Is Everything Efficient?

Some thoughts on the misconceptions associated with efficiency

In our Thanksgiving newsletter, we mentioned that the way that economists use the word “efficiency” is sometimes different from the way that it is used in everyday conversation. In economics, efficiency most often refers to the idea of Pareto efficiency, which means that there are no further gains from trade to be had, or that no one can be made better off without being made worse off.

Many economists use this as a welfare criterion. These economists write down a model and solve for the Pareto efficient allocation. They then solve for the market equilibrium of the model to determine if the market allocation is the same as the Pareto efficient allocation. If so, the market allocation is considered efficient. If not, the economist takes the additional step of designing a policy that would produce the efficient allocation.

The UCLA brand of price theory, however, takes an alternative approach. Rather than treating Pareto efficiency as a welfare criterion, the UCLA school often treated Pareto efficiency as a starting point for the analysis. This view has often been characterized as saying that “whatever is, is efficient.” While I don’t dispute the use of this descriptor, I do wish to defend this approach to economics from a caricature of this view.

The idea behind this approach is that people will tend to take actions that are in their own best interest. Potential gains from trade will not go unrealized. Everyone has an incentive to improve their position. If there is a potential trade that benefits at least one party to the trade without harming anyone else, then the trade will take place.

The reason that this idea is important is that it enhances our understanding of the real world. If an economist writes down a model that shows that a Pareto improvement is possible and unrealized, this begs the question as to why these gains from trade go unrealized. After all, if everyone has an incentive to do the best they can, why do they leave gains from trade unexploited? Thus, identifying a possible Pareto improvement is not the end of the story, but rather the beginning. A good price theorist should ask: What costs or constraints are missing from the model that exist in the real world?

The UCLA brand of price theory often focused on one aspect that was missing from conventional models: transaction costs. In many neoclassical models, the cost of using the price mechanism to allocate resources is zero. However, in many real world situations, the cost of using the price mechanism is positive (and perhaps large). In addition, when the costs associated with using the price mechanism are sufficiently large, people tend to design institutions to reduce the cost of allocating resources (e.g., firms).

While this might not seem like a big deal, it is actually really important for thinking about policy. A lot of economists use the “whatever is, is efficient” descriptor as a pejorative. They view this statement as akin to nihilism. They conclude that this view implies that world is the way it is and there is nothing we can do about it. They mock this because they know better than these plebeians what is good for them. Of course, what they are mocking is straw man.

These critics are often wrong for one of two reasons. The first reason is that they confuse what is optimal in their model with what is optimal in the real world. The second reason is that they confuse efficiency with optimality.

Let’s start by discussing this first point. If there are relevant constraints or transaction costs in the real world and not in the model, then the model’s policy prescriptions can be wrong. What the UCLA approach says is that if some sort of behavior seems obviously suboptimal, then there is likely something that is missing from the analysis. If the modeler has missed an important real world constraint or real world cost, then what they are arguing is suboptimal might not be suboptimal at all. It is only suboptimal in some idealized world. In addition, to the extent that policy can improve the market allocation, the best approach to doing so might be to reduce the relevant transactions costs or relax a particular constraint.

The second point is also important. What is efficient and what is optimal are not always the same thing. However, economists often use the two words interchangeably.

Ronald Coase famously argued that the assignment of property rights might be important for the allocation of resources precisely because of issues like transaction costs. For example, suppose that there is one resource and there is a dispute over the property rights to that resource. Person A would generate greater value from the use of the resource than Person B. However, transaction costs are prohibitively high to prevent the market from reallocating the resource. The court system is called on to resolve the property rights dispute. If the court assigns property rights to Person A, the resource will generate its most high-valued use. If the court assigns property rights to Person B, the resources will not only not generate it most high-valued use, but transaction costs prevent the resource from being transferred to the party that would produce the most value. Thus, the assignment of property rights to Person B is suboptimal.

However, as Harold Demsetz points out, there is a difference between what is efficient and what is optimal. Courts exist outside the market. If the court assigns property rights to Person B in the example, the outcome is suboptimal. However, in either case, the allocation is efficient given the court’s assignment of property rights. As Demsetz (p. 114) explains, even Coase uses the wrong terminology:

Given that the court lies outside the economic system, what really is the “inefficiency” that Coase (incorrectly) attributes to the economic system? It is that the market does not tolerate the bearing of transaction cost to correct for the court’s error if the cost of doing so exceeds the gain in the value that is to be expected from realigning the ownership of the entitlement. The market is accused of being inefficient because it is efficient!

Demsetz’s point is important. Different rules will produce different allocations. There might be some preference ranking of these allocations. However, given that a particular rule implemented, the allocation will be efficient.

I like this approach to economics because it makes economics more descriptive and less prescriptive. It prioritizes explaining the world over the presumption that it is easy to make the world a better place.

Rather than confidently concluding that the world is backwards and needs to be rescued by economists and their models, the presumption of Pareto efficiency forces economists to think carefully about what is going on. What are the relevant costs and/or constraints that are missing? Sometimes, this type of thinking reveals that people are working with the wrong model or have ignored an important characteristic of their model. Other times, one might conclude that a seemingly suboptimal policy is actually optimal given the relevant constraints (as examples, see here, here, here, and here). Ultimately, what this UCLA approach suggests is the need for a little humility — admittedly a tough ask for some academics.