Economic Efficiency in a World of Frictions

As the literature has given increasing attention to the roles played by transaction costs and bounded rationality in shaping economic outcomes, attempts have been made to redefine the concept of economic efficiency. The traditional criterion, which is linked to the standard Pareto conditions, is said to lead to the nirvana fallacy. The newer, alternative definitions, however, are also open to criticism on grounds that they involve contradictory assumptions. It appears that, for logical consistency to hold, only a loose, qualitative definition of allocative efficiency can be established for a system in which decision makers have limited cognitive capacity and both transaction and deliberation costs are positive. Given this interpretation, the analytical focus should shift from concern with narrow technical issues of allocative efficiency to a consideration of how legal, social and other constraints can be changed to improve economic performance.