Economic Efficiency: Making the Most of Our Resources

Efficiency is a word that is thrown around a lot these days. Many businesses are trying to be more efficient with their resources. Many individuals are trying to be more efficient with their time. In other words, they want more output for their input of a limited resource. That resource may be money, energy, or even hours. In a world with limited resources (scarcity), economic efficiency is an important goal. It is also a difficult, if not impossible, thing to measure because it is subjective.

Economists often define "Economic Efficiency" as using a resource for its highest value. Value is usually determined by the dollar amount paid for a resource. However, sometimes what may be an efficient use of limited resources for one person may be an inefficient use for another.

History shows that at the micro level, efficiency is something that can be measured if inputs, outputs, values, and goals are well defined. At the macro level, efficiency is difficult, if not impossible, to measure simply because, as good as economists' equations are, there are still too many unknown variables to measure, and value remains subjective.

Many factors contribute to economic efficiency. One important tool that multiplies production capacity is the division of labor. In his economic treatise, the Wealth of Nations, Adam Smith famously illustrated how several men performing different steps of pin-making would be able to make substantially more pins apiece than if they each had been completing the entire process on their own.

The same is true for trade. When individuals or countries specialize in one type of work, especially if it reflects their comparative advantage (what they do best), they will be better off by trading their products with other people or other nations. On the flip side, countries with barriers to trade often protect inefficient businesses. Because they lack outside competition, protected firms do not have the incentive to improve efficiency in order to survive.

Despite our inability to measure economic efficiency broadly, the beauty of a market economy is that it tends to allocate resources to their most efficient, highest valued use, even without one person knowing all the facts. Adam Smith's "Invisible Hand" is an apt description of this market process. The invisible hand uses triggers like prices to indicate what people value most (demand) and then incentivizes producers to use resources toward those preferred uses (supply).

In The Use of Knowledge in Society, economist F.A. Hayek investigates whether this market-driven, competitive system, or a system of central planning is more efficient in using available knowledge to allocate resources. He finds the price system to be more economical because it communicates crucial time-sensitive bits of information in a simple way that coordinates behavior. For instance, high prices signal scarcity and discourage people from consuming too much of an item. A centrally-planned system would have much more difficulty responding quickly to such constantly changing factors.

While many glorify laissez-faire and the role free markets play in efficiency, it is also true that government provides an important underlying structure. Without a just legal system in place to protect property rights and enforce contracts, it is much harder to do business. Government is also often responsible for basic infrastructure such as roads and bridges that facilitate the transportation and interactions needed to carry on daily business. Some would call these instances of market failure.

Market failure is defined as a situation where the market operates inefficiently when left on its own. For example, if one person paid for the public good of hiring an army, no one in that locale would have an incentive to contribute because they would already get protection for free. Limited common resources (e.g., natural resources) can risk depletion if everyone uses as much as they want without any motivation to conserve them for others. Monopolies left unchecked may raise their prices and drop production to gain extra profit. Many believe government oversight is the solution to these problems.

While some cases may warrant intervention, government is not a guarantee of efficiency. Neither is it likely that the government will limit intervention only to cases of true market failure. Instead, implementing Keynesian strategies of deficit spending in an attempt to stimulate the market and create jobs are commonplace. Some basic calculation suggests that these routes may be less than efficient when comparing money spent with the number of jobs created. Another problem is government subsidies distorting the normal price signals and creating extra demand of a scarce resource.

Though perfect efficiency is impossible to attain, it can be a helpful ideal to work toward in business, government, and personal life. This topic explains the meaning of economic efficiency and investigates the best routes to achieving it on both a micro and macro level.

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Quotes on economic efficiency from leading experts and economists.

Commentary or Blog Post

"Here’s what looks like a policy dilemma. To attain the economic growth that it desperately needs, the United States must improve its schools and train a workforce capable of competing in the global economy. Economists Eric Hanushek, Dean Jamison, Eliot Jamison, and Ludger Woessmann estimate that improving student achievement by half of one standard deviation—roughly the current difference...

"What do these results indicate for public policy? Our analysis did not show that expanding public transit would achieve large gains in economic efficiency. Even in cities with a high concentration of office space in the CBD, we estimate that increasing transit ridership by 10 percent will increase office rents by no more than 0.5 percent. For all other cities, we estimate that increasing transit ridership will have no effect on office rents. On the other hand, public transportation has many benefits beyond increasing office rents. For example, it can increase access for people without cars, reduce traffic congestion, and improve air quality. It does not appear, however, that increasing transit ridership will significantly increase agglomeration economies."

"OK, so without the stimulus, there would be anywhere from 200,000 to 1.5 million fewer people employed right now? That means the current cost-per-job created is somewhere between $4.1 million and $540,000."

"Companies have received more than $10 billion to create jobs and renewable energy by building wind farms, solar projects and other alternatives to oil and natural gas under section 1603 of the American Recovery and Reinvestment Act of 2009. The program expired in December, and President Barack Obama proposed last week that Congress revive it in the 2013 budget, says the Wall Street Journal...

The author addresses the issue of whether or not, in the pursuit for economic efficiency, it is right to believe that humans have unlimited wants and that meeting as many as possible is the highest end in life.

This web page, part of an online economics textbook written by Professor Robert Schenk of Saint Joseph's College, gives a basic definition of economic efficiency with a helpful illustration of the concept.

"Efficiency is a tricky concept. Once it is understood what economists mean when they refer to efficiency, it becomes clear that it is a much broader, and more desirable, goal than many people realize."

"It may seem heartless to worship efficiency at any cost, including lost jobs and decimated communities, but it is important to understand that increased efficiency is the only way a society’s standard of living will improve. If your company raises your pay without becoming more efficient, it will have to raise its prices in order to pay you. This is true of all companies. And if all companies raise their prices to allow for higher wages, you will end up just running in place, with your higher wages exactly matched by the higher prices of the things you buy. It is only if your company and others find a way to pay you more without charging more that your living standard goes up."

This article explains the importance of the free exchange of private property to achieving economic efficiency.

"In an article in the New York Times on Sunday, Barry Schwartz, a psychology professor at Swarthmore College wrote on an article, 'Economics Made Easy.' The article set out to explain economics to non-economists, while also defusing the 'hysterical criticism' of capitalism and private equity in general, as well as of Bain Capital in particular. ... What the NYT article misses is that improved efficiency by cutting costs is only one of three ways in which a society's standard of living can improve."

"Over the past decade a new buzzword has come to be infused into the public policy debate. 'Energy efficiency' is now a major part of any new initiative in the areas of energy policy, transportation policy, environmental policy, land use policy, building code and zoning policy, and even tax policy. It seems that no matter what governments at any level do, from building buildings to formulating and implementing legislation, 'energy efficiency' has to be a consideration."

"From Mexico to India to China, governments fearful of inflation and street protests are heavily subsidizing energy prices, particularly for diesel fuel. But the subsidies — estimated at $40 billion this year in China alone — are also removing much of the incentive to conserve fuel."

"In a perfect world of universal health care, a dollar spent would be a dollar put to good use. Yet rankings of Canada's health care performance paint a less-than-ideal picture."

"Labor specialization is one of the key features of modern economic systems, enabling factories and other business operations to produce goods on a global scale and to increase productivity. Labor specialization, also known as division of labor, was first recognized by Adam Smith in his classic economics text 'Wealth of Nations' and helped spur the Industrial Revolution and the technology-driven world in which we live."

"The noneconomic views of trade all seem to stem from a common root: the tendency for human beings to emphasize tribal rivalries. For most people, viewing trade as a rivalry is as instinctive as rooting for their national team in Olympic basketball. To economists, Olympic basketball is not an appropriate analogy for international trade. Instead, we see international trade as analogous to a production technique. Opening up to trade is equivalent to adopting a more efficient technology. International trade enhances efficiency by allocating resources to increase the amount produced for a given level of effort. Classical liberals, such as Richard Cobden, believed that free trade could bring about world peace by substituting commercial relationships among individuals for competitive relationships between states."

"So influential was John Maynard Keynes in the middle third of the twentieth century that an entire school of modern thought bears his name. Many of his ideas were revolutionary; almost all were controversial. Keynesian Economics serves as a sort of yardstick that can define virtually all economists who came after him."

"Without much fanfare, the Department of Energy (DOE) recently updated the list of loan guarantee projects on its website. Unlike in 2008, when Barack Obama pledged to create 5 million jobs over 10 years by directing taxpayer funds toward renewable energy projects, there were no press conferences or stump speeches. But the data are nonetheless revealing: for the over $26 billion committed since 2009, DOE Section 1703 and 1705 loan guarantees have created only 2,298 permanent jobs – that's $11.45 million per job."

"Economists since Adam Smith have understood the enormous potential for productivity due to the division of labor. Overall productivity increases dramatically by splitting a job into several separate tasks performed by different people, each focused on their specific task. Ricardo further developed this understanding and showed that even in situations where one person outperforms another in every one of these tasks, both are still better off each focusing on the task for which they have a comparative advantage."

"If you believe, with Smith's modern disciples, that unfettered pursuit of self-interest always promotes society's interests, you probably view all taxes as a regrettable evil — necessary to pay for roads and national security, but also an unwelcome drag on economic efficiency. The problem, according to this view, is that taxes distort the price signals through which the invisible hand guides resources to their best destinations. Smith's more nuanced position supports a different view of taxes. When market prices convey accurate signals of cost and value, the invisible hand promotes the common good. But prices often diverge from cost and value and, in those cases, taxes can actually help steer resources toward more highly valued uses."

"N. Scott Arnold's outstanding book makes a vital contribution to the debate over socialism; but Arnold has in part misconceived his own achievement. Since the collapse of socialism in the Soviet bloc, the world has had to recognize a fact long known to students of Mises. Centrally planned socialism is not, as its proponents imagined, a system vastly more efficient than the 'anarchy of the market.' Far from it: socialism cannot solve the calculation problem and thus cannot function at all."

Chart or Graph

Professor Robert Schenk of Saint Joseph's College provides a helpful illustration of the concept of economic efficiency.

The author created this index of "top ten countries in terms of economic efficiency for 2013," based on factors including economic freedom and legal structure. It shows Singapore and Hong Kong at the highest levels and holding, while the U.S. appears to be in 8th place and falling.

"[F]or the over $26 billion committed since 2009, DOE Section 1703 and 1705 loan guarantees have created only 2,298 permanent jobs – that's $11.45 million per job."

"As shown in figure 5, among the three types of private schools, there were no significant differences in reading performance at grade 4 in 2003. The average scale scores in 2003 for students at grade 8 in both Catholic and Lutheran schools were higher than the average score for those in Conservative Christian schools."

"In most countries that do not subsidize fuel, high prices have caused oil demand to stagnate or fall, as economic theory says they should. But in countries with subsidies, demand is still rising steeply, threatening to outstrip the growth in global supplies."

Analysis Report White Paper

"Why should taxpayers subsidize ethanol? The most commonly offered rationales—that ethanol reduces harm caused by our reliance on foreign oil and a host of air pollution problems—do not hold up to scrutiny. Foreign oil dependence is not a substantial foreign policy or economic problem, and ethanol offers little remedy for any problems that might exist.

"In the end, the money that towns across America gave General Motors did not matter."

"Economic planners of a country want to allocate scarce resources optimally such that it maximizes overall welfare. Since an economy consists of various economic agents with diverse interests, allocating resources optimally becomes an intricate task. Economic planners have two mutually opposing means to solve this allocation problem: planning versus competition.

"The education industry has two characteristics which make it a prime candidate for a study of efficiency: size and rising costs. Education represents one of the largest industries in the nation with estimated total direct expenditures of about $108 billion in 1974-75, representing about eight per cent of the gross national product.

This Econ 101 PowerPoint presentation discusses the possible roles of government in making markets function efficiently. For one, government creates the physical and legal infrastructure that facilitate market transactions. Sometimes government also steps in when it is believed there is a failure of the market to function efficiently, as in the case of monopoly power or externalities.

Nakamura studies the question of how to understand the changing economy of the new millenium. Should it be understood in the pattern of Adam Smith's "Invisible Hand" or in the practice of fast-paced development and disposal coming with creative destruction?

"This is the first in a three part series where we identify the most attractive international investment opportunities for the next ten years. We start out by looking at economic efficiency, i.e. the fundamental freedoms and legal framework, which facilitates successful investing."

Virtually every government intervention made in the name of efficiency is tainted with logical abuses.

"This paper analyzes the timing, pace and efficiency of the on- going job reallocation that results from product and process innovation. There are strong reasons why an efficient economy ought to concentrate both job creation and destruction during cyclical downturns, when the opportunity cost of reallocation is lowest.

“Privatization means shifting some or all aspects of service delivery from government to private-sector providers. It is a strategy to lower the costs of government and achieve higher performance and better outcomes for tax dollars spent. ..."

"The point to be emphasized in this paper is that if one starts with a different view of efficiency and market optimality, an entirely different set of conclusions relative to government intervention can be reached."

"The financial crisis of 2008 challenged the public consensus supporting free market economies. This paper argues that the current shift in favor of heavy regulation and government intervention in the economy arises from a failure in the economic discourse concerning what constitutes market efficiency, the costs of government intervention, and the role of public policy."


Mike Munger and Russ Roberts discuss Adam Smith's idea of specialization of labor and the Ricardian theory of comparative advantage.

"People don't like to think that anyone's labor is worth less than the minimum wage. Someone might end up flipping burgers for $5.00 an hour. You might think the minimum wage is a way of paying some sort of dignity premium -- hence language like 'living wage.' People with such good intentions look at the direct beneficiaries of these policies, say, burger flippers now making $7.50 an hour. They pat themselves on the back. But they rarely count the invisible costs: willing human beings who never get hired in the first place."

"Why are some countries wealthy while other nations are poor? Prof. James Otteson, using the ideas of Adam Smith, explains how the division of labor is a necessary and crucial element of wealthy nations. Additionally, Otteson explains Smith's idea of the invisible hand, which explains how human beings acting to satisfy their own self interest often unintentionally benefit others."

"Prof. Steve Horwitz addresses the common belief that the world is running out of natural resources. Instead, there are economic reasons why we will never run out of many resources. In a free market system, prices signal scarcity. So as a resource becomes more scarce, it becomes more expensive, which incentivizes people to use less of it and develop new alternatives, or to find new reserves of...

Mr. Anger describes the difference between technical efficiency and economic efficiency and walks students through some problems on how to mathematically find these values.

"In this video lecture we seek to understand what makes equilibrium price and quantity the most efficient price and quantity combination in a competitive market. Economic efficiency is defined, and we examine the effect on efficiency of any quantity of output less than or greater than the equilibrium quantity, at which marginal benefit equals marginal cost."

Mr. Strickland addresses the difference between equity and efficiency. He says that both issues should be considered in economic arguments. While free market principles may be more efficient, perhaps they are not always equitable, but this delves into the area of opinion.

"What does trade do? Comparative advantage is the foundation of the division of labor and exchange, but it's rarely understood. 'The Great Prosperity Machine" explodes the absurdities of protectionist dogmas by showing what trade accomplishes -- prosperity and peace.'"

"When people compete for grants, subsidies, and other government handouts, economists see a phenomenon called rent seeking. The 'rent' is the money being offered. When government gives money away, the people who compete for it incur costs—sometimes more money will be spent in total trying to compete for a grant than the amount of money being given away. These costs are rarely considered in policymaking, but perhaps they should be. One major cost of rent seeking, as Prof. Michael Munger points out, may be that the government awards money to organizations with the best lobbyists, not necessarily those providing the best services."

"'Economic Efficiencies' -- Is bigger always better? Do we sacrifice our lifestyle and our sense of community when we strive for better efficiency in agriculture?"

"Why are prices important? Prof. Daniel J. Smith of Troy University describes the role that prices play in generating, gathering, and transmitting information throughout the economy. Information about the supply and demand of different goods are dispersed among different buyers and sellers in an economy. Nobody has to know all this dispersed information; individuals only need to know the relative prices. Based on the simple information contained in a price, people adjust their behavior to account for conditions in supply and demand, even if they are unaware of that information."

"Walmart is a highly disruptive firm. No one like losing jobs, but what is the other side of Walmart moving into a community? What are the consequences of stopping firms like Walmart from moving in to a community? Mark Hendrickson from Grove City College explains in this video."

Primary Document

This economic classic is noted for providing us with terms for and expositions of such key economic ideas as the division of labor, "invisible hand," self-interest as a beneficial force, and freedom of trade.

"This volume describes the underlying economic rationale for congestion pricing and how it can be used to promote economic efficiency. It lays out the basic theory of travel demand and traffic flow and shows how inefficient pricing of the road network helps create an economic loss to society, as well as the means by which this can be alleviated through pricing...."

This report chronicles the differences between public and private schools in areas such as race, class, and academic achievement. This piece specifically focuses on student achievement in private schools and finds that "[s]tudents at grades 4, 8, and 12 in all categories of private schools had higher average scores in reading, mathematics, science, and writing than...

"This essay, which was published as a pamphlet by the Hogarth Press in July 1926, was based on the Sidney Ball Lecture given by Keynes at Oxford in November 1924 and on a lecture given by him at the University of Berlin in June 1926.

This essay is worth reading for especially two reasons. First of all, for the wealth of historical information about the origin of the laissez-faire...

"I am delighted that Dr. Rizzo, in chapter 4 [of Time Uncertainty, and Disequilibrium], is calling the highly touted concept of 'efficiency' into grave question. I would like to carry his critique still further."

Hayek's famous 1974 Nobel speech spoke to the "Pretence of Knowledge" within economics. As Hayek noted:

"It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences - an attempt which in our field may lead to outright error...

"...Government intervention can increase economic efficiency when market failures or externalities exist. Political choices may lead to second-best economic outcomes, however, and some argue that, for that reason, market failures can be preferable to government intervention. In the absence of market failures and externalities, there is little economic justification for government intervention, which lowers efficiency and probably economic growth. But government intervention is often based on the desire to achieve social goals, such as income redistribution. Economics cannot quantitatively value social goals, although it can often offer suggestions for how to achieve those goals in the least costly way."

F.A. Hayek presents a very thorough analysis on the role of knowledge and infomation in societies, how it is transmitted in various societies and economic systems, how a lack of knowledge ultimately proves to be the downfall of central planning, and other key topics.




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