Economic Efficiency
A function of the ratio of the actual value of an economic variable to the potential value of that same economic variable
What is Economic Efficiency?
Economic efficiency is, in mathematical terms, a function of the ratio of the actual value of an economic variable divided by the potential value of that same economic variable.
Economic Efficiency Formula
Economic efficiency is basically just a measure of how good things are economically, compared to how good they could potentially be. The formula for determining economic efficiency is as follows:
Pareto Efficiency
In economics, the concept of efficiency most commonly used is that of Pareto Efficiency. The efficiency measure is named after Vilfredo Pareto, an Italian engineer and economist. An allocation is Pareto efficient if it is impossible to, from that point, make someone better off without making someone else worse off. An outcome is said to be Pareto inefficient if it is possible to make at least one agent better off without making any other agent worse off.
1. Pareto efficiency in individual consumption
In consumer behavior, a consumption bundle is Pareto efficient if it is impossible to increase a consumer’s consumption of one good without decreasing the consumer’s consumption of some other good.
Graphically, it implies that a consumer always consumes on the border of his indifference set and not at its interior. All points in the exterior of the indifference set give the consumer more utility, but they are infeasible as the consumer can’t afford them.
A Pareto efficient consumption bundle always lies on the indifference curve. In the graph above, the grey shaded area represents the less than set for the indifference curve (orange curve) U0. All points in the interior region give strictly less utility than a point on the indifference curve.
2. Pareto efficiency in individual production
In production behavior, a production bundle is Pareto efficient if it is impossible to increase a producer’s production of one good without decreasing the producer’s production of some other good. Graphically, it implies that a producer always produces on the border of his production possibility set.
A Pareto efficient production bundle always lies on the production possibility frontier. In the graph above, the grey shaded area represents the less than set for the production possibility frontier (orange curve) Q0. All points in the interior region give strictly less output than a point on the production possibility frontier curve.
3. Pareto efficiency in income or wealth distribution
In his research, Vilfredo Pareto observed that 20% of the Italian population held 80% of the country’s wealth. Pareto remarked that the distribution of wealth, although morally questionable, was efficient in economic terms. A wealth distribution is Pareto efficient if and only if the sum of individual wealth is equal to the aggregate wealth. As long as no resources are wasted, one person owning all the wealth in the world is considered just as efficient as the entire world population having equal wealth.
Criticisms of Economic Efficiency
The concept of efficiency used by economists is often criticized by philosophers and political scientists. The criticism stems not from the logical construct of Pareto efficiency but from the fact that economists tend to justify policy recommendations on the basis of efficiency improvements (rather than taking into account moral or social issues).
Related Readings
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)® certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:
Financial Analyst Certification
Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!
