Economic Efficiency

Economic efficiency studies production, distribution, and consumption assuming that the goal of these activities is to gain a return from using or moving resources. It is similar to the concept of mechanical efficiency, which measures the efficiency of physical processes by relating energy output to energy input.

However, unlike physical processes, in which output and input measures are the same—for example, newtons—measuring the efficiency of an economic action involves transforming physical quantities of resource inputs into physically different outputs, which may be valued in monetary units, or utility (i.e., satisfaction) units, or by some other measures, for example “equity” or “fairness,” on which unanimous agreement may be lacking. Without agreement as to what is the relevant output measure or goal (e.g., your satisfaction or mine?), discussions of efficiency quickly become debates about what it is that should be valued by individuals, producers, and society at large. That debate is not addressed here.

An economically efficient action leads to more of the quality being sought, be it profits for producers, satisfaction for consumers, equity for citizens, or whatever the chosen measure, while using no more resources than were used before. Studying resource use in production, distribution, and consumption has been the main focus of economics since the first sustained writing on the subject in ancient times—for example, Xenophon's Oeconomicus, written in approximately 380 BCE. It is considered in both microeconomics and macroeconomics.

To examine the concept of economic efficiency, it is necessary to define it in production, distribution, and consumption. Production combines resources into one or more outputs constrained by the quantity of resources, the available technology, social concerns, rules, regulations, and any other considerations producers face. Exchange activity consists of using resources in moving goods and services through space and time, again under given technological and social considerations. Exchange is another form of production, where moving a good from Place A to Place B is a substitute for producing that good at B. Consumption activity consists of using goods and services to derive satisfaction subject both to consumers' resource constraints and to social considerations.

Efficiency requires that changes made in any allocation, using the same resources and technologies, improve the situation of at least one party without at the same time reducing the well-being of any other. Usually, a change in a producer's profits—total revenue minus total cost—is the measure of a change in productive efficiency. However, profits need not be the measure, and even if they are, this does not exclude the fact that producers have to work within both technological and social constraints. For consumers, efficiency requires that any change from the status quo raising at least one person's satisfaction does not result in the worsening of anyone else's utility or satisfaction.

Economic efficiency may be consistent with equilibrium, a state where all opportunities have been explored and no profit- or utility-enhancing opportunity (including side payments by gainers compensating losers) remains. This condition is known as Pareto efficiency (or a Pareto optimum), after Vilfredo [Page 640]Pareto. However, equilibrium is not the necessary outcome of a search for efficiency as search behavior, experimentation, random acts, changes in the state of the world, changes in technology, change in the legal system and rules and regulations, and so on can easily be seen to keep an economy in motion as opposed to a state of rest.

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