"Efficiency" is the miracle of our market economy. Why does the market by itself lead to efficient solutions? A crash course on one of the most discussed issues in economics. See how it works, when it fails and what requirements have to be fulfilled.
In economics, the term "efficiency" appears in several contexts. It is a central term for the description of results in economics.
First, let’s have a look at how the competitive market system results in efficient allocations.
In order to understand this issue we build a simple model. We imagine two individuals, each of whom acts rationally and with self-interest and each has his own given preferences. This means we take as a basis the behaviour of the homo oeconomicus. Suppose they live in a world with two goods, for example apples and pears. We further assume that each person has an initial supply of these two goods, say 5 pears and 5 apples. Our individuals have different preferences, one prefers pears to apples and vice versa. What can they do?
Pears and apples
The answer is obvious: they can trade apples against pears in order to satisfy their preferences. This trading process continues until they arrive at a point where no one is willing to make further transactions because every additional trade would be unfavourable for at least one of them. These resulting allocations are called efficient, because there is no further allocation which improves the position of one person without having a negative effect on the position of the other.
Although in the real world goods are exchanged against money, this trivial trading process describes the elementary activity in our economy. Money is just a trade medium in order to simplify this trading process. Every participant of this so-called "gains from trade-process" tries to achieve the highest level of utility determined by his individual preferences. In this case "efficiency" describes the optimal, maximum output of a given quantity of input, here the initial supply of 5 apples and 5 pears.
Our simple model with two individuals can be thought of as a description of the interaction between, for example, two or more countries, groups of people… interaction between whatever kind of economic participants.
There are two important facts that must be taken into consideration in the context of efficient allocations. Lets have a look at each of them in turn:
First it is important to know that this trading process doesn?t work in all circumstances. Two main requirements have to be fulfilled to ensure it can function. First of these is a guarantee of property rights. Our underlying homo oeconomicus would rob and steal instead of trading if this behaviour were allowed. If everyone robs and steals we are in an unproductive anarchy that is less beneficial for everyone. The second requirement demands that the conditions of free competition have to be fulfilled. This means that there must be some kind of institution to protect competition – preventing circumstances such as monopolies. This shows that a market economy must operate within a functioning administration of justice that watches over the economic actions in a fair manner.
If you look at the situation in the different countries around the world you see that these requirements are quite often not fulfilled. Anarchy, corruption, political instability or a high crime rate prevent the market from providing efficient allocations.
Rational solutions and Mother Nature
Second, there are some situations in which the market economy is not able to provide efficient solutions. For example let us take a look at the problem of pollution. Why are we, for example, polluting the air if clean air would be better for all of us? This problem of collective self-damage is created by the rational decisions of each individual. Such problems occur in contexts involving goods from whose consumption nobody can be excluded and that can be consumed free of charge, like air, soil, ground water etc.
Consider a company that pollutes ground water. Why should it stop or reduce its poisonous production if it is not held responsible for the consequences and doesn?t have to pay any compensation? In this situation the company doesn?t have any incentive to protect the environment despite the fact that a healthy environment would be better for all of us. In other words, rational behaviour, that led to efficient allocations in our model above, now leads to collective self-damage. This so-called "prisoner?s dilemma" explains the failure of the market economy in relation to these kinds of goods.
"Efficiency" in terms of production
Efficiency also plays an important role in the field of production. Imagine a profit-maximizing firm that produces one output with two input factors. We now hold the level of output constant and look for the combination of input factors that consumes the fewest units. Obviously, for every level of output there is only one combination that fulfils this requirement. This minimum combination is efficient. Here the term efficiency describes the optimal minimal input for a given output.
In contrast to efficiency, the term effectiveness is the quotient of – in terms of economics – output and input, the productivity, which shows how many units of output one gets from one unit of input. In physical terms it is the quotient of work and energy.