When goods and services are produced at the lowest possible cost and in the quantities that provide the greatest possible benefit?

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.

• The efficiency principle states that an action achieves the most benefit when marginal benefits from its allocation of resources equal marginal social costs.
• The goal is to produce desired products at the lowest possible cost, eliminating deadweight loss or misused resources.
• The efficiency principle lays the theoretical groundwork for cost-benefit analysis, which is how most decisions regarding the allocation of resources are made.
• The principle is central to the study of economics but is difficult to apply in practical scenarios because it is based on many assumptions.

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.

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.

Economic efficiency is when all goods and factors of production in an economy are distributed or allocated to their most valuable uses and waste is eliminated or minimized.

• Economic efficiency is when every scarce resource in an economy is used and distributed among producers and consumers in a way that produces the most economic output and benefit to consumers.
• Economic efficiency can involve efficient production decisions within firms and industries, efficient consumption decisions by individual consumers, and efficient distribution of consumer and producer goods across individual consumers and firms.
• Pareto efficiency is when every economic good is optimally allocated across production and consumption so that no change to the arrangement can be made to make anyone better off without making someone else worse off.

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.

Some terms that encompass phases of economic efficiency include allocative efficiency, productive efficiency, distributive efficiency, and Pareto efficiency. A state of economic efficiency is essentially theoretical; a limit that can be approached but never reached. Instead, economists look at the amount of loss, referred to as waste, between pure efficiency and reality to see how efficiently an economy functions.

The principles of economic efficiency are based on the concept that resources are scarce. Therefore, there are not sufficient resources to ensure that all aspects of an economy function at their highest capacity at all times. Instead, scarce resources must be distributed to meet the needs of the economy in an ideal way while also limiting the amount of waste produced. The ideal state is related to the welfare of the population with peak efficiency also resulting in the highest level of welfare possible based on the resources available.

Productive firms seek to maximize their profits by bringing in the most revenue while minimizing costs. To do this, they choose the combination of inputs that minimize their costs while producing as much output as possible. By doing so, they operate efficiently; when all firms in the economy do so, it is known as productive efficiency.

Consumers, likewise, seek to maximize their well-being by consuming combinations of final consumer goods that produce the highest total satisfaction of their wants and needs at the lowest cost to them. The resulting consumer demand guides productive (through the laws of supply and demand) firms to produce the right quantities of consumer goods in the economy that will provide the highest consumer satisfaction relative to the costs of inputs. When economic resources are allocated across different firms and industries (each following the principle of productive efficiency) in a way that produces the right quantities of final consumer goods, this is called allocative efficiency.

Finally, because each individual values goods differently and according to the law of diminishing marginal utility, the distribution of final consumer goods in an economy are efficient or inefficient. Distributive efficiency is when the consumer goods in an economy are distributed so that each unit is consumed by the individual who values that unit most highly compared to all other individuals. Note that this type of efficiency assumes that the amount of value that individuals place on economic goods can be quantified and compared across individuals.

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

Even if Pareto efficiency is reached, the standard of living of all individuals within the economy may not be equal. Pareto efficiency does not include issues of fairness or equality among those within a particular economy. Instead, the focus is purely on reaching a point of optimal operation regarding the use of limited or scarce resources. It states that efficiency is obtained when a distribution exists where one party's situation cannot be improved without making another party's situation worse.