Steve Bain

Economic Efficiency Explained (Types & Models)

Economic efficiency in economics is one of the easiest concepts to misunderstand, because there are many different types of efficiency that economists refer to. The three main types are often labeled ‘productive efficiency’, ‘allocative efficiency’, and ‘dynamic efficiency’.

All of these concepts will be introduced in this article, with links provided to more in-depth articles for those readers who wish to know more.

Efficiency itself is a fairly simple concept to explain, it simply refers to a situation where all economic resources and products are being utilized and distributed in a way that optimizes output levels (both now and in future periods), while also allocating that output to consumers in a way that optimizes the total amount of utility for consumers.

That’s easily said, but building up the economic models that are needed to illustrate this is a little trickier. Luckily for you, dear reader, I’m going to set it all out in a nice clear and concise manner, step-by-step. You will need to read the related articles that I link to if you want to bring your understanding up to graduate level but, unlike the economics textbooks, my site spares you the overcomplex and unnecessary mathematical diversions.

Before continuing, let me briefly explain the three main types of efficiency in economics, and keep in mind that complete efficiency can only be achieved in a state of perfect competition, which itself is only a theoretical abstract. Nevertheless, some markets are closer to it than others, and are relatively more efficient as a result.

Types of Economic Efficiency

  • Allocative efficiency occurs when resources are allocated in a way that satisfies consumer preferences and maximizes societal welfare. In other words, it is achieved when the distribution of goods and services matches the preferences of society, minimizing ‘deadweight losses’ from sub-optimal allocations.
  • Productive efficiency is attained when an economy produces goods and services at the lowest possible cost. This implies that resources are utilized in the most cost-effective manner, minimizing waste and inefficiency in the production process. This is sometimes confused with a slightly different concept i.e. ‘technical efficiency’.
  • Dynamic efficiency receives far less attention in the textbooks, but it focuses on the important long-term aspects of resource allocation. It involves the ability of an economy to adapt and innovate over time, ensuring sustained growth and improvements in the standard of living.

For more information on these concepts, click the links above. I’ve also provided links to some related concepts at the bottom of the page.

Partial and General Equilibrium Analysis

In my sections about different market structures i.e., perfect competition and monopolistic competition, the models presented are based on ‘partial equilibrium analysis’, i.e. the study of efficient and inefficient outcomes in specific markets. However, this does not consider how outcomes in one market impact upon other markets in the broader economy.

We already know, from my article about complementary goods & substitute goods, that price & output changes in one market will impact price and output decisions in related markets. In truth, all markets are related in some way, because all products are produced with more or less the same inputs i.e. land, labor, capital and entrepreneurship.

This means that, for example, an increase in market demand for one product will tend to increase the demand for shared inputs, putting upward pressure on the prices of those inputs (wages, energy costs, borrowing costs etc.). This means that, to understand economic efficiency at the level of the entire economy, partial equilibrium analysis of specific markets in isolation to other markets is inadequate – we need to move towards a model of ‘general equilibrium analysis’.

General Equilibrium Analysis

General equilibrium is impossible to illustrate with diagrams, not even in a theoretical sense, because there are too many dimensions involved. Instead, economists usually present such models in terms of two alternative goods/resources. It may be possible in some cases to imagine a single good compared to a composite good that represents all other goods, but it is not necessary to do so because the basic principles are the same.

In my article about the Marginal Rate of Transformation, I have explained and illustrated how producers in an economy can efficiently allocate resources in order to produce different combinations of two alternative goods on the Production Possibility Frontier.

The optimal production point will depend on prices, and that depends on the relative amount of one good that consumers are prepared to sacrifice in order to get more of the other good, this is explained in my article about the Marginal Rate of Substitution, which explains how goods are efficiently allocated once they have been produced.

An understanding of these two related concepts, and related concepts, is required if you wish to understand general equilibrium analysis. That does mean that you’ll need to do a little digging to get to the bottom of all this, but that’s all part of the fun, and none of the material is too difficult for beginners to grasp.

Readers should also keep in mind that these models only operate for a given level of technology, i.e. static efficiency. Nothing is said about how consumers/producers achieve efficiency in a world where saving and investment levels affect future growth and investment. This all relates to dynamic efficiency i.e.; how productive capacity can most efficiently increase supply of goods and services over time.

Efficiency versus Equity

Economic efficiency and equity represent two fundamental but sometimes conflicting goals. Equity is concerned with fairness and justice in the distribution of resources and opportunities among members of society. It focuses on ensuring that everyone has a fair and just share, regardless of their initial circumstances.

Of course, notions of fairness fall into the realm of normative economics rather than positive economics, and that means that there is no precise way to agree on fair outcomes.

The interaction between economic efficiency and equity often involves a trade-off. Policies that emphasize economic efficiency, such as market-driven approaches, may result in unequal distributions of wealth and income. On the other hand, policies aimed at achieving greater equity, such as progressive taxation or social welfare programs, usually introduce inefficiencies in resource/goods allocation.

Investments in human capital, including education and healthcare, can contribute to both equity and efficiency. A well-educated and healthy workforce is generally more productive, positively impacting economic efficiency. Simultaneously, ensuring equal access to education and healthcare can promote equity and welfare by reducing disparities in opportunities.

Market Failure and Government Intervention

At the beginning of the article, I advised you to keep in mind that only perfectly competitive markets can deliver complete economic efficiency, this is true but such conditions are never met. No market is perfectly competitive, but most are reasonably so.

The point is to not let perfection be the enemy of the good. Free-markets are nearly always more efficient than the alternatives, but there are still many cases where market failure is significant enough to demand action by the government.

Government intervention is often seen as a means to correct these market failures and improve economic efficiency. However, the effectiveness of government intervention is a subject of much debate. While there are instances where intervention is justified and can lead to positive outcomes, we should remain skeptical of real-world attempts, because government failure is very common. This is due to:

  • Government interventions can suffer from bureaucratic inefficiencies, excessive red-tape, and lack of accountability.
  • Policies designed to correct one market failure can sometimes create other distortions, or ‘unintended consequences’.
  • Government interventions may be influenced by special interest groups, leading to policies that benefit a select few rather than the broader public.

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