"Briefing Room"
"Economic Network""

Robert Kuttner, "Everything For Sale", p.24-28, 1997.

The Three Efficiencies

As the reader may have noticed, so far we have been dealing mainly with one form of efficiency, the form that economists call "allocative efficiency": markets, using price signals, steer resources to uses that maximize outputs relative to inputs; the price system responds to consumer choices, takes advantage of specialization, and hence optimizes performance for a given level of resources.

As noted, this brand of efficiency imagines a snapshot of consumer preferences at a given point in time. It does not consider the issues that concerned John Maynard Keynes- whether the economy as a whole has lower rates of growth and higher unemployment than it might achieve. Nor does allocative efficiency deal with the question of technical advance, which is the source of improved economic performance over time. Technical progress is the issue that concerned the other great dissenting economic theorist of the early twentieth century, Joseph Schumpeter.

A review of both economic history and economic theory suggests that there are three very different concepts of efficiency in economic life. We might call them Smithian, Keynesian, and Schumpeterian. For the most part, the study of markets is dominated by issues of allocation- the efficiency of Adam Smith. Keynesian efficiency, by contrast, addresses the potential output that is lost when the economy is stuck in recession, performing well below its full-employment potential. Increasing allocative efficiency in such circumstances doesn't help. It may even hurt to the extent that intensified competition in a depressed economy may throw more people out of work, reduce overall purchasing power, and deepen the shortfall of aggregate demand. The economy of the 1990s has offered the paradox of escalating gains to productivity via Smithian efficiency, coexisting with declining purchasing power and declining job security for most ordinary people. Resources are allocated in a more market like manner, but overall performance is nonetheless mediocre and living standards are mostly stagnant.

By contrast, World War II is history's great example of an event that grossly violated allocative efficiency yet stimulated broad improvements in living standards. During the war, the United States had wage and price controls, rationing, coerced savings, monopolistic military contracts, and a variety of other affront, to free-market pricing. There was massive state intervention throughout the economy. During the peak of the war effort, nearly 50 percent of production was in response to government procurement contracts, most of which entailed monopoly pricing.

All of this violated ordinary supply and demand; it was profoundly inefficient in an allocative sense efficiencies. Yet in a Keynesian sense the war was stunningly efficient. In 1941, the economy had still not fully recovered from the Great Depression. Unemployment remained at over 11 percent, and growth from June 1940 to June 1941 was less than 2 percent. But by June 1942, the economy was at full employment. Industry, which had resisted making investments because demand was slack, suddenly poured billions of dollars into war-production plants. Industry was recapitalized, at state-of-the-art technology. A generation of skilled workers was trained to operate it. Although nearly half of what was produced during the war was literally manufactured only to be blown up, the stimulus of war production rekindled economic growth. GNP increased by about 50 percent in just four years, a rate that has never been equaled before or since. By war's end, civilian purchasing power was one-third higher than it had been before Pearl Harbor. Although private savings rates rose, much of the money that paid for the war was borrowed, through war bonds. But despite a record debt/GDP ratio of 119.8 percent at the war's end- more than double the "dangerous" ratio of the mid 1990s- this high debt was perfectly compatible with the two decades of record growth that followed.

Standard free-market economics simply does not know how to treat these two very different kinds of efficiency in the same analytical frame. As James Tobin, the Yale economics Nobelist, once quipped, "It takes a lot of Harberger triangles to fill up an Okun gap." Tobin was referring to Professor Arnold Harberger's little triangular diagram depicting the economic loss that results from monopoly prices. When monopolists use their market power to sell fewer units of product at a higher price, consumers pay more to obtain less. By extension, any departure from a free-market price results in an allocative loss that can be graphed as a triangle. The "Okun gap" is named for Arthur Okun, the Keynesian chairman of President Kennedy's Council of Economic Advisers. Okun was fond of calculating the difference between the actual GNP and the economy's potential output were it at full employment. The point of Tobin's quip is that little allocative efficiencies do not compensate for big Keynesian inefficiencies of insufficient purchasing power, low growth, and high unemployment. At the same time, Tobin's deliberately and splendidly mixed metaphor- triangles and gaps- underscores that standard analysis lacks a common metric for assessing in the same conversation the interaction of these two conceptions of efficiency. If a Keynesian intervention reduces allocative efficiency by distorting market prices, but appropriately stimulates demand, standard market economics is literally unable to calculate a priori whether the trade-off is worth the candle.

The postwar boom was also built on what I am terming "Schumpeterian" efficiencies. Joseph Schumpeter was the great prophet of technical progress as the engine of growth, and the defender of imperfect competition as the necessary agent of technical progress. Large, oligopolistic firms often turn out to have the deepest pockets. They keep on innovating, to defend their privileged market position and to fend off encroachment. Innovation within a structure of stable oligopoly may be more reliable than innovation in a context of fierce and mutually ruinous price competition. Casual readers (or nonreaders) of Schumpeter may remember him as the prophet of "creative destruction", a phrase that he indeed coined to describe the onrushing turbulence of capitalism. But the usual cartoon of Schumpeter gets his meaning backward. Schumpeter's concern was how a market system could endure despite its many propensities toward ruinous competition. He was no advocate of creative destruction. The moderm economy offers many examples of Schumpeterian efficiency. The old regulated Bell telephone monopoly generated excess profits, many of which were plowed back into Bell Labs. A regulated rate structure also created pricing incentives for investing in ever more advanced switching technology, since profits grew with the rate base, and the rate base grew with the base of installed capital. The German economy is famous for cartels and semi-cartels that resist price competition and emphasize technical progress. The Japanese economy, likewise, blends price competition and nonprice competition. South Korea is perhaps the most noteworthy case of Schumpeterian development that thrived by departing from "correct" pricing. The South Korean government made capital available at negative interest rates to favored industries and not only tolerated but often organized cartels.

James Kurth, a political economist at Swarthmore, has coined the useful phrase "Military Schumpeterianism". This is an ingenious twist on the oft-repeated observation that the postwar boom was built on "Military Keynesianism", by which commentators meant the reliable stimulus of defense spending; this substituted for a more explicit and aggressive Keynesianism of large deficit spending for civilian purposes, socialized savings, public-works investment, and so on. Kurth's point is that, though large and persistent military outlays may have indeed had macroeconomic benefits, defense contracts also had immense benefits for technical innovation, industrial stabilization, and market leadership- the efficiency of Schumpeter.

A series of long-term military contracts to a prime vendor produced assaults against allocative efficiency- the hundred dollar hammers, thousand dollar toilet seats, cost-plus windfalls regularly exposed in congressional investigations yet also produced stunning technical advances and market leadership. Who thinks that Boeing would be the world's leader in aircraft sales absent World War II and the Cold War? As with Tobin's quip about triangles and gaps, standard economics has difficulty weighing the allocative loss of the hundred dollar hammer against the dynamic gain of jet technology.The list of technical gains generated by spinoffs from the warfare state is legion. Indeed, the reduction in defense outlays has caused a significant cut in funding for basic research, much of which was provided under the defense umbrella. Recent research by Maryellen R. Kelley of Carnegie-Mellon University suggests that the network of military prime contractors and subcontractors also provides immense benefits in technical diffusion of best-practice manufacturing (which was necessary to meet difficult specifications and fine tolerances), analogous to similar benefits of Japanese keiretsu and German bank-industry-labor interlocks. The common element here is long-term association and forms of competitive discipline that offer shelter from pure price competition.

As a matter of technical economics, there is a Schumpeter/Smith disjuncture that parallels the Keynes/Smith disjuncture. An economy that is performing according to the precepts of allocative efficiency is likely to have both avoidable unemployment and collective underinvestment in technological advance. A perfectly competitive market will spend too little on innovation both because profits will be too low, and because of well-known "externality" dilemmas.

An externality, please recall, is a cost or benefit to the economy as a whole that is not captured by a party to an immediate transaction. A negative externality is a cost, such as pollution, that is imposed on others. A positive externality, such as the broad gain from a new invention or from training an employee, is a benefit to society whose economic return is not fully realized by the innovator. Because investments in innovation are risky and because they often benefit competitors, market forces tend to underinvest in innovation. Indeed, the more "perfect" the competition, the less money is left over to invest in innovations that have broadly diffused benefits but that may not pay off to the investor for decades, if ever. The greater the rate of creative destruction, the less available are the monopoly "rents" that are the innovator's reward and necessary shelter. (In economic terminology, a "rent" is a super-normal profit that would be competed away in a perfect market.)

The more the economy relies on casino like capital markets, the less the availability of patient capital. But when is oligopoly relatively "efficient," and when is competition mutually ruinous? From a purely Smithian perspective, the question is nonsensical ex hypothesis. Oligopoly is never efficient, because more competition is always better. However, as Douglass North, the first economic historian to win the Nobel Prize in economics, observed in his 1993 Nobel Lecture, "It is adaptive rather than allocative efficiency which is the key to long run growth." This is, of course, the efficiency of technical progress of Schumpeter.

Another problem with allocative efficiency: the market's allocation of resources is only "efficient" based on a given distribution of income- one that reflects not only the verdicts of prior efficient markets, but also historical accidents. "Property is not theft", wrote R. H. Tawney, rebutting the anarchist Proudhon, "but a good deal of theft becomes property." Remarkably, the set of goods purchased by the existing income distribution is deemed simultaneously "efficient" and substantially arbitrary.

In principle, we could have a wide range of possible income distribution and start the economic game again, and the usual supply-and-demand discipline would efficiently resume. Though this happens occasionally (as in the case of land reforms, or social revolutions), for the most part the allocative efficiency of the market presumes the actual income distribution bequeathed to us by recent history. By market criteria, therefore, it is allocatively efficient for a millionaire to spend an extra fifty dollars on a fine after-dinner cigar, and for a pauper to starve in the streets for lack of money to eat. The price system doesn't care about that: its job is simply to match willing buyers with available sellers, and to be a buyer you need money.

Conventional economics usually replies that it is still more efficient to let market-determined supply and demand determine prices and prizes; if we don't like the social consequences, we can always redistribute income after the fact. Fine- but who are "we"? This rather airy conclusion innocently overlooks how wealth buys, among other things, power and how power resists income redistribution.

The usual construct of purely allocative efficiency also begs the question of "Efficiency for what?" Market pricing is an arguably efficient means, not an end. The goals, values, habits, and institutions of a good society may include an essentially market economy, but must be set by extra-market processes and forces. In their enthusiasm for the market mechanism, many theorists insist market values are an end, not a means, and that whatever society results from market forces is by definition the best available, as well as one that has delivered just rewards. Milton Friedman and his disciples have made valiant but ultimately unconvincing efforts to infer extra-market values from the functioning of the market mechanism. If markets thrive on well-informed consumers, then a market society requires free expression. If markets express voluntary exchange and free choice, then they are the natural handmaiden of liberal democracy. This sounds plausible in the abstract, until we remember that Nazism, fascism, Latin American military dictatorships, East Asian autocracies, and a wide range of other authoritarian regimes coexisted all too well with a basically capitalist form of production and exchange. Liberal democratic values, not to mention social ones, must be found elsewhere. Taken to an extreme, markets tend to destroy them.

(*Italics, bolding, and underlining is provided for study purposes)



Review the reading, "The Three Efficiencies", and determine whether the following statements are True or False and explain you answers:

1.) The Keynesian efficiency is concerned with the lost output associated with recessions and depressions- the Business Cycle.

2.) Adam Smith was interested in "equity" and "equality" not "allocative efficiency"- using markets and price signals to steer resources to their best uses in response to consumer choices.

3.) World War II was a good example of Adam Smith's efficiency.

4.) Schumpeterian efficiency is concerned with tecnological progress (the shifing out of the PPC Model's curve) and his view that "Pure Competion" and "Creative Destruction" is key to continued economic growth.

5.) What is all this talk about "Triangles and Gaps"?

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $