Economic efficiency is a state where nothing can be adjusted so that someone is made
better off without someone else being made worse off, and is formally called
Pareto efficiency (after
Vilfredo Pareto). Often,
economists distinguish among productive or technical efficiency, (
static) allocative efficiency, and dynamic efficiency, however Pareto efficiency subordinates all of these. Productive, allocative and dynamic efficiency are now discussed in turn.
Allocative efficiency is usually used in a somewhat misleading fashion, and it is helpful to preface it with the words “in-period” or “static” to make its meaning clear. In-period allocative efficiency takes as given existing plant and technology. A situation is in-period allocatively efficient if nothing can be adjusted so that someone is made better off without someone else being made worse off. In-period allocative efficiency typically guarantees overall economic inefficiency, so it is neither necessary nor sufficient for economic efficiency. This is because an in-period allocatively efficient distribution typically does not reward investors for take risks in the sinking of costs.
However, sometimes allocative efficiency is used (as its name would suggest)
to mean overall economic efficiency.1 This can cause a great deal of confusion, especially when the textbooks and 101 lectures focus almost exclusively on in-period allocative efficiency for expositional purposes.
Productive, or technical efficiency occurs when least cost production techniques are used (the firm operates on its cost function). Put another way, a firm that is technically efficient cannot increase its output without increasing its costs (or cannot reduce its costs holding output constant). Productive efficiency is neither a necessary nor sufficient condition for allocative or overall efficiency. An example that demonstrates it is not necessary is when technical efficiency requires an industry structure that implies market power (for example, natural monopoly). In these circumstances it may be more efficient to have, on the grounds of technical efficiency, too many suppliers because the increased competition of “too many” firms creates allocative efficiency gains that exceed any technical efficiency losses. The Averch-Johnson effect and x-inefficiency are other examples of productive inefficiency.
To summarise the relationship between productive or technical efficiency and in-period allocative efficiency: In-period allocative efficiency subsumes productive efficiency. The presence of in-period allocative or economic efficiency guarantees productive efficiency, except where competition is more important than technical efficiency. In the case of the exception, in-period allocative and economic efficiency oust technical efficiency as a criterion. In the absence of the exception, productive efficiency is necessary but not sufficient for in-period allocative and overall economic efficiency.
Dynamic efficiency is contrasted to in-period allocative efficiency, and as a concept is only necessary when one has discussed in-period allocative efficiency. It is then necessary to note that in-period allocative efficiency is not necessary economically efficient, as it may lead to inefficient outcomes over time. There are two reasons for this. First, holding technology constant, new plant can be installed. Second, research and development can be undertaken to advance technology. Note, however, if dynamic efficiency means that over time nothing could be rearranged so that someone could be made better off without making someone else worse off, then it really is plain old economic efficiency. The term dynamic has simply been appended to efficiency to indicate what distinguishes this broader concept from in-period allocative efficiency.
Footnotes
1 For example and discussion, see Cabral, 2000, at pp. 28-9.
References
Cabral, L (2000),
Introduction to Industrial Organisation, MIT Press, pp. 26 ff.