Economic efficiency – an ideal of the past?

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Economic efficiency was the mantra of most of the 1990s, and still provides the backdrop to current political debates. Yet recent developments in the Australian social landscape suggest that it should be relegated to an ideal of the past.

Economic efficiency is one of the most commonly spouted bits of jargon in Australian politics. It makes an appearance on most evening news bulletins, it’s dotted through our newspapers, and rolls easily off the tongues of our politicians. But not many of us know what it actually means.

Indeed, the fact that we hear it so often adds to the confusion. Efficiency is one of those words that has both a technical meaning and a popular meaning. The two are often blurred in political debates. Policies are developed using the technical concept. Politicians then hit the hustings invoking its popular meaning. Some welcome the rhetorical slippage.

In economic theory, the central question is how we target our resources to produce the houses, clothes, cars and other goodies that we value most. The challenge is how to divvy up a scarce set of resources to produce the things that will make the greatest contribution to human wellbeing.

Economic theory argues that the market offers the perfect solution to this problem. It argues the market acts like a democracy of consumption. The way you and I spend our hard earned cash drives the system. What we are prepared to pay for determines what gets made and which businesses survive. Through our spending we cast a vote about how our society’s collective resources are used.

Economists argue that when a market is competitive, this is the best possible method for solving the problem. What we are prepared to splash out on is the best possible indicator of what we really value. When competition forces businesses to set prices to reflect what an item costs, you have a perfect match. Our spending patterns drive an economy that is fine tuned to producing the things that will boost our wellbeing most.

When economists talk about efficiency, this is what they are talking about most of the time. An efficient economy is one that matches up what people want to buy, with what actually gets made. It should optimise a community’s wellbeing.

It is important to point out that despite the political rhetoric, efficiency in this technical sense is not a big driver of growth. There can be expected to be a one off improvement if an economy shifts from an inefficient distribution of goodies to an efficient one. But after that there is little that connects efficiency to the ongoing expansion of an economy. It is not able to explain why we are able to produce ever more iPods, g-strings and boutique beers.

Growth is the ability to produce more stuff. Some growth comes from being able to cut down more trees and dig more out of the ground. But the bulk of it comes from us getting much better at doing things.

One way of characterizing growth is to tell the story of industrialization. In the days of cottage industries people had to make almost everything for themselves. They needed skills in farming, carpentry, spinning fabrics and sewing, baking and metal working. They were ‘jacks of all trades’ and masters of none. Industrialization has seen the ever increasing specialization of labour. We increasingly focused on producing a narrower range of items, and then trading them with others. As we each became more expert in our particular task we also became more productive at it. We were then able to trade with others who had also specialized. The total amount of goodies produced skyrocketed.

The economic theories that teach us about efficiency have only arm waving offerings to make in explaining growth. While efficiency is, in the jargon, all about allocative statics, growth is a dynamic phenomenon. The political rhetoric fudges the connection too. For all the talk that blurs them into the one concept, the two are markedly different.

It is not at all clear that technical efficiency necessarily leads to growth. While efficiency is underpinned by competition, growth is underpinned by trust that makes the growing chains of production possible. Efficiency assumes that the relative cost of services and comparative advantage is set, while growth highlights how skills and abilities and comparative advantage are acquired. While efficiency seeks to minimize any fat around the bottomline, growth is reliant on investment that may take long lead times. This is an argument to be expanded on. However, immediately at hand is a different challenge to the ideal of efficiency.

Efficiency & Economic Reform

The years of economic reform were squarely focused on ‘efficiency’ in the government sector. Volume after volume of Productivity Commission reports pushed the same line. They strove for a shift away from universal services to user pays market principles. They aimed to strip away all the props that cushioned government activities from the customers’ ultimatum. They dashed away government ownership, price controls and regulations. By forcing government services to face the test of profitability, they aimed to channel economic activity into making the things we value most.

This revolution on the service side was clearly aimed at achieving the objective of efficiency. However, there are developments afoot on the consumer side of the equation which bring the efficiency ideal into question.

While how much we value a particular goodie does affect how much we are prepared to pay, it is not the only factor at work. The total budget we have got to spend comes into the equation too. No matter how much I want a swanky new PDA – that will play a constant stream of 80s trash, take photos and tell me when I have forgotten my brother’s birthday – it is just not within my budget’s possibilities at the moment.

A democracy in which we cast our votes by what we spend, is inevitably a democracy on a sliding income scale. Those with fat wallets or gold credit cards have a big say, while those who skimp the last few days through to pay day have little say. The number of dollars in your wallet translates directly into how many votes you have.

An efficient economy will deliver quite different bundles of goods depending on the income distribution. For example, imagine a community with a total wealth of $500,000 that is made up of 10 people. Imagine one person earns $400,000 a year and the other 9 earn about $11,000 a year. An efficient economy will deliver one luxurious home, one person’s worth of exquisite food, and one wardrobes worth of expensively tailored clothes. It will also provide survival accommodation, food and clothes for the other 9 people.

Thanks to trohaa

In contrast, if the same community divvies up its resources equally the economy will produce quite a different bundle of goods. In an equal society all 10 people would get $50,000 each. In that instance an efficient economy would provide moderate level housing, reasonable clothes, and decent quality food for all 10. The exact mix of things each person gets would reflect their personal priorities. Some will skimp on housing for feistier fashions, while others will go the gourmet foods. Yet it will all fall into a moderate range.

Generally speaking, what the economy produces will reflect a mix of what we value, and the income distribution. In a reasonably equal society, we would expect that the patterns of the economy would more strongly reflect our individual preferences . As the income divide stretches out, we would expect income effects to take over. As the gap between rich and poor balloons, the mix of goods will increasingly reflect the income distribution.

The challenge Australia faces is that we are facing such a yawning gap between rich and poor. Once upon a time we were indeed the egalitarian nation we like to believe we are. However, that has turned about in the last 25 years.

Fred Argy tells us we now have the third largest gap between rich and poor in the developed world. We come in only behind the US and the UK in our division between the haves and have nots.

Andrew Leigh points to the explosion in executive salaries as one of the drivers. His research found that while in 1980 the top 1 per cent received 5% of all personal income, by 2002 they were pocketing 9% of all personal income.

He also observes that in 1992 the typical executive in one of Australia’s top 50 companies earned 27 times the wage of an average worker. By 2002, a top CEO earned 98 times the wage of an average worker.

The story at the bottom is equally disturbing. The poorest 40% of households only account for 6% of the nation’s wealth. The bottom 20% only accounting for 1%.

As the divide between rich and poor continues to balloon, we will have to ask ourselves what the pursuit of “efficiency” offers us going into the future. How much will a person’s preparedness to pay reflect the value of what was once a government service? And how much will it simply reflect who the service is provided to? When drought stricken farmers stop paying for broadband will it be because the connection to the wider world is not important to them? When inner city community health clinics go under will it be because the homeless and addicted didn’t need healthcare? Will the planning of future roads include an assessment of the socio-economic status of the communities they are seeking to link up? Will the communities who can’t pay tolls be less in need of being connected to the greater city?

Efficiency is quite distinct from growth. And one has to wonder what this centrepiece of the reform era will have to offer us in the future. Perhaps it should simply become a relic of a bygone era.