Mises Wire

Why the Misuse of the Word “Efficiency” Is Such a Problem

An important impediment to understanding valuable insights economists have to offer is that they have trained people to ignore their pronouncements on efficiency. Economists’ common use of a standard of efficiency known as “potential compensation,” which is at odds with a more important concept in which efficiency is advanced whenever there is a Pareto improvement (named after Vilfredo Pareto), is a major reason.

Say there were 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. That would make such an arrangement a Pareto improvement, because those whose rights were involved were made better off, and no one was harmed. 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, because some lose, violating the Pareto standard.

When compensation is acceptable and is paid, all parties get more in value than they give up. In such cases, what economists call efficient—in that there is the potential, via compensation, to make all parties better off—is same as what each individual sees as enhanced efficiency for themselves. In that case, there is no gap between the Pareto standard and that based on potential compensation.

But when compensation is not paid, what is alleged to be efficient for society under the potential compensation standard need not be an efficiency improvement for each party. This violates the Pareto standard, because some parties involved are 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.

The confusion can be compounded by economists’ tendency to also say that something is efficient if the “right” or “optimal” quantity of output is produced. Unfortunately, even if that quantity (unknowable in the absence of a market process to reveal it) 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 losers, despite such supposed efficiency. This discrimination, whether imposed through regulations (e.g., restrictions imposed on owners of affected properties under the Endangered Species Act) or taxes (e.g., through progressive income taxes), breaks the connection between alleged efficiency and the enhanced well-being of those affected.

These confusions train others to ignore economists’ efficiency statements when dealing with what Franz Oppenheimer termed “the political means” of seeking one’s self-interest. 

If an allegedly “efficient” policy does not make Eve better off, why should she care whether economists term the policy efficient? Those in her position (which all of us all too frequently are in) 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 call 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 which the parties involved agree are efficiency enhancing.

Economists’ pronouncements about “efficient” programs, poorly explained if explained at all, are used to support all sorts of government programs that violate the most central meaning of efficiency—the Pareto standard of gains, but not losses, to willing exchange participants. Yet such efficiency claims can always be heard from some economists—whom Henry Hazlitt once called “the best buyable minds,” in Economics in One Lesson.

As Hazlitt (and others) laid out, they sometimes look at short-run effects while ignoring often far more important longer-term effects; ignore or undercount relevant costs (including the additional costs to society from the distortions caused by the additional taxation); overcount benefits (alleging, for example, multiplier effects of spending, while ignoring the same multiplier effects in the opposite direction from the taxation required); 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. And such warping of benefit-cost analysis from a technique to analyze issues more carefully and systematically, as Ben Franklin used it, into a framework to misrepresent them more convincingly, supports false claims that harming those affected increases efficiency.

Thinking in terms of efficiency can be helpful in increasing our well-being. But economists’ sloppy and inconsistent use of “efficiency” is a powerful source of misunderstanding. That is why whenever arguments are couched in efficiency language, one must evaluate them with great care before giving them credence.

In particular, a crucial underlying principle is that if the people who know the relevant circumstances and tradeoffs continue to cooperate across markets, they must believe it is efficient for them to do so, given their circumstances and alternatives. So overturning their decisions by government fiat is prima facie evidence that inefficiency will be created. Similarly, 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 justified by claims of enhancing 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, efficiency has largely been demoted from a useful term of analysis and insight to little more than another warning that the wise should watch their wallets.

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