Efficiency in Economics - Essay Example

The term ‘efficiency’ and its numerous derivatives are among the most widely used words in contemporary vocabulary and are applied to various spheresof our life. In economics the notion of efficiency is equally very important (Beckert and Harshav, 2002, pp.2-4). Let us carefully explain what economists mean by efficiency, and in the process also try to understand why economists consider monopolies to be inefficient. First of all, it is essential to remember that as in other spheres of our life efficiency in its economic application is also a relative term. Efficiency can never be complete, and it always needs to be measured in relation to certain criteria. For economic efficiency the basic criterion is value, so that changes that tend to increase value are deemed efficient and changes that decrease it are thought to be inefficient. However, a state of affairs that can be qualified as economically efficient need not necessarily remain efficient when viewed from the point of view of other criteria. So, value is not only a relative quality but a subjective one as well because something has value only if there are those who want it. In this situation a question arises as to how can one be sure that value is maximised? One of the traditional answers of economists to this questions is contained in what is known as Pareto optimality, named so after Italian economist Vilfredo Pareto who postulated that if a change can leave somebody better off than before, and at the same time will not make situation of others worse, then the initial situation was not the one of the highest possible value because an improvement could yet be introduced (Wikipedia, 2006). And when the highest possible value is obtained, then any change that may improve one`s condition must inevitably be harmful for somebody else. This situation was defined by Pareto as allocative efficiency. Economists are concerned about economic efficiency for two reasons. The positive reason of their interest stems from the fact that people are seeking value, and this search can take place in any social circumstances so that on condition that enough money can be obtained people are ready to go for immoral, risky, and criminal occupations. From the theoretical point of view we can attribute this quest for value to the mentioned striving to maximise utility and profit, and when situations emerge that an unexploited value exists which is possible but not yet captured economists usually need to provide an account of why no ways are found to utilise this value. Thus, the striving for value is the engine behind market economies. Another reason why economists are interested in economic efficiency, which we can characterise as normative, is based on the need to offer policy recommendations. While some aspects of policies can be evaluated without the help of normative assumptions, if for instance several situations or policies have to be compared in order to decide which of them is preferential a basic ground for evaluation is warranted. In this respect the notion of economic efficiency assumes the role of such a starting point of analysis (Mankiw, 2006, pp.572-574). Of course, remembering our observation about the relative nature of the very notion of efficiency, economists usually combine it with other relevant criteria that help more thoroughly evaluate relative merits of various situations. At this point some remarks should be done that will bring the theoretic representation of the economic efficiency closer to the real life. For one, the value put in the spotlight of the concept of economic efficiency is closely connected with goals of people. In this respect, from the point of view of economic efficiency all goals must be equally valid, and no goals can formally be given superior status. Still, in reality the situation is much more complicated than that as for the Christian world view it is immoral to seek goals out of pure egoism. On the contrary, to be moral people should care about the well-being of other members of one`s community. Also, economists normally ignore a factor that is often present, namely envy between people and the desire to harm others. Indeed, if one person is always unhappy when another gets happier, than the possibility to neatly evaluate economic efficiency in accordance with Pareto optimality disappears (Schultz, 2001, pp.33-35). Besides, in practice not all goals have the same relation to value determination as some goals are given more attention than others. For instance, in market economies the goals set by the rich who have more resources are typically more appreciated that those of the poor. In these circumstances it can be seen how it is possible that for those who dislike this state of affairs an economically efficient situation may actually be inferior to the economically inefficient state in which more equity is present. By the way, there are often trade-offs between economic efficiency and equity, which is the notion that relates to the resources distribution and is therefore tightly connected with concepts of social justice and fairness (Schultz, 2001, pp.82-105). So, even though in economical vernacular discussions about economic efficiency may be quite complicated and technical, on ground of what we have observed we can formulate the principle of economic efficiency is rather simple terms. For this we just have to imagine that there is a certain group of resources, for instance time of labour, availability of materials and machinery, etc. Now, this group of resources can be used in three alternative ways. The use 1 is capable of generating a final product that consumers would value at $100, the use 2 can produce a product valued at $75 by consumers, and the use 3 can create a product worth $50. The concept of economic efficiency dictates that the available group of resources has to be used for the production by means of the use 1 as this use will bring the highest value, and if in reality resources are indeed used so the result can be said to be economically efficient. On the contrary, if uses 2 or 3 are employed, then economy is not generating as much value as possible, and therefore is economically inefficient. In this respect it is important to point out that in ideal circumstances market economies will create conditions when the use 1 that has the highest value to consumers will be preferred by producers who in their turn would be able to bid the most for resources available to them. However, the real life again intervenes to make it harder for market participants to employ the most efficient uses, and to instigate them to opt for less efficient ones instead. For one, governments via regulations, taxes, or other economic means may change the interrelation between the cost of resources and resulting values that consumers are ready to assign to various uses. Economic inefficiency is also increased in situations when information about values that consumers assign to products is not fully accessible to producers. When all such efficiency inhibitors combine so that a market cannot achieve the use 1, economists consider this situation to be indicative of market failure, of which a great variety of scenarios exist (Mankiw, 2006, pp.149-152). Having a general understanding of what economists mean by efficiency, we may also overview the three requirements needed for an economy to be able to exploit value as much as possible. These are production efficiency, exchange efficiency, and product-mix efficiency. The first requirement indispensable for an economy to be efficient is that it has to be on what is called its production-possibilities frontier when no more goods or services could be produced with the available technology and resources. As long as additional production could yet create additional value, this state is below the production-possibilities frontier and is inefficient, again because economy was not on the frontier in the first place. By the way, there can be a lot of points on the production-possibilities frontier that correspond to the condition of production efficiency if only the demand that all available resources must be used is met, and that resources are used in a proper way. This last observation is quite essential and actually is a necessary condition for the complete usage of resources. Indeed, for example if people are randomly assigned to their jobs or if some irrelevant criteria are used for their selection economy will not be able to produce as much as it could and correspondingly is economically inefficient. The second requirement necessary for an economy to be efficient is exchange efficiency, which describes the state of affairs when no mutually beneficial trades are possible. Similarly to the issue of the production-possibilities frontier, if a trade can be advantageous for one participant and increase perceived value while at least not being harmful for other participants, then the ensuing improvement uncovers the previously existing inefficiency. The third requirement stems from the fact that even when on the production-possibilities frontier, economy may still not be efficient because not all points on that frontier are of the same value. Therefore, to be efficient economies must achieve such a point on the production-possibilities frontier when a mix of products contains the highest possible value, the condition known as the product-mix efficiency that actually constitutes the third requirement (Mankiw, 2006, pp.153-158). In this regard, it is important to remember that as one of the well-known examples of product-mix inefficiency serve monopolies. To see why this happens, we should remember that allocative efficiency which we have mentioned earlier is achieved in case of a coincidence between the cost of the resources consumed for production and the value, i.e. price, that consumers assign to a produced product or service. To promote this kind of efficiency to maximise total economic welfare the requirement must be satisfied that price equals marginal cost which represents the cost associated with the production of each additional unit of output with normal profit included. Under monopoly, a market participant can rise price above marginal cost and thus boost overall revenue and profit. As a result, if both monopolists and competitive market participants have equal costs then the welfare is lost under monopoly due to a dead-weight loss of consumer surplus that represents the monetary equivalent of the reduction of economic efficiency that makes prices, supply or demand on market different from what they would be in free market where prices and output are competitive (Lipsey and Chrystal, 2004, ch.11-12). As a well-known real-life example of price formation under monopoly may serve results of the anti-monopoly investigations conducted in the end of the nineties against Microsoft which uncovered that this company`s pricing policies were compatible with monopoly power as Microsoft did not take into account prices of competitors, kept artificially high prices on older operating systems, and felt free to charge different prices for the same product to different original equipment manufacturers (OEMs) according to company`s preferences (United States Department of Justice, 1999). Returning to the theoretical considerations, as an accompanying effect of the reduction of economic efficiency, monopoly also produces less output and therefore uses resources less efficiently than under a perfect competition, so that it does not lie on the production-possibilities frontier. Still, there are situations when monopolies can actually be more economically efficient than competition, for example when a single company, often the first one in its area of activity, can manage to serve the whole market without exhausting itself, or when one company completely satisfies demand in terms of quality and price so that the possibility of profitable competition from the side of other firms is doubtful (Djolov, 2006, pp.9-14). Sources Beckert, J., and Harshav, B. (2002). Beyond the Market: The Social Foundations of Economic Efficiency. Princeton University Press. Djolov, G., G. (2006). The Economics of Competition: The Race to Monopoly. Best Business Books. Lipsey, R., A., and Chrystal, A. (2004). Economics. Oxford University Press. Mankiw, N., G. (2006). Principles of Economics. South-Western College Pub. Schultz, W. (2001). The Moral Conditions of Economic Efficiency. Cambridge University Press. United States Department of Justice. (1999). U.S. vs. Microsoft: Court`s Findings of Fact. Retrieved July 10, 2006, from http://www.usdoj.gov/atr/cases/f3800/msjudgex.htm Wikipedia. (2006). Vilfredo Pareto. Retrieved July 09, 2006, from http://en.wikipedia.org/ wiki/Vilfredo_Pareto Read More