Efficiency Principle

What Is the Efficiency Principle?

The efficiency principle is an economic tenet stating that any action achieves the greatest benefit to society when the marginal benefits from the allocation of resources are equivalent to its marginal social cost. It lays the theoretical groundwork for cost-benefit analysis, which is how most decisions regarding the allocation of resources are made.

Understanding the Efficiency Principle

Efficiency principle is also at the heart of allocative efficiency, the perfect state where every good or service is produced up to the point where the last unit provides a marginal benefit that is equal to its marginal production cost. At this magical point, which almost never is achieved, there is no deadweight loss or misused resources.

The efficiency principle, the idea of producing desired products at the lowest possible cost, leverages many basic tenets underlying economics. It assumes that consumers make decisions and trade-offs at the margin, meaning they carefully weigh the benefits of buying one additional unit of a given item. It also assumes that people are rational, choosing the cheaper product when comparing two of equal benefit, or the one with the most benefits if the items are priced equally.

At the aggregate level, the efficiency principle holds that the net result of all consumers making rational decisions results in the best possible benefit to society, in dollar terms, with total production at its lowest possible cost. On the contrary, reallocating the goods or producing them inefficiently, where there are too many of one good and not enough of another creates market distortion.

The efficiency principle has some limitations as well. It makes sense in theory but is difficult to apply. It is central to the study of economics, but there is no practical economic indicator associated with it. There are simply too many assumptions that must be made to determine marginal social costs. There is no government agency that tracks allocative efficiency, and if there was, almost no one would believe the agency’s conclusions.

Example of the Efficiency Principle

Let’s say, for example, that a lemonade stand, which sells only lemonade and chocolate-chip cookies, represents the economy. Lemonade costs $1 a glass and cookies are $0.50 each.

Given the total underlying supply of lemons, sugar, chocolate chips, and labor, the stand can produce a total of 75 cups of lemonade and 50 cookies in a given time frame at a cost of $20. In this scenario, let's also assume market demand is for only 75 cups of lemonade and 50 cookies.

Under the efficiency principle, the total output should be $100, or $75 from the lemonade and $25 from the cookie, and profit should be $80, or the $100 in revenue minus costs of $20.

If the total output is less than $100, there is deadweight loss somewhere in the economy. Moreover, if the stand produces any other combination of lemonade and cookies, the result will be inefficient. It will not meet total demand at the lowest possible cost, and will not achieve the best possible $80 benefit.