Economic Efficiency: Definition and Examples

Economic Efficiency

Investopedia / Lara Antal

What Is Economic Efficiency?

Economic efficiency is when all goods and factors of production in an economy are distributed or allocated to their most valuable uses and waste is eliminated or minimized. A system is considered economically efficient if the factors of production are used at a level at or near their capacity.

In contrast, a system is considered economically inefficient if available factors are not used to their capacity. Wasted resources and deadweight losses may cause economic inefficiencies.

Key Takeaways

  • Economic efficiency refers to how effectively a society's scarce resources are used to produce goods.
  • Economists have several ways of measuring economic efficiency, based on the allocation of inputs, costs, or the allocation of final consumer goods.
  • Productive efficiency is a situation where firms seek the best combination of inputs to lower their costs of production.
  • Allocative efficiency means that economic resources are distributed in a way that produces the highest consumer satisfaction relative to the cost of inputs.
  • Pareto efficiency refers to a situation where it is impossible to improve one person's situation without harming another person's situation.

Economic Efficiency

Understanding Economic Efficiency

Economic efficiency implies an economic state in which every resource is optimally allocated to serve each individual or entity in the best way while minimizing waste and inefficiency. When an economy is economically efficient, any changes made to assist one entity would harm another. In terms of production, goods are produced at their lowest possible cost, as are the variable inputs of production.

Some terms that encompass phases of economic efficiency include allocative efficiency, productive efficiency, distributive efficiency, and Pareto efficiency. A state of economic efficiency is essentially theoretical; a limit that can be approached but never reached. Instead, economists look at the amount of loss, referred to as waste, between pure efficiency and reality to see how efficiently an economy functions.

Economic Efficiency and Scarcity

The principles of economic efficiency are based on the concept that resources are scarce. Therefore, there are not sufficient resources to ensure that all aspects of an economy function at their highest capacity at all times. Instead, scarce resources must be distributed to meet the needs of the economy in an ideal way while also limiting the amount of waste produced. The ideal state is related to the welfare of the population with peak efficiency also resulting in the highest level of welfare possible based on the resources available.

One way to measure economic efficiency is based on the unused productive capacity of an economy or system. In the United States, this is reported in the Quarterly Survey of Plant Capacity Utilization, issued by the census bureau every three months.

Efficiency in Production, Allocation, and Distribution

Productive firms seek to maximize their profits by bringing in the most revenue while minimizing costs. To do this, they choose a combination of inputs that minimizes their costs while producing as much output as possible. By doing so, they operate efficiently; when all firms in the economy do so, it is known as productive efficiency.

Consumers, likewise, seek to maximize their well-being by consuming combinations of final consumer goods that produce the highest total satisfaction of their wants and needs at the lowest cost to them. The resulting consumer demand guides productive (through the laws of supply and demand) firms to produce the right quantities of consumer goods in the economy that will provide the highest consumer satisfaction relative to the costs of inputs. When economic resources are allocated across different firms and industries (each following the principle of productive efficiency) in a way that produces the right quantities of final consumer goods, this is called allocative efficiency.

Finally, because each individual values goods differently and according to the law of diminishing marginal utility, the distribution of final consumer goods in an economy is efficient or inefficient. Distributive efficiency is when the consumer goods in an economy are distributed so that each unit is consumed by the individual who values that unit most highly compared to all other individuals. Note that this type of efficiency assumes that the amount of value that individuals place on economic goods can be quantified and compared across individuals.

Economic Efficiency and Welfare

Measuring economic efficiency is often subjective, relying on assumptions about the social good, or welfare, created and how well that serves consumers. In this regard, welfare relates to the standard of living and relative comfort experienced by people within the economy. At peak economic efficiency (when the economy is at productive and allocative efficiency), the welfare of one cannot be improved without subsequently lowering the welfare of another. This point is called Pareto efficiency.

Even if Pareto efficiency is reached, the standard of living of all individuals within the economy may not be equal. Pareto efficiency does not include issues of fairness or equality among those within a particular economy. Instead, the focus is purely on reaching a point of optimal operation regarding the use of limited or scarce resources. It states that efficiency is obtained when a distribution exists where one party's situation cannot be improved without making another party's situation worse.

How Does Privatization Affect Economic Efficiency?

Many economists believe that privatization can make some government-owned enterprises more efficient by placing them under budget pressure and market discipline. This requires the administrators of those companies to reduce their inefficiencies by downsizing unproductive departments or reducing costs.

What Is the Difference Between Technical Efficiency and Economic Efficiency?

Technical efficiency refers to how effectively a company or system maximizes production based on a limited number of inputs. A company is said to be technically efficient if it cannot produce more goods without increasing the number of inputs used in production, such as labor or raw materials. In contrast, economic efficiency seeks to minimize the number of costs per unit. This may be a similar goal to technical efficiency, but they are not always the same.

How Do Taxes Affect Economic Efficiency?

Taxes often have the effect of reducing economic efficiency by introducing deadweight losses. For example, a sales tax on a certain product increases the price, thereby reducing sales. These lost sales are considered a deadweight loss because they represent potential economic activity that was not realized because of the sales tax.

How Does Advertising Affect Economic Efficiency?

Advertising can increase economic efficiency by supporting competition between different companies in the same market. As businesses compete for consumers, they may rely on advertisements to inform buyers of the best bargains and products. If a business successfully attracts more customers through advertising, it may be able to reduce its costs due to economies of scale. However, advertising can also have negative effects, such as persuading consumers to buy overpriced products.

The Bottom Line

Economic efficiency refers to the effective utilization of productive resources, such as agricultural land, manufacturing capacity, raw materials, or labor. Economists have several ways of measuring economic efficiency. Understanding and improving efficiency is one of the main objectives of economics.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Census Bureau. "Quarterly Survey of Plant Capacity Utilization."