Efficiency

Analysis of efficiency in the context of resource allocation has always been a central concern of economics, and it is an essential element of modern microeconomic theory. The ends of economic activity are the satisfaction of human needs within resource constraints, preferences, and technological constraints. In this broad sense, an efficient use of scarce resources within a given technological environment is one that maximizes the satisfaction of aggregate needs for a given set of preferences. In a narrower sense, efficiency is a commonly agreed upon criterion to compare the economic desirability of different allocations, or states of the economy, and different allocation mechanisms or institutions. The incomparability of economic preferences gives rise to a criterion that is independent of the distributional characteristics of the allocations (or institutions) compared (Pareto efficiency). Whether construed as a general purpose of economic activity, or as a criterion for evaluating different allocations and exchange institutions, efficiency is a purely technical notion that is neither related to justness or equality criteria, nor to any moral or ethic questions of economic activity.

Pareto efficiency: An economic allocation is inefficient if there is an alternative allocation in which all agents are better off in terms of their own objective functions (utilities, profits, payoffs); it is said to be Pareto efficient if there is none such alternative allocation. Put differently, in an Pareto efficient state, it is impossible to improve one agent's state without making at least one other agent worse-off. This criterion generalizes the one of a maximal aggregate surplus to situations with incomparable objective functions (preferences). It is weak in that typically entire continua of Pareto efficient states exist; the criterion is therefore important mainly as a negative one, ruling out (institutions leading to) inefficient states as undesirable. With incomplete information about the agents' preferences, the notion of Pareto efficiency is ambiguous. An operational criterion of efficiency then depends on the state of the resolution of uncertainty: different allocations can be compared in terms of their ex-ante, their interim, or their ex-post efficiency.

Literature: Reiter (1987)

Entry by: Jan Vleugels and Joachim Winter

June 17, 1999
Direct questions and comments to: Glossary master