Historical Background
The term “efficiency” derives etymologically from the Latin word efficiens, which in turn originates from the Latin verb ex facio, which means “to obtain something from.”(2) The application to economics of this view of efficiency as the ability to “obtain something from” predates the Roman world and can even be traced back to ancient Greece, where the term “economics” (??????µ?a) was first used to refer to the efficient management of the family home or estate. In Economics, 380 years before Christ, Xenophon attributes to Socrates the assertion that economics is “a branch of knowledge” of a sort “by which men can increase estates,” that an estate is “identical with the total of one’s property,” and that property is “that which is useful for supplying a livelihood.”(3) Xenophon himself, upon presenting such a modern and subjectivist definition of economics, goes on to explain in the subsequent dialogues that there are two different ways to increase one’s estate, and these are ultimately equivalent to two different aspects of efficiency.
One aspect coincides with that of “static efficiency” and consists of the sound management of the available (or “given”) resources, to prevent them from being wasted. According to Xenophon, the primary way to achieve this efficient management is by keeping the home in good order (4), as well as by carefully supervising the handling of one’s goods, monitoring and caring for them as well as possible. Xenophon sums up the set of abilities necessary for an efficient management of “given” resources with the wise answer offered to the great Barbarian king who “had happened on a good horse, and wanted to fatten him as speedily as possible. So he asked one who was reputed clever with horses what is the quickest way of fattening a horse. ‘The master’s eye,’ replied the man. I think we may apply the answer generally, Socrates, and say that the master’s eye in the main does the good and worthy work.” (5)
Nevertheless, along with this aspect of efficiency, which we have described as “static,” Xenophon introduces a complementary “dynamic” facet, which consists of the attempt to increase one’s estate through entrepreneurial action and by doing business with it. What is involved is the effort to increase one’s goods by way of entrepreneurial creativity; that is, by trade and speculation, more than the effort to avoid wasting the resources already in one’s power. Xenophon provides two examples of specific activities to illustrate this task based on entrepreneurial activity. One example entails the purchase of poorly tended or barren land with a view to improving it and later selling it at a much higher price.(6) Another example of dynamic efficiency, which makes it possible to increase one’s estate and gather new resources, is found in the activity of those merchants who buy wheat where it is abundant, and therefore inexpensive, and transport and sell it at a much higher price in places where drought or poor crops have led to a shortage and hunger.(7)
This tradition of clearly distinguishing between two distinct facets of efficiency, the static and the dynamic, survived even until the Middle Ages. For example, Saint Bernardine of Siena felt that the income of merchants and craftsmen was justified on the basis of their industry and pericula: by the sound, diligent management of their (given) resources; that is, by assiduous behavior typically oriented toward preventing waste (static efficiency); and by the acceptance of the risks and dangers (pericula) which arise from any entrepreneurial speculation (dynamic efficiency).(8)
The Influence of Mechanical Physics
Nevertheless, despite these hopeful beginnings, with the arrival of the modern age the concept of economic efficiency gradually narrowed and diminished, until it came to denote merely the static aspect; in other words, diligent action aimed at preventing the waste of “given” resources. The effect which the emergence and development of mechanical physics ultimately exerted on the evolution of economic thought, especially from the nineteenth century onward, had a decisive influence on this reductionist trend, which noticeably impoverished the concept of efficiency as Xenophon had formulated it, with its two distinct facets.
In fact, with the arrival of the modern age, physics replaced astronomy as “science par excellence” and was ultimately built upon the idea of “energy,” an abstract concept all physicists discuss and debate about, even if they do not manage to completely agree on the precise essence of energy in the absence of empirical evidence of its effects in the form of force or movement.(9) Along these lines, the “law of conservation of energy” came to play a key role in the development of physics, and we should not ignore its essentially static nature (“energy is neither created nor destroyed, only transformed”). Later the second law of thermodynamics stated that in all physical processes some energy is wasted, for instance in the form of heat which dissipates, and therefore physical systems are not reversible. Both laws were integral to the great evolution of physics throughout the nineteenth century and explain why most scientists think of physical phenomena almost exclusively in terms of “energy.” Moreover, the main practical application of physics emerged in the development of mechanical engineering, which was built entirely on the (static) concept of energy efficiency, defined by engineers as the “minimization of energy waste.” The steam engine, which became the classic capital good in the Industrial Revolution, provides an excellent example. The steam engine transforms heat into movement and the lifting of weights, the goal of all good mechanical engineers being maximum (static) efficiency, or maximum movement with minimum energy consumption or waste.
This reductionist idea of (static) efficiency came to dominate in colloquial language as well. Hence, the definition Webster’s Dictionary supplies for “efficient” rests on the notion of minimizing waste: “Marked by ability to choose and use the most effective and least wasteful means of doing a task or accomplishing a purpose.(10)” In Spanish, the concept of efficiency is closely related to the capacity for achieving a specific outcome or yield. The Diccionario de la Lengua Española defines the term rendimiento [“yield”] as “the ratio between the product or result obtained and the means used” (both of which are assumed to be given or known).
Perhaps at this time it is most important to highlight the negative influence which the static conception of energy efficiency has exerted on the development of economics. Hans Mayer(12) and Philip Mirowski have pointed out that neoclassical economics developed as a copy of nineteenth-century mechanical physics: using the same formal method, yet replacing the concept of energy with that of utility and applying the same principles of conservation, maximization of the result, and minimization of waste(13). The leading author most representative of this trend, and the one to best illustrate this influence of physics on economic thought, is Leon Walras. In his paper, “Economics and Mechanics,” published in 1909, he claims that in his Elements of Pure Economics he uses mathematical formulas identical to those of mathematical physics, and he stresses the parallel between the concepts of force and rareté (which he regards as vectors), and between those of energy and utility (which he regards as scalar quantities).(14)
In short, the influence of mechanical physics eradicated the creative, speculative dimension which belonged to the idea of economic efficiency from its very origins, and all that remained was the reductionist, static aspect, which focuses exclusively on minimizing the waste of (known or given) economic resources. By way of example, let us recall the definition of “efficient allocation” which The New Palgrave Dictionary of Economics provides and which it credits to Stanley Reiter: “going as far as possible in the satisfaction of wants within resource and technological constraints.”(15) (Note the assumption that resources and technology are given.) It is both revealing and discouraging to find that the entry devoted to economic efficiency by what is undoubtedly the leading dictionary in our discipline includes absolutely no mention of the dynamic aspect of this concept. This omission is particularly illustrative and disheartening in light of the fact that neither resources nor technology are “given” in real life, but can vary and actually do vary continually as a result of entrepreneurial creativity. Moreover, the true changing nature of these factors clearly indicates the existence of an entire, time-honored dimension of efficiency (the dynamic dimension, which, as we have seen, can be traced back as far as Xenophon) that can only be forgotten at a high cost to the economic analysis of reality.
The reductionist conception of static efficiency also had a great impact on business organization from the beginning of the twentieth century, when Taylorism emerged. In fact, Frederick W. Taylor, in his famous book, The Principles of Scientific Management (1911), advocates the establishment in all industries of a “productive efficiency” department to pursue the following aims: first, to supervise workers; second, to measure the time spent on a job; and third, to avoid any kind of waste.(16) This reductionist concept of static efficiency actually turned into a sort of idol which seemed to command the sacrifice of everything, and this static-efficiency obsession (which might best be described as “worship”) spread even to the realm of political ideology.
The Fabian socialists Sydney and Beatrice Webb provide a compelling example of this phenomenon. This married couple were shocked by the “waste” they observed in the capitalist system and founded the London School of Economics in an effort to champion the reform of the economic system. The object of such reform would be to eliminate waste and make the system “efficient.” The Webbs later made no secret of their warm admiration for the “efficiency” they believed they observed in Soviet Russia, to the point that Beatrice even declared, “I fell in love with Soviet Communism.” Another noted author to be lured by the static conception of economic efficiency was John Maynard Keynes himself, who, in his introduction to the 1936 German edition of his General Theory expressly states that his economic-policy proposals “are more easily adapted to the conditions of a totalitarian state.” Keynes also unreservedly praised the book Soviet Communism, which the Webbs had published in 1933.(17)
“Welfare Economics” and the Static Concept of Efficiency
The development described above peaked in the 1920s and 1930s, when the static concept of economic efficiency became the focal point for a whole new discipline which came to be known as “welfare economics,”(18)and which grew from a series of alternative approaches. According to the Pigouvian analysis, an economic system would reach maximum efficiency when the marginal utility of all factors is equalized, something which would require the redistribution of income until each actor derived the same marginal utility from his last monetary unit. Pigou thus upholds the tradition of strict utilitarianism initiated by Jeremy Bentham and later continued by the naive marginalists (Sax, Sidgwick, etc.). It is obvious that Pigou’s approach involves interpersonal comparisons of utility and metascientific value judgements, and hence it was soon generally replaced with the alternative Paretian approach.
From a Paretian perspective, an economic system is in a state of efficiency if no one can be made better off without making someone else worse off. This view, although still essentially static, seemed to circumvent the need for interpersonal comparisons of utility and paved the way for those welfare economists (Lerner and others) who formulated the so-called “first theorem of welfare economics,” according to which a system of perfect competition attains allocative efficiency in the Paretian sense. The next step was to identify a number of “market failures” which supposedly generated inefficiencies (in the static sense of the word) by distancing the economic system from the model of “perfect competition.” (Initially monopolies and externalities were dealt with, followed by more sophisticated sources of static inefficiency, such as asymmetric information, moral hazard, and incomplete markets.) At the same time, and as an alternative, the Kaldor-Hicks approach was presented, including the analytical principle of “potential compensation”: situation II is considered more efficient than situation I if those who benefit can compensate those who lose (Kaldor); or if those who are made worse off by situation II cannot prevent the change by “bribing” those who stand to gain from it (Hicks).(19)
Theorists subsequently formulated the “second fundamental theorem of welfare economics,” which stated that Pareto efficiency is compatible with various initial resource allocations. This theorem requires the belief that criteria of efficiency and fairness can be considered in isolation and that they can be combined in different proportions. Bergson and Samuelson, on their part, introduced the “social-welfare function,” which, although it again lapses into interpersonal comparisons of utility, would enable us to eliminate the indeterminacy of the point of maximum efficiency among all which are Pareto efficient and make up the production possibility curve. However, Arrow later demonstrated the impossibility of obtaining a social-welfare function which satisfies certain reasonable conditions of consistency (“third fundamental theorem of welfare economics”). The economist Amartya K. Sen, another winner of the Nobel Prize, demonstrated along the same lines that it is impossible to conceive of a social-welfare function which meets both the criteria for Pareto optimality and the traditional standards of liberalism, basically because individual ordinal-utility rankings cannot be aggregated, and thus the social-welfare function cannot possibly fulfill all individual preferences.(20)
Criticism of Welfare Economics and the Concept of Static Efficiency
For obvious reasons, we cannot elaborate on all existing criticisms against the different standards of static efficiency that have appeared in the area of welfare economics. These approaches have already been critically analyzed in a wealth of literature which we are unable to reproduce here. Nevertheless, we will summarize the most common objections, mainly to contrast them with the one we consider by far the most significant, and which up to now has been almost entirely disregarded.
First, the different criteria of static efficiency established in the context of welfare economics involve the more or less covert introduction of value judgements devoid of scientific objectivity. As we have indicated above, this is clear of Pigou’s approach and the social-welfare function, since, in order to have any operative content, both require interpersonal comparisons of utility, which are scientifically unacceptable according to the general consensus among economists since Lionel Robbins. Furthermore, it is not altogether clear that comparisons of utility can be made even by the same individual in relation to himself if they correspond to different points in time and to the contexts of different actions. In such a case, even when the same person is involved, he would often be attempting to compare diverse and heterogeneous dimensions which are scarcely comparable with one other. Moreover, not even the Paretian approach, despite the appearances, could be considered completely neutral with respect to interpersonal comparisons and value judgements: an envious person, for example, might actually feel worse in the event of a Paretian improvement (if someone were to gain without “appearing” to worsen anyone else’s situation, except, of course, that of the envious person).
Second, the assorted approaches of welfare economics contain a serious flaw: they imply that individual utility rankings and the different possibilities that open up for each actor are “given”, that is, known and unchanging. To put it another way, it is assumed that these rankings and possibilities always reflect “utility functions,” which are also presumed constant and known. This assumption is especially restrictive and objectionable in the case of Pigou, whose normative proposal of income redistribution not only involves interpersonal comparisons of utility, but its practical implementation would entail a radical change in the corresponding “utility functions” and also profoundly impact the process of entrepreneurial coordination, a much more significant effect still, as we shall see.
Third, the notion of technical efficiency, borrowed from mechanical physics, continues to strongly influence static-efficiency criteria. This is so despite the many efforts of highly distinguished economists (Robbins, Lipsey, Alchian and Allen, etc.) to differentiate technical or technological efficiency from economic efficiency once and for all.(21) It has been contended that while technical or technological efficiency would consist of minimizing inputs in physical terms (such as tons of coal, barrels of oil, etc.) to produce a certain outcome, economic efficiency would consist of the same; that is, the minimization of inputs, yet in terms of cost (i.e. units of input multiplied by market price) instead of in physical terms. Nevertheless, if one assumes, as is assumed with all of the static-efficiency criteria mentioned, that technology and market prices are “given”, in other words, that they are known and constant, then plainly the modus operandi of economic efficiency (the static version) and that of technical efficiency would be identical: both would amount to maximization via a mere mathematical operation subject to known restrictions. We can conclude, then, that within the context of welfare economics, a striking similarity in form exists between the concept of technical efficiency and the static notion of economic efficiency. To put it another way: the static conception of economics reduces the principle of economic efficiency to a simple technical issue of maximization, which in any case could be resolved with a mere computer into which someone would enter the data always presumed known in the models of static efficiency.(22)
Nevertheless, regardless of the importance of the above critical assessments, they fall short of what we see as the essential criticism to be leveled against the different efficiency standards propounded within welfare economics: that these standards focus solely on one of the two aspects of economic efficiency, namely the static aspect, which entails the presumption both that resources are given and constant, and that the fundamental economic challenge is to avoid wasting them. Furthermore, when, for example, a company, social institution, or entire economic system is to be judged, such criteria completely ignore its Dynamic Efficiency, understood as its capacity to foster entrepreneurial creativity as well as coordination; in other words, the entrepreneurial capacity to seek, discover, and overcome different social maladjustments.
In fact, we believe our most important goal should not be to move the system toward the production possibility frontier (while deeming the corresponding curve “given”), but rather to systematically apply the criterion of dynamic efficiency, which focuses on the capacity of the system to continually “shift” the production possibility curve to the right. Thus the importance of overcoming the traditional static criteria of economic efficiency with a more complete, alternative standard which takes into account the dynamic dimension of every economic system. In the next section, we will discuss our dynamic-efficiency criterion in greater detail.
Jesús Huerta de Soto
Professor of Political Economy
King Juan Carlos University of Madrid, Spain
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(2) Blánquez 1998, 567, meaning 2.
(4) “My dear, there is nothing so convenient or so good for human beings as order.” Xenophon 1979, Ec.8.3.
(6) “On the other hand, to a careful man, who works strenuously at agriculture, no business gives quicker returns than farming. My father taught me that and proved it by his own practice. For he never allowed me to buy a piece of land that was well farmed; but pressed me to buy any that was uncultivated and unplanted owing to the owner’s neglect or incapacity. ‘Well farmed land,’ he would say, ‘costs a large sum and can’t be improved.’…Now nothing improves more than a farm that is being transformed from a wilderness into fruitful fields. I assure you, Socrates, that we have often added a hundredfold to the value of a farm.” Xenophon 1979, Ec.20.22-24.
(7) “So deep is their love of corn that on receiving reports that it is abundant anywhere, merchants will voyage in quest of it: they will cross the Aegean, the Euxine, the Sicilian sea; and when they have got as much as possible, they carry it over the sea, and they actually stow it in the very ship in which they sail themselves. And when they want money, they don’t throw the corn away anywhere at haphazard, but they carry it to the place where they hear that corn is most valued and the people prize it most highly, and deliver it to them there.” Xenophon 1979, Ec.20.27-28.
(9) in fact, the term “energy” also derives etymologically from Greek and means “vigorous action.
(10) ”Webster’s Third New International Dictionary. 1981. Chicago and London: Encyclopedia Britannica. 1:725. (Italics added.)
(11) “Proporción entre el producto o resultado obtenido y los medios utilizados.” Diccionario de la Lengua Española. 1992. Madrid: Real Academia Española, Espasa Calpe. 559, 1254.
(13) Mirowski 1989. Mirowski later (2002) refined even further his critical analysis of the mechanicism of the neoclassical school, which he refers to as “the Cyborg incursion into economics.”
(14) “Aussi a-ton déjà signalé celles des forces et des raretés comme vecteurs, d’une part, et celles des énergies et des utilités comme quantités scalaires, d’autre part.” Walras 1909, 318. Quoted by Mirowski, op. cit., 220.
(15) The New Palgrave Dictionary of Economics. 1987. Edited by John Eatwell, Murray Milgate, and Peter Newman. London: Macmillan. 2:107.
(17) Keynes 1973, 7:26, 28:333-334. Keynes also echoed the assertions of those intellectuals whose thinking was clouded by the economic “victories” of the Soviet Union (“I have seen the future and it works”). See also Ralph Raico 1997.
See the following section.
(18) See the following section.
(19) On the practical impossibility, in any case, of applying the criterion of Kaldor-Hicks, see the article by Stringham (2001, 41-50).
(20) For a summarized update on the issue, see Gámir 1996.
(21) Robbins 1972, 36-37; Lipsey 1966; Alchian and Allen 1964, 435-437.
(22)After writing this paper, I noticed Buchanan suggests the same idea in Buchanan 1979, 25.