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Beware of an Inefficiently Narrow Understanding of Efficiency

In my latest column for AIER, I plead for a broader understanding of economic efficiency – a broader understanding that incorporates the insights of the late, great Julian Simon. A slice:

But I believe that the anonymous commenter is nevertheless on to something important – namely, there’s no reason why the concept of “efficiency” should refer only to how well existing resources and knowledge are used. The work of the late Julian Simon suggests a broader and more useful meaning of economic “efficiency.”

Simon taught that there are no “natural resources.All of the things that we identify as “resources” were only made that way by the creative human mind. The viscous, noxious, and malodorous sludge that centuries ago polluted the streams of western Pennsylvania was a nuisance to the native Americans then living in that part of the world. But that sludge is now a resource only because creative human minds figured out how not only to transform petroleum into fuel, plastics, and other goods that satisfy human desires, but also how to perform this transformation in a manner that makes it worth doing.

A mainstream economist would not classify pre-Columbian native Americans’ failure to refine petroleum into fuel and other outputs as “inefficient.” And given these native Americans’ state of knowledge, that mainstream economist’s decision makes sense. But because the human mind is capable of innovation – because the human intellect is capable of creatively turning heretofore worthless (or even harmful) raw materials into valuable resources – the relative efficiency of an economic system ought to be judged not only by how well it enables and incites people to reallocate existing resources in ways that result in greater outputs, but also by how much it encourages people to create new resources.

My plea here is for economists to stop always taking as fixed both the existing state of technical know-how and the existing stock of resources. To recognize that human minds in free markets create resources – to recognize that human creativity transforms what would otherwise be worthless raw materials into economically useful and valuable resources – is to recognize that the existing stock of resources is not fixed. And so in an open market economy, the stock of resources will never be fixed. The size and contents of that stock will change over time and that change is appropriately reckoned to be a result of the economic system.

It follows that a failure of the economic system to effectuate some achievable amount of resource creation is an inefficiency on par with the failure of an economic system to use today’s existing stock of resources in ways that yield maximum output value (as judged by consumers).

It seems to me, therefore, that Noah Smith is wrong – even beyond the reasons mentioned by David Henderson – to assert that in advanced economies “there are relatively few efficiency gains to be had.” Or at least, the ghost of Julian Simon gives reason to question this claim by Smith.