In economics, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services. An economic system is said to be more efficient than another (in relative terms) if it can provide more goods and services for society 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 (commonly referred to as Pareto efficiency).
- 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.
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 or neoliberalism, 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.
The mainstream view is that market economies are generally believed to be more efficient than other known alternatives and that government involvement is necessary at the macroeconomic level (via fiscal policy and monetary policy) 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 provides some basis for the belief in efficiency of market economies, as it states that any perfectly competitive market equilibrium is Pareto efficient. 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, in the form laissez faire (little or no government role in the economy) follow from the 19th century philosophical tradition classical liberalism, and are particularly associated with the mainstream economic schools of classical economics (through the 1870s) and neoclassical economics (from the 1870s onwards), and with the heterodox Austrian school.
Advocates of an expanded government role follow instead in alternative streams of progressivism; in the Anglosphere (English-speaking countries, notably the United States, United Kingdom, Canada, Australia and New Zealand) this is associated with institutional economics and, at the macroeconomic level, with Keynesian economics. In Germany the guiding philosophy is Ordoliberalism, in the Freiburg School of economics.
Microeconomic reform are policies that aim to reduce economic distortions via deregulation, and increase economic efficiency. However, there is no clear theoretical basis for the belief that removing a market distortion will always increase economic efficiency. The Theory of the Second Best 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.
There are several alternate criteria for economic efficiency, these include:
- Pareto efficiency
- Kaldor-Hicks efficiency
- Allocative efficiency
- Distributive efficiency
- Dynamic efficiency
- Productive efficiency
- Optimisation of a social welfare function
- Utility maximization
For applications of these principles see:
- Efficient market hypothesis
- Welfare economics
- Production theory basics
- Microeconomic reform
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 and 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 in the 19th century and Objectivism 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) 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, trade-offs between efficiency and distributive justice, particularly in redistribution 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).
- Economic equilibrium
- Welfare economics
- Distribution (economics)
- Business efficiency
- Financial market efficiency
- Compensation principle
- Economics terminology that differs from common usage
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