A market is called efficient when resources are used in a way that maximizes the production of goods and services at the lowest cost. Economic efficiency is a relative term; an economy is more efficient when it produces more goods and services for society than another by using the same or lower input. Economists recognize several ways of measuring or talking about the ways economies may be efficient; some of the most common include efficiency of scale, productive efficiency, technical efficiency, allocative efficiency, dynamic efficiency and social efficiency. Efficiency types are not mutually exclusive; more than one can describe a market or economy.
Efficiency of Scale
When a producer makes more of something, usually the cost of production per unit falls. There is limit to this effect; eventually, producing a greater quantity will no longer pay off. When production approaches this limit, there exists efficiency of scale.
Productive efficiency is achieved when a producer uses the least amount of resources to produce goods or services relative to others. The producer might achieve this by exploiting economies of scale or by having the advantage of the most efficient production technology, the cheapest labor or minimal production waste.
A prerequisite for allocative efficiency, technical efficiency describes production that has the lowest possible opportunity cost. Material and labor resources are not wasted in the production of goods or services in technically efficient production. When it’s achieved, technical efficiency allows for but doesn’t guarantee allocative efficiency.
When a society’s value for a certain good or service (the amount they pay for it) is in equilibrium with the cost of resources used to produce it, it is called allocative efficiency. It’s typically achieved not by accident but when a society allocates its resources to producing what society values most.
Economists use dynamic efficiency to describe a market in the long term. A society with a high dynamic efficiency offers consumers more choices of higher quality goods or services than in another society. For example, as research and development improves products over time, and makes quality items cheaper to make, the market experiences increased dynamic efficiency over time.
Social efficiency is a concept somewhat more abstract that the other types of efficiencies. It occurs when the benefit of producing something doesn’t outweigh the negative effects production has on society. The nature of social efficiency makes it relevant to the discussion of externalities. Externalities are the outside effects of production on society and can be positive or negative; for example, a negative externality of a power plant is pollution.