Economic efficiency is one of the most important concepts economists use to classify and understand the social world. Unfortunately, it is also one of the most misused. There are two aspects of economic efficiency, the positive and the normative, both of which must be understood in order to apply the concept fruitfully. The former involves analyzing whether a given state of affairs is or is not efficient; the latter involves ascertaining whether a given state of affairs ought to be changed, presumably in favor of a more efficient one. This essay will show how, after going over the positive aspects of efficiency, misunderstanding efficiency results in unjustified normative conclusions wherein efficiency becomes the stated motivation for public policy that (unintentionally) impedes the achievement of other social goods. The essay will conclude by arguing that economists’ misuse of one of their fundamental concepts is a consequence of their misunderstanding the scope of their discipline.
A situation is economically efficient if it is impossible to make any individual better off without making other individuals worse off. In this context, ‘better’ and ‘worse’ refer to individuals’ own estimations of their welfare. (We are still in the realm of positive economics; all we are claiming is that individuals can be better off or worse off, in reference to their own value scales.) One reason that economists tend to look favorably on markets as institutions for exchanging and allocating resources is that they tend towards efficiency. Provided background institutions protect private property rights, enforce contracts, and uphold a general and nondiscriminatory rule of law, the nexus of exchange relationships economists call ‘the market’ comprises individuals trading with each other in mutually beneficial ways. As long as nobody is coerced into an exchange, the only reason anyone would enter into an exchange is that they expect to be made better off. (Individuals can make mistakes, of course, but this does not change the fact that ex ante, voluntary trade is win-win). In a hypothetical state of affairs where no additional mutually beneficial trades can be made, each individual has been made as well off as possible, conditional upon not forcibly redistributing resources, which would improve some individuals’ wellbeing at the expense of others’. Gains from trade have been exhausted; the situation is efficient.
A property of economic efficiency to which economists pay significant attention is the maximization of the dollar value of society’s scarce resources. To see why efficiency entails maximizing the value of society’s resources, imagine a simple scenario where an auctioneer is auctioning off an apple. Suppose Allen is willing to pay, at most, one dollar for the apple; Bob is willing to pay, at most, two dollars. Imagine after bidding one dollar, Allan is given the apple. Is this situation efficient? Clearly not; both Allen and Bob could gain, in their own estimation, by engaging in a further exchange: Assuming for convenience no trades take place when individuals are indifferent between the apple and its dollar price, Allen would be willing to sell the apple for $1.01 or more, and Bob would be willing to buy the apple for $1.99 or less. Whatever intermediate price for the apple is reached, it will be priced for more than the one dollar bid by Allen. What is true in this simple example is true of markets in general: arbitrage of goods across space and time (buying low in one town and selling high in another, simultaneously buying and selling options contracts, etc.), cost minimization efforts within firms, and entrepreneurial discovery all tend to maximize the value of society’s resources as the result of competitive bidding and cooperative exchange within markets.
Here’s where things get tricky. Maximizing the value of resources is not economic efficiency, but it is sometimes treated so by economists. The above scenario showed that the dollar value maximization of society’s resources was a consequence of the efficiency-tending market process. Note that efficiency is an ‘emergent’ property of markets. It is unintended and undesigned by policymakers and market actors alike. It is a bottom-up process that is governed by the institutions within which market exchange takes place—property protection, contract enforcement, rule of law—and cannot meaningfully be divorced from this process. It is easy to fall into the trap of thinking that, because a more efficient situation is welfare-enhancing, and that a higher dollar value on the price tag of society’s scarce resources entails increased efficiency, public policy should be aimed at redistributing resources such that the dollar maximization criteria is satisfied. But public policy of this kind severs the link between efficiency and welfare, because it confuses the consequence for the cause. When economic efficiency becomes a goal of public policy, uncritically jumping from the positive to the normative, it is no longer the unintended result of individuals engaged in exchanges, who directly bear the costs and benefits of their actions. Instead it becomes an imposition of one group’s (policymakers and bureaucrats) ideas on more preferred resource allocations on other groups (traders in the marketplace). Frequently, the former reap the benefits of this arrangement, but the latter bear the costs.
Attempting to engineer economic efficiency in a top-down manner, rather than appreciating the necessity of it emerging in a bottom-up fashion, can result in the unintentional destruction of other social goods. For example, the modern economics literature is saturated with papers that purport to show that various exchange relationships are replete with ‘market failures’—situations where individual exchanges fail to maximize economic efficiency, either because individuals do not realize the true costs and benefits of their actions, or because individuals ignore some of the costs and benefits of their actions because the costs and benefits accrue to third parties. These are very real possibilities in economic life, and they frequently call for some sort of institutional solution. But the blunt instruments of regulation and redistribution, especially in the modern bureaucratic-managerial state, are ill suited to solve these problems. Tinkering with markets as if they were machines almost always undermines the integrity of property rights, implicitly re-writes contracts, and makes law arbitrary and unpredictable. As we have previously seen, commercial relationships cannot flourish in this sort of environment. Although the stated intention of these policies is to improve the working of markets, the actual result is in eroding the background conditions for markets to function in the first place.
The above highlighted some problems with the use of economic efficiency as a normative justification for correcting markets. There are also difficulties with efficiency as a normative criteria in itself. For example, efficiency refers to individuals’ self-estimated welfare, which means it is judged with respect to individuals’ own preferences. But it may be that individuals’ preferences are best satisfied by engaging in behaviors that undermine the previously-discussed institutions that preserve a free and prosperous commercial society. ‘Giving people what they want’ is a contentious normative criterion when what people want is itself normatively contentious! These concerns and a host of others are difficult for the economics profession, as it currently exists, to handle. This is because modern economics conceives itself as part positive science, part social engineering. But this was not always so. Economics, back when the discipline was referred to as ‘political economy,’ had just as much to do with the humanities and ethics as it did social science. A return to a broader conception of economics—‘between predictive science and moral philosophy,’ in the words of economics Noble laureate James Buchanan—is necessary if economics is to serve the ends of rendering the social world intelligible, and understanding the requisite institutional framework for the ‘good society.’ Economists frequently misapply their core tools, such as efficiency, because they have lost sight of the potentialities of their discipline. Even state of the art tools can only be put to clumsy use when in the hands of the untrained.
This essay is based on Alexander Salter’s academic paper, ‘Playing at Markets: A New Austrian Perspective on Macroeconomic Policy.’
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Editor’s note: The featured image is “The Wealth of Nations” by Seymour Fogel, courtesy of Wikimedia Commons.