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The Trouble With Efficiency

April 11, 2001

I'd like to examine a technique by which interventionism is often justified: the appeal to efficiency. The basis of the technique is the employment of neoclassical equilibrium analysis to demonstrate that the free market has produced an "inefficient" outcome, and to recommend some government intervention that will rectify the situation, leading to increased "social utility."

A leading proponent of such analysis, Judge Richard Posner, has "described the common law as a tool to maximize aggregate social wealth." (I'm quoting Steve Kurtz, interviewing Posner in the April 2001 issue of Reason Magazine.)

Steven Landsburg, in his textbook Price Theory, gives an example of the use of the efficiency criterion for resolving legal disputes among individuals. A group of ten students would like to burn down their professor's house; the professor is not in favor of the idea. Landsburg explains how to use the efficiency criterion to settle this dispute:

According to the efficiency criterion, everyone is permitted to cast a number of votes proportional to his stake in the outcome, where your stake in the outcome is measured by how much you'd be willing to pay to get your way. So, for example, if ten students each think it would be worth $10 to watch the professor's house go up in flames, while the professor thinks it would be worth $1,000 to prevent that outcome, then each of the students gets 10 votes and the professor gets 1,000 votes. The house burning is defeated by a vote of 1,000 to 100.

Some of the problems with this approach should be obvious. First of all, what if it was just the professor's tool shed the students wanted to burn? Perhaps they really love to watch fires, and would be willing to pay $100 each to watch the shed burn. Meanwhile, the shed is only worth $500 to the good professor. It's "efficient" for the students to go ahead and burn down the shed, even if they never have to pay the professor. One thousand dollars of "utility" has been gained at the expense of a loss of only $500 of utility.

Let's momentarily set aside any moral compunctions we might have about allowing people to destroy or abscond with another's property simply because they enjoy this more than the owner suffers from the loss. Even on its own terms, this efficiency analysis is a failure, because it doesn't take into account the loss of efficiency in a society when people don't feel their property is secure. Of course, such a number is incalculable, because different social arrangements do not appear as goods for sale on the market, so that none of us has any idea of how to price such things.

Just because we can't calculate such a figure doesn't mean that secure property rights have no value; we might suspect, in fact, that this value is enormous. Several authors have recently written books stressing the importance of property rights for prosperity, including Tom Bethell (Noblest Triumph: Property and Prosperity Through the Ages) and Hernando De Soto (The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else).

De Soto, for instance, says that the ordinary people of Third World countries have a great deal of property, but that they are hindered in exploiting it because they do not have a clear, recognized title to the land. He estimates that 81 percent of the rural land in Peru is owned without legal title, while in Egypt, well over 80 percent of all land is owned in such a fashion. If these authors are correct, then a calculation of efficiency that leaves out the effect of secure property rights is like an estimation of the effect of a nuclear bomb that takes into account all relevant factors except the nuclear reaction itself.

The second problem with this analysis is that the "prices" used are not prices at all. The parties involved are only asked to say how much something is worth to them. Why not just pick a really big number? If you're not going to have to pay the price, then what the heck, just name it--simply say that it's worth a billion dollars to you to see the prof's house burn. Various tricks, involving possible consequences for lying, can be used to try to get around this problem, but none of them solve a more serious problem: We don't know how much we value something until we really have to pay for it.

Imagine, if you will, that we visit a children's swim club, and ask the kids if they're willing to make the sacrifices necessary to become an Olympic champion swimmer. We'd probably get many positive responses, despite the fact that perhaps only one in ten thousand young swimmers really is willing to pay the costs of becoming an Olympian. Efficiency analysis implies that we'd be better off if we just ask the swimmers what they would sacrifice to make the Olympics, and then appoint those who bid the highest to the team. Think of all that training time that would be saved!

It is only in the process moving toward a goal and experiencing the costs ourselves that we discover what those costs really are. This is what Israel Kirzner terms entrepreneurial discovery. A smoker suffering from a bad cold may swear he'll never smoke again, but it will not be until he feels better and is offered a cigarette that even he can discover if this is true. Without actually undertaking the discovery process, "costs" are simply guesses as to what the costs might turn out to be.

Efficiency analysis also assumes that the prices we arrive at by such quizzes are equilibrium values; in other words, they are final prices. For this to be true, everyone would have to agree on the future usefulness of all of the factors of production. But Austrian economist Peter Lewin points out:

The whole [market] process is driven by differences in opinion and perception between rival producers and entrepreneurs. The value they place on the resources at their disposal or which they trade are not, in any meaningful sense, equilibrium values. They reflect only a "balance" of expectations about the possible uses of the resources. One cannot use such values meaningfully in any assessment of efficiency…

The problem Lewin describes plagues the use of Pareto optimality as a criterion for justifying intervention as well. Under this criterion, a policy is "good" if at least one person affected by the policy is better off because of it, while absolutely no one is worse off. In simple cases where we can clearly see a Pareto optimal solution, we can just voluntarily implement it. If I'm sitting around with three of my friends, and we all feel we'd be better off if we were playing bridge, then we can simply play bridge; we don't need a "policy" implemented to get the game going. In real-world policy situations, it's almost impossible to conceive of finding Pareto optimal solutions. Even a policy that would unambiguously result in everyone in the country having more goods would not meet with the approval of many environmentalists and ascetics.

Somewhat ironically, since ideas like the efficiency criterion are often used to justify government intervention in the economy, market prices are the sole means by which we can move toward economic efficiency. It is only when people must actually pay the cost of their choices that we can be sure that, at least in their eyes, the choice is worth the cost. The only way we can know how much it is worth to the students to burn the professor's house, and how much that house is worth to the professor, is if the students really have to pay the professor enough that he agrees to let them go ahead. State intervention destroys the very mechanism by which the market achieves efficient outcomes.

These criteria and others like them are attempts to formulate a "scientific" measure of "better" economic outcomes that stand apart from the value judgment of the person who is classifying the outcomes. But only human judgment creates the categories of "better" and "worse," and all judgment is individual judgment.

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Gene Callahan, who writes frequently for Mises.org, is working on a book called Economics for Real People. See his Archive or send him MAIL


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