Overview: Efficiency

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A central issue in microeconomics is under what circumstances individual pursuit of self interest is harmonious with the good of the group. We saw in the prisoners' dilemma that what seemed good for the individual could be bad for the group, but that a simple change of incentives brought individual self-interest and the good of the group into harmony. Now that we have the examined the logic of rational choice and the theory of the firm, we have the concepts needed to take a more in-depth treatment of this issue. We begin by exploring the concept of economic efficiency.

We have already had a preview of economic efficiency in the discussion of consumers' and producers' surplus. Consumers' and producers' surplus is value as people perceive it. An market outcome is economically efficient if value is maximized.

Economic efficiency is central to microeconomics because it helps us probe how markets work (its positive side) and it also provides a criterion for evaluation of markets (its normative role). If a market is economically inefficient, we have to ask why people are leaving value on the table. Why do they not find ways to capture that value? We will see in later chapters that asking this question leads us to appreciate a number of business practices. The normative aspect leads us to the concept of market failure and prompts questions of whether government policy can remedy the failure or whether it contributes to it.

Concern about economic efficiency is as old as economics. Adam Smith was writing about this concept, though he did not use the term, when he wrote about the invisible hand, the idea that individual action can spontaneously and without central direction contribute to the common good when the right incentives are in place.

After you complete this unit, you should be able to:

  • Define economic efficiency, Pareto optimality, welfare loss.
  • Explain the three situations that allow an increase in economic efficiency.
  • List at least two assumptions needed before one can take economic efficiency seriously as a normative criterion.
  • Explain why a competitive market economy can, in theory, be economically efficient.
Copyright Robert Schenk