Too much Efficiency

Recently, I wrote about the confusion, common among economists, between optimality and efficiency.   Of course, everyone with an economics education knows the difference, but the point I made then (and now) is that there is a tendency to muddle the distinction in practice.  Today I want to talk about (at least part of) the reason.

To illustrate the issue, let me ask a question:  Is gift exchange (as opposed to market exchange) efficient, or is it inefficient?   This is an important question since anthropologists tell us that gift exchange is a common mechanism for primitive economies and also because certain political groups favor gift exchange over market exchange as a kind of means to escape inequalities (as an aside, I don’t understand how anyone could think that gift exchange would possibly decrease inequality, rather than make it much much worse… those without social networks would be shut out entirely!  But I digress).

The typical answer that you might hear from an economist is “of course gift exchange is inefficient!”  I agree, that’s probably correct.   I’m also reasonably sure that gift exchange is efficient.   I believe that both those statements are correct. So what’s going on here?   How can gift exchange be both efficient and inefficient?   Easy.   There’s at least two very different notions of efficiency involved.

In fact, here off the top of my head are some of the notions which economists sometimes refer to as “efficient” (altho, I make no claim that this list is exhaustive):

  1. Pareto Efficiency:  no one can be made better off without making some else worse off.
  2. Optimality:  the preferred outcome of a hypothetical social planner.
  3. Allocative Efficiency:  only the proper balance of goods is traded (i.e. marginal benefit = p).
  4. Production Efficiency:  the proper balance and number of goods are produced (i.e. p = marginal cost at the production frontier).
  5. Cyclical Efficiency:  my own term… a catchall for everything from Okun gaps to sub-optimal inflation targets.
  6. Informational Efficiency:  all available information is used.
  7. Dynamic Efficiency:  the time-path of consumption is not strictly dominated by another (i.e. compared to a time-separable, constant discount utility).

So, back to my example: gift exchange.   In which sense is gift exchange inefficient?   That’s easy.  The inefficiency is informational and allocative.  That is to say that people end up with the wrong goods and they end up with the wrong goods in part because there is information available in the population which is not being utilized (namely, the fact that I know what I want, but you probably don’t).   This is the standard answer, and it’s very intuitive for the average non-economist.

So in which sense is gift exchange efficient?   It turns out that gift exchange is Pareto efficient.   Don’t believe me?   Think that’s impossible since everyone supposedly has the wrong allocations in a gift exchange economy?   Ah ha!   The thing is, Pareto efficiency is evaluated at constant allocation.   So, let’s evaluate the problem at constant allocation: person i has allocation x_i.   In case ME, x_i is arrived at through pure market exchange.   In case GE, x_i is arrived at through pure gift exchange.   So here’s the issue:  is u_i(x_i) higher in case ME or in case GE?   The right answer is GE, so everyone is made better off in the gift exchange counter-factual.   Frankly, I think that anyone who’s ever gotten the gift they wanted ought to know that such gifts are cherished and experimental studies have backed that observation up.

We can always ask why this is the case.  Personally, I think it’s as simple as noting that reciprocity is a more powerful human emotion than greed and unlike the other notions of efficiency, Pareto efficiency depends on that sort of thing.

Of course, the fact that gift exchange is alloctively inefficient and informationally inefficient means that it’s not a very good mechanism for running an economy.   Economist-as-engineers really ought to care about such things, and we do!  Still, it’s a reminder that we should always be careful to keep in mind which notion of efficiency we are talking about.

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  1. May 19, 2014 at 3:55 pm
  2. May 30, 2014 at 5:24 pm

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