One of my first part-time high school jobs was in telemarketing. I worked for a company that had a contract with a state police organization to raise money for the disabled officers fund. Yes, I was one of those annoying people who would call you during dinner and try to guilt you into giving money to support disabled police officers. Whether you think it is a good cause or not, that job opened my eyes the importance of incentives.
After a year or so on the job, the office manager pulled me and another guy aside and offered us promotions to part-time office managers. Each of us would take the managing duties for two nights a week and we were free to develop strategies for our team of callers that would give them the incentive to raise as much money as possible. Our pay was contingent on the performance of the team.
My competitor chose the following strategy: At the end of the night we will add up all of the committed pledges and you will get paid an equal percentage of the total of all pledged donations.
His thinking was that by providing equal incentives to everyone, everyone would work harder.
My strategy: At the end of the night you will be paid a percentage of the donations you bring in.
My thinking was that everyone would have more of an incentive to work if they were paid according to their own results.
At the end of a month guess who had been paid more as manager? Yep, I won.
Now you may be tempted to say "But it's not all about profit, it might be the case that your strategy made a lot of money for one really good caller and everyone else made almost nothing." That's right, that may very well have been the case, but remember the overall goal--to make as much money as possible for everyone involved: In particular the disabled police officers. My strategy resulted in a bigger overall pie to be divided among everyone involved. That's efficiency. But is efficiency all it's cracked up to be? Is efficiency fair?
In deciding how best to allocate our scarce economic resources, many argue that there is a trade-off between equity and efficiency. As Greg Mankiw puts it in his now standard Principles of Microeconomics textbook:
Another trade-off society faces is between efficiency and equality. Efficiency means that society is getting the maximum benefits from its scarce resources. Equality means that those benefits are distributed uniformly among society's members...When government policies are designed, these two goals often conflict...In other words, when the government tries to cut the economic pie into more equal slices, the pie gets smaller.
I agree with Mankiw, to an extent. That was the point of my example at the beginning of this post, given the goal of maximizing the size of the economic pie, a policy which aims at equity creates incentives inconsistent with the goal. There is a way to reallocate the scarce resources (in that case the employees) to better achieve the goal of maximizing donations. Conditional on a given goal, we can define an allocation as efficient or not efficient and evaluate that based on objective/observable outcomes.
But what is missing from this discussion and what is implicitly assumed in Mankiw's definition of efficiency is that everyone is OK with the goal of maximizing the size of the economic pie. Efficiency does not imply the goal of maximizing total economic productivity; to the contrary, maximizing total economic productivity is the subjective goal to which the objective definition of efficiency is being applied.
This distinction is important because it is often assumed that there is a one-to-one correspondence between total economic productivity and total societal well-being or happiness. Therefore to improve societal well-being, concerns of equity must be thrown away since total economic productivity can only be maximized through efficiency. Hence the trade-off. But what if there is not a one-to-one correspondence between happiness and total economic productivity? Does that render the concept of efficiency--and consequently economics--useless?
Quite the contrary and this is where some of the critics of economics overreact when they see Mankiw-like definitions of efficiency. Efficiency is usually defined with the underlying subjective goal of maximizing total productivity. But what if society values equality? That is, what if total productivity is only part of what determines well-being and people actually care about making sure others are looked after--at least minimally. Then we can't be efficient right? According to the definition of efficiency above, that's right. There is no way to efficiently achieve the goal of maximizing total economic productivity if our goal is to maximize something else.
The trade-off that is typically discussed between equity and efficiency is really a trade-off between equity and total economic productivity. The logical problem comes in assuming that total economic productivity and total well-being are synonymous. But what if part of our societal goal is some concept of equity? Can we still achieve it efficiently? I'm pretty sure. Efficiency doesn't have to be predicated on the particular goal of maximizing total economic productivity. So with that, I offer the following definition of efficiency:
Efficiency is achieving a particular social goal using the least amount of society's resources as possible.
That social goal may be total economic productivity, or it may be any one of a million other distributions of social well being. No matter the goal, economics provides a valuable set of tools for understanding how to achieve those goals using the least amount of society's resources--and thereby freeing those resources for other uses (or nonuses).
With that said, I will reveal my hand. I believe maximizing total productivity is the best goal. I fully recognize that this is a subjective stance. But conditional on that, well-functioning markets are the best way of achieving that goal and imposing equity concerns up front lessens the incentive to achieve the maximum productivity. That is Mankiw's point. There are after-the-fact ways to transfer wealth that don't distort the incentives created by well-functioning markets.
Make the pie big first. Then slice it.