tl;dr:

This argument is a walkthrough of the argument against inefficiency as an real explanation in the tradition of Coase, Demsetz, and Alchian. Briefly, inefficiency is the result of being unaware of some constraint on the system and then failing to realize that what appears to be inefficiency must always actually be your ignorance of some constraint on the system. The universe does not glitch. Near the end I also take up the question of how a fake explanation was able to persist for so long in economics, especially after Coase proved in 1960 that there is no such thing as inefficiency.

 

 

The Jargon

You may have noticed that economists talk about efficiency a lot. Normally efficiency refers to an input-output ratio, but that's not usually how economists use the term. Economists normally use efficiency to denote to a system of exhausted opportunities. An efficient system can't be improved, given the constraints on the system. More often that not these opportunities refer to Pareto improvements. A system that has exhausted all possible Pareto improvements given the constraints on the system is called Pareto efficient.

Pareto Improvements and Pareto Efficiency

A Pareto improvement is any change that makes at least one person better off without making anyone else worse off. Economists like Pareto improvements because they're unambiguously good or neutral for everyone by definition. Only a misanthrope can complain about a Pareto improvement. A system that has no remaining Pareto improvements is called Pareto efficient. A system which has some remaining is called Pareto inefficient.

Not all Pareto efficient systems are good. A world where Sauron controls the rest of the world as slaves from his towers in Mordor would be Pareto efficient, since there's no way to free all the slaves without hurting Sauron. It might be good to save the world at Sauron's expense, but it wouldn't be a Pareto improvement. Still, all else held equal, it's always better to be in a Pareto efficient system than a Pareto inefficient system. A Pareto improvement that doesn't happen doesn't help anyone, after all. Pareto improvements can only make people better off. Moving from a Pareto inefficient system to a Pareto efficient system is by definition a free lunch.

Pareto improvements have come under fire in two main ways. The first is that by focusing only on improvements which don't make anyone worse off, many potentially beneficial changes to the world are ruled out, most notably redistribution of wealth and income. Redistribution may be an improvement, but because it hurts the people who lose some of their wealth and income, it isn't a Pareto improvement. Handling this problem is what Kaldor-Hicks efficiency is for, which we get to farther down.

The other major criticism of Pareto improvements is that it is virtually impossible to find any. Picking $20 up that was just lying on the street abandoned hurts the person who would have come after you. The world is incredibly complex, and the odds of some action making no one worse off is low, to say the least. And if you include the utility of misanthropes and evil people, Pareto improvements might become completely impossible. We'll handle this problem by ignoring it, since it's not a problem in simple models.

There Ain't No Such Thing as a Free Lunch

So if moving from a Pareto inefficient system to a Pareto efficient system is a free lunch, that raises an obvious problem:

There ain't no such thing as a free lunch.

Which means that Pareto inefficient systems can't exist. The only type of system that can exist is a Pareto efficient one.

The economic logic is simple and inexorable. A Pareto inefficient system by definition contains outstanding Pareto improvements. A Pareto improvement is a benefit to at least one person at no cost to anyone else.

So in order for a Pareto inefficient system to exist, there has to be an economic agent--because otherwise we're not dealing with an economic system--who forgoes a benefit for some reason other than a cost to himself or someone else. And if he willingly forgoes the benefit because of the cost to someone else, that is in fact a cost to himself, the disutility he experiences from the suffering of someone else, or if he forgoes the benefit because the cost to someone else induces that someone else to stop him from pursuing the improvement, that would also only happen if that someone were able to impose a sufficient cost on him. So we can restate Pareto inefficiency as a system where an economic agent forgoes a benefit for some reason other than the cost of doing so.

There is a problem:

Economic agents aren't allowed to do that.

Economic agents have to take any benefit that is not outweighed by the cost of doing so, where the cost of doing so is the foregone benefit from not doing the next best thing. That's what economizing behavior is. Maximization of benefits/minimization of costs, since costs are foregone benefits they are identical criteria. An economic agent isn't allowed to forgo a benefit for anything other than a even greater benefit somewhere else, which is to say, a cost that is too high.

And just in case you think you've found a loophole, "cost" is a pretty expansive term. It refers to things like how much time and money you have to give up to get something, but if you don't want to do something because it would embarrass you, or it would make your mother sad, or because something about it just feels off...then that's the cost. In fact, the term is sufficiently expansive so as to include any reason for not doing something.

So an economic agent can't forgo a benefit without a reason, without an explanation. By definition. And having economic agents is the fundamental premise of economics. They're the ones who follow the laws of economics. Without economic agents you don't have economics.

So we can restate Pareto inefficiency as a system where an economic agent forgoes a benefit for no reason. Which they're not allowed to do.

And it makes absolutely no sense. Pareto inefficiency is like a starving man who has suddenly been put in front of a large banquet of all the food he's been dreaming about for months. And then he doesn't eat. For no reason. If he doesn't eat because he forgot how, or because he's dealt with the cognitive dissonance produced by starving to death by convincing himself that starving to death is natural and trying to fight it is a sign of hubris, or because he feels weird being in a thought experiment, or anything at all, then that's the cost and there's no outstanding Pareto improvement. And in fact, calling this confusing situation inefficient doesn't do anything to alleviate my confusion.

So we just have this starving man not eating the delicious food set out before him and this cannot be explained in any way. That's Pareto inefficiency. And that's nuts. 

What About Kaldor-Hicks Efficiency? You Promised!

Kaldor-Hicks efficiency is what economists turn to when Pareto efficiency proves too restrictive, which it always does. Kaldor-Hicks efficiency is similar to Pareto efficiency, but whereas Pareto efficiency counts the number of outstanding Pareto improvements with zero being the efficient level, Kaldor-Hicks efficiency counts the number of outstanding Kaldor-Hicks improvements, with zero being the efficient level. A Kaldor-Hicks improvement is any change that makes at least one person better off that they would, if it was possible, be willing to compensate the person made worse off, if there are any. For example, if a change makes one person $10 better off, and another person $5 worse off, the person made better off would, if it only it were possible, be willing to pay the person made worse off the five dollars necessary to make the latter indifferent to the change. Essentially, it's a cost-benefit test. If the total benefits from the change exceeds the total costs, such that you could take some money from the winners to completely compensate the losers and still have some left over for the winners, that's a Kaldor-Hicks improvement. All Pareto improvements are Kaldor-Hicks improvements but not all Kaldor-Hicks improvements are Pareto improvements.

So what about Kaldor-Hicks inefficiency, when you have some outstanding Kaldor-Hicks improvements? Does it make any sense?

Suppose Abe steals a car from Barry. The car is worth $40,000 to Abe, who likes nice cars, and only worth $30,000 to Barry, who takes a more practical view of his vehicle. That's not a Pareto improvement since Barry is hurt, but it is a Kaldor-Hicks improvement since Abe could compensate Barry the $30,000 and still have $10,000 left over. So, ignoring all external and additional effects of the theft beyond the benefit to Abe and the loss to Barry, in order to achieve Kaldor-Hicks efficiency, Abe would have to steal Barry's car, right?

So Abe, the economic actor that he is, sneaks over Barry's fence late at night, creeps around to where the garage is...

...And Barry, the economic actor that he is, nearly blows Abe's head off with a double-barrelled shotgun. Cursing and shrieking, Abe escapes with his tail between his legs as Barry calmly reloads.

(Yes, I'm from Texas, why do you ask?)

Is the system now inefficient? After all, the Kaldor-Hicks improvement didn't happen.

Remember, the question isn't whether it would be a net plus for Abe to have successfully stolen Barry's car. That's built into the assumptions of the thought experiment. It wouldn't be a Kaldor-Hicks improvement if it wasn't a net plus. But that's not quite the same thing as asking if it's inefficient.

Syllables aren't inherently significant; what matters is the associations and concepts they draw up inside your head. And what inefficiency calls up for me is something that isn't being optimized given the constraints on the system. Something about the economics is wrong, something is happening that shouldn't be given the constraints. I don't mean that somebody should be doing something different because it would be better that way, I mean that somebody should be doing something different because the laws of economics predict something different. With a Pareto improvement, for example, the idea of a Pareto improvement not happening in a world of economic actors, what we call Pareto inefficiency, means that somebody is economizing wrong, not in a backwards-looking way, but in a forwards-looking way, such that given the economic actor's information, utility function, degree of rationality and cognitive operations, etc., that economic actor should have done something differently even though he couldn'thave done anything differently given the constraints and the laws of economics.

And if we look at this Kaldor-Hicks improvement that didn't happen, we can see that Barry didn't do anything he should have done. Sure, letting Abe steal his car would have been a net benefit for the world, but what does Barry car? He's out $30,000. The proper economic thing for Barry to do is to stop the theft (so long as the cost of doing so is less than $30,000). Abe did what was efficient for him, and Barry did what was efficient for him. And so if everyone does what's efficient, how can that add up to inefficiency?

What About Social Efficiency?

"Obviously individuals will always do what's efficient for them," you say. "But that's how it works. Individually efficient actions lead to outcomes that are inefficient for the group. Ever heard of the Prisoner's Dilemma, you idiot?"

Wow, that escalated suddenly. But moving from individual efficiency to group efficiency doesn't save the concept.

Let's go back to a very simple Pareto improvement. A man pours coffee for himself in the morning, making him better off at no cost to anyone else. Hooray, we have achieved Pareto efficiency. Except...

...Wouldn't it have been even better if while pouring himself a cup of coffee, he had turned into the happiest man alive, world peace and prosperity was achieved for all time, and the next arc of HPMOR didn't take ages to come out? Clearly we have a very Pareto inefficient system here, since all these Pareto improvements didn't happen.

The obvious problem with this logic is that all those "Pareto improvements" weren't possible. They could have happened if the universe were a very different place, but it's not, so they didn't. Any improvement that isn't allowed by the laws of the system and its constraints doesn't count. If they did count, then any system short of absolute utopia would be inefficient.

So let's look at the Prisoner's Dilemma. Individually both prisoners want to defect. But if they both follow the dominant strategy, they'll be worse off than if they both cooperate. This is usually presented as showing how individual doing what's efficient for them leads to group inefficiency.

But it's the same problem. The limited information people have and the decisions their brain makes given that information and the incentives they face are constraints that are just as real as the constraints which prevent our good friend above from becoming the happiest man in the world while he pours his coffee. If we're going to acknowledge that the improvements thatdon't physical constraints like how much steel there is or how much energy it takes for something to happen doesn't mean that the given system is inefficient, then social constraints like information, incentives, and cognitive abilities shouldn't either. The poor prisoners might wish they lived in a different world, one where a different set of information, incentives, and cognitive abilities allowed them to both cooperate, but they don't. Similarly, we might all wish we lived in a world of infinite free energy, but we don't. If the latter fact doesn't render our reality inefficient, then why should the former?

Whatever Is, Is Efficient

Armen Alchian, the most powerful economist ever, would always tell his students, "Whatever is, is efficient."

That should be pretty obvious by now if you've followed everything I've said so far. Inefficiency seems to posit some kind of glitch in the universe, that given to the laws and constraints on the system, an economic actor isn't economizing even though economic actors economize by definition. That or inefficiency seems to be a case of the Mind Projection Fallacy: by comparing the real world to some imagined better world, no matter how impossible it may be given the current constraints, the real world suddenly seems to fall short of a mark that the universe isn't actually paying any attention to. Well, the universe doesn't glitch and the mere ability to imagine some better alternative to the real world does not in fact imply an non-exhausted opportunity in the real system.

Do Economists Actually Believe in Inefficiency?

This is the first fundamental theorem of welfare economics, as stated by F.M. Bator:

"It is the central theorem of modern welfare economics that under certain strong assumptions about technology, tastes, and producers' motivations, the equilibrium conditions which characterize a system of competitive markets will exactly correspond to the requirements of Paretian efficiency."

So yes, yes they do. They believe in inefficiency a lot. Look how strong the assumptions they think are necessary for efficiency to occur. We're a very long ways from "Whatever is, is efficient," here.

Inefficiency: A Fake Explanation

How could you come to believe that the universe glitches occasionally? 

You don't, obviously. But if the logical conclusion of what you do believe is that the universe glitches occasionally, that's a sign of a fake explanation. Suppose you posit God as an explanation for rainfall. Now, this could be a real, falsifiable hypothesis about a wizard who lives in the sky. It could also be a fake explanation. In the latter case, "God" is an empty word that just serves as an intellectual stop sign. It posits "I don't know" as an explanation, which is to say no explanation as an explanation. If you took the fake answer seriously, you would think that everyone who says that God causes rainfall thinks that rainfall makes no sense within the universe.

Inefficiency occupies the same role within economics. It doesn't explain anything. It's false, in its form as a falsifiable hypothesis, which claims that there exists foregone benefits that are not explained by any cost, and it's not even wrong in its form as a fake explanation, which claims that you can explain foregone benefits without explaining them.

If you aren't buying it, let's talk about transaction costs. Transaction costs, as the name implies, are the costs of transacting. More specifically, it's used by economists to refer to the cost of using the price system. In 1960, Ronald Coase applied the concept of transaction costs to externalities, with startling results. Before 1960, everyone thought of externalities as inefficient, in both the sense of a system with externalities was supposed to have outstanding Pareto improvements, and in the sense that nobody knew what caused externalities and so "explained" them by calling them inefficient, with a few exceptions such as Frank Knight, who pointed out that economists didn't know how to explain the existence of externalities. Then Coase exploded both those ideas.

An externality is an external cost, where somebody does something that makes someone else worse off on the margin without suffering proportionally himself. The archetype is pollution. A polluter who pollutes in the process of producing some product makes other people worse off without having to pay himself for the harm, which means that on the margin he'll be hurting others more than his product benefits himself and others. That net harm was supposed to imply an outstanding Pareto improvement, since some people would benefit and others would not be harmed if the pollution was lessened and the polluter was then compensated for reducing his pollution. Why this didn't happen was unexplained, of course.

Coase pointed out that what explained why these exchanges weren't happening must be to do with some set of costs which prevent exchanges from happening. He called those costs "transaction costs."

Essentially, the mystery is why people don't use the price system to internalize externalities. For example, suppose Abe builds a factory next to Barry's house. On the margin Abe benefits $5, and the pollution from his factory costs Barry $10. 

The solution to this is obvious. Barry will pay Abe any amount of money from $5 to $10 to not pollute. Abe will agree to any amount of money over $5 to stop polluting and Barry will agree to pay any amount of money under $10 to prevent the pollution. They'll both benefit. So how can externalities possibly exist? Economic agents should automatically internalize them.

The only possible real answer, as Coase realized, is that the cost of Abe and Barry using the price system, the transaction cost, must exceed the range of payments they will both agree on. If it costs Abe and Barry $6 to agree to some price on the externality, then there will be no price they can both agree on, and the externality will persist.

Coase substituted a real explanation, transaction costs, for a fake explanation, inefficiency, and won a Nobel Prize for it. But in fact his argument applies to much more than pollution. All the various types of supposed economic inefficiency, such as monopoly and collective action problems, are really just externalities. In the case of monopoly, people would like to pay the monopoly to behave more competitively but can't due to the cost of using the price system, and in the case of collective action problems, people would like to pay others not to defect but can't again due to transaction costs.

All the standard forms of economic inefficiency are really just exchanges that don't take place due to transaction costs. But any cost, not just transaction costs, prevent exchanges. The cost of steel prevents some people from buying steel from people who want to sell them steel. I'd like to buy a lot of steel if it cost nothing, but that's not the case. Is that inefficiency? If not, then why are exchanges that don't happen because of the cost of transacting any different? This is really just the same point as above that any foregone benefit that is explained by a cost isn't inefficient. There's no inefficiency in the system anywhere.

It's especially important to notice that the explanation for externalities, i.e. all types of "inefficiency," came well after the concept of inefficiency had become a firm part of economics. Fake explanations are what people naturally turn to in the absence of a ready real explanation. Economists did not know about transaction costs when they began to study externalities. They knew absent some constraint that externalities should not exist, and they had absolutely no idea what that constraint was. Their mistakes were failing to realize that economics always demands that everything be explained by some constraint, and failing to realize that "inefficiency" is a fake explanation.

The New Problem

So inefficiency is a fake explanation. Whatever is, is efficient. Great. Here's the problem. Coase proved that externalities, and by extension, everything, are efficient back in 1960. He won a Nobel Prize for it. It's the most cited economics paper of all time. The point is, economists already know that the transaction costs analysis proves the efficiency of externalities. So why do economists still call things inefficient? Check any textbook, read any blog, ask any economist, and they will all (with perhaps the exception of those trained by Armen Alchian) tell you that externalities, imperfect competition, public goods, and so on are all inefficient. Even though they know that all of these things are the efficient economic response to transaction costs, they still call them inefficient.

That's weird.

Inefficiency: More Than a Fake Explanation

Economists still use the term "inefficiency," but not as an explanation. In fact, the term has two other purposes. They are:

1. As a substitute for "bad" that sounds more scientific and objective.

2. As a label for models lacking certain qualities.

Inefficiency Doesn't Mean Bad (And Efficiency Doesn't Mean Good)

Economists use the terms this way, but they shouldn't. And it produces a great deal of confusion when economists don't realize that inefficiency does not imply bad and efficiency does not imply good (since everything is efficient, then so was the Holocaust). 

Carl Dahlman, in "The Problem of Externality, correctly goes through the application of transaction costs to externalities to conclude that "it is not possible to specify any class of transaction costs that...generate externalities that constitute deviations form an attainable optimum...." But he retreats from the conclusion that everything is efficient, saying "If we include transaction costs in the constraints, this appears to be the unavoidable conundrum we end up in: externalities are irrelevant, monopoly problems do not exist, public goods present difficulties, and so on." Alas, "It is difficult to see, then, how it is possible to prove analytically that the presence of externalities imply welfare problems."

Dahlman's argument is, I believe, the primary reason economists dislike the conclusion that everything is efficient. The argument to them implies that all is well with the world by definition. Tyler Cowen, in his paper "The Importance of Defining the Feasible Set" calls the conclusion that everything is efficient "extreme" and says that "Virtually everyone rejects this view and many people scorn it." Dahlman calls the conclusion "Unpalatable to many economists."

But of course it is very easy to show that externalities imply welfare problems without using welfare economics. If Abe's pollution on the margin benefits him $5 and costs Barry $10, that's a net loss. That's bad. It's certainly not inefficient--there's no outstanding Pareto improvement unexplainable by the laws of economics. But it is bad. Even an economist should be able to see that.

So what's interesting here is that economists don't seem entirely cognizant of the fact that they're using "inefficient" to mean "bad."

Inefficiency as a Label

Let's go back to the first fundamental theorem of welfare economics:

"It is the central theorem of modern welfare economics that under certain strong assumptions about technology, tastes, and producers' motivations, the equilibrium conditions which characterize a system of competitive markets will exactly correspond to the requirements of Paretian efficiency."

We know that this is wrong because any system which obeys the laws of economics will exactly correspond to the requirements of Paretian efficiency. We also know that economists have known that this is wrong since 1960. So why hasn't the first fundamental theorem of welfare economics been consigned to the trash heap?

The answer is that inefficiency has taken on a life of its own, a new life as a completely meaningless label. Let's go back to Bator's paper. Discussing the question of externalities, he says,

"Yet is it possible that due to more or less arbitrary and accidental circumstances of institutions, laws, customs, or feasibility, competitive markets would not be Pareto-efficient....It is easy to show that if apple blossoms have a positive effect on honey production...a maximum-of-welfare solution, or any Pareto-efficient solution," will associate with apple blossoms a positive Langrangean shadow-price. If, then, apple producers are unable to protect their equity in apple-nectar and markets do not impute to apple blossoms their correct shadow value, profit-maximizing decisions will fail correctly to allocate resources at the margin."

Bator's right, of course, that resource allocation would be better in a world free of externalities, although I'm not sure why he thinks that that means resource allocation is incorrect in the actual world we live in. But more importantly, notice that Bator isnot using inefficiency as an explanation here. He has an explanation for the externality:"institutions, laws, customs, or feasibility." He even goes on to say,

"The important point is that the difficulties reside in institutional rrangements, the feasibility of keeping tab, etc....Apple nectar has a positive shadow price, which, if only payment were enforceable, cause nectar production in precisely the right amount and even distribution would be correctly rationed. The difficulty is due exclusively to the difficulty of keeping accounts...." (emphasis added)

Bator's not confused about the externality. He's not looking for a fake explanation. He understand exactly how the laws of economics move through the economic agents over the constraints on the system to produce externalities. He doesn't think there's anything inefficient about externalities. When Bator calls externalities "inefficient," by that he means absolutely nothing at all. He fully explains the phenomenon in question and then adds on an extra term that does nothing at all. It's like describing the laws of motion, and then saying that they tell the Motion Fairy how to move things, or like observing the order and lawfulness in the universe and attributing that to God.

Inefficiency in this sense is merely a label. Some economic systems are labeled efficient. These are the systems which meet "certain strong assumptions about technology, tastes, and producers' motivations" in "the equilibrium conditions which characterize a system of competitive markets." Any system which does not meet that definition is labeled inefficient.

How a Fake Answer Took on a Life of Its Own

I can only speculate on how inefficiency transformed from a fake answer to a multi-function word that in addition to being a fake answer is also an objective-sounding substitute for "bad" and a label that means nothing. But it's easy to guess how inefficiency could come to mean "bad" since inefficiency is something bad. You would always want to move from an inefficient to an efficient system. And over time things slip bit by bit until inefficiency is just the word economists use to refer to bad things they want to change. As for how inefficiency became a label, that seems like it could be the consequence of pre-1960 economists noticing that all the efficient system had certain qualities and all the inefficient ones lacked those qualities. It's easy to imagine that over time economists began to think that it was that combination of qualities and only that combination of qualities which allow for the possibility of efficiency. Pre-1960, that's what they would have observed.

 

 

Additional reading

In this paper Demsetz makes much the same analysis that I do in terms of demonstrating that what economists call inefficient isn't. He does, however, claim that issues of "strategic behavior" might deserve to be called inefficient. He offers no justification for this view, and issues of strategic behavior seem just as well-explained by constraints and the laws of economics to me as anything else.

Those of you with access to JSTOR should look at "The Problem of Externality" by Carl J. Dahlman in The Journal of Law and Economics, Vol 22, No. 1 of April 1979, pages 141-162. He also goes through the application of transaction costs to externalities conclude that externalities are efficient. He retreats from the conclusion, however, citing both the general distaste economists have for saying that everything is efficient, and he wonders how one would know that externalities and the like are bad if they are not inefficient.

Anything and everything written by Ronald Coase is relevant and important.