Economic Efficiency Concepts - Term Paper Example

Economic Efficiency Concepts Introduction There are various topics and studies which economists have delved into in the field of microeconomics. Mofatt (2009) defines microeconomics from The Economists Dictionary of Economics as "the study of economics at the level of individual consumers, groups of consumers, or firms... The general concern of microeconomics is the efficient allocation of scarce resources between alternative uses but more specifically it involves the determination of price through the optimizing behavior of economic agents, with consumers maximizing utility and firms maximizing profit." This is basically a study of factors which affect economic decisions of individuals, households and business enterprises in specifically defined markets. In view of these, a relevant topic encompassing economics at the abovementioned level is the concept of economic efficiency. Economic efficiency is normally defined as “a ratio of the quantity of some measure of output to the quantity of input required to bring it about. In economic theory, the desired output of economic activity is taken to be an increase in social utility, and the input required is some combination of the productive resources of land, labour and capital.” (The Citizens Compendium 2009) It is in this regard that this essay is written to determine the concepts underlying economic efficiency. Categories of Economic Efficiency In examining economic efficiency, there are three categories that need to be presented to give a clearer view of this concept: productive efficiency, allocative efficiency and distributive efficiency. Productive efficiency is “the optimum combination of resources required to produce a given output at a given state of technology at which the ratio of their marginal products to their marginal costs are equal, because otherwise output could be increased at a given level of cost by increasing one input and reducing another.” (ibid. par. 5) On the other hand, allocative efficiency means that “resources are allocated optimally between two outputs when the ratios of their marginal social utilities to their marginal social costs are equal - because social utility could otherwise be increased by switching resources from one output to the other”. (ibid. par. 6) Finally, distribution efficiency is achieved when “each consumers margin rate of substitution of one product for the other is the same as that of the other consumer; that is to say when the ratio of the marginal utilities of the two products is the same for the two consumers, because otherwise they could gain from a swap” (ibid. par 7). Criterion for Economic Efficiency According to Schneck (2007), “the criterion for economic efficiency is value. A change that increases value is an efficient change and any change that decreases value is an inefficient change.” He further averred that value is subjective; meaning, it differs depending on the perception of the person viewing it. This criterion is relevant to the concept of economic efficiency in terms of determining how value is maximized. Accordingly, “if there is some change that makes someone feel better off, but making this change does not make anyone feel worse off, then the original situation was not one of highest value. Improvement was possible. When the highest value is reached, then any possible change that helps anyone must harm someone else. This way of defining economic efficiency, Pareto optimality, is named after Vilfredo Pareto, an early mathematical economist.” (ibid.) Pareto Optimal Pareto optimal is defined as “conditions under which the state of economic efficiency (where no one can be made better off by making someone worse off) occurs” (BusinessDictionary 2009) Illustrative Concept of Economic Efficiency Schneck (2007) simply described the concept of economic efficiency in terms of value of use to consumers using the following illustration, to wit: “Suppose that we have a bundle of resources (hours of labor, raw materials, machines, etc.) and that this bundle has three potential uses. In use A, it produces output that consumers value at $25; in use B, it produces output worth $22 to consumers; and in use C, it produces output worth $20 to consumers. The concept of economic efficiency says that these resources should be used to produce the output of use A because it has the highest value. If these resources are in fact used in A, the result is economically efficient. If they end up being used to produce either B or C, the economic system is not producing as much value as it could, and the result is economically inefficient. Furthermore, a market economy will tend to use the resources for use A. Because use A has the highest value to consumers, we expect that the producers of A should be able to bid the most for the resources. Normally, those who want to use it to produce C will only be willing to bid up to $20 for these resources, the producers of B will only be willing to bid up to $22, but the producers of A will be willing to bid up to $25. Hence, the market system has a tendency to shift resources to their highest-valued use.” Economic Inefficiency When factors do not interplay to satisfy the concept of economic efficiency, it is said that economic inefficiency occurs. This happens when (using the abovementioned illustration) the bundle of resources would not be used to produce A, but instead, would be used for B or C. According to Schneck (2007), this scenario happens when government undertakes measures “to tax, regulate, or subsidize so that the relative values that consumers put on these uses do not get reflected in the bidding for the resources. Economic inefficiency can also occur when markets for some reason do not properly transmit the valuations that consumers place on the products. When the market cannot get resources to use A, economists say that we have a case of market failure.” (ibid). Conclusion Schneck (2007) appropriately concluded the discussion on economic efficiency by making three qualifications: (1) “The first is that people are rational, that they know what is best for themselves and act accordingly. If people do not know what is best for themselves or do not act in a rational way to achieve their goals, the whole normative basis for economic efficiency is undercut. (2) The most distinctive aspect of a market economy is its dynamic nature. Market economies are constantly changing their environments. (3) Whatever makes one better off makes the other unhappy. With a system of preferences such as this, the notion of economic efficiency may lose meaning because there may be no possible moves that are mutually advantageous.” The concepts underlying economic efficiency could be very intricate and complicated given that an economic market operates in a dynamic framework. The discussion presented herein gave a simplified approach using a static framework where factors and resources were held constant. This is actually not the case in the real world. By being aware that economies operate in a more complex environment, one should evaluate the concepts of economic efficiency utilizing preferences, resources, and technology in the most appropriate way. Works Cited BusinessDictionary.com. (2009). Definition of Pareto Optimum. Retrieved on June 22, 2009 from Mofatt, Mike (2009). What is Microeconomics? About.com. Retrieved on June 22, 2009 from Schneck, R. (2007). What is Economic Efficiency? Retrieved on June 22, 2009 from The Citizens Compendium. (2009). Economic Efficiency. Retrieved on June 22, 2009 from Outline of Economic Efficiency Concepts Introduction Categories of Economic Efficiency Production Efficiency Allocation Efficiency Distribution Efficiency Criterion for Economic Efficiency Pareto Optimal Illustrative Concept of Economic Efficiency Economic Inefficiency Conclusion Works Cited Read More