If you’ve ever heard an economist expound on policy, you’ve surely heard the claim that this or that course of action is more ‘efficient’. We economists are prone to toss out this term as our trump card; who can argue they want *less* efficiency?
But just what does efficiency mean? First there is the conceptual division between allocative versus productive efficiency; then there is the separate issue of how to actually *measure* efficiency.
It is important to keep in mind that efficiency is a positive concept, not a normative one (see my post on economic methodology), and that is where much of the confusion lies.
This is usually the sense in which efficiency is used. Given a set of goods, what does it mean for the goods to be ‘efficiently’ distributed among some persons? A situation is allocatively efficient if all goods are allocated to their highest valued use.
Again, it is important to emphasize that this is not a statement of good or bad; it is merely a way of talking about the world. There are many other potential ways to allocate scarce goods: lottery, first come first serve, feats of strength, and so on. All of these can be debated normatively using different criteria, but this is beside the point of economic inquiry.
Markets are what allow allocative efficiency to be reached. When people are able to freely exchange goods, under the standard assumptions of microeconomic theory, then it follows that an allocative equilibria will be reached. (How this fares in the real world with real humans is another matter).
Productive efficiency is not mentioned nearly as often as allocative efficiency, though it is potentially far more widely spread. When a market is productively efficient, goods are being produced at their lowest cost, and the price of a good is equal to its marginal cost of production.
In the ideal of perfect competition, all firms are using the lowest cost production technology; if they weren’t, they would have to charge more, and they wouldn’t be in business. So the idea of productive inefficiency is most relevant in non-competitive industries, such as government mandated monopolies, or industries with high barriers to entry, where something prevents those with the knowhow to produce goods at lower cost from doing so.
What standards do economists use to judge the efficiency of a situation? The two most common are Pareto and Kaldor-Hicks:
Simply put, a world is Pareto efficient if no person can be made better off without making someone else worse off. A Pareto improvement then is one that makes at least one person better off while making nobody worse.
What standard is used to judge better off or worse off? Usually with Pareto analysis that’s left up to the judgement of the people involved, and as such the concept is pretty useless in trying to judge actual policy making. Why? Well, *any* change that is made will upset somebody, somewhere. You know the type of person, the one who gets upset at others’ good fortune. As such, the world is already Pareto efficient; no Pareto improvements can be made.
Given the limitation of Pareto efficiency, the most commonly used efficiency concept is Kaldo-Hicks, which uses monetary equivalents to judge better/worse off. Benefit or harm from a policy change is quantified, and as long as society as a whole sees a net gain in wealth, that is considered a Kaldor-Hicks improvement. Hence, when K-H improvements can no longer be made, the world is considered to be K-H efficient. Another way of stating this is that the dollar value of social resources is maximized.
This is the standard governments use when in cost-benefit analyses, and this is the sense in which trade makes societies better off. Yes, there are some particular losers, but society as a whole is better off. In theory, the gains from trade can simply be redistributed to compensate those losers, but of course that’s easier said than done.