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What Is Economic Efficiency?
Efficiency is a relative term. It is vital that this
point be understood. Efficiency is never absolute; it is
always relative to some criterion. This can be seen when one
asks if farms are more efficient in the United States or
China. The farming techniques in China are more efficient
than those in the United States when measured in terms of
output per unit of land, output per unit of fossil fuel, or
output per unit of machinery. The farms in the United States
are far more efficient in terms of output per man-hour. The
statement that farms in one country are more efficient than
farms in another makes no sense unless the criterion on
which efficiency is measured is given.
The criterion for economic efficiency is
value. A change that increases value is an efficient
change and any change that decreases value is an inefficient
change. A situation that is economically efficient may be
inefficient when judged on different criteria. An example
may make this concept clear.
In the late 1960s, an electric utility in New York wanted
to build a storage facility at a location called Storm King
Mountain. The plans called for electrical pumps that would
force water up the mountain during the night to a storage
reservoir. During the day, the water would flow back down
the mountain to produce electricity. However, the laws of
physics reveal that it takes more electricity to pump the
water up the mountain than can be recovered when it flows
back down. Thus, this project cannot be energy efficient.
Still, the company wanted to build it because they believed
that it was efficient economically.
To understand the company's point of view, a brief
digression into methods of generating electricity is
necessary. Most electrical utilities rely primarily on very
large power plants that are fueled either by coal or nuclear
fuel. These plants take a long time to heat up or cool down;
they run best when they run at a constant rate. But the
demand for electricity varies over the course of a day. At
2:00 a.m., for example, it is very low; at 4:00 p.m. it is
quite high. Electric utilities have several options to meet
this daily fluctuation. On one extreme, they could run main
power plants at a high daily level, or peak demand, and
simply let any surplus electricity go to waste. At the other
extreme, they could run the main plants at the lowest daily
level and also run "peaking plants" to provide additional
power when it is needed. A peaking plant is a generator,
often fueled by natural gas or diesel fuel, that can be
turned on and off quickly. Although much cheaper to build, its
fuel cost per kilowatt is higher than with a main plant.
The utility company in the Storm King case would have
used electricity generated during periods of slack demand,
when electricity was "cheap," to pump water, and would have
generated electricity with the water during periods of peak
demand, when electricity was "dear." The company believed
that this was the cheapest way it could meet the daily
demand for electricity, and hence thought that it was
economically efficient.
Value is subjective. A thing has value only if someone
wants it. How then can we know if value is maximized? If
there is some change that makes someone feel better off, but
making this change does not make anyone feel worse off, then
the original situation was not one of highest value.
Improvement was possible. When the highest value is reached,
then any possible change that helps anyone must harm someone
else. This way of defining economic efficiency, Pareto
optimality, is named after Vilfredo Pareto, an early
mathematical economist.
Economists are interested in economic efficiency for two
reasons, one positive and the other normative. The positive
reason is based on the observation that people search for
value. We see this search for value vividly illustrated in
the occupations of pimp, drug pusher, and hit man; given
enough money, any occupation, no matter how immoral or
risky, will attract people. On the theoretical level, we
have seen this search for value in discussing utility
maximization and profit maximization. The search for value
is the driving force of market (and perhaps most nonmarket)
economies. If there are situations in which there is
unexploited value, that is, value that is possible but which
no one obtains, the economist needs to explain why someone
does not find a way to capture this value.
The normative reason stems from a desire to make policy
recommendations. It is possible to discuss some aspects of
policy without normative assumptions. An economist can
predict, for example, whether a policy will or will not
achieve the goals set for it. But economists often want to
do more. They often want to compare two policies or two
situations and decide which is better. To decide which is
better requires some sort of basis for ranking situations.
Thus, if they want to ask whether government regulation of
utility prices, a tariff on steel, or a program to train
unskilled workers helps society, economists need a criterion
on which to base their answer. Economists generally use the
criterion of economic efficiency to evaluate situations,
though they often supplement it with other considerations
because economic efficiency is not the only way to judge the
relative merits of two situations.
The value maximized in the notion of economic efficiency
reflects the goals people have. The concept of economic
efficiency treats all goals as equally valid; no goals are
considered better than other goals (with one
exception--envy--discussed in the following paragraph). Not
everyone agrees. Judging goals has been a central feature of
the Judeo-Christian tradition. Generally, this tradition has
condemned as immoral goal-seeking that emphasizes the most
narrow individualism such as hedonism. To be moral, people
must take into consideration the well-being of some others
as a goal, including family or clan members and others who
are members of a community grouping.
The one goal as a goal economists outlaw (usually by
ignoring it) is the desire to harm others, or envy. If one
person feels unhappy whenever another feels better off,
there is no possible way to rank situations. In addition,
envy is destructive of cooperation, and so it has few
supporters.
Not all goals are equal in determining value. The goals
of some are given more emphasis than the goals of others. In
a market economy, the goals of the rich are given more
weight than the goals of the poor. The rich have more
dollar votes.
If one dislikes the goals that people pursue, or if one
believes that the goals of some people--the rich--are given
too much emphasis and the goals of others--the poor--are
given too little, one may believe that an economically
efficient situation is inferior to one that is economically
inefficient.
Discussions of economic efficiency can be terribly
technical. But there is an easy
way to see what it is all about.
Copyright
Robert Schenk
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