Freeman

ARTICLE

Economic Efficiency

Value Is Determined by More than Money and Material Considerations

MARCH 01, 2001 by DWIGHT R. LEE

Economic efficiency is the standard that economists use to evaluate a wide range of things. Economists who favor markets argue that they generate outcomes more efficient than do socialism or government regulation. As we shall see in the next few months, economists don’t like pollution because it is inefficient. This emphasis on efficiency seems strange, if not reprehensible, to many people. They are convinced that economists are so narrowly focused on efficiency that they ignore the truly important things in life. Who but someone lacking completely in a sense of what makes life meaningful doesn’t recognize that pollution is bad because it harms the environment? We should get rid of it whether or not it is efficient.

This criticism is unwarranted, though understandable. Efficiency is a tricky concept. Once it is understood what economists mean when they refer to efficiency, it becomes clear that it is a much broader, and more desirable, goal than many people realize.

Technical versus Economic Efficiency

People often think of efficiency as an objective ratio of inputs to outputs. For example, they sometimes argue that the internal-combustion engine is inefficient because only a small percentage of the energy in the gasoline is converted into motion. Furthermore, the argument continues, it is possible to build engines that convert a larger percentage of gasoline energy into motion. But such objective measures of technical efficiency are meaningless by themselves because they leave out the relative values people place on things, values that are necessarily subjective. Even the argument that the internal-combustion engine is inefficient depends on valuing motion, which people do. But motion is not the only thing they value. For example, much of the energy in gasoline is converted into heat, some of which can be channeled inside the car. So even if all the energy in gasoline could be converted into automotive motion (which it can’t), people in cold climates would be willing to sacrifice some of this technical efficiency to heat their cars. This reduction in technical efficiency would increase economic efficiency, which involves making marginal sacrifices of one thing (motion) to obtain marginal increases in something people value more (heat).

One might argue that we should make engines as technologically efficient as possible since, even if we did, there would still be enough heat generated to warm a car. But this ignores the subjective value people place on lots of things that must be sacrificed to increase technical efficiency. Sure, new engines might convert more of the energy in gasoline into motion, but doing so would require diverting resources away from producing other things of value. Long before technical efficiency was maximized, the marginal cost of improving that efficiency would exceed the marginal value. This would reduce economic efficiency because it requires sacrificing more value (marginal cost) than is realized (marginal value).

Fortunately, market prices provide the information and motivation required to achieve economic efficiency. For example, engine producers increase profits by improving the technical efficiency of engines until the marginal revenue from the improvement declines to the marginal cost. Since marginal revenue tends to reflect how much consumers value additional improvement, and the marginal cost reflects the value of the goods and services sacrificed to make additional improvement (since input prices reflect their value in alternative uses), engine producers increase their profits by improving engines only as long as they add more value than is sacrificed. That’s not technically efficient, but it is economically efficient because it increases the total value realized from scarce resources.

Our discussion of economic efficiency should provide comfort to those who worry that we are wasting resources by using more than we need. We do use more of some resources than we need, but that is not wasteful if it allows us to create more value. In the engine example, using additional gas in technically inefficient engines frees resources to create more value than the gas is worth. This is not fundamentally different from leaving a light on in the bathroom because I am watching an exciting golf match on TV, something many would say is wasteful. But it’s not! Sure, I’m using more electricity than I need, but by doing so I’m using my time for something I value more than the electricity I could save. (If not I would have left the program and turned off the light.)

Electricity provides another good example of increasing economic efficiency by doing something easily seen as wasteful. Almost 20 percent of the hydroelectricity used in the United States is produced by pump-storage, the use of electricity to pump water uphill into a reservoir so the water can be released to generate electricity. It takes significantly more electricity to pump the water uphill than is generated when the water runs back downhill, so pump-storage is clearly not technically efficient. But pump-storage is widely used because it increases economic efficiency and avoids waste. The value of a kilowatt of electricity depends on when it is available. Late at night, additional electricity is worth much less than it is during the day and into the early evening. So electricity can be used to pump water uphill from midnight until early morning with little value sacrificed. That lost value is more than made up by the value of the electricity produced by releasing the water during the day when electricity is very valuable. Pump-storage reduces the amount of electricity available to consumers, but it increases economic efficiency and reduces waste by shifting availability from periods when it is worth less to periods when it is worth more.

Freedom and Efficiency

People often argue that wide-ranging government restrictions on our freedom are necessary to promote efficiency. But economic efficiency is impossible without freedom because it is not the narrow concept many accuse it of being. It is about increasing value as determined by the diverse and subjective preferences of hundreds of millions of individuals. The only way people can effectively communicate information about their values to those best able to respond is through the freedom to engage in market transactions for whatever and with whomever they choose. This freedom, for example, allows a person to take what seems to be a less-productive (and lower-paying) job than he could have because he enjoys the work, or prefers the location, or feels a duty to care for elderly parents, or numerous other reasons that can be fully known only to those faced with the particular tradeoffs involved. The freedom to take the lower-paying job, and to make any other choice in a free market, is essential for economic efficiency because value is determined by far more than just money and narrow material considerations.

ASSOCIATED ISSUE

March 2001

ABOUT

DWIGHT R. LEE

Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.

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