Who is Efficient?

Mr. Summers is a member of the staff of the Foundation for Economic Education.

Which businesses make the most efficient use of the factors of production: natural resources, labor, and capital goods? That is, which businessmen are the least wasteful in their efforts to market goods and services?

To find the answer, we must have a means of comparing a businessman’s product with the factors of production he has used in its creation. That is, we need a standard that applies to goods and services as well as to natural resources, labor, and capital goods.

At first glance, this is a pretty tall order. We usually think of raw materials in terms of tons, labor in terms of hours, capital goods in terms of tools, and products in terms of usefulness. How does one compare usefulness with tons, hours, and tools?

Fortunately, in a free market we are not forced into such arbitrary decisions. For when the market is free, we need not think in terms of natural resources, labor, capital goods, goods and services per se, but rather, we may use prices the market attaches to these items.

Is free market pricing the proper standard to use in judging business efficiency? We will know the answer when we understand how free market prices come into being.

When the market is free, businessmen present customers with goods and services, and asking prices for these goods and services. Of course, consumers are not forced to buy from any one merchant. If they feel that a given merchant’s asking price is too high, they take their business elsewhere. Competition among businessmen causes them to base their asking prices on their anticipations of how consumers will react to these asking prices. Only when a customer reacts favorably does an asking price become a selling price.

Thus, businessmen are guided by consumers in the formation of prices of consumers’ goods. How are prices of the factors of production determined?

Businessmen bid among themselves for natural resources, labor, and capital goods. However, here again businessmen are guided by consumers, for their bids are based on their anticipations of customers’ reactions to the goods and services these factors will be used to produce. Hence, a given factor of production will go to the businessman who feels he can put that factor to the most valuable use. Valuable to whom? Valuable to the person whose favorable reaction the businessman seeks — the consumer.

We have thus found a standard — free market pricing — that applies to raw materials, labor, capital goods, goods and services. How can this standard be used to judge business efficiency?

From the point of view of consumers — and we are all consumers — the answer is straightforward. Businesses whose expenditures for factors of production are less than their sales of goods and services have made efficient use of factors of production. Businesses whose expenditures exceed their incomes have made inefficient use of these factors. Hence, businesses that earn profits are efficient; businesses that lose money are inefficient.

In a free market we can use prices to test business efficiency. However, as government interventions take us away from the free market, we lose our simple test, and it becomes more and more difficult to judge efficiency.

Government interventions influence prices in many ways. Controls on wages and prices are obvious examples. When wages and prices are set by the government, and not by consumers, businessmen still seek profits, but such profits are an indication that a firm’s governmentally determined revenues exceed its governmentally determined expenses, not that a firm has efficiently served consumers.

Other forms of intervention also influence prices. Zoning, tariffs, import quotas, export restrictions, I.C.C. regulations, rent controls, minimum wage laws, union monopoly privileges, and so forth affect business balance sheets in countless ways. The more these balance sheets are affected by the government, the less they are affected by consumers. And the more the government interferes, the less valid the consumers’ test of efficiency becomes.

The ultimate intervention is government control of an industry. Mail delivery is a good example. Is the Post Office efficient? It loses hundreds of millions of dollars every year. Suppose postal rates were raised to show a profit. We would still have no way of judging Post Office efficiency because consumers would still have nowhere to turn for lower rates and/or better service. Postal rates are not determined by consumers, but rather, are set by bureaucrats backed by a police force standing ready to imprison anyone who challenges the Post Office’s legal monopoly.

Only in a free market, where businessmen face constant competition, can business efficiency be tested, for only in a free market can consumers encourage efficient production with profits and discourage inefficient production with losses.