Welfare Economics - Efficiency

Efficiency

Situations are considered to have distributive efficiency when goods are distributed to the people who can gain the most utility from them.

Many economists use Pareto efficiency as their efficiency goal. According to this measure of social welfare, a situation is optimal only if no individuals can be made better off without making someone else worse off.

This ideal state of affairs can only come about if four criteria are met:

• The marginal rates of substitution in consumption are identical for all consumers. This occurs when no consumer can be made better off without making others worse off.
• The marginal rate of transformation in production is identical for all products. This occurs when it is impossible to increase the production of any good without reducing the production of other goods.
• The marginal resource cost is equal to the marginal revenue product for all production processes. This takes place when marginal physical product of a factor must be the same for all firms producing a good.
• The marginal rates of substitution in consumption are equal to the marginal rates of transformation in production, such as where production processes must match consumer wants.

There are a number of conditions that, most economists agree, may lead to inefficiency. They include:

• Imperfect market structures, such as a monopoly, monopsony, oligopoly, oligopsony, and monopolistic competition.
• Factor allocation inefficiencies in production theory basics.
• Market failures and externalities; there is also social cost.
• Price discrimination and price skimming.
• Asymmetric information, principal–agent problems.
• Long run declining average costs in a natural monopoly.
• Certain types of taxes and tariffs.

To determine whether an activity is moving the economy towards Pareto efficiency, two compensation tests have been developed. Any change usually makes some people better off while making others worse off, so these tests ask what would happen if the winners were to compensate the losers. Using the Kaldor criterion, an activity will contribute to Pareto optimality if the maximum amount the gainers are prepared to pay is greater than the minimum amount that the losers are prepared to accept. Under the Hicks criterion, an activity will contribute to Pareto optimality if the maximum amount the losers are prepared to offer to the gainers in order to prevent the change is less than the minimum amount the gainers are prepared to accept as a bribe to forgo the change. The Hicks compensation test is from the losers' point of view, while the Kaldor compensation test is from the gainers' point of view. If both conditions are satisfied, both gainers and losers will agree that the proposed activity will move the economy toward Pareto optimality. This is referred to as Kaldor-Hicks efficiency or the Scitovsky criterion.

See also: first welfare theorem