2.4 Efficiency

The term “efficiency” is often used in economics and public finance. In economics, it refers to the allocation of resources such that overall welfare to society is maximized. In the context of public finance, let us focus for now on Pareto or Kaldor-Hicks efficiency. Pareto efficiency is achieved when no person can be made better off without another person being made worse off. Since this is very restrictive, the Kaldor-Hicks efficiency offers a less stringent alternative. Under Kaldor-Hicks efficiency improvement, there is a positive net benefit to society such that winners could—at least theoretical—compensate the losers after a policy change. Although Kaldor-Hick efficiency is usually the basis for a cost-benefit analysis, the drawback is that the compensation is potential and may never be realized. Consider the table with the individual benefits and costs associated with a single project.

Individual Resident	Individual Benefit	Cost Share	Individual Gain
A	$3,500	$2,000	$1,500
B	$1,000	$2,000	($1,000)
C	$1,500	$2,000	($500)
D	$4,500	$2,000	$2,500
E	$1,500	$2,000	($500)
Total Benefit	$12,000	$10,000	$2,000

The project is Kaldor-Hicks efficient because the total benefit ($12,000) exceeds the total cost ($10,000). However, the project is not Pareto efficient because the costs exceed the benefits for some people. This project would also not pass a majority vote.