Chapter 10 EFFICIENCY Marco SavioliEfficiencyA natural presumption is that much of the growth in productivity that occurs is the result of changes in technology. This is reasonable for advanced countries Productivity is much lower in poor countries than in rich countries, but many of the most advanced technologies are being used in poor countriesEfficiency: effectiveness with which factors of production and technology are combined to produce output. It is an umbrella concept used to capture anything that accounts for differences in productivity other than differences in technologyDecomposing productivity A into technology and efficiencyA=T×ETechnology T represents knowledge about how factors of production can be combined to produce outputEfficiency E measures how effectively given technology and factors of production are actually usedSuppose that India is G years behind the United States technologically. That is, the level of technology in India in 2009 was the same as the level of technology in US in the year2009 –GT2009,India=T2009−G,USLet g be the growth rate of technology in the UST2009,US=T2009−G,US×1+g GT2009,US=T2009,India×1+g GT2009,India=1+g−GT2009,USA India=T India×E IndiaA US=T US×E USA India A US =T IndiaT US×E IndiaE USE India E US =A IndiaA UST IndiaT USThe ratio of productivity was obtained before, the ratio of technology can be calculated given information on the growth rate of technology g(0.57) and the technology gap measured in years GTable 10.1 Decomposition of Productivity Gap Between India and the United StatesAnalyzing cross-country dataUnless lags in technology are extremely large, mostof the difference in productivity between India and the United States must be the result of a difference in efficiencyGiven the speed with which many advanced technologies such as cell phones and computers have reached India, it is hard to believe that the average technology gap were indeed equal to 30 yearsWith such a technology gap, the difference in efficiency would be the dominant source of the difference in productivity between the two countriesDifferences in efficiency: case studiesThe case that efficiency is an important determinant of output would be greatly strengthened if we could observe efficiency more directlyWe will examine a number of case studies, in which we can isolate efficiencyIf we find that efficiency plays a strong role in these cases, we will have support for the argument that efficiency is important more generallyUnionOne of the best examples of low output as a result of innefficiency, the Soviet economy was relatively good at accumulating factors of production: its rate of investment in physical capital was higher than that of the US, and its workforce was fairly well educatedIn terms of technology, the USSR was at par in areas related to national defense and it lagged behind in areas not viewed as priorities, like consumer goodsThe USSR was a distaster in terms of producing output, in 1995, the year Mikhail Gorbachev took power, GDP per capita was less than one-third the US levelOne cause of the Soviet economy’s inefficiency was central planning, which began with Joseph Stalin’s first «five-year plan» in 1928UnionCentral planners did a poor job of fulfilling the roles that prices play in coordinating activity in a market economy, such as channeling productive inputs to the firms thatvalue them most, giving firms an incentive to producegoods that are in high demand, and equalizing thequantities that are supplied and demandedAs a result, shortages were rampant. Waiting in line to purchase whatever consumer goods were available became an accepted part of life in the Soviet Union, and output was reduced because firms were frequently unable toobtain crucial inputs. Further, the need to meet production quotas often led firms to produce the wrong goodsCentral planning in the Soviet UnionA second source of inefficiency in the Soviet economy wasthe lack of incentives for managers and workersBecause firms had no owners seeking to maximize profits, managers of firms had no incentive to minimize theirproduction costs, much less to implement newtechnologies that would raise productivityBecause so many goods were in short of supply, firms similarly had no incentive to maintain the quality of their output –consumers would snap up whatever the firmsproduced. Plant managers had little leeway to fireunproductive workers or to reward those who did a good job, so absenteism and on-the-job drunkennes wererampantTextiles in 1910In 1910 textile workers in New England earned50% more than similar workers in England, twice as much as workers in France and Germany, 3 times as much as those in Italy and Spain, and more than10 times as much as those in Japan, India, and ChinaNeither differences in technology, in the sense of some countries using more advanced productive methods than others, nor differences in raw materials are able to explain differences in wages among countriesFigure 10.1 Wages and Machines in the Textile Industry, 1910Textiles in 1910Workers in high-wage countries tended up to six times as much machinery as workers in low-wage countries. Each loom in the more-developed countries, though tended by fewer workers, produced more outputDifferences in factory organization and in labor practices are evidently the main explanation. Workers in the poorer countries were capable of tending more machines, but something in the way the economy was organized prevented them from doing so. This«something» is exactly the concept of efficiencyTable 10.2 Productivity in Selected Industries in the Early 1990san industryJapan’s steel and automobile industries were more productive than their US and German counterparts, but food processing in Japan was less than half as productive as in the other countriesGerman productivity was close to that of the US in three of the four industries examined but fell far behind in telecommunications. The differences in productivity at the industry level were much larger than those in aggregate productivityan industryDifferences in the organization of production among the countries is an explanation for these productivitydifferencesJapanese automobile makers work closely with their parts suppliers to streamline procedures and improveproductivity. In germany and the US the relationship ismore antagonistic; suppliers fear that if they improve their productivity, the firms to which they sell their parts willsimply negotiate lower purchase pricesDifferences in productivity within a single industry are even visible within a single country. Health care in the US: same amount of output (health) produced with different amount of inputs and with no variation in technologyFigure 10.2 U.S. Subsurface Coal Mining: Output, Price, and Output per Worker-Hour, 1949–1994Singleindustry ina singlecountryPeriod inwhichproductivity felldramatically: 1969-78 Becausetechnology wasunlikelyto bemovingbackward overthisperiod,productivity↓→efficiency↓1949-1994Between1969 and 1978, output per worker-hour fell by one-half. Over the same period, the total quantity of coal produced hardly changed at allThe real price of coal shot up during the 1970s, mostly asa result of rising oil prices. Increased demand for coalmade coal-mining companies highly profitable. The rise in profits in turn improved the bargaining position of the mine workers’ union because it raised the cost that the union could impose on firms by going on strikeThe union took advantage of its improved bargaining position to change work rules so as to raise the level ofemployment–and thus lowered productivity1949-1994This sort of behavior, in which employers are forced to hire more workers than are required for production, is called featherbedding.The trend in coal productivity reversed itself again in the 1978-94 period, when productivity rose by a factor of 3No burst in technological progress explains this jump in productivity. Rather, the driving factor was a decline in the price of coal, as oil prices fell and competition fromnonunionized open-pit mines in the West increasedSubsurface coal mines faced the choice of improving productivity or closing down altogether, so the bargaining power of the coal miners’ union weakened substantiallyTypes of innefficiencyThere are different ways in which economies can be inefficientIn some cases, resources such as capital and labor are used for doing things that have no economic value, or they remain unusedResources used in production may be channeled into the wrong parts of the economy or to firms that do not use them as well as possibleFinally, various forces may prevent the use of available technologies that yield a higher level of output for the available inputs of factors of productionOne type of inefficiency occurs when resources are diverted from productive to unproductive activities–that is, uses without economic valueFor a society as a whole, the fewer resources used for production, the less produced, and the less consumedFrom the perspective of the individuals who engage in them, unproductive activities can be perfectly rational –people earn more for themselves by engaging in unproductive activitiesSuch an unproductive activity must necessarily involve some redistribution–that is, taking output away form othersCertain unproductive activities, such as theft and smuggling, are illegalIn addition to wasting resources directly(in the case of burglary, using labor to break into houses rather than to produce output), such activities also require further nonproductive spending on the part of those who would rather not see their property taken away (hiring guards or installing alarm systems)In some poor countries, unproductive activities also include kidnapping for ransom, banditry, and even civil war, where the object of conflict is the right to eploit natural resourcesRent seeking: unproductive activities that involve the use of laws or government institutions to bring private benefitsAn economic rent is a payment to a factor of production that is in excess of what is required to elicit the supply of that factorRent seeking usually arises in cases where government policy creates an artificial or contrived rent, such as through licenses or protected monopoliesOne of the reasons that capital cities of many developing countries are so big is that firms locate there to maximize their chances of capturing rents generated by the governmentIn addition to the direct costs expended on rent seeking, a second form of waste occurs when the best and brightest workers choose to enter government service to reap the rewards of briberyThe extent to which people devote their efforts to producing output rather than trying to get a bigger slice of the pie depends on the relative rewards of these two activities, that depend on institutionsA second form of inefficiency results when labor or capital is simply not used at all. Such idle resources may take several formsIn the case of workers, the inefficiency includes both actual unemployment, where a worker has no job, and underemployment, where a worker has a job but spends only a fraction of her work time producing outputCapital can similarly be unemployed(a factory that sits unused) or underemployed(a factory running at less than full capacity)Unemployment of workers and capital often results from macroeconomic instabilityUnderemployment frequently results from institutional arrangements that encourage the hiring of more workers than are needed. State-run enterprises are notorious for their overstaffingUnderemployment of workers entails a transfer of resources from one person to another. The employee who is paid for not working is receiving a subsidy fromsomeone else in the economy. Althoug he may be better off using his labor unproductively than he would be if he were using it productively, society as a whole is worse offMisallocations of factors among sectorsAnother form of innefficiency occurs when resources are used in producing the wrong things. In such a case ofmisallocation the inefficiency will be less obvious than in the case of resources not being used at allA significant form of this innefficiency is misallocationamong sectors of the economyWe consider this problem in a simple setting. Suppose there are two sectors in the economy. In each sector,there is a production function by which capital and labor are transformed into output. Total output of the economy is the sum of the output in the two sectors. The value of the output will be maximized when the marginal product of labor in the two sectors is the sameFigure 10.3 Efficient Allocation of Labor between SectorsFigure 10.4 Overallocation of Labor to Sector 1Misallocations of factors among sectorsAutomatic reaching of optimal allocation of labor between sectors labor will be paid its marginal product as a wageif the marginal product is different in sectors of theeconomy, workers will have a strong incentive to move fromthe sector with low to the sector with high marginal productThis movement of labor will lower the wage in the sector that has high marginal product and will raise it in the sector with low marginal product. The movement of labor will continue until the two marginal products are equalized, and thus the quantity of output is maximized: Adam Smith’s«invisible hand»Factors might not be allocated according to their marginal products: factors may not be able to move between sectors in response to the signal provided by differences in the payments they receive, or the payments received by factors may notreflect their marginal productsBarriers to mobilityIf there are barriers to mobility between sectors, then a gap in wages may persist. The higher these barriers, the larger the gap between marginal products that can be sustained, and thus the larger the degree of inefficiency One type of barrier between sectors is geographic isolation. Because moving from one part of a country to another involves costs, both economic and phychological, interregional wage gaps may persist for a long timeAnother type of barrier arises if a minimum wage is imposed in the high-wage sector. The process by which people move from the low-wage to the high-wage sector will be short-circuited(marginal product= min wage)Wages not equal to marginal productIf workers are not paid their marginal products, then a difference between sectors in the marginal product of labor will not automatically translate into a difference in wages, so workers will not have an incentive to move betweensectorsFamily members who work together on a farm do not receive a formal«wage». Rather, the output of the farm is generally divided equally among the family members.Workers are receiving a payment of their average product higher than the marginal product of labor(in a farm, land is fixed). By contrast, a worker who leaves the farm towork in the industrial sector will receive a wage equal to her marginal productIf there is segmentation or discrimination in the labor market, wages differ from marginal productsFigure 10.5 Overallocation of Labor toFarming When Farmworkers Are PaidTheir Average ProductTheresultingallocationof labor willmean thatthemarginalproduct infarming islower thanthemarginalproduct inindustryEfficiency gains from sectoral reallocationReallocation of factors–from sectors with a low marginal product to other sectors–can be a major source of growthSectoral reallocation out of agricolture and into manufacturing was a component in the growth of Taiwan and South KoreaEase of geographic mobility may be one explanation for the particularly high efficiency of the US economy. Americans are willing to relocate in search of economic advantage–and this willingness is aided by having a large country with a singlelanguage. Europeans have much deeper cultural roots in the places where they were born: less geographic mobilityThe most dramatic example of labor reallocation in the world today is China, where workers are moving both from agriculture to industry and from the impoverished interior of the country to more prosperous coastal regionsfirmsFirms differ in their levels of productivity for any number of reasons: inferior technology, poor organization, bad managementIn a well-functioning economy, resources move from less to more productive firms, raising productivity in the economy. This shift happens naturally when firms compete with each otherA high-productivity firm can make a profit at prices that lead less productive firms to lose money. Less productive firms are thus driven out of business, and the capital and labor they used are absorbed by more productive firmsfirmsMany things can get in the way of this reallocation of resourcesIf low-and high-productivity firms collude to maintain high prices rather than competing with each other, then low-productivity firms will be able to stay in business and thus not free up the factors they are usingSimilarly, many low-productivity firms manage to get government help staying in business, in the form ofsubsidies, favored contracts, trade protectionIn government-owned firms, workers’ wages are not closely related to the amount of output they produce.Workers or other resources may be allocated amongindustries on the basis of managers’ political powerfirmsA firm with a monopoly will restrict production to keepprices high, so it will not hire more workers even if the marginal product of labor is higher than the wage. The marginal product of labor will be higher in monopolizedindustries and firms tend to employ too little laborDifferences in marginal products between firms therefore indicate a misallocation of resourcesAnother indicator is the correlation between firm size and productivity level. Given a fixed degree of variation inproductivity among firms, the economy as a whole will be more efficient to the extent that the larger firms are more productive. In the US the correlation is positive and large;in Western Europe smaller; in Eastern Europe smaller stillFinancial system: banks and other institutions, markets for stocks and bonds, government agenciesmonitoring/regulatingThe financial system directs capital toward its most productive use by evaluating returns from investmentprojects, pooling the savings of many individuals to allow for large investments, monitoring the outcomes ofinvestment projects to make sure that investors areproperly compensated, and spreading the risk of any one project among a large number of individualsThe financial system also allows for more specialization in production. In addition, by channeling investment funds to people who have good investment projects the financialsystem profoundly affects the degree of income inequality and intergenerational economic mobilityVariety of measures to assess the degree of financial development in a country: size of the banking system measured by the value of bank deposits relative to GDP; the degree of development of the stock market is measured at the «turnover ratio» (value of shares traded in a given year divided by the total value)Strong correlation between the degree of financial system development and the level of GDP per capitaDevelopment accounting: link much tighter between financial development and productivity than between financial development and factor accumulation→financial development raises economic efficiencyA number of types of evidence point to causality runningfrom finance to income:good financial system preceded growthbanking deregulation in the US; states that liberalizedtheir markets experienced faster economic growth thansimilar states that did notin countries with well developed financial systems,industries dependent on the financial system are thosethat particularly do wellinvestors most protected under the English legalsystem; differences in legal origin predict differences in financial development as well as economic growthHow can countries improve the functioning of their financial system? Existing evidence is that:Government-owned banks perform more poorly than those that are privately heldCountries that permit foreign banks to compete in their domestic banking systems have more efficient finance than those that do notStrong legal systems that protect the interests of small investors relative to corporate «insiders» lead to more efficient allocation of capitalIt occurs when a technology could feasibly be used–that is, there are no barriers to the transfer of technology such as patents, secrecy, and lack of tacit knowledge–but someone deliberately prevents its useBecause there is no physical or technical obstacle to the use of an intentionally blocked technology, we think of technology blocking as a form of inefficiency rather than as a type of technological backwardnessThe reason for most technology blocking is that a new technology, although beneficial for society as a whole, makes someone worse offJoseph Schumpeter→creative destruction: economic changes brought about by the introduction of a new technology. Those whose livelihoods stand to be destroyed by a new technology will try to block itOften comes from workers, but also from firmsIts success depends on the relative power of those who are hurt by a new technology and those who benefit from itRich countries may be even more prone to technology blocking than poor ones. The reason is that blocking a new technology often requires the assistance of a well-functioning government。
