TECHNICAL EFFICIENCY AND ECONOMIC EFFICIENCY

Before proceeding, we want to distinguish between technical efficiency and economic efficiency. Technical efficiency is achieved when the maximum possible amount of output is being produced with a given combination of inputs. The definition of a production function assumes that technical efficiency is being achieved because the production function gives the maximum output level that can be achieved for any particular combination of inputs. Thus, technical efficiency is implied by the production function.

To illustrate the concept of technical efficiency, consider a firm that manufactures electric generators using an assembly-line process that begins with workers manually performing five steps before the generator reaches a computer-controlled drill press. At this stage, the computer-controlled drill makes 16 holes that are required for final assembly. In the process of drilling 16 holes almost one pound of iron is removed. Using this production process, the firm employs 10 assembly-line workers and one computer-controlled drill press and produces 140 generators each day. A production engineer studying this process discovers that moving the computer-controlled drill press to the beginning of the assembly line, ahead of five steps that are performed manually, will save labourers energy each day - the generators weigh one pound less when they get to the workers on the assembly line. By moving the drilling to the beginning of the production process, the same 10 workers and one drill press can produce 150 generators per day. The production engineer is unable to find any other change in the production process that would further increase output. Now the firm is operating in a technically efficient manner; 150 generators is the maximum number of generators that can be produced daily using 10 labourers and one drill press.

Economic efficiency is achieved when the firm is producing a given amount of output at the lowest possible cost. This is a constrained optimization problem.

One should be careful about labeling a particular production process inefficient. Certainly a process would be technically inefficient if another process can produce the same amount of output using less of one or more inputs and the same amounts of all others. If, however, the second process uses less of some inputs but more of others, the economically efficient method of producing a technically efficient level of output depends on the prices of the inputs. Even when both are technically efficient, one process might cost less - be economically efficient - under one set of input prices, while the other may be economically efficient at other input prices.