Inmicroeconomics,economic efficiency, depending on the context, is usually one of the following two related concepts:[1]
These definitions are not equivalent: amarket or othereconomic system may be allocatively but not productively efficient, or productively but not allocatively efficient. There are alsoother definitions and measures. All characterizations of economic efficiency are encompassed by the more generalengineering concept that a system isefficient oroptimal when it maximizes desired outputs (such asutility) given available inputs.
There are two main standards of thought on economic efficiency, which respectively emphasize thedistortions created bygovernments (and reduced bydecreasing government involvement) and thedistortions created bymarkets (and reduced byincreasing government involvement). These are at times competing, at times complementary—either debating theoverall level of government involvement, or the effects ofspecific government involvement. Broadly speaking, this dialog takes place in the context ofeconomic liberalism orneoliberalism, 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.
A market can be said to haveallocative efficiency if the price of a product that the market is supplying is equal to themarginal value consumers place on it, and equalsmarginal cost. In other words, when every good or service is produced up to the point where one more unit provides amarginal benefit to consumers less than the marginal cost of producing it.
Because productive resources arescarce, the resources must be allocated to various industries in just the right amounts, otherwise too much or too little output gets produced.[2] When drawing diagrams forbusinesses, allocative efficiency is satisfied if output is produced at the point where marginal cost is equal to average revenue. This is the case for thelong-run equilibrium ofperfect competition.
Productive efficiency occurs when units of goods are being supplied at the lowest possibleaverage total cost. When drawing diagrams for businesses, this condition is satisfied if the equilibrium is at the minimum point of theaverage total cost curve. This is again the case for the long run equilibrium of perfect competition. For an extensive discussion of many other types of productive efficiency and its measures (Farrell, Hyperbolic, Directional, Cost, Revenue, Profit, Additive, etc.) and their relationships.[3]
The mainstream view is thatmarket economies are generally believed to be closer to efficient than other known alternatives[4] and that government involvement is necessary at the macroeconomic level (viafiscal policy andmonetary policy) to counteract theeconomic cycle – followingKeynesian economics. At the microeconomic level there is debate about how to achieve efficiency, with some advocatinglaissez-faire, to remove government distortions, while others advocate regulation, to reducemarket failures and imperfections, particularly via internalizingexternalities.[citation needed]
Thefirst fundamental welfare theorem provides some basis for the belief in efficiency of market economies, as it states that any perfectly competitivemarket equilibrium isPareto efficient. The assumption of perfect competition means that this result is only valid in the absence ofmarket imperfections, which are significant in real markets.[citation needed]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.[5][6]
Advocates oflimited government, in the formlaissez-faire (little or no government role in the economy) follow from the 19th century philosophical traditionclassical liberalism. They are particularly associated with themainstreameconomic schools ofclassical economics (through the 1870s) andneoclassical economics (from the 1870s onwards), and with theheterodoxAustrian school.
Advocates of an expanded government role follow instead in alternative streams of progressivism; in theAnglosphere (English-speaking countries, notably the United States, United Kingdom, Canada, Australia and New Zealand) this is associated withinstitutional economics and, at the macroeconomic level, withKeynesian economics. In Germany the guiding philosophy isOrdoliberalism, in theFreiburg School of economics.
Microeconomic reform is the implementation of policies that aim to reduceeconomic distortions viaderegulation, and move toward economic efficiency. However, there is no clear theoretical basis for the belief that removing amarket distortion will always increase economic efficiency.
Thetheory 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.
Economic efficiency can be characterized in many ways:
Applications of these principles include:
