What is Economic Efficiency?

Comparative advantage was one of the great lessons of the classical economists. David Ricardo is credited with the discovery and the argument for trade that is now popular. This was an early example of what we might understand as economic efficiency. You can think about the wine and cheese production that ca0n be done in one hour in say Switzerland vs. Portugal. 

Bottle of Wine/HourWheel of Cheese/Hour
Switzerland53
Portugal42

Looking at this diagram, it seems that Switzerland is a more productive country and would not need to interact with the less productive Portugal. This was not what was empirically observed in the days of Ricardo. Countries would import resources from countries that would appear to produce them less efficiently. If we think about the cost of wine in terms of cheese, then we would understand why. If you are in Switzerland, then for every bottle of wine you could instead produce 0.6 wheels of cheese. If you are in Portugal, then for every bottle of wine you could instead produce 0.5 wheels of cheese. This means that to produce wine is more expensive in Switzerland compared to Portugal in terms of Cheese. So it is more efficient to produce Cheese in Switzerland and trade with Portugal to get wine. By trading, both countries mathematically will maximize their access to wine and cheese. 

This kind of reasoning is about specialization and efficient use of resources with alternatives. Ideally, you want to use the least quantity of labor and raw materials to make the same good. This provides us with an interesting answer to another related question; Why do we trade? If you want something and someone can provide it cheaper, then you will go with the person who can do it cheaper rather than do it yourself. But this hardly explains why you want something. What makes something value to you? Certainly not the effort and labor you put into it. There are a lot of things you could put time into, but you choose not to for good reasons. If you feel hungry, you might want to get some food. But if you are full and satisfied, then food is not that big of a concern. These feelings are entirely subjective.

We need to understand that people make decisions based on fulfilling things they subjectively value. You might like apples and being willing to spend more money to get apples than another. You might be best suited towards picking apples and find that it is the best use of your time. In this sense, we have our understanding of supply and demand. 

If you benefit by $10 from the consumption of an apple, then you would be willing to pay up to $10 to have that apple. If it costs $1 to pick an apple, then you are willing to pick that apple if you can sell it for more than $1. The reasons for these can just be a matter of preference. Maybe you really love eating apples or enjoy picking apples. Your cost and benefit can also be relative to other material alternatives, such as we talked about in comparative advantage. The cost to pick the apple is not just the effort, but also the opportunity to fish or something else you could be doing with your time.

We see from this diagram, that a price is established where people can no longer get more benefit without exceeding the cost to others. Trading at a price is efficient, because people who can get more gain than you from something are willing to compensate you more than something is worth to you. All parties involved gain from such interactions. These gains from trade are Pareto Efficient outcomes. This means that everyone benefits so far as no one can be harmed.

So we have this economic story about everyone benefiting, but there is a question you might ask. What about harming some people to benefit others? Well if we want to do it in an efficient manner, then we have to decide how much harm is worth the benefit of another. This is a tricky question, but there is a solution if we go back to thinking about supply and demand. Here we want to think about what happens when we tax something. Taxation is just a means of taking from one group and giving to another. It is harming some people to benefit others. 

Well the tax imposes a cost on people who want to make a trade. This means that less trades would occur. But how can we measure the harm? One solution is the difference between supply and demand in the area of lost trade. These are trades where people will get more value, because they are willing to pay a price higher than the cost. The benefit minus the cost here is the gains unrealized or deadweight loss. This logic is very useful, because it does not rely on defining what is good for people. You just assume people act out what is in their own interest and you observe. Taxes in this case prevent society from realizing these benefits. This is the basics of economic welfare analysis.

Does this mean that taxes and other forms of redistribution provide no benefit. Well by the standard we set there are situations where taxes are actually very efficient. What if there are costs that are external to the buyer and the seller. You can think of the fact that various products require pollution to produce. When you buy some product that requires pollution, you donโ€™t think about the effects that it causes to society. This is because it makes the environment a little worse off. Now imagine if we had a situation where everyone did this and we had no mechanism to control this. 

In our supply and demand model, a buyer and a seller donโ€™t experience the external cost or in general externality by definition. This means that it doesnโ€™t affect their decision making. These costs are however real and means that people will engage in trade while it may benefit them, but cause harm to others. We can use the same tool of welfare analysis to measure the harm of externalities. This is looking at benefits and costs as what people are most willing to pay. In this case this additional cost is what people are willing to pay in order to not be polluted. 

Ideally we would want to find a way for people to make up for this social cost. Normally this would mean compensating the victims, but in many cases this is really hard. Welfare analysis gives us an interesting way to think about the problem. Some people are harmed and others benefit, but as long as benefits minus cost for every trade is positive, then there is no net harm. Now some people might benefit by some quantity of dollars and others might be harmed by some quantity of dollars, but as long as there is no net loss in value everything is fine. 

One solution is to actually just put a tax on the trade, this is called a pigouvian tax. Here you force the private cost to equal to the social cost. This means that the government benefits and others lose, but on the net it is balanced out. This is an efficient solution according to the scheme.

This kind of welfare analysis we have done here is based on Kaldor-Hicks efficiency. When most economists talk about economic efficiency this is usually what they mean. It preserves the logic of the more strict Pareto efficiency, which is that you determine benefit by the most you are willing to pay. In this sense, we can measure the harm of pollution by how much money people will pay to avoid getting polluted.

There are a few ways of critiquing economic efficiency as we have defined it. The main contention is whether we can say that $5 of harm towards one person is actually equivalent to $5 benefit to another. 

On one hand many people in economics argue that this is beyond the scope of economics as a science. Making these judgements requires a normative framework and amounts to utilitarianism. Regardless if you are a utilitarian, it is not something which is verifiable by science. If you reject utilitarianism you can default to Pareto or Mises. Ludwig von Mises, one of the fathers of modern micro-economic theory, basically rejects the idea of welfare analysis because of this methodological boundary. He saw the job of economics just to study human action. Economic policy is usually more concerned with making efficient allocations of resources. This has led to a kind of conflict between economic theory and economic policy. 

Now one way we can take this utilitarian analysis is to look at happiness instead of money. If you take $5 from a poor person and give it to a rich person, most people would think this is wrong. Now people are usually much more sympathetic to taking $5 from a rich person and giving to a poor person. Now you might be willing to even allow some economic loss inorder to transfer from the rich to the poor. Why would people have these feelings? Well people believe that at some point money causes less happiness for the rich. If we are being hedonic utilitarians where we want to maximize happiness, then we would want to think about how much happiness money causes. 

Here we need to look into the experimental research in happiness economics. The most advanced happiness models are of Stevenson and Wolfers. They propose that the causation of money to happiness is logarithmic. If you earn $10,000 per year, then in order to double your happiness under the model, you would need to earn $100,000,000. If this is the public policy model, then it would lead us to figure out what is the most effective taxation inorder to get the most money to redistribute for public happiness.

I think that all of these ideas have a truth to them, but we need to recognize that thinking about efficiency is making various judgments about how the world ought to be. I think each way of looking at the world gives us something useful, but is not the entire truth. It is a matter of philosophy and what is pragmatic towards the goals you want to achieve. Every idea here has a practical purpose.

Ideas which stress the benefits of private and cooperative behavior should not be undermined. We have been able to benefit so much by stressing the rights and freedoms of individuals. At the same time people establish themselves as rent seekers or engage in other types of behavior that harms others for their benefit. At the same time a study of human action needs to critically examine the psychology of people. If we want to make things feel better we should study what gives people satisfaction and try to work towards that. This later analysis is not always as obvious with the basic tools of economics as people have their own sets of biases. 

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