I agree that it is possible to make a description of an economy in such terms as there being no inefficiency. Just as (and closely related to the fact that) it is possible to make a description of a person's actions in such terms that they are never irrational; everything they do, they do because they value the most doing it. But is this a fruitful way of thinking?
Let us take an example, varying a bit on novalis'. You are walking and see $20 on the street, about to fall into the drain. Counsciously, you think you should pick it up; but somehow, you don't and keep walking instead. What actually happened, though you are not really conscious of it, is that you were momentarily distracted by music from a passing car, and while trying to identify the song your brain failed to issue the order "bend and pick the money" until you had walked a couple of steps past it, at which points the sunk costs fallacy made you loath the idea to walk back.
Now, there are two ways of describing this:
a) The outcome, despite appearances, was Pareto-efficient; you valued identifying the music and not retracing your steps more than the $20, otherwise you would have picked it up.
b) The outcome was inefficient; you don't really place any intrinsic value on the things your brain chose; it was just a glitch that made you momentarily irrational.
The question is not which description is true. It is which is more fruitful, more generalizable, more able to interpret and predict your behavior in new circumstances. I suspect that the answer is certainly the second one when we want to do neuropsychology and cognitive science. The first one might make pure economics more simple and elegant, but at the cost of isolating it form other sciences.
I would point out the vast distance between reality and the usual toy model of economics inhabited by omniscient economic agents.
Even if you ignore the fact that human beings are not rational (and, of course, behave very differently from economic agents), throwing imperfect knowledge and uncertainty of the future into your constructs is probably enough to change the landscape a great deal.
Armen Alchian, the most powerful economist ever
... whom nobody has ever heard of? Like, he's not a Nobel prize winner or anything.
Also, isn't this post sort of meaningless? That is, doesn't it simply boil down to saying "everything is the way it is, and it couldn't be any other way"?
For instance, imagine that I walk by a $20 bill on the street (for the sake of argument, let's say that immediately after I walk by it, it's blown into a storm drain and destroyed). I miss it because I'm looking up in order to count air conditioners, which I'm doing because I had an argument with my landlord, which happened because because because and so on back to the beginning of the universe. Clearly, me picking up that $20 would have been a Pareto-improvement. Was it "possible"? Here's one post that discusses that.
Variants on the $20 scenario have on occasion actually happened. It's not interesting to say that me picking up the $20 "couldn't" have happened. What's interesting is how we make decisions; how we decide that certain states are/are not reachable. If we had access to the mind of God (metaphorically), the only "possible" states would those states in the actual world. There would be no scenario that was not Pareto-efficient, because there would be only one possible scenario.
...whom nobody has ever heard of?
Though he wasn't a public figure, he was actually pretty famous in his field. I assumed /u/BenjaminLyons meant the "powerful" but lightheartedly.
me picking up that $20 would have been a Pareto-improvement
If it were something other than currency (say, a watermelon), I'd agree. But picking up a twenty-dollar bill has the same welfare effects as minting one yourself. If you spend it, you'll boost prices slightly, which harms other buyers. (And if you don't spend it, it's still not a Pareto-improvement, because you haven't benefited from it--unless you just like having money around, in which case your example could have been about anything at all.)
Edit: I see now that even finding a watermelon would not be a Pareto-improvement, except under the unrealistic assumption that a watermelon is not a substitute for other goods.
I'm pretty sure that argument proves too much: A watermelon substitutes for some other watermelon that I might have bought, so my grocer is worse off because the value of their watermelons are now slightly lower.
You are right that finding a watemelon would also have pecuniary externalities, assuming you would have bought a watermelon if you hadn't stumbled upon one.
Finding the watermelon would still be better than finding currency (assuming in both cases that what you found would not otherwise have been found or used by anyone else)--better by the value of one watermelon--but it would not be a Pareto-improvement.
Thanks!
This leads me to wonder whether the ubiquity of externalities means no Pareto improvements exist in the real world.
Yoiks! Consider:
I have a Dodge Charger and would rather have a plymouth fury. You have a plymouth fury and would rather have a dodge charger. We trade. That is a Pareto improvement.
I grew 30 cauliflower and only want 2 for personal consumption. You bought 10 dead laptops and from them assembled 5 working laptops, you only want one. You want some cauliflower, I want a laptop. We trade. That is a Pareto improvement.
I have time on my hands but I want money.. My employer wants some research done more than it wants $1000 which it has. They pay me to do the research for them. That is a Pareto improvement.
The facts that I cannot then do something else with my car, cauliflower, or time does not stop the side by side comparison of NOT trading with trading from being a Pareto improvement in any of these cases. It just means that a different set of other Pareto or non Pareto trades are available in the status quo ante and status quo after trades described above.
The facts that I cannot then do something else with my car, cauliflower, or time does not stop the side by side comparison of NOT trading with trading from being a Pareto improvement in any of these cases.
Agreed, although novalis, fortyeridania & I are referring to externalities rather than personal opportunity costs. And if I start taking every esoteric kind of externality into account, it's pretty hard to think of a trade that doesn't exert ripple effects through them.
I have a Dodge Charger and would rather have a plymouth fury. You have a plymouth fury and would rather have a dodge charger. We trade. That is a Pareto improvement.
A novalis/fortyeridania-type reply here would presumably be that the trade means I no longer buy a Charger and/or you no longer buy a Fury (or substitutes for those), which is the same kind of externality as if I no longer buy a watermelon because I found one. (A similar argument applies if instead of trading, at least one of us sells our car and buys something with the money.) That kind of argument seems to apply to nominally Pareto-improving trades in general, although I'm not sure how seriously to take it.
Yes, many economists use "efficiency" when they should admit they mean "good."
However, I think you've misused "efficient" in much of this essay. Specifically, when you talk about an individual agent acting "efficiently," you often just mean "rationally." Example:
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?
This is confused, because (as the definitions you cite show) efficiency is a property of states of affairs, not of actions.
Moreover, efficiency is only a well-defined concept when it's made relative to constraints. If you remove all constraints, then obviously "whatever is, is efficient," because things couldn't have been different. But if you introduce constraints, then efficiency (and inefficiency) become meaningful.
A concept with very similar properties is that of optimality. Saying that a system is optimal (or not) only makes sense if it's optimal relative to constraints.
Tossing a constraint out of the system and then not allowing the system to adjust is exactly how economists convinced themselves of inefficiency. They didn't know about transaction costs but did realize that externalities shouldn't exist in their absence, albeit not explicitly. They observed the reality of externalities and did not realize they were the result of the adjustment to the reality of transaction costs, so they concluded they were inefficient. Coase put that to rest in 1960.
It is necessary not to allow the system to adjust in order for it to be inefficient. In other words, it is necessary to not allow the system to obey the laws of economics.
I think people have recommended to you before that you spend some time on here focusing on issues that aren't economics. I'm going to repeat that recommendation. At minimum, this would give you more experience with what sort of articles are or are not likely to be well-received here and how to write things in a way that is useful and gives arguments people will pay attention to.
My uncle picks up a book on Amazon that says that stock N is the best stock out there because it had a 35% dividend return. he buys stock N and loses half his money in 3 years. How do you twist his decision to buy that stock to make it efficient?
My sister pays $28/month to the phone company for a landline (plus $35/month for internet), while I buy a VOIP modem and get a Google Voice number for free and I have phone in my hope for $0/month plus a one time purchase of the modem for $35. How is my sister's decision twisted around to make it efficient?
Thanks, Mike
This wall of text is in a bad need of tl;dr. A single paragraph coherently explaining what the point is would be very helpful.
While I'm here...
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.
...I'm not sure about this. Google Scholar currently says Coase's "The Problem of Social Cost" has 21,502 citations, but Kahneman & Tversky's "Prospect theory: An analysis of decision under risk" apparently has 27,143, and Jensen & Meckling's "Theory of the firm: Managerial behavior, agency costs and ownership structure" apparently has 38,476.
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.
Of course you can explain anything. You can always say: "God did it." Your statement: "A rational agent made an efficient choice" doesn't provide any additional useful information.
If you allow any type of explanation you can't do any economics based on numbers anymore. You can't even say 2+2=4 because 2+2=4 is a statement that makes certain assumptions about your unit of measurement.
To do economics you have to make certain assumptions about the nature of economic transactions that allow you to use certain mathematical axioms.
Actors that don't follow those assumptions get called inefficient and that's useful.
If you allow any type of explanation you can't do any economics based on numbers anymore.
Sure you can. It's just that your numbers will be fuzzy and you'll have to use not math but statistics. You won't be able to get much use out of mathematical axioms, but you'll be able to build statistical models that include and, hopefully, quantify uncertainty involved.
Sure you can. It's just that your numbers will be fuzzy and you'll have to use not math but statistics. You won't be able to get much use out of mathematical axioms, but you'll be able to build statistical models that include and, hopefully, quantify uncertainty involved.
No, most statistical models need assumptions about the data distribution. You don't get very far without throwing assumptions in your model.
most statistical models need assumptions about the data distribution.
I don't think that is true (though we can quibble about what constitutes "most"). Assumptions about data distributions generally allow you to make strong statements about best/optimal/efficient estimators, but those, while useful, are not really necessary for building models.
Most statistical models need assumptions about stability -- basically that data from the past is relevant to making statements about the future -- but that is a general requirement of almost any forecasting.
Let's say we have a guy who finds utility in donuts. He however is also afraid of the number 13. So he prefers having 12 donuts to having 13 donuts just as he prefers having 14 donuts over having 12 donuts.
If you allow people with utility functions like that you are going to have real problems with saying anything worthwhile throught he use of math even if you do use statistics.
If you allow people with utility functions like that you are going to have real problems with saying anything worthwhile throught he use of math even if you do use statistics.
First, I don't think so.
Second, I much prefer imperfect models that are representative of the real world (where some guys are afraid of the number 13) to neat and sterile models of imaginary simulations.
Second, I much prefer imperfect models that are representative of the real world (where some guys are afraid of the number 13) to neat and sterile models of imaginary simulations.
Could you give examples of economical models that give useful insight which allow those utility functions?
I am not sure what are you asking for. First, any statistical model with an error term can handle occasional weird cases by sweeping them into the "error". Second, discontinuous functions are not something outrageous or strange. Sure, an assumption of a monotonous utility function makes life much easier, but being easy is a tertiary, at best, goal of model building.
First, any statistical model with an error term can handle occasional weird cases by sweeping them into the "error".
If I have a model of how data is distributed, I think that model contains assumptions.
Baysians have their priors that go into models. Frequentists usually assume that the data follow a normal distribution (or some related distribution) plus an error term.
I don't think there are models without inbuild assumtions
Sure, an assumption of a monotonous utility function makes life much easier, but being easy is a tertiary, at best, goal of model building.
Models exist to help us make sense of the world. Airplanes are still designed with newtonian physics in mind because it's a nice easy model. Only if you know how many weird cases there are.
Keeping your model as simple as possible while still being able to make good predictions is the name of the game.
I don't think there are models without inbuild assumtions
A model is a simplified description of the world. It is a synonym of "map" (in the map vs territory sense).
Let's say I sit by the window and count up the gender of people passing by. After some time I have X males, Y females, and Z undetermineds. My model is that the probability of a recognizeably-male passing by my window is X / (X + Y + Z). It's a trivial model, but it's still a model and I don't see what in-built assumptions it comes with except for, as I mentioned before, the assumption of stability (aka that the past is relevant to the future).
Models exist to help us make sense of the world.
Some are. But others exist to make accurate forecasts and for them being "easy" is not a goal.
Other people have expressed general disagreements with this post. I find it hard to comment on those since I'm not sure how to interpret the post in the first place. I understand what it's saying paragraph by paragraph, but I can't mentally integrate all of it into a set of conclusions that's nontrivial, accurate, and doesn't rely on defining connotatively loaded terms like "efficiency" in an unusual way.
Instead, I'm going to take issue with one specific part of the post, the discussion of Coase's explanation of externalities. From the post:
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.
This is mistaken, because transaction costs are not the only explanation for why two parties can fail to negotiate a mutually beneficial resolution of an externality. Here's one way that could happen.
Suppose there are no transaction costs at all: Abe & Barry are teleported to the negotiating table and told they'll both be compensated for whatever time it takes for them to reach an agreement, so negotiating costs them nothing.
Once Abe & Barry have their bearings, Abe realizes he's probably the only person who knows the precise marginal benefit of the factory to himself, and Barry realizes he's probably the only person who knows the factory's exact marginal cost to himself. Abe & Barry, knowing just enough about negotiation to be dangerous, decide to enhance their bargaining strength by exaggerating how good the status quo is for themselves. So Barry complains that the factory's pollution costs him $5 (instead of $10), and Abe says his factory is worth $10 (instead of $5).
If Abe assumes Barry is being honest, and Barry assumes Abe is being honest, no money changes hands. (Barry thinks Abe will demand at least $10 to close the factory, but sees no point in giving Abe that much, so Barry doesn't make an offer. And since the original description of the problem implies Barry has no power to have Abe's factory shut down against Abe's wishes, Abe has no incentive to compensate Barry.) The factory carries on emitting pollution and the externality remains uncorrected!
More realistically, Abe & Barry will suspect each other of tactical lying. If so, they can't trust each other's claims about the factory's benefit/cost, and so neither has any more information than before they spoke.
To move things forward, Barry might offer Abe some arbitrary sum of money to close the factory, but this might not help. Barry presumably won't offer ≥$10 because the factory only hurts him to the tune of $10. If Barry offers ≤$5, Abe will refuse, and the status quo will remain. Finally, if Barry offers between $5 and $10, Abe might accept...but Barry will've revealed he was originally lying about the factory's cost to himself, and Abe might hold out in the hope that Barry will then offer a little more. For example, if Barry offers Abe $6, Abe will probably infer that Barry's suffering at least $6 of loss because of the factory, and most likely even more. At that point Abe might refuse the $6 in the hope that Barry will then offer $7. If Barry does then offer $7, Abe might decide to push his luck again and hold out for $8. This game could well continue until Barry gives up and negotiations break down. (Worse still, if Barry realizes that Abe might hold out like this, Barry can't even infer a lower bound on how much Abe values the factory. If Barry offers Abe $8 and Abe says no, is it because Abe thinks the factory is worth at least $8 or just because Abe is holding out for more?) If Barry's offers all fail, the factory will again carry on emitting pollution and the externality will again remain uncorrected.
These concerns are purely tactical and independent of transaction costs. The underlying problem is incomplete information, which opens the door to tactical behaviour that can make Coasian negotiation (and negotiation generally) fail. It follows that when Coasian negotiation fails, the explanation is not always as straightforward as the cumulative transaction costs being too high.
(I don't care that you didn't use the standard font, BTW.)
I typed up this article entirely within the default LessWrong editor, so I'm damned if I know what happened.
novalis and Alejandro1,
Yes, I'm saying that the economic universe is as deterministic as the physical universe. That doesn't mean that you can't make bad decisions, stupid decisions, or decisions that you regret. It just means that your decisions have to make sense according to the laws of economics given all the constraints on the system. It's important because economists don't think that's true. They think there are outstanding Pareto improvements. They think (thought--now inefficiency is jumbled up with a couple of other meanings and it's hard to say exactly what they mean) externalities are explained by inefficiency, not some constraint. You shouldn't have to know specifically about transaction costs to know that inefficiency is a fake explanation and if something doesn't make sense in the world, then you're either doing the math wrong or missing a piece of information. If you call something Pareto-inefficient, you're saying that something exists that, given the constraints on the system, the laws of economics would not allow to exist.
If I miss a $20 for some reason that seems silly like wanting to hear a piece of music or because I'm counting air conditioners, then that's just as valid an explanation as me missing the $20 because the $20 doesn't exist, or because I am physically paralyzed and cannot pick up the money, or any other reason. Something like "I just had to hear that music" or "I was busy counting air conditioners and didn't see it" sounds trivial to the human brain, but the universe doesn't bother to check if you think something's silly before executing it.
Armen Alchian is well known to economists. I said he was powerful in the sense that he was very good at economics, not that he actually wielded power, in case that wasn't clear. He will always be on the top of the list of economists who should have won the Nobel Prize and didn't.
Would you also says that a rock that tumbles down a mountain or a wave crashing on the shore is behaving efficiently? If yes, then the concept is meaningless, everything that happens according to the laws of nature is efficient. If on the other hand you say that only agents behave efficiently, then I would reply that humans are not always agent-like entities, and sometimes behave more similarly to rocks than to true agents.
My example of missing the $20 was supposed to illustrate this, but it seems not to have worked, so I will try once more with an AI program. Imagine an AI programmed to trade in the stock market, aggregating information about prices and executing trades in order to maximize some coded measure of profit. Presumably it is behaving efficiently if anything is. Now imagine that a quantum fluctuation in the hardware causes it to behave (for a second until the error is corrected) against the coded way and throw away some profit. Does its behavior "make sense according to the laws of economics given all the constraints on the system."?
I contend that if you say the AI behaved efficiently when it left some "money on the table", you might as well say a falling rock is being efficient, you are using the word to describe something that at the moment was not behaving agent-like at all. And you agree that the AI did not behave efficiently at the moment, then I will contend that humans have the same kind of problems all the time.
The only way you can get around this is by saying that once you decide to count a human or AI as an economic agent, you will describe its actions so that they are all efficient by definition, even at the times they are not very agent-like. You are of course allowed to do this, and it might even make your model of economics more simple and elegant (though hardly more predictive!). But you cannot then say grand things like "The laws of economics do not allow inefficiencies", "The economic universe is as deterministic as the physical universe", etc., and think they are deep and meaningful. They are only true because of the definitions you have chosen to use.
I agree that it is possible to make a description of an economy in such terms as there being no inefficiency. Just as (and closely related to the fact that) it is possible to make a description of a person's actions in such terms that they are never irrational; everything they do, they do because they value the most doing it. But is this a fruitful way of thinking?
Let us take an example, varying a bit on novalis'. You are walking and see $20 on the street, about to fall into the drain. Counsciously, you think you should pick it up; but somehow, you don't and keep walking instead. What actually happened, though you are not really conscious of it, is that you were momentarily distracted by music from a passing car, and while trying to identify the song your brain failed to issue the order "bend and pick the money" until you had walked a couple of steps past it, at which points the sunk costs fallacy made you loath the idea to walk back.
Now, there are two ways of describing this:
a) The outcome, despite appearances, was Pareto-efficient; you valued identifying the music and not retracing your steps more than the $20, otherwise you would have picked it up.
b) The outcome was inefficient; you don't really place any intrinsic value on the things your brain chose; it was just a glitch that made you momentarily irrational.
The question is not which description is true. It is which is more fruitful, more generalizable, more able to interpret and predict your behavior in new circumstances. I suspect that the answer is certainly the second one when we want to do neuropsychology and cognitive science. The first one might make pure economics more simple and elegant, but at the cost of isolating it form other sciences.
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.
