Efficiency

From Greg Mankiw I got this interesting piece by Uwe Reinhardt critiquing the economic idea of efficiency – it’s a sequel to an earlier argument by Reinhardt. It interests me that both articles pop up in the business pages of the NYT.

Roughly efficiency means in a producer setting that more valued output is obtained from given productive inputs.

In Reinhardt  1 the point is made that no matter how hard economists seek to emphasise the notion that ‘efficient’ need not mean ‘better’ the connotation that an efficiency improvement increases welfare is difficult to dispel.   The increased efficiency – for example the gains in total production in the US economy over recent decades – can accrue to a minority with most being worse off.  This has happened. The standard response of microeconomics is to say increased production is good because the extra output can be redistributed to make everyone better off – the so-called Second Fundamental Theorem of Welfare Economics.  The difficulty is that such distributions often are not made – they were certainly not in the US case – and, in any event, it is difficult to come up with the redistributions that do not in themselves create efficiency losses – all taxes except for pure profits taxes (including the RSPT) and proportional profits taxes distort incentives and reduce efficiency.

I agree with these types of arguments but few economists that I know seriously target output maximisation alone.  Most economists understand that the pursuit of efficiency invariably creates both winners and losers unless fairly unrealistic compensations are made.

Reinhardt 2 points out that efficiency gains that improve everyone’s welfare are elusive.  Most changes advocated by economists – for example appreciation of the Chinese RMB – help some (e.g. the shareholders of US manufacturers) and harm others (e.g. US consumers).  Economists really have no business making such recommendations – it is better to adopt the strict constructionist approach of not arguing for such policies on the basis of economic ‘science’ but simply to point out who gains and who loses with various policy prescriptions.  An alternative approach I like (I picked it up from an  old (1953) though very worthwhile book on progressive taxation) is for economists to take the policy objectives of politicians or others as given and to stick to the positive question of whether policies advance the objectives that are intended.

The Kaldor-Hicks criterion of accepting that efficiency gains advance welfare if potentially after redistributions everyone can be made better-off (they need not be) is deceitful since it amounts to ignoring equity issues.  It amounts to endorsing the pursuit of efficiency gains alone.  For example it would contend that pure transfers have no efficiency costs.

The Reinhardt type arguments are perennial discussion points in economics but they are worth repeating.  Economists are overly fond of advancing policy claims – recent arguments for revaluing the RMB are an example – on the basis of efficiency considerations alone.  This isn’t sensible. (404)