Efficiency

[Amaroq]

A few months ago, my roommate made an interestingly strange statement to me. "The most efficient economy is one with no profit."

I knew implicitly that it was wrong, but I couldn't figure out how. So I simply said, "Why does it need to be efficient?" The response was, "It doesn't. Just saying, in the most efficient economy, nobody charges more than what they need to produce the product and sustain themselves."

(I've since seen holes in that one, such as how to judge how much someone must consume before they aren't just sustaining themselves anymore.)

This came up in my head again today. I started to examine the concept of efficiency in my head to form an explicit understanding of it. I found myself getting lost in thought, and actually enjoying coming up with ideas to describe it.

When you make a statement about efficiency, you're (hopefully) presupposing two types of value judgments. A value that you are trying to maximize, and cost(s) (the spending of something valuable in the course of gaining your target value) that you're trying to minimize.

A nice example I came up with would be three wooden spoon-making businesses. The value they are acting to maximize is wooden spoons. The cost they are trying to minimize is a large supply of wood they bought earlier. (Simplistic example, I know.)

Spoon-maker A uses a cookie-cutter-esque approach to producing his spoons. Even though he's tailored the cutting so that the spoons are cut with as little empty space between them as possible, the shape of the spoons causes spoon production to produce a pile of wooden slivers to be leftover from the spoon making process.

Spoon-maker B uses the same cookie-cutter approach as Spoon-maker A, but he's also invested in a wood-compressing machine. He has the same sized pile of wood leftover that Spoon-maker A had, but he can mash the slivers together into a solid supply of wood again, then resume the cookie-cutter approach until he's used up all his wood.

Spoon-maker C hears of a new invention that liquefies wood into any desired consistency. Spoon-maker C invests in this new invention, and devises a completely new method of spoon production. The wood is liquified into the consistency of a melted marshmallow and whipped with a blender. The wood is infused with tiny air pockets as it is fluffed. The end result is that he effectively doubles the amount of wood he has to work with by mixing air into it. This is done under high pressure so the air presses out strongly enough to uphold the strength of the spoon. (I'm completely bullshitting here and making this all up, by the way.) The wood is then poured into a mold. Contact with the mold smooths the porous surface of the wood so that, for all intents and purposes, it's looks the same and has the same strength as Spoon-maker A's and Spoon-maker B's spoons.

Spoon-maker A makes, oh, say 80 spoons with his supply of wood, with a pile of splinters leftover big enough to create 20 more spoons. Spoon-maker B, able to use the extra wood, uses all of the wood and produces 100 spoons. They both lost the same amount of wood, but B created more spoons with his supply. His operation is more efficient than Spoon-maker A's.

Spoon-maker C not only uses all of his wood, but makes the same supply go twice as far with his new wood-whipping process. He produces 200 spoons. Efficiency-wise, Spoon-maker C is far superior than the others.

Were this real life, other costs such as time and money would've been considered. But I was just having fun with it. Do you guys have any interesting thoughts? Is the definition of efficiency I came up with pretty good, or is there already a better one I haven't heard of?

Even with these thoughts I came up with, I'm still unsure about how to judge the statement about an efficient economy. To me, it appears as if he had no target value to maximize, and any amount of money pooling in any place at once was what he wanted to minimize.

Edited January 22, 2010 by Amaroq

[DavidOdden]

With reference to your three spoon-makers, you have to include a time-range component. Comparing A and B and assuming that both firms will exist only for 1 year, maybe A is more efficient because the cost of the compressing machine is twice the raw materials value of the splinters in a year's production. Of course they are of comparable efficiency if the firms will exist for just 2 years, and B is more efficient if they exist for 3+ years. The glitch is that these compressors tend to break down after a couple of years and you have to replace them.

So being efficient is maximizing "output unit value" divided by "output unit cost", with respect to a time frame. That is, "maximize profit".

[ukelelemasta]

I would ask your room mate to define efficiency for you. Then go from there. But an economy run without a profit motive is inneficient for it 1) defies human metaphysics and 2) therefore produces nothing. Was the light bulb just created to light peoples houses? No profit in mind. Was the automobile created to carry the middle class long distances for no cost? No profit in mind. If your friend says that we should force people to produce then ask him how much quality a ration of food and a whip to the back will produce.

[khaight]

I would ask your room mate to define efficiency for you. Then go from there.

Your friend's assertion is based on a widespread mainstream economic theory called "pure and perfect competition". The Objectivist economist George Reisman wrote an article criticizing this doctrine many years ago, called "Platonic Competition". He recapitulates his critique in his book Capitalism: A Treatise on Economics in chapter 10, section 10. See in particular the subsection titled "The Doctrine of Pure and Perfect Competition" starting on p. 430. (A PDF of Reisman's book can be downloaded free from his website.)

[softwareNerd]

Shortly after Adam Smith, classical economists switched the focus of economics away from production and toward "distribution" of income (David Ricardo and John Stuart Mills were the most destructive in this regard.) They looked at incomes and classified them into:

• wages (paid for labor),
  
• interest (paid to borrow capital)
  
• rent (paid to use something to which someone else has an exclusive right)
  
• profits (see below)
  

The income that a businessman receives was seen as a mix of all these. For instance, let's say he gets an income of $500,000 each year. Suppose he could employ someone else to manage the business for him @ $250,000; and suppose he invested $500,000 of his own capital in the business but could have got the money from elsewhere paying $100,000 in dividends and interest. So, of his total income, (500k - 250k - 100k) = $150,000K is "economic profit". (We'll leave out "rent", which these economists hate even more than they hate profits.)

The deepest arguments against profit come from economists who think that "economic profit" is basically being paid for doing nothing at all (because a wage component has been subtracted out). Of course, business owners are different from employees, and profit is a vital driving force in an economy. Unfortunately, too many economists are rationalistically caught up in a fictional world rather than looking at the real one.

As someone suggested, you will have to ask your friend what he means by efficiency, and why he thinks profits as inefficient. Chances are that his views are based on an assumption that businessmen as parasitical to the extent that their income consists of "economic profit".

As for the positive view: while relative efficiency leads to relative profitability, the overall efficiency in an economy does not lead to overall profitability. (Fallacy of composition to suppose that it does.) For instance, if all companies start to computerize their records and become more efficient the end result will be less costs for all, but also cheaper products from them, with profitability returning to the norm for the economy as a whole. So, if the norm for profitability is (say) 5%, a new improvement would raise some particular business's profitability to (say) 15%, but as the technique is copied or as the company displaces its competitors, the profitability will fall back to 5%.

These spurts of profitability (and, even more, the striving for such profitability) takes the whole economy to ever more efficient levels of productions. There is constant incentive to become more efficient to make more profit, but as that spreads profits come down again.

Of course there are some causes behind the long term level of profitability, but it is not economy-wide efficiency.

[TheAllotrope]

I don't think anyone has here clearly defined the concept of efficiency as a technical economic term, though sNerd kind of got at it a bit. There's a bit of a difference between technical efficiency (how well you make spoons) and economic efficiency. Efficiency, as presented in economics, refers to how market transactions apply to people's costs of production and value-judgments. The point of an economy is to maximize value, which comes generally from maximizing wealth (if you want to maximize value, that also means getting that wealth into the hands of people who are willing and able to pay for it, ie trading). Everyone is out to maximize value: the producer wishes to get the most money for his goods, and the buyer the most goods for his money. The efficient case is where the last good traded was done so at a point where both parties are indifferent, meaning the marginal cost was equal to the marginal price (ie, the supply and demand curves intersect). This point is value-maximizing. It is simply not true that there is no profit in such a situation, just that the producer made no profit on the last good sold. Even this is misleading, because economic analysis of "profit" breaks into two categories, "normal" and "economic". A normal profit means it covers opportunity cost. If you're earning $1 million a year in salary, and your next best job is also $1 million, that salary is considered "normal" profit, despite being quite high relative to other economic actors. "Economic profit" refers to when people earn more than their opportunity cost. Your friend is somewhat correct in pointing out that a "perfectly competitive" market has no economic profit, but that doesn't mean no profit. The value-maximizing solution is also profit maximizing.

But good luck finding a perfectly competitive market. Economists such as Milton Friedman are quick to point out that no market is "perfectly competitive", just that their decisions can often be modeled as if they were. Besides, expectations of economic profits lead to investments and therefore economic growth. An economy limited by opportunity cost is stagnant.

Economists have a tendency to presume a world in which a non-gain is a loss. Conflating the two creates some problems. Obviously, the most fundamental alternative to something isn't "the idealized case", it's nothing. A producer may be generating more profit than an economist's model might say they "ought to", but the fact remains they are creating a lot of wealth, without coercion. Now try having an "efficient" outcome where people's rights (namely, property rights) are not respected, and tell me how far that system gets.