Economic Efficiency in A Nutshell
Economists can get very technical when they discuss the
topic of economic efficiency,
and most of the rest of the reading selections in this unit
are going to get technical. But the basic idea of
economic efficiency is very simple and can be
illustrated in a simple example.
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.
However, there are a variety of circumstances under which
that bundle of resources will not get used for A, but
will be used for B or C. One way that can
happen is for the government 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. There are a wide variety of
cases in which market failure can happen, and examining them
is an important part of microeconomics.
In a discussion of the prisoner's
dilemma, we considered whether what was good for the
individual was good for the group. The concept of economic
efficiency makes this discussion more precise and specific.
When the outcome of people's individual actions is
economically efficient, what is good for the individual is
good for the group. When the outcome is economically
inefficient, then what is good for the individual is not the
best for the group.
Now that we have a clear, intuitive understanding of what
economic efficiency means and why we can expect markets to
have a tendency to get us there, we can begin a more
technical look at the topic by examining the three
conditions needed for an economy to avoid unexploited value:
production, exchange, and