Physicists label a system efficient if it minimizes the energy expended in accomplishing some task, while environmentalists talk about efficiency as the absence of waste in an ecological system. Economists take a different approach to efficiency.
Economic efficiency is achieved when we produce the combination of outputs with the highest attainable total value, given our limited resources.
Three different types of efficiency parallel the three basic economic questions: (a) allocative efficiency addresses what things will be produced, (b) productive efficiency addresses how to produce them, and (c) distributive efficiency addresses who will use specific outputs.
Using all of society's resources to produce mustard and sawdust instead of a mix of more useful goods would obviously waste resources.
Allocative efficiency requires the pattern of national output to mirror what people want and are willing and able to buy.
The social value of output from given resources is maximized in an allocatively efficient economy.
It is usually easier to identify inefficiency than to describe an efficient situation. Mountains of mustard and sawdust would be allocatively inefficient nuisances. Another example: England's nationalized auto industry built taxis according to the same design from World War II into the 1970s, long after the rest of the world abandoned unreliable 1940s technologies and archaic 1940s styles.
Expending more resources than the minimum required to produce a given level of a specific product is also wasteful.
Productive (technical) efficiency requires minimizing opportunity cost for a given value of output. Equivalently, efficiency requires maximum output for a given cost, or using given resources.
Production is technically inefficient whenever production costs are unnecessarily high or if more output could be produced without raising costs or using more resources.
For example, the saying that “too many cooks spoil the broth” implies that excess company in the kitchen is economically inefficient. More good food presumably could be produced using fewer resources if some of the cook's helpers left. Society as a whole is also productively inefficient if excessive unemployment holds output below the maximum possible from the resources available.
The question of “Who?” is divisible into distinct issues of (a) the distribution of income and wealth, and (b) the distribution of goods. Suppose the distribution of income (discussed later in the book) is a settled issue, and that our economy produces precisely what people want. Ensuring that goods get to the right people may still be a problem.
Distributive efficiency requires that specific goods be used by the people who value them relatively the most.
By relatively, we mean one person's preferences for certain goods relative to other goods, when compared to other people's preferences among goods. Relative likes and dislikes crucially determine who will gain the most from which goods. Suppose, for example, that you have gallons of orange soda (which nauseates you) but lack broccoli, your favorite food, while I have bushels of broccoli (which I despise), and I love orange soda. An exchange of your orange soda for my broccoli is obviously in order. Such exchanges are automatic when people buy and sell things, regardless of whether we deal with our fellow citizens–or foreigners.
Distributive efficiency to accommodate people's preferences requires that consumers maximize the satisfaction available from their individual budgets. (Relative budget sizes are a separate issue of distribution.) When this occurs, all individuals also minimize their outlays to obtain goods yielding given total satisfaction to them. You currently consume inefficiently if you could gain by changing the mix of goods you now buy for a given cash outlay. Alternatively, you could cut your total spending and maintain the satisfaction now yielded by your inefficient purchasing pattern.
People try to act efficiently, expanding activities when the extra benefits are expected to exceed the extra costs, and reducing those for which cost saving is expected to exceed any benefits forgone. You could always turn off lights and adjust thermostats when you leave home to avoid “wasting” gas or electricity, but many of us absentmindedly leave on lights and heat or cool empty rooms. Saving energy conscientiously may absorb time more valuably used in other ways, but recognition that a current buying pattern is inefficient prompts changes in behavior. A $700 utility bill might shock you into trying harder to conserve energy—another example of a relative price acting as an incentive.
All opportunity costs must be minimized to attain an economy-wide state of efficiency that combines allocative, productive, and distributive efficiency. The Italian scholar Vilfredo Pareto (1848-1923) was the first economist to theorize that whenever any change from the current situation must harm at least one individual, then current patterns of consumption and production must be efficient. This implies that resources are allocated so that they produce the most valuable combination of goods possible—every drop of potential net benefit must be squeezed from the resources available. Pareto’s idea is so powerful that economists often refer to economy-wide efficiency as Pareto efficiency.
Economic efficiency, broadly considered, means that it is impossible for anyone to gain unless someone else loses.
Alternatively, economic inefficiency exists if altering production or exchanging goods could allow at least one person to gain, with no one else losing. Thus, whenever there are potential but unrealized gains to someone entailing losses to no one else, the current situation is inefficient. Inefficiency means that appropriate corrections would enable society to cope better with scarcity.
The bargains people make usually represent moves toward greater efficiency. All direct parties to a voluntary transaction expect to gain or they would not bother. For example, you will not trade an apple for my orange unless you value the orange more than the apple, and vice versa. Trading your apple for my orange raises your satisfaction from a given outlay because you now have a subjectively (to you) more valuable orange. I gain in a similar fashion. Thus, efficiency is usually enhanced through trade (whether domestic or international), and a failure to trade when such gains are possible is inefficient. In fact, if only one of us would gain by a trade but no other party would be harmed, failure to trade is inefficient, even if the trade is deemed by some people to harm equity.