Efficiency and all that

Replying to Jason Soon, Tim Dunlop puts his finger on one of the more embarrassing secrets of economics. Although we use the term ‘efficiency’ all the time, we don’t really have a consistent and rigorous definition of what it means for an economic policy to improve efficiency. A typical welfare economics textbook will define an economic situation as Pareto-efficient if there is no other situation that would constitute a Pareto-improvement, that is, make some people better off and no-one worse off. This doesn’t just require technical efficiency in production. It’s also necessary that there be no unexploited gains from trade (often called allocative efficiency)
So a Pareto-improvement would be an improvement in efficiency. But policies that naturally produce Pareto-improvements are as scarce as hen’s teeth. So when economists talk about improvements in efficiency, they are usually talking about one of the following possibilities (neither of which is generally defined in a rigorous fashion)
(a) If the gainers from the policies felt like it, they could fully compensate the losers while remaining better off themselves
(b) If the government chose it could tax the gainers, still leaving them better off, and use the proceeds to fully compensate the losers
Cases like (a) are common, but, in the absence of an outbreak of altruism among the beneficiaries of efficiency-oriented policies, don’t tell us much about the impact of policy changes on the welfare of society as a whole. If a policy change makes all 20 million Australians (but one) $100 poorer and James Packer $2.1 billion richer, it’s not helpful to know he could pay us back and keep $100 000 for himself if he chose.
Cases like (b) are more relevant, but the required analysis to show that a policy satisfies this condition is generally difficult and rarely done.