What is economic efficiency and how does it impact welfare?

2 Allocative efficiency

Allocative efficiency occurs when goods and services are distributed according to the preferences and needs of consumers, reflecting their willingness to pay and marginal benefit. This means that there is no overproduction or underproduction of any good or service, and that the total surplus, which is the sum of consumer surplus and producer surplus, is maximized. Consumer surplus is the difference between what consumers are willing to pay and what they actually pay, while producer surplus is the difference between what producers receive and what they are willing to accept. Allocative efficiency implies that the market price is equal to the marginal cost of production, which is the additional cost of producing one more unit. Allocative efficiency is important for welfare because it ensures that resources are allocated to the most valued uses and that the net benefits to society are maximized.

3 Dynamic efficiency

Dynamic efficiency occurs when there is continuous innovation and improvement in the quality and variety of goods and services, as well as in the methods and processes of production. This means that there is investment in research and development, human capital, infrastructure, and technology, which can increase the productivity and competitiveness of firms and industries. Dynamic efficiency implies that there is a balance between the current and future consumption and production, taking into account the opportunity cost of investing in the present versus the future. Dynamic efficiency is important for welfare because it enhances the long-term growth and development of the economy, as well as the living standards and choices of consumers.

4 Pareto efficiency

Pareto efficiency occurs when it is impossible to make anyone better off without making someone else worse off, or when there is no Pareto improvement possible. A Pareto improvement is a change that makes at least one person better off and no one worse off. Pareto efficiency implies that there is no deadweight loss, which is the loss of surplus due to market failures or distortions, such as taxes, subsidies, externalities, monopoly, or public goods. Pareto efficiency is important for welfare because it represents a situation where there is no conflict or trade-off between efficiency and equity, or between the size and distribution of the economic pie.

5 Social efficiency

Social efficiency occurs when the marginal social benefit of an activity is equal to its marginal social cost, or when the net social benefit is maximized. The marginal social benefit is the additional benefit to society from one more unit of the activity, while the marginal social cost is the additional cost to society from one more unit of the activity. The net social benefit is the difference between the total social benefit and the total social cost. Social efficiency implies that there is no market failure or externality , which is a cost or benefit that affects a third party who is not involved in the activity. Social efficiency is important for welfare because it reflects the optimal level of the activity from the perspective of society as a whole, taking into account both the private and external effects.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?