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Saturday, March 1, 2008

Misunderstanding Efficiency

Virtually Every Government Intervention Made in the Name of Efficiency Is Tainted with Logical Abuses

Gary Galles is a professor of economics at Pepperdine University.

Efficiency—getting the most value from a given amount of resources—is important in a world of scarcity. The more efficient people are, the better off they can make themselves. That’s why economists are always talking about efficiency. Unfortunately, what economists have to say on the subject is frequently misunderstood or misleadingly portrayed. A primary reason for this is the confusion about what economists actually mean by the term.

Economists do not mean technical efficiency, in the sense that the most efficient car is the one that gets the most miles per gallon. Gasoline is not the only scarce good. As a result, it is sometimes cheaper to “waste” gasoline in order to have more of other things we value more, such as safety, room, style, or acceleration. What people value more depends on their preferences and circumstances (which only those individuals know—a major reason why centralized decisions about what is efficient fail, as they do in other areas). Each of us may be willing to sacrifice some gasoline for more of other things. The same is true for all the other goods we trade off against one another every day.

Similarly, efficiency does not necessarily (or even usually) mean state of the art. Many of the costs of doing things “the old way” have already been incurred—for example, the cost of existing capital equipment—and need not be borne in the future. In contrast, doing things the “new and improved” way does require that new investments be made and new costs incurred. For many, the added benefits or savings do not justify those added costs, making the old way more efficient in their circumstances. That is why most people do not live in the latest house or drive the latest car, and why airlines fly a variety of older planes as well as newer ones.

Efficiency does not necessarily mean the absolute cheapest, but it does mean the lowest-cost way to do something at a given level of quality. The efficient widget (economists’ traditional undefined good) is the lowest cost one at a given quality. But when anything beyond the lowest quality is desired, efficiency does not mean the cheapest widget. This point is often misunderstood, which may be why non-economists so often incorrectly believe economists think efficiency requires reducing quality to the lowest possible level in order to lower costs. That ignores an added aspect of efficiency—the efficient level of quality. Economists know, but often communicate poorly, that efficiency results in higher quality whenever those involved believe that the added value of the higher quality justifies the higher cost of achieving it.

Similarly, the most efficient way to make widgets in small volumes is not the same as for large volumes. As a result, when smaller volumes are planned, the lower costs that could be achieved if far greater volumes were desired are irrelevant as a standard of efficiency.

Misunderstanding efficiency also arises from the belief that the question “what is efficient?” has an objective, universal answer, so that it is just a matter of turning things over to experts. In fact, the first part of the answer to general efficiency questions is, “it depends,” because any number of changes in circumstances or relative scarcities can change the answer. That is why the second, much harder part is to recognize the many variables that the answer can depend on and how much it depends on them. This is sometimes illustrated by “ugly American” tourists in a foreign country who see locals doing things differently and conclude that they are wrong or stupid. Actually they just face different circumstances, making their different ways efficient for their particular situations.

Potential Compensation

These confusions could be avoided if economists were clearer in explaining their valid insights into efficiency. But beyond a lack of clarity, an even greater threat to understanding is that economists have trained people to ignore their pronouncements on efficiency. Economists’ use of a standard of efficiency known as “potential compensation” is a major reason for this.

Say there was a policy that supposedly produced $100 in benefits for Adam and imposed $40 in costs on Eve. In that situation Adam could conceivably compensate Eve with something between $40 and $100. If such compensation was actually arranged and voluntarily agreed to, both parties would reveal their beliefs that the result was efficient because both expected to benefit. This is what happens in voluntary market transactions. However, in public policy, compensation is not generally paid to the losers, so “potential compensation” is a misleading guide.

When compensation is acceptable and paid, all parties get more than they give up. In such cases, what economists call efficient is nothing more than what is efficient for each individual. There is no social entity for which things can be efficient or inefficient. But when compensation is not paid, what is alleged to be efficient for society need not be efficient for each party. This violates the essential understanding economists have of an increase in efficiency—at least one party is made better off and no party is made worse off. In the example above, Eve is made worse off by a supposedly efficient policy. That is why we so often see people strenuously object to “efficient” policies, requiring government coercion to enforce the supposedly beneficial “solution” over their objections.

Sometimes people ignore economists’ efficiency claims because of the economists’ tendency to say something is efficient if the “right” or “optimal” quantity of output is produced. Unfortunately, even if that quantity (which is unknowable in the absence of a market process) were to be produced, affected parties could not know if it would actually benefit them until they knew how the cost burden would be distributed. Those who turn out to be disproportionately burdened could easily be made losers. This discrimination, whether imposed through regulations (such as restrictions imposed on owners of affected properties under the Endangered Species Act) or taxes (such as through progressive income taxes), breaks the connection between alleged efficiency and the well-being of those affected.

If an allegedly efficient policy does not mean that Eve is better off, why should she listen to those who say we should do what is efficient? Those in her position (and all of us are all too frequently placed in exactly that position) learn to ignore efficiency pronouncements as irrelevant to the real question—“Am I helped or hurt?” As a result, people learn that if they are helped (their benefits exceed their costs), they don’t care if it is accomplished through means economists would term inefficient. On the other hand, if they are hurt (their costs exceed their benefits), they don’t care if economists term it efficient. In contrast, market exchanges by their nature are restricted to those the parties involved agree are efficient.

Many economists also employ an unattainable efficiency standard to find alleged market failures everywhere. That standard is the model of perfect competition, which assumes away such “minor” real-world issues as uncertainty; differences in information; changes in products, processes, or preferences; marketing; search costs; future goodwill effects of present actions; entrepreneurship; and more. In fact, it assumes away almost every source of change that could make creating new voluntary arrangements efficient for participants. But failing to conform to a model that assumes so many issues away hardly establishes the real world as lacking efficiency.

Further, perennial market critics not only see market failures where they don’t exist, they often blame what are really government failures on the market. (For example, they talk about market failures in health care, when that is one of the most subsidized, mandated, restricted, and regulated markets in America.)

Making things worse, many also jump from undemonstrated assertions of “inefficient” market failures to the non sequitur that government will increase efficiency by intervening. That ignores a mountain of evidence documenting government inefficiency everywhere one looks, which means that even situations that fall well short of perfect efficiency standards most likely will not be improved, and may be dramatically worsened, by government “solutions.”

Despite gaping holes in logic, efficiency language is used to support all sorts of government programs that simply ignore this and other problems, such as rent-seeking and corruption. Instead, efficiency promises can always be heard from some economists—those whom Henry Hazlitt called “the best buyable minds.” They look at short-run effects while ignoring often far more important longer-term effects; they ignore or undercount relevant costs (including the additional costs to society from the distortions caused by the additional taxation); they overcount benefits (alleging, for example, multiplier effects of spending, while ignoring the same multiplier effects on the opposite direction from the taxation required); they count benefits as costs (many government projects are alleged to generate income and jobs, as if they were both benefits, when only the income is a benefit, and the jobs are the costs people incur to get the added income); and perform a host of other logical contortions to justify the unjustifiable.

Thinking in terms of efficiency can be helpful in increasing our well-being. But misusing efficiency logic and language is also a powerful source of misunderstanding. Whenever arguments are couched in efficiency language, one must evaluate them with great care before giving them credence. There are some indicators that show when distrust of alleged efficiency improvements is appropriate.

Disguised Transfers

If the people who know all the relevant circumstances and tradeoffs continue to do something, they must believe it is efficient for them. So overturning their decisions by government fiat is prima facie evidence that inefficiency will be created. If people object to having a supposedly efficient policy imposed on them, that policy violates the standard that no one is made worse off. And when efficiency language disguises the transfer of decision-making over a person’s property to someone else, making the beneficiary the effective owner without paying for the privilege, the transfer is not really about efficiency.

Unfortunately, virtually every government intervention made in the name of efficiency is tainted with logical abuses, unless viewed as a way for the beneficiaries to more efficiently take what belongs to others. As a result, the word has been demoted from a useful term of analysis and insight to little more than another warning to watch your wallet.

  • Gary M. Galles is a Professor of Economics at Pepperdine University and a member of the Foundation for Economic Education faculty network.

    In addition to his new book, Pathways to Policy Failures (2020), his books include Lines of Liberty (2016), Faulty Premises, Faulty Policies (2014), and Apostle of Peace (2013).