On the global financial crisis: system reliability should take precedence over efficiency

[I am posting this old piece because of its direct relevance to the 2008 global financial crisis. It was first distributed in 2001 and subsequently included as Chapter 23 in my book Towards a Political Economy of Information.] The gist of this piece is the proposal to make reliability as important a criterion for decision-making as efficiency. The piece provides the theoretical basis of such policies as economic protectionism, import/export control, capital flow regulation and other State regulatory tools.]

In an earlier letter to the Human Ecology Review[2], I proposed reliability as an alternative criterion for socio-economic decision-making instead of efficiency. This paper pursues that idea further.

Definitions

Efficiency is a measure of how well transformation of matter or energy occurs. To be efficient means to get the most from the least. The higher the efficiency, the better the transformation is occurring. Efficiency is usually computed from the ratio of useful output to input. To be accurate, the computation must take into account all inputs to a process; otherwise, the computed efficiency may exceed 100%. This will imply that the transformation process itself is creating new matter or energy, which contradicts fundamental laws of physics.

Since energy transformation always produces waste heat, the energy efficiency of any process is always less than 100%. If some of the material outputs are not usable (e.g., wastes), then the sum of the useful material outputs will be less than the sum of the material inputs too, and the material efficiency of the process will likewise be less than 100%.

Economists often express the inputs and outputs of a process in monetary terms, because their interest is in processes where the monetary outputs exceed the monetary inputs. Furthermore, economists often compute the difference instead of ratio between outputs and inputs, because their interest is in absolute monetary amounts instead of ratios. In such cases where the focus is on absolute amounts, this paper uses the term “gain” instead of “efficiency.” An example of gain is the producer’s profit, which is revenues minus costs. Another example is the total utility to the consumer of a set of goods minus the total price of these goods.

Because both are measures of output relative to input, gain is closely related to efficiency and is used whenever absolute magnitudes are more important than relative magnitudes.

Among business firms, gain is really of more interest than efficiency, the best firms being those who manage to squeeze the last marginal bit of gain (i.e., profit) from their business operations.

Among natural persons, the output of interest is not necessarily matter, energy, or money but a vaguer concept like welfare, utility, or happiness, which makes measuring efficiency or maximizing it harder.

Like firms, economies today also tend to maximize gain (i.e., efficiency and inputs), not only efficiency. To maximize gain, one can increase the inputs to a process, or the efficiency by which the inputs are transformed into outputs, or both. Expanding one’s global reach is one way of increasing inputs. The economies-of-scale argument (higher efficiency through larger scale of operations) also supports a global strategy. Thus, gain-maximization strategies directly lead to globalization.

Because economies include all firms and natural persons, macro-efficiency is very difficult in practice to maximize or even simply to measure. To cope with this problem, economists have settled on a curious rule for improving the efficiency of economies step by step: improve somebody’s welfare without reducing anybody else’s, and keep doing this until nobody’s welfare can be further improved without reducing somebody else’s. This is the economist’s Pareto efficiency, which is obviously lower than full theoretical efficiency, but is itself a theoretical construct that is hardly ever seen – not even approximated – in reality.

Efficiency and economic theory

Despite these theoretical problems, efficiency is probably the most common criterion for economic decision-making in modern society. Nearly all modern economic policies cite efficiency as their ultimate goal, even if measuring it can be quite difficult.

Efficiency is the rationale for the idea of competition in a free market. It is also the reason cited for dismantling the welfare policies of the State and the welfare state itself. It is cited as the reason for privatization programs. Advocates for the international division of labor and economies of scale cite efficiency as their goal. Globalization, which extends the economies-of-scale idea to its utmost, also invokes efficiency as reason.

When policy-makers select between alternative options, efficiency is often at the top of the list of criteria for selection.

Critiques of efficiency

The efficiency criterion has been criticized from at least three vantage points: 1) from efficiency advocates themselves; 2) from the social justice viewpoint; and 3) from the ecological viewpoint.

The first critique comes from within the advocates of efficiency itself. This critique retains efficiency as its main criterion for policy formulation, but points out flaws in the way efficiency is computed and efficiency estimates distorted, usually due to the incomplete accounting of inputs and outputs. Incomplete accounting occurs by ignoring non-market transactions or by externalizing costs.

An example of non-market transactions is subsistence production, where a considerable portion of the output is for direct consumption. Unless such production is accounted for, a subsistence economy may appear an inefficient, low-output economy. In fact, production for consumption is quite efficient because it saves marketing, storage and distribution costs. An important subset of production for direct consumption is household work, the non-accounting of which is a major critique of women’s movements against current economic systems.

Still another example of incomplete accounting occurs in U.S. agriculture, which prides itself in its increasing “efficiency,” with less than 10% of its population producing food for twice its population size. Yet, the energetic efficiency of U.S. agriculture has actually gone down over the decades: at the start of this century, it required less than one calorie input to produce a calorie of food; today, it needs more than 10 calories to produce the same amount.

Costs are externalized by passing them on to politically-weak social sectors, to the environment, or to future generations. This can lead to false impressions of high efficiency and mask gross inefficiencies within the system.

All such incomplete accounting distort efficiency comparisons.

The social justice critique

The social justice critique of the efficiency criterion suggests as a higher criterion the concept of equity. According to this critique, efficiency does not ensure equitable sharing of the output and often results in a reduction in equity (i.e., increasing gap between rich and poor).

This critique often presents efficiency as a problem of production (how to allocate input resources to maximize output), and equity as a problem of distribution (how to allocate the output to minimize the gap between rich and poor). Thus, from the vantage point of many equity critics of efficiency, maximizing efficiency and ensuring equitability are parallel objectives which may or may not conflict.

The ecological sustainability critique

The third critique of efficiency comes from the vantage point of ecology. According to this critique, efficiency only looks at a linear process that transforms input A into output B. This critique points out the problem of a linear process: the continuous transformation of input A into output B will gradually use up A and accumulate B. How will A be replaced? Where will B go? The more efficient such a linear process becomes, the faster A is used up, the faster B accumulates in the ecosystem. In a real world, a linear process is eventually an unsustainable process.

Just as the social justice critique insists that the output B must be equitably distributed, the ecological sustainability critique insists that the linear process must be turned into a cyclical one, so that the final output of the process eventually goes back to become fresh input into another – or even the same – process. This is what Barry Commoner called “closing the circle.”

A new critique of the efficiency criterion

This paper proposes a fourth critique of the efficiency criterion, from the vantage point of engineering and systems design. Such vantage point is becoming increasingly useful, since economic systems today are as much a product of social engineering and conscious design as they are a product of unplanned evolutionary development. This new critique also complements the social justice and ecological sustainability critiques of efficiency.

In engineering and systems design, another criterion for design optimization is often deemed more important than efficiency. This is the criterion of reliability.

While efficiency and reliability are related, they are not the same. Efficiency is a measure of how well a system transforms its inputs into useful output. It is usually expressed in terms of the ratio of useful output to input. Reliability is a measure of how long a system performs without failing. It is usually expressed in terms of a mean time between failures (MTBF). It may also be expressed in terms of the probability of non-failure.

One Comment

  1. Posted October 6, 2012 at 9:50 pm | Permalink

    always i used to read smaller articles or reviews which also clear their motive, and that is also happening with
    this piece of writing which I am reading at this time.

3 Trackbacks

  1. […] this piece, he proposes reliability as an alternative criterion for socio-economic decision-making instead of […]

  2. […] continue Roberto Verzola’s important contribution to a ‘green’ p2p economics […]

  3. By Efficiency Vs Reliability in economic decision making on December 25, 2008 at 12:21 pm

    […] This paper suggests restoring the criterion of reliability to its rightful place above efficiency in the list of important criteria for socio-economic decision-making. This would be the first step in rescuing society and economics from the dead-end and possible catastrophe created by pure gain-maximizers. Reliability and modularization sit on the very solid theoretical foundations of the engineering sciences and system design. Hopefully, they can provide better theoretical guidance for the difficult socio-economic decisions that we must make today. Read more […]

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