Economic Efficiency
In economics, the term "economic efficiency" is defined as the use of resources in order to maximize the production of goods and services. An economically efficient society can produce more goods or services than another society without using more resources.
A market is said to be economically efficient if:
- No one can be made better off without making someone else worse off.
- No additional output can be obtained without increasing the amounts of inputs.
- Production proceeds at the lowest possible cost per unit.
Externalities
An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur the cost or benefit . Externalities are either positive or negative depending on the nature of the impact on the third party. An example of a negative externality is pollution. Manufacturing plants emit pollution which impacts individuals living in the surrounding areas. Third parties who are not involved in any aspect of the manufacturing plant are impacted negatively by the pollution. An example of a positive externality would be an individual who lives by a bee farm. The third parties' flowers are pollinated by the neighbor's bees. They have no cost or investment in the business, but they benefit from the bees.
Externality
This diagram shows the voluntary exchange that takes place within a market system. It also shows the economic costs that are associated with externalities.
Externalities and Efficiency
Positive and negative externalities both impact economic efficiency. Neoclassical welfare economics states that the existence of externalities results in outcomes that are not ideal for society as a whole. In the case of negative externalities, third parties experience negative effects from an activity or transaction in which they did not choose to be involved. In order to compensate for negative externalities, the market as a whole is reducing its profits in order to repair the damage that was caused which decreases efficiency. Positive externalities are beneficial to the third party at no cost to them. The collective social welfare is improved, but the providers of the benefit do not make any money from the shared benefit. As a result, less of the good is produced or profited from which is less optimal society and decreases economic efficiency.
In order to deal with externalities, markets usually internalize the costs or benefits. For costs, the market has to spend additional funds in order to make up for damages incurred. Benefits are also internalized because they are viewed as goods produced and used by third parties with no monetary gain for the market. Internalizing costs and benefits is not always feasible, especially when the monetary value or a good or service cannot be determined.
Externalities directly impact efficiency because the production of goods is not efficient when costs are incurred due to damages. Efficiency also decreases when potential money earned is lost on non-paying third parties.
In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the market declines.