The Social Science Encyclopedia, Second Edition
In a restricted sense, economic efficiency is often taken to mean that resources or inputs should be used so as to produce an output in the cheapest possible way. It is the cost of a combination of inputs which is of interest, not the use of a single input. The economically efficient input combination is the one which yields a specified output level at the least possible cost. The use of a single input (e.g. energy) can, of course, be further reduced, but so much extra is then needed of other inputs that the total cost increases. Alternatively, one can speak of efficiency when a firm produces as much as possible (maximizes output) at a specified total cost. This illustrates the fact that the concept of efficiency is used in different production contexts. Similarly, one can speak of efficiency in consumption. Individuals who aim at achieving the highest possible level of utility, subject to their income, will allocate their income between goods in such a way that the marginal rate of substitution between any two goods (the satisfaction derived from an extra unit of the first commodity divided by the satisfaction derived from an extra unit of the second commodity) is equal to the ratio between their prices. This is the criterion for efficiency in consumption.
The concept of economic efficiency, as attributed to the Italian economist Vilfredo Pareto (1848–1923), is usually interpreted in a broader sense.
Pareto specified a condition of optimal or efficient allocation of resources which is referred to as the Pareto condition. According to this criterion, a policy change is socially desirable if everyone is made better off by the change (the weak Pareto criterion), or at least some are made better off, while no one is made worse off (the strong Pareto criterion). When the possibilities for making such policy changes have been exhausted, society is left with an allocation of commodities that cannot be altered without someone being made worse off. Such an allocation is called Pareto-optimal or efficient.
Under certain conditions, a market economy will be Pareto efficient. The important relationship between competitive equilibria and Pareto optimality is that, when a competitive equilibrium exists, it attains Pareto optimality. This result, which is known as the First Theorem of Welfare Economics, provides a strong argument for the advocates of a pure market economy. The result says that the perfect market economy simultaneously yields efficiency in production and consumption.
Per-Olov Johansson
Stockholm School of Economics
Karl-Gustaf Löfgren
University of Umeå
Further reading
Johansson, P.-O. (1991) An Introduction to Modern Welfare Economics, Cambridge, UK.
Pareto, V. (1971) Manual of Political Economy, London.
Varian, H.R. (1992) Microeconomic Analysis, New York.
See also: Pareto efficiency; welfare economics.
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