ECONOMIC EFFICIENCY

A Critical Appraisal
 • We have just learnt that perfectly competitive
markets are efficient.
• To recapitulate, we defined efficiency in a
particular way (?).
• And have made the argument that a perfectly
THE FREE MARKET competitive market equilibrium is efficient.
ARGUMENT • Smith’s basic claim was :
• “The free market system is like an invisible
hand that can… coordinate the behaviour of a
multitude of individuals, interested only in
maximizing their own selfish utility, so as to
bring about efficiency and a socially optimal
outcome.”
 Markets are efficient in the pareto sense.

WHAT IS
What is Pareto efficiency?
ECONOMIC
EFFICIENCY?

An economy is in a Pareto Efficient state when no

further changes in the economy can make one person
better off without, at the same time making another
worse off.
 EXPLANATION OF THE TERM
PARETO EFFICIENCY

• Suppose there are two states of the world X and Y.

• If it is the case that at least one person is better off in state X, and everyone else is at
least as well off in state X as in Y, then we say that X is Pareto Superior to Y.
• If it is the case that at least one person is worse off in state X, and everyone else is at
least as well off in state X as in Y, then we say that X is Pareto Inferior to Y.
• If it is the case that one person A who is better off in X compared to Y, but there is
another person B who is worse off in X than in Y, then we say that states X and Y are
Pareto Non-comparable.
• Finally, if it is the case that there is no way we can improve anyone from X without
making another person worse off, then X is Pareto efficient.
 PARETO State Distribution
EFFICIENCY X Person A has Rs. 80 and
COND… person B has Rs. 20.

• Anytime we hear the word

efficiency in economics, unless
otherwise stated, it is used in
Y Person A has Rs. 100 and
the Pareto Efficient sense. person B has nothing.
• Illustration: Any allocation of a
fixed resource is always Pareto
efficient.
Z Person A has Rs. 100 and
• Suppose total wealth in society
is Rs. 100, and there are only person B has nothing.
two individuals A and B.
 ABSENCE OF INTERPERSONAL
COMPARISON IN PARETO EFFICIENCY

• One of the biggest problem of Pareto efficiency is the inability to carry out interpersonal
comparisons. ie. One does not compare the welfare of one party with the welfare of the
other party. We simply compare the welfare of one party in one situation with the welfare
of the same party in other situation when commenting on pareto efficiency.
• For most practical situations, if we are facing two policies, it would usually be the case
that a certain policy is good for one group of people but makes another group of people
worse off, and exactly the opposite for another policy. That is to say, typically, there are
winners and losers from a policy outcome. In the absence of the ability to carry out
interpersonal comparisons, Pareto Efficiency is not exactly a very useful policy tool.
• But, one strength is that if we can identify a Pareto superior policy (no one worse off, and
at least one person better off), then we must advocate for that policy.
 K A LD O R - H I C K S EF FI C I EN C Y- I M P R O V E D
D E FI N I TI O N O F EF FI C I EN C Y O V ER PA R ETO
E FF I C I E N C Y

• Suppose there are two states (1 and 2) of the world which are Pareto non-comparable.
• Suppose the party who is better off in the second state, can potentially compensate the
party which is worse off in this state so that they are exactly as well off as in state 2 (they
were worse off without the compensation) as they were in state 1, then we can say that 2 is
a Kaldor-Hicks improvement over state 1.
• Important to note is that this is theoretically better, because the compensation is potential
and not actual.
• This bypasses the problem of interpersonal non-comparability by introducing the
possibility of compensation.
 • Before embarking on the criticisms of efficiency, let
F I R S T F U N D A M E N TA L
W E L FA R E T H E O R E M O F
ECONOMICS
us remind ourselves the First Fundamental Welfare
Theorem of Economics. Quoting from Kaushik
Basu’s book:
• If we have a competitive economy, where all individuals
choose freely according to their respective rational self-
interest, then (given a few technical conditions) the
equilibrium that will arise will be Pareto optimal.
TOWARDS A
CRITIQUE…
 The action-theoretical assumption that actors maximize their utility or
their profit in their actions; and the idea that decentralized economic
processes exist in, or at least strive for, an equilibrium in which the
independently acting economic subjects can achieve an optimal
realization of their economic plans.

The first theorem of welfare theory was formulated from this postulate,
which says that, given a sufficient number of markets, the competitive
BASIC action of all producers and consumers, and the existence of an equilibrium,
PREMISE: A the allocation of resources is Pareto-optimal in this equilibrium: none of
the actors can enhance his/her utility by a change in the allocation of
RECAP goods without impairing that of at least one other actor.

The optimality of the allocation situation in the equilibrium legitimates

the market as the central economic institution with a capacity for
universal approval.
 1. CRITICISM: NOT VERIFIABLE

• There is no way to empirically verify this claim of efficiency. To quote Kaushik Basu:
• First and foremost, ... like all theorems in mathematics, it does not really say anything testable
about the real world or anything that would allow us to make any predictions. Instead, it
establishes the equivalence between two definitions: equilibrium and optimality.
• Can we weigh all possible states of world of allocating resources and then make a
statement like competitive market equilibrium is pareto efficient?
 2. SELF-INTEREST?

• Before going on to other critiques, we have to first look at what the definition of efficiency
is premised on.
• Our calculations of efficiency, recall how we calculated consumer’s and producer’s
surplus, is based on the premise that welfare is equal to preference satisfaction.
• Why is that? Recall class discussion.
• We have to impose the condition that individuals have to be self interested. No other
regarding preferences can be allowed, because that can lead to perverse social outcomes.
 OTHER MOTIVES?

• We are forced to impose self-interested individuals to avoid perverse market

outcomes. But this poses two sorts of problems.
• a)  Just because we include self-interested behaviour in our model does not
change reality. In the real world, people are motivated by a host of factors
including love, affection, empathy, jealousy, sadism etc. So what that we now
theoretically impose self-interested behaviour?
• b)  By throwing away other regarding behaviour to avoid perverse outcomes,
we have also thrown away possibilities of cooperation, altruism, sympathy,
empathy and so on.
 3 . I N D I V I D U A L S A R E N O T ATO M

What does it really say about the real world?

• Does the benign by-line ‘given a few technical conditions’ ever hold?
• One of those conditions that need to be true is that individuals have to be numerous, or their
effect on others have to be very small, such that each individual (both consumers and producers)
are price takers. This is very similar to what we can expect in physics with atoms, but with
human beings in society, this could pose problems.
• What if there is a group or collective decision? What if individuals behave/choose as strategic
agents? Then we are outside the realm on non-cooperative competitive equilibrium, and we find
ourselves in the realm of some sort of cooperative game theoretical situation.
 OTHER CRITICISMS

• 4. Individuals have to be well informed while forming their preferences. If not, then again
we can have perverse outcomes.
• 5. Preferences are not formed or deformed in any way.
6. The notion of efficiency has very little ethical attraction. It does not talk about equity,
has no promise of being against any oppression, and does not ensure that outcomes will be
against anything that is morally abhorrent. The outcome will be efficient in the Pareto
sense only.
 7.CRITICISM: EMPIRICAL REALITY
IS DIFFERENT

• The criticism argues both on an epistemological and an empirical level: an objective

glance at the action of actors in economic situations demonstrates at once that they often
do not follow the prescriptions of the model of the maximization of utility.
• As defined by the theory, “irrational” action is so prevalent in economic contexts that it
does not seem admissible to exclude it simply as a deviation from the theoretical system
for understanding economic processes.
 THE DEFENSE…

• However, the development of empirical weaknesses of economic theory is not regarded as

a convincing starting point for a criticism.
• The question of “ought to” are considered more than the question of “what is out there”…
• The strength of economic theory resides in the normative postulation of the connection
between the action model of homo-economicus and a model of order derived from it in
which efficient allocation equilibria prevail.
• Normative here means that recommendations for action can be derived from the
theoretical models that imply how actors have to act if they want to optimize their
individual utility, while the invisible hand of the market at the same time produces an
equilibrium with optimal allocation of resources.
 COUNTER

• A criticism of orthodox economic theories should begin with this strong point of the
connection of models of action and order and should show why the normative claims of
the theory are untenable.
• One needs to show-
• Using the rational-actor model, strategies are recommended that lead to Pareto-inferior results.
• Because of the structure of the situation, it is not possible to identify an optimal manner of action.
• Example: One needs to describe such situations where “irrational strategies lead to
superior results”… or instead individual maximizing utility, all parties maximize the
utility of the group as a whole.
• This would require co-operation instead of competition amongst the parties.
 EXAMPLE 1: CO-OPERATION

• Jens Beckert calls this situation ”being rational is actually irrational”.

• According to the thesis that follows from this type of critique, we can imagine social order in the economy as
defined by “an efficient allocation” of resources only if the actions of the actors are also integrated into
nonmarket mechanisms of coordination.
• The FFWT claim is that a non-cooperative outcome is Pareto Efficient. Non-cooperative because no one
talks to each other, and everyone does their own thing, and yet we have efficient outcomes. Two sorts of
criticism can be made here:
• a)  One sort of criticism is that, individuals can operate in a collective and act as strategic agents.
• b)  But, even without that, there is another criticism that individuals can act non-cooperatively, and can still
end up in a suboptimal situation—the most famous example of this is the Prisoner’s Dilemma.
WHE RE COOPERAT ION AND NOT COMPET ITION
LE ADS TO SOCIALLY E FFICIENT OUT COME

Country B
Nuclear State Non-Nuclear State
(Threat of war) (Peace)
Country A Compete Co-operate
Nuclear State 1, 1 Nash 10,0
(Threat of war) equilibrium
Compete
Non-Nuclear State 0,10 7,7 Socially
(Peace) efficient
Co-operate outcome
 EXAMPLE B: UNCERTAINTY

• This example is devoted to a second limit of the economic model of action, which can be
attributed to the problem of uncertainty.
• The problem is not that an individually rational strategy of behavior impedes the achievement
of efficient results, as in the problem of cooperation, but rather that an optimal strategy cannot
be discerned.
• We want to maximize our utility, but we do not know which strategy of behavior we should
choose for that because we do not know the causal relations from which we can deduce an
optimizing decision.
• It is impossible to act rationally.