ECON 378
Lecture Seven: Efficiency
Sources: Murray Rothbard, “The Myth of Efficiency;” Jesus Huerta de Soto, The Theory of Dynamic Efficiency and also “Four Hundred Years of Dynamic Efficiency” (a speech); Roy E. Cordato, “The Austrian Theory of Efficiency and the Role of Government;” Mario Rizzo, in Time, Uncertainty, and Disequilibrium.
Efficiency is one of the most important concepts in economics.
Mainstream economists have different versions of efficiency – as do Austrian economists to some degree.
Much of the mainstream theory of efficiency was developed very early on (early part of the 20th century). A person whose economic methods might be considered a good representation of this historical beginning to the concepts used today is our old friend, Leon Walras. In 1909 he wrote a paper entitled, “Economics and Mechanics” in which he claimed that the mathematical formulas he used in his book Elements of Pure Economics were identical to those in mathematical physics.
There were others that followed this methodology. Basically they were copying 19th century mechanical physics – “using the same formal method but replacing the concept of energy with that of utility and applying the same principles of conservation, maximization of the result, and minimization of waste.” (Huerta de Soto – Four Hundred Years . . .).
Mainstream concepts:
There seem to be two fundamental ideas that provide the foundation for mainstream efficiency theory: Pareto optimality and our old friend, the model of perfect competition. (Cordato)
Model of Perfect Competition (let’s dig deeper):
Remember, in long run equilibrium, firms are said to be operating efficiently for two reasons:
Productive Efficiency:
Productive efficiency focuses on how much output can be produced from a given
stock of resources. An economic entity (person, firm or country) is said to be
productively efficient if they are using the “least cost” manner of production.
Cost here is usually measured in some physical form – Deb uses 2 hours
(resource) to produce a widget, while Bob uses 3 hours
(quality constant) -
Deb is more productively efficient.
Allocative
Allocative efficiency is achieved when resources are allocated to their highest valued use. This is measured by the value consumers place on a good or service (reflected in the price they are willing to pay). The idea is that when the resource goes to the highest bidder – this is its highest valued use (its opportunity cost is of lower value). Therefore, cannot go to a more highly valued place.
Another way of talking about these efficiency criteria:
Marginal Benefit = Marginal Cost
Another way of saying this is that when price is equal to marginal cost (which is true in the long run equilibrium), the marginal benefit received by the consumer (reflected by the price) equals the marginal value of the alternative uses of the factors that went into the production of the output (given by marginal cost). Remember – these cost curves include opportunity cost – the MC curve in the model represents the opportunity cost of the resources used to produce the good.
So the value each consumer is getting (P) = the value of the next best alternative (MC).
If output increased – the value to the consumer of the marginal product would be less than the value given up from other uses. Price is less than marginal cost. There is a higher valued use for these resources and they should go there. Therefore, not efficient.
If output decreased – the value lost would be greater than the value to be gained in some alternative use. Price is greater than marginal cost. Value is greater than opportunity cost – should continue moving resources in. Therefore, not efficient.
GRAPH:
This situation is also Pareto Optimal:
Pareto Optimality
Pareto defined allocative efficiency as a situation where no one can be made better off without making someone else worse off. An allocation is Pareto efficient or Pareto optimal when no further Pareto improvements can be made – in other words, when no one can be made better off without making someone else worse off.
Since in the model – long run equilibrium – there is no place resources could move that would make people better off (increase value) without making people in the market in question worse off (resources move out – they lose).
So basically, these criteria are used to judge, for example, an economic policy for society as a whole. This is known as “welfare economics.”
Social Efficiency (welfare economics)
Basically, take the MB = MC criteria we discussed above and aggregate everything.
The socially efficient level of output and or consumption occurs when social marginal benefit = social marginal cost. At this point we maximize social economic welfare.
SMB = SMC
The idea here is that there are private costs and then there might be external costs as well (for example, both costs are created in the process of producing something). Social costs include both private + external.
Same with benefits. There are private benefits from, for example, consuming something, but there could also be external benefits created as well. Social benefits include both private + external.
In order for there to be social efficiency, social marginal benefit from the production (for example) must = social marginal cost from the production.
So:
The presence of externalities that are not considered by individuals in society means that the private optimum level of consumption / production often differs from the social optimum (socially efficient level).
In the diagram above the social optimum level of output occurs where social marginal cost = social marginal benefit (point B). A private producer not taking into account the negative production externalities might choose to maximize their own profits at point A (where private marginal cost = private marginal benefit).
This divergence between private and social costs of production is what Rothbard was discussing in your reading.
Austrian Criticisms of Mainstream Efficiency Criteria
1. The Pareto optimal rule cannot be used as a social rule for two major reasons (which are overlapping to some degree):
a. Costs and benefits are subjective and cannot be measured. A cost/benefit analysis that includes putting dollar values to everything is simply making two large leaps: one, that a dollar value can be put on everything, and two, that a dollar to me is of equal value to you.
For example – let’s say we do a cost/benefit analysis and that says that the cost of instituting a tax on an industry is = $500,000 in lost productivity. But the benefit is that $500,000 (just by chance) of tax revenue is generated and therefore, it is an efficient tax. So the $500,000 lost by those who do not benefit from the productivity is supposedly = the benefit from those who receive the tax dollars. Pareto optimal!!
However,
b. Interpersonal utility comparisons are impossible. Cannot compare the utility or value of one person to another. Cannot say that if a person is made better off – vs. someone else being made worse off. So how does anyone ever know if there is a Pareto optimal situation?
Rothbard: “Fallacy of the concept of social cost - costs can't be added, measured, compared and are not observable by an outside party - and they are transitory.”
2. Much of mainstream economics basically holds that everyone’s ends are basically the same. “The alleged common end is a higher standard of living,” (Rothbard). But this not reality. The difficulty in choosing one social program or another resides in the fact that the term “welfare” is vague and individuals would have different opinions with regard to what is welfare enhancing or not. As Rothbard puts it – individual ends are bound to conflict. Additive concepts are meaningless.
Rothbard’s examples of social ends – we all have the same living conditions and wear blue garments or the enslavement or slaughter of a certain ethnic group.
If we take the second example and talk about it in externality terms – always assuming that externalities should be internalized:
The disliked social or ethnic group constitutes a “visual pollutant” or negative externality for other groups. So this must be internalized so that SMC = SMB. The ethnic group must pay everyone else to put up with them!! Yikes!
Or another example: A family with children might think it quite fair that everyone in the area of a school pay property taxes to educate their children. People without kids might think differently.
The argument goes: But Betty (the childless taxpayer) benefits from others being educated (better society, less crime, more productivity, etc.) - Therefore, Betty should pay for the positive externality she is receiving - to make sure her SMB = SMC.
Plus: why minimize social costs?
Even if there was some way to determine costs – and we want to minimize social costs – this would certainly include a value judgment (that costs should be minimized – even at the expense of other criteria).
Rothbard: Why should social costs be minimized?
If so, how absolute should this commitment be?
This becomes a problem for economists. Many people believe that a certain amount of efficiency may be dropped in exchange for more equity (usually income equality, for example).
How would you respond to that?
3. Economic efficiency within mainstream economics, including within welfare economics, is focused on “its static dimension. It is assumed that purposes and resources are set and stable, and that the problem will be solved either by minimizing consumed resources or by maximizing purpose.” (Huerta de Soto)
This is a static efficiency concept. Efficiency is defined again, as an end state – and the knowledge that exists in that end state is given. Even when we just look at a firm, for example, we can never know that we have maximized or minimized anything. Perfect knowledge does not exist.
DO ICE SEVEN
Austrian Theories of Efficiency (see Cordato and Huerta de Soto especially):
1. Efficiency and the Individual:
Austrians, as always, start the analysis with the individual. So the question is: what constitutes efficient activity for the individual actors in society?
Here most Austrians conclude that “an efficient course of action would be to apply means that are consistent with attaining the desired goal or program of goals. Inefficiency arises when means are chosen that are inconsistent with the desired goals.” (Cordato)
This is what Rizzo is saying when he says that we cannot talk about efficiency without talking about ends. The ends must be stated first – before we can judge whether or not we attained our ends.
So remember – if someone’s goal is to take 3 hours mowing a lawn that could be mowed in one hour – and he takes 3 hours – then the economist can’t say he is not being efficient from this point of view.
So efficiency is the crux of the economic problem facing the individual. This goes back to Menger – people figuring out how to best satisfy ends (figuring out the causal connections between a good and meeting an end).
But remember – the successfully meeting ones ends is subjective. An outside observer does not decide what is successful.
Here’s where Rothbard takes the subjectivity and uncertainty that Austrians emphasize to its logical conclusion.
Rothbard: We can’t even talk about efficiency from the standpoint of an individual.
Why? Because the individual doesn’t know if his means are the “most efficient” way of obtaining his ends even if he did attain his ends. The individual doesn’t have that knowledge.
So can we say:
a. the individual is efficient in that he attained his end (and he attained it in the time, etc. that he wanted to take) or
b. given the knowledge that the individual has now – he is acting efficiently if he attains his end (again, and he attained it in the time, etc. that he wanted to take).
Rothbard would probably say OK with these. He is basically responding to the idea that efficiency is used with the idea of perfect knowledge in mainstream economics.
2. Society and Efficiency:
Important here: Austrians do not see societal efficiency apart from the efficiency of the individuals that comprise it.
They recognize that society cannot have goals apart from those of the individuals within it.
Here is Kirzner:
Society is made up of numerous individuals. Each individual can be viewed as independently selecting his goal program . . . and each individual adopts his own course of action to achieve his goals. It is therefore unrealistic to speak of society as a single unit seeking to allocate resources in order to faithfully reflect “its” given hierarchy of goals. Society has no single mind where the goals of different individuals can be ranked on a single scale.
Therefore – to an Austrian economist, the only kind of “social efficiency” (if we have to use that term) is:
Again, Kirzner: “Efficiency for a social system means the efficiency with which it permits its individual members to achieve their several goals.”
This is the efficiency criteria we have been discussing in this class thus far. Remember, we have said – given than we want coordination between individual wants or ends and resources – then what rules might we put in place to achieve this.
Coordination basically meaning that individual wants are being met – whatever they might be.
3. Determinants of Efficiency: Knowledge and Coordination.
The key to economic efficiency, from an Austrian perspective, for both the individual and society, is knowledge.
The extent to which an individual acts efficiently will be determined by the amount of knowledge he possesses regarding the appropriate means for attaining his desired ends.
Example: Bob wants to buy a car. Bob has been pretty sheltered his whole life – so he goes to a department store to buy his car. He is ignorant – therefore, he chooses an inefficient means (even in his own mind after the fact) to obtaining his end. But through doing this – his knowledge improves. He learns there are no cars at the department store. And maybe a clerk tells him where he needs to go. His future actions will probably be more efficient than the ones before (however, we can't be static -- perhaps in the future department stores will start selling cars!).
This is also true in markets generally – given what we have been discussing. Markets utilize and spread knowledge of individual wants – allowing many of those wants to be satisfied.
Let’s return to Bob. He is willing to pay a maximum price of $15,000 for his new car. He has visited some dealers and found that none of them are willing to sell him a car for that (low) amount. There is a dealer across town, that he is not aware of, that will sell him a car for $14,000 Without Bob knowing about this dealer, no coordination of plans takes place and inefficiency arises in the market (Bob does not satisfy his end of buying a car).
As more knowledge is gained – Bob finds out about the dealer across town – efficiency is improved.
Note: an equilibrium situation in a market (where S = D), would be an efficient situation given this criteria because there is perfect coordination (and perfect knowledge). But Austrians would emphasize that that is a model, not reality -- and that it is the PROCESS of obtaining the knowledge, not just jumping to the end state that really matters.
4. Dynamic Efficiency (or Inefficiency and the Coordinating Process):
At any given point in time the available information in an economy will be scattered throughout the market. Some plans will be uncoordinated, and inefficiencies will arise.
But it is the “natural forces” in the market itself which act to correct for these inefficiencies. It is the market concepts of price and entrepreneurial activity that ensure the diffusion of knowledge and the tendency toward efficient use of resources (these are the “means” in the market economy that help individuals obtain ends.)
Let’s return to Bob: Remember that he is willing to pay $15,000 for a car. The offers he is aware of are all at $17,000. Here is a chance for an entrepreneurial profit. Betty, a profit-seeking entrepreneur, who’s always on the lookout for a fast buck (you know the type) – knows about the dealer across town – and about Bob’s willingness to pay $15,000. She buys the car for $14,000 and sells it to Bob for $15,000.
Coordination has taken place and efficiency has been improved in the economy (two individuals have met their ends and are better off).
This whole process is what is called “dynamic efficiency.”
From Huerta de Soto: “Dynamic efficiency may be described as the capacity of an economic system to stimulate entrepreneurial creativity and coordination.”
So let’s look deeper into Rothbard’s idea that efficiency is a myth:
If we can’t judge a policy based upon efficiency, since there really is no such thing as “welfare economics” to an Austrian economist -
What must our decisions regarding policy, law, rights, etc. be based upon?
Rothbard concludes: ethics and justice.
And Huerta de Soto claims that dynamic efficiency emerges from the ethical model that respects private property, specifically the appropriation of the results of entrepreneurial creativity.
In other words – the ethical value judgment being made in the Austrian view of efficiency is that individual’s should be able to pursue their own wants. They have the “right” to do so – as individual and subjective as these wants might be (as long as they do not aggress against another’s person or property in the process).
PLUS - that obtaining these wants in an "efficient" manner is a good thing!
Huerta de Soto then claims that this ethical position allows for more dynamic efficiency in the economy. If we are free to own property, trade, etc. then we are more likely to discover better ways of doing things.
If we are free in other ways as well – we also discover better ways of doing things.
Simple Example/Question: If Bob is free to have a purple house instead of conform to a city code that all houses must be in a shade of brown or grey – how might that lead to more discovery? What might be discovered that otherwise would not have been?
Let’s Relate this to the Popular Production Possibilities Frontier (PPF)
In mainstream economics, the PPF model is often used to demonstrate efficiency:
All points that lie on the PPF can be said to be productively efficient – we are using all resources and the best technology – all points are considered equally “productive.”
A point on the frontier is productively efficient - but inside the frontier we can increase production of both goods by making fuller use of existing resources or increasing the efficiency of production (better technology).
Graph:
Note all of the assumptions behind this model –
1) More is better (value judgment)
2) Wealth = production of goods and services (value judgment)
So with both 1 and 2 an increase in GDP is considered a good thing and wealth enhancing.
3) Value of what people want is left out of the model unless there is a discussion of allocative efficiency – one point on the frontier. Where on the frontier we "should" be – then that point is also considered Pareto Optimal. We cannot produce more of something (make people better off) without producing less of something else (make others worse off).
In The Austrian view –
1) It is not more goods and services that it considered better. It is more ends met (more coordination) that is better. ( Value judgment)
2) Wealth is subjective. Depends upon the ends that each individual desires.
3) Basically, let’s put “free or open” time on one axis (a desired end by some in the economy) – since there is always an opportunity cost of our time even when we are being entrepreneurial and discovering new information and more of other ends being met - on the other axis. If we obtain more dynamic efficiency then the frontier will shift out. It is not that we get more time – but that we get more time to use as we would prefer to use it. Another end being met – and other ends being met as well.
Graph:
DO ICE SEVEN (a)