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How is Efficiency Obtained?

Mises Daily: Thursday, March 13, 2008 by

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Economic policy is nowadays always measured against the standard of economic efficiency, that is, static efficiency. A concrete economic policy is deemed to be good if it improves the static efficiency of the market. The ideal economic policy should be the one able to drive the market to the nirvana of perfect competition, in which static efficiency is maximized, as is social welfare.

The concept of the state of perfect competition has been widely criticized by the main exponents of the Austrian School, including Mises, Hayek, and Rothbard. However, government officials and mainstream economists seem impervious to their reasoning. So, they keep analyzing and studying the alternatives of economic policy according to this absurd standard.

What I propose to do in the following lines, it is to draw on the classic example of Robinson Crusoe, as used by Murray N. Rothbard in Man, Economy, and State,[1] to try to follow what would have been the life of our hero had he attempted to maximize static efficiency.

With our focus on the maximization of the utility of just one individual, we can avoid the complexities related to the interplay of the different scales of values of each individual present in the market. Of course, the insurmountable difficulties of trying to attain a social optimum given unknown and different scales of values to the policy maker have been brilliantly exposed already.[2]

Before going on with the tale, a brief introduction to the two natures of economic man is in order.

The Maximizing Individual and the Entrepreneurial Individual[3]

The usual view of the individual from an economic point of view is that of a "maximizer." The economic problem consists of selecting those courses of action, with respect to given means, that will secure the fulfillment of as many of his goals (in order of significance) as possible. The maximizing individual is passive, automatic, and mechanical: a human calculator, capable of finding the solution implicit in the configuration of given resources and ends. These are the individuals who populate mainstream economics.

Together with this nature, there exists the entrepreneurial side of the individual. This side allows the individual the very perception of the ends-mean framework, which constitutes the starting point to the economizing procedure referred to above. Human action's purpose is more ambitious than just maximizing the use of a set of resources; it aims at removing uneasiness and making the individual better off. The entrepreneurial side of the individual is active, creative — human.

If the world were free of uncertainty, the maximizing nature of the individual would be the only one needed. But this is not the case: the world changes continually, and so do the environment and the other individuals. There's no given set of data with an implicit solution that can be calculated by the market. Instead, what is needed is alertness to changes in ends and means, so that in each moment those can be solved in the best way possible.

Let's return now to Robinson Crusoe, whose adventure is about to begin.

Arrival on the Island

Newly marooned, Crusoe is soaking wet, hungry, thirsty, and tired. As we know, human action is purposeful. In the case of our castaway, it is probably also urgent. He is aware of his goals and has his scale of values: first, he has to drink, then eat something, try to make a fire, and finally sleep.

How does the maximizing individual progress in this situation? How will he optimize the use of given resources in order to attain his goals? Of course, that leads us to another question: what exactly are his resources, his means?

No answer can be provided by the maximizing individual. Nor can it be done by mainstream economists in search of optimal static efficiency.

Unless Robinson Crusoe resorts to his basic instincts, he will die of hunger and thirst. He will just stay there trying to maximize … nothing. There are no given resources. End of story for the optimizer.

Of course, we know this won't happen. And this can be denied by no mainstream economist or government official, not even by the harder defenders of static efficiency and perfect competition as paradigm of the market.

Robinson Crusoe will start looking for food, water, and wood, in order to solve his more urgent needs. That is, the entrepreneurial side of Robinson Crusoe will start working.

In other words, the maximizing side of Robinson Crusoe needs as a starting point a set of goals and means. Goals are known, but what about the means? Mainstream economics is unable to explain how human beings in the perfect-competition market will decide which the appropriate means are to attain their goals.

First Equilibrium

Let us assume, for the sake of the argument, that this glimpse of the entrepreneurial Robinson fades out, yet leaves him aware of two resources at his disposal: "land" (in the form of a tree with berries) and "labor." From the use of both resources, he is able to collect berries, say, at a rate of 20 berries per hour.

Consequently, if he works 1 hour, he will get 20 berries, 40 if he works 2 hours, and so on. As has been empirically shown, men enjoy work up to a certain point, after which they prefer leisure time.

The optimal behavior for Robinson Crusoe will be whatever provides the maximum utility of berries and leisure time. The law of diminishing marginal utility tells us that the more one individual owns of a specific good, the less valuable to him is the next unit.

The more berries he gets, the less leisure time he'll have. Thus, he will value each new berry less and less and each foregone hour of leisure more and more. Of course, there is a point of equilibrium in which global utility for Robinson Crusoe is maximized: the moment in which, according to his specific scale of values, one more hour of leisure time is valued more than the next 20 berries. At that moment, he will stop working and rest (possibly eating the fruits after his considerable effort).

Let us suppose that, for him, it is optimal to pick berries for 10 hours and spend the rest of his time enjoying the leisure of the sea and the sand. The price for his 200 berries is 10 hours of leisure time. Here he is, in the point of optimal static efficiency.

And here he will stay forever. Unless, for some reason, his scale of values changes, he will get up each day, work for 10 hours, eat his berries, watch the ocean, and sleep. If his scale of values does change, he might work more hours and rest less, or rest more and work less, but we can be sure that the equilibrium-seeking, utility-maximizing Robinson Crusoe will never do as Rothbard suggests, and create a basic berry-picking tool to improve the productivity of his labor.

In other words, the maximizing individual is not able to progress. He lives in a closed world of means. Given those means, he, as a computer, is able to determine the most satisfactory way of using them according to his goals. And that is the role that mainstream economists leave to the economic human being.

Interference of Third Parties: Consequences of Antitrust or Sector Regulation

Bad as things seem for this version of Robinson Crusoe, we needn't worry. Any real human being in his situation will eventually show his entrepreneurial side, and he will figure out how to use the berry-picking stick and even build a wood house.

But what would happen if there were a regulator assuring the perfect functioning of this peculiar market? This regulator knows, based on mainstream economic theory, that the best outcome for the welfare of Robinson Crusoe is precisely 200 berries and 14 leisure hours. This is, after all, the optimal combination demonstrated by Crusoe's own past behavior.

The well-intended regulator may decide to act as an antitrust regulator and punish any deviations from this efficient ideal, or he may decide to act as a sector regulator (e.g., setting prices) by imposing the efficient ideal directly. In either case, the same result is obtained: the entrepreneurial side of Robinson Crusoe is inhibited, making it far less likely that any productivity-enhancing innovations can take place. Even if Crusoe had figured out how to use a stick to increase the hourly rate of berry picking from 20 to 50, the antitrust regulator wouldn't allow this deviation from the static efficient outcome. (Is Crusoe erecting barriers to entry? Or maybe being predatory?)

$60 $50

The problem is not that the static economic model does not reflect the reality, as has been shown in the description of Robinson Crusoe's arrival to the island and in his first attainment of equilibrium. The real problem is that this model is used by regulators to make decisions — decisions that are apparently more complex than those just described, but in essence the same, and with similar consequences. Thanks to antitrust and sector regulation, there are still plenty of economic activities in which the berry-picking rate remains at 20 per hour.

The conclusion can be drawn from Hayek:

The real economic problem in all this is not whether we will get given commodities or services at given marginal costs but mainly by what commodities and services the needs of the people can be most cheaply satisfied. The solution is always a voyage of exploration into the unknown, an attempt to discover new ways of doing things better than they have been done before.[4]

This voyage, of course, can only be taken by the entrepreneurial side of the individual, unhindered by antitrust and sector regulation.


Fernando Herrera-González writes from Spain, where he is pursuing a Ph.D. from Universidad Polítécnica de Madrid in Austrian Economics applied to telecommunication regulation. Send him mail. Comment on the blog.

Notes

[1] Rothbard, Murray N., Man, Economy, and State. See chapter 1.

[2] For example: Rothbard, Murray N.: "Toward a reconstruction of Utility and Welfare Economics," 1956.

Also: Huerta de Soto, J.: "La teoría de la eficiencia dinámica," Procesos de Mercado: Revista Europea de Economía Política, vol. I, no. 1, Spring 2004.

[3] See Kirzner, Israel M., Competition and Entrepreneurship, chapter 2.

[4] Hayek, F.A.: "The Meaning of Competition," in Individualism and Economic Order. See pages 100–101.