freedom of religion, speech, press, assembly, and free markets....

 in the 19th century and Objectivism
Objectivism
Objectivism or Objectivist may refer to:* Any standpoint that stresses objectivity, including;* Philosophical objectivity, realism, the conviction that reality is mind-independent* Moral objectivism, the view that some ethics are absolute...

 in the 20th century) argue that such economies protect property rights and are thus both free and just, regardless of whether or not they are more efficient, though advocates also generally believe that laissez faire economies are more efficient.

Others argue that laissez faire leads to concentration of power and thus curtails liberty and reduces competition, and leads to unjust distribution of income and wealth, regardless of whether it increases efficiency, for example in the early 20th century American progressive movement – some (such as the Freiburg school
Freiburg School
The Freiburg School is a school of economic thought founded in the 1930s at the University of Freiburg.It builds somewhat on the earlier Historical school of economics but stresses that only some forms of competition are good, while others may require oversight. This is considered a lawful and...

) argue that laissez faire decreases efficiency in addition to being unfree and unjust, while others argue that government involvement may reduce efficiency, but that this is an acceptable cost for the increase in liberty and justice.

In welfare economics
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

, trade-offs between efficiency and distributive justice
Distributive justice
Distributive justice concerns what some consider to be socially just allocation of goods in a society. A society in which incidental inequalities in outcome do not arise would be considered a society guided by the principles of distributive justice...

, particularly in redistribution
Redistribution (economics)
Redistribution of wealth is the transfer of income, wealth or property from some individuals to others caused by a social mechanism such as taxation, monetary policies, welfare, nationalization, charity, divorce or tort law. Most often it refers to progressive redistribution, from the rich to the...

 – to the extent that a certain policy decreases efficiency – is often visualized by the metaphor of the leaky bucket, imagining income or wealth as water moved between individuals, and inefficiency as leakage. Opponents of redistribution argue that redistribution is not only inefficient (the bucket leaks), but unjust (income or wealth should not be redistributed by the government at all, but rather the market alone should decide distribution).

See also

  • Economic equilibrium
    Economic equilibrium
    In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...

  • Welfare economics
    Welfare economics
    Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

  • Distribution (economics)
    Distribution (economics)
    Distribution in economics refers to the way total output, income, or wealth is distributed among individuals or among the factors of production .. In general theory and the national income and product accounts, each unit of output corresponds to a unit of income...

  • Business efficiency
    Efficiency ratio
    The efficiency ratio, a ratio that is typically applied to banks, in simple terms is defined as expenses as a percentage of revenue , with a few variations. A lower percentage is better since that means expenses are low and earnings are high...

  • Financial market efficiency
    Financial market efficiency
    In the 1970s Eugene Fama defined an efficient financial market as "one in which prices always fully reflect available information”.The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources.This includes producing the...

  • Compensation principle
    Compensation principle
    In welfare economics, the compensation principle refers to a decision rule used to select between pairs of alternative feasible social states. One of these states is the hypothetical point of departure...

  • Inefficiency
    Inefficiency
    The term inefficiency has several meanings depending on the context in which its used:*Algorithmic inefficiency - refers to less than optimum computer programs that might exhibit one of more of the symptoms of:** slow execution...

  • Economics terminology that differs from common usage
    Economics terminology that differs from common usage
    In any technical subject, words commonly used in everyday life acquire very specific technical meanings, and confusion can arise when someone is uncertain of the intended meaning of a word...