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What Is Economic Efficiency?

Efficiency is always relative to some criterion; it is never absolute. 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. For example, 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 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.1 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.

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1Plants using this principle have been built. For example, the Mount Elbert plant in Colorado is mentioned in a Wall Street Journal article from September 13, 2010, "Water Surge".

Copyright Robert Schenk