Question

What are the advantages and dis-advantages of the measures of economic efficiency. Also, what are the strengths and weaknesses of each of the measures of economic efficiency as they relate to capital allocation and decision making.

Answer 1

Economic efficiency implies an economic state in which every resource is optimally allocated to serve each individual or entity in the best way while minimizing waste and inefficiency. When an economy is economically efficient, any changes made to assist one entity would harm another. In terms of production, goods are produced at their lowest possible cost, as are the variable inputs of production.

Factors for Analysis of Economic Efficiency

Basic market forces like the level of prices, employment rates and interest rates can be analyzed to determine the relative improvements made toward economic efficiency from one point in time to another. The amount of waste during the production of goods and services can also be considered if the current allocation of resources is ideal in regards to consumer demand.

Economic efficiency is, roughly speaking, a situation in which nothing can be improved without something else being hurt. Depending on the context, it is usually one of the following two related concepts:

• Allocative or Pareto efficiency: any changes made to assist one person would harm another.
• Productive efficiency: no additional output can be obtained without increasing the amount of inputs, and production proceeds at the lowest possible average total cost.

Disadvantages:

Measuring economic efficiency is often subjective, relying on assumptions about the social good, or welfare, created and how well that serves consumers. At peak economic efficiency, the welfare of one cannot be improved without subsequently lowering the welfare of another. In this regard, welfare relates to the standard of living and relative comfort experienced by members within the economy.

Even if economic equilibrium is reached, the standard of living of all individuals within the economy may not be equal. Pareto’s efficiency does not include issues of fairness or equality amongst those within a particular economy. Instead, the focus is purely on reaching a point of optimal operation in regards to the use of limited or scarce resources.

Pareto Efficiency

Pros:

Pareto efficiency or Pareto optimality is a state of allocation of resources from which it is impossible to reallocate so as to make any one individual or preference criterion better off without making at least one individual or preference criterion worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian engineer and economist, who used the concept in his studies of economic efficiency and income distribution. The concept has been applied in academic fields such as economics, engineering, and the life sciences.

The Pareto frontier is the set of all Pareto efficient allocations, conventionally shown graphically. It also is variously known as the Pareto front or Pareto set.

A Pareto improvement is a change to a different allocation that makes at least one individual or preference criterion better off without making any other individual or preference criterion worse off, given a certain initial allocation of goods among a set of individuals. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made, in which case we are assumed to have reached Pareto optimality.

"Pareto efficiency" is considered as a minimal notion of efficiency that does not necessarily result in a socially desirable distribution of resources: it makes no statement about equality, or the overall well-being of a society.

The notion of Pareto efficiency has been applied to the selection of alternatives in engineering and similar fields. Each option is first assessed, under multiple criteria, and then a subset of options is ostensibly identified with the property that no other option can categorically outperform any of its members.

Criticisms:

It would be incorrect to treat Pareto efficiency as equivalent to societal optimization, as the latter is a normative concept that is a matter of interpretation that typically would account for the consequence of degrees of inequality of distribution. An example would be a school district with low property tax revenue versus one with much higher revenue. Generally, more equal distribution occurs with the help of government redistribution.

Pareto efficiency does not require a totally equitable distribution of wealth. An economy in which a wealthy few hold the vast majority of resources can be Pareto efficient. This possibility is inherent in the definition of Pareto efficiency; often the status quo is Pareto efficient regardless of the degree to which wealth is equitably distributed. A simple example is the distribution of a pie among three people. The most equitable distribution would assign one third to each person. However the assignment of, say, a half section to each of two individuals and none to the third is also Pareto optimal despite not being equitable, because none of the recipients could be made better off without decreasing someone else's share; and there are many other such distribution examples. An example of a Pareto inefficient distribution of the pie would be allocation of a quarter of the pie to each of the three, with the remainder discarded. The origin (and utility value) of the pie is conceived as immaterial in these examples. In such cases, whereby a "windfall" is gained that none of the potential distributees actually produced (e.g., land, inherited wealth, a portion of the broadcast spectrum, or some other resource), the criterion of Pareto efficiency does not determine a unique optimal allocation. Wealth consolidation may exclude others from wealth accumulation because of bars to market entry, etc.

The liberal paradox elaborated by Amartya Sen shows that when people have preferences about what other people do, the goal of Pareto efficiency can come into conflict with the goal of individual liberty.

Productive Efficiency:

An example PPF: points B, C and D are all productively efficient, but an economy at A would not be, because D involves more production of both goods. Point X cannot be achieved.

Productive efficiency occurs under competitive equilibrium at the minimum of average total cost for each good, such as the one shown here.

Productive efficiency is a situation in which the economy could not produce any more of one good without sacrificing production of another good. In other words, productive efficiency occurs when a good or a service is produced at the lowest possible cost. The concept is illustrated on a production possibility frontier (PPF), where all points on the curve are points of productive efficiency.^[1] An equilibrium may be productively efficient without being allocatively efficient— i.e. it may result in a distribution of goods where social welfare is not maximized. It is one type of economic efficiency.

Productive efficiency requires that all firms operate using best-practice technological and managerial processes. By improving these processes, an economy or business can extend its production possibility frontier outward, so that efficient production yields more output than previously.

Productive inefficiency, with the economy operating below its production possibilities frontier, can occur because the productive inputs physical capital and labor are underutilized—that is, some capital or labor is left sitting idle—or because these inputs are allocated in inappropriate combinations to the different industries that use them.

In long-run equilibrium for perfectly competitive markets, productive efficiency occurs at the base of the average total cost curve—i.e. where marginal cost equals average total cost—for each good.

Due to the nature and culture of monopolistic companies, they may not be productively efficient because of X-inefficiency, whereby companies operating in a monopoly have less of an incentive to maximize output due to lack of competition. However, due to economies of scale it can be possible for the profit-maximizing level of output of monopolistic companies to occur with a lower price to the consumer than perfectly competitive companies.

Other factors:

Specialisation

Specialisation occurs when a business focuses on producing a limited number of goods and leaves the production of other goods to other businesses. Specialisation can also occur by: Region. e.g. Sheffield and Steel International. Coffee and Brazil

Advantages of Specialisation to a Business

• As workers specialise they become quicker at producing goods, this reduces costs of production
• Level of production increases
• Workers are able to develop expertise

Disadvantages of Specialisation to a Business

• Increased costs of training workers
• May be a decrease in quality as workers are bored by doing the same job

Advantages of Specialisation to Workers

• Improve their skill level and expertise
• Receive more money as they do a more specialised job

Disadvantages of Specialisation to Workers

• Boredom due to monotony of job
• Quality of work and skills may suffer due to boredom
• Workers could be replaced by machinery

Exchange

As you specialise you only produce a fixed amount of products.In order to get all of the products that you require you need to exchange goods / services with other businesses / individuals. By exchanging products you can ensure that you fulfil your needs and wants

Division of Labour

The division of labour is where workers concentrate on a performing a few tasks and then exchange their output for other goods and services

Production & Productivity

Production is the process of creating, growing, manufacturing, or improving goods and services.

Productivity measures the efficiency or rate of production. It is the amount of output (e.g. number of goods produced) per unit of input (e.g. labor, equipment, and capital).

Labour productivity measures the amount of output per worker