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Dynamic versus Static
Efficiency: Matthew McCartney (SOAS, University of
London) © Copyright 2004 Matthew
McCartney This
paper begins by outlining the neoclassical theory of efficiency, using
international trade in Bangladesh as a case-study. This notion of efficiency is extremely
narrow, and concerned only with the allocation of a given quantity of
resources. Competition is better
modelled as a dynamic process. This
difference is considered in the context of Bangladesh. The phase-out of the WTO’s
Multi-Fiber Arrangement (MFA) quota regime will
lead to intensified international competition for textile exports. Dynamic efficiency can be defined as a
virtuous circle of increasing productivity, output and wages (the high-road). Likewise a vicious circle of reduced wages,
longer hours and intensified working conditions is possible (the
low-road). Neoclassical economics has
no means to distinguish between these two processes, if all returns are
equalised at the margin it is perfectly possible for both to be considered
efficient. Dynamic efficiency is
argued here to be an alternative paradigm to neoclassical economics. The implications for economic analysis and
policy making are briefly considered.
The principal conclusion of this paper is that the narrow view of
efficiency has restricted the relevance of neoclassical economics. A more realistic interpretation of how
economies function as dynamic not static entities is important in properly
evaluating the conflicting and complementary roles of government intervention
and the free-market. The most
important implication of dynamic efficiency is in setting a theoretical basis
of for the economic analysis of the developmental state.
The explicit theoretical
rationale of liberalisation according to neoclassical economics is to achieve
an efficient (static) allocation of resources. The link to economic growth is implicit,
rational individuals will save according to criteria such as the life-cycle
hypothesis, profit maximising firms will utilise these available resources to
invest efficiently. In a free market
there is no such thing as growth that is too slow, growth reflects the time
preferences of individual agents.
Price signals link the short and long-run and there is no need to
consider the two separately. In
international trade neoclassical economics offers a strong theoretical
prediction. The theory of comparative
advantage states that a country will export goods intensive in its abundant
factor, and import those intensive in its scarce factor. For South Asia with a relatively low area
of land per person1 and abundant labour, exports should
principally comprise labour-intensive manufactured goods rather than primary
sector products. Structural adjustment
should see a shift in the composition of production from capital-intensive
import substituting industries2 to export-orientated
labour-intensive industries. A
well-documented and lauded example of such growth3 is the
phenomenal expansion of the ready-made garment sector (RMG)
in Bangladesh. Exports were negligible
in 1979/80, by the late 1990s Bangladesh had become the twelfth largest
apparel exporter in the world, the RMG sector
accounted for about 76% of total export earnings. By the late 1990s the industry employed
1.5m people, 90% of them women. The
change is efficient from a neoclassical perspective, the abundant resource
(unskilled/ female labour) has been re-allocated (rural-urban migration) in a
rational response to price incentives.
Efficiency in neoclassical Economics
The
neoclassical concept of efficiency is extremely narrow, this is revealed in
striking clarity by an examination of four well-used microeconomics
text-books4. In general
‘efficiency’ gets only a passing mention and is entirely subsumed by the
concept of Pareto efficiency. In
Gravelle and Rees (1992) and Kreps
(1990) efficiency is solely a static concept concerned with the efficient
level of output of public and private goods, efficient risk sharing, solution
to bargaining, the Edgeworth Box, and Walrasian equilibrium5. In Mas-Colell
(1995) efficiency gets six entries in the index, the Pareto concept appears
76 times. Kreps
(1990) doesn’t bother to separate them, “Efficiency, see Pareto efficiency”
(p824) notes the index, Pareto efficiency in its various forms appears 26
times. Also in Varian (1992)
efficiency appears only as Pareto efficiency (p225). The
necessary requirements for Pareto efficiency (Gravelle
and Rees, 1992, p479-485) are ‘efficient consumption’, ‘efficient input
supply’ and ‘efficient input use’ (production efficiency) and ‘efficient
output mix’. Theses are the “three types of efficiency embodied in a Pareto
optimal exercise” (Mas-Colell, 1995, p564). The first is consumption efficiency, where consumers have allocated their
budgets to maximise their own well-being (utility maximisation). The marginal rate of substitution between
any two goods equals their price ratio.
The second is production
efficiency, where producers cannot alter the ratio of inputs to raise
output or reduce the cost of a given volume of production. The marginal rate of technical substitution
between any two inputs equals their price ratio. The final measure is aggregate output efficiency, where resources are allocated
simultaneously to achieve both production and consumption efficiency. Where for example in a society of bipeds an
equal number of right and left shoes are produced. Utility and profit maximisation will ensure
consumption efficiency and the efficient use of inputs and composition of
outputs. Glancing
again at the index in Gravelle and Rees (1992) at
‘dynamic’ reveals only a set of references that give more mathematical rigour
to the concept of static equilibrium.
By dynamic efficiency neoclassical economics means the existence,
stability and uniqueness of equilibrium.
Dynamic analysis is shorn of any substance and asks simply whether an
economy in equilibrium (existence) subject to an exogenous shock will return
(stability) to its original position (unique). There are a few cases such as the cobweb
model which has a unique equilibrium but any deviation from which can produce
an explosive divergence of price and output, such are at most given passing
attention. Imperfect Information and Market Failure: A Radical Departure? Theorising
on imperfect information and markets failures appears to be a radical
departure from the neoclassical paradigm.
However this analysis implicitly accepts efficiency as being a static
concept, Pareto Efficiency as the benchmark and government policy as a means
to make the world look more like the neoclassical theory. If
there exists a wedge between social and private costs (an externality), a
taxation, subsidy or regulation can push the economy towards the overall
social optimum. An optimal Pigouvian tax can replicate efficient allocation, see for
example Mas-Colell et al (1995, p355). Similarly government policy may help solve
the preference revelation problem for public goods, see Varian (1992,
p425). There may be some problems
government policy is unable to overcome such as moral hazard and asymmetric
information in the market for bank loans.
The market is then constrained to allocate resources in a second best
world, see Stiglitz and Weiss (1981). The very notion of ‘second-best’
illustrates the striking normative preference for Pareto Efficiency It
is not with the analysis of market and information imperfections that we are
forced to confront the implications of an alternative paradigm. The crucial assumption is an economy that
is static, where efficiency is measured at a moment in time. In an alternative world, when we consider
the dynamics of competition, investment and growth, what we mean by efficiency
takes on a radically new meaning. An
implication of this proposition is introduced in the context of future
prospects for the Bangladeshi textile industry. Competition is a Dynamic Process
As of December 31st
2004 textile and clothing products will be subject to WTO
rules, with the final abolition of the MFA6. When the MFA was being implemented in the
1970s Bangladesh was not considered to be a viable exporter, consequently it
was never subject to its strictures.
Other potentially competitive exporters such as Sri Lank, India, Pakistan
and China have been subject to binding MFA quotas on apparel and textile
exports. Bangladesh has been able to
export into an open niche in world markets since the late 1970s, after 2005
Bangladesh will face intensified competition on world markets. There are broadly two potential outcomes,
the low and high-road of competition.
The latter is ‘dynamically efficient’, leading to rising wages and
productivity over time. The concern of
neoclassical economics with efficient allocation has no theoretical means to
distinguish these two processes, as long as marginal equalities are retained
according to neoclassical criteria even the low-road of competition could be
judged efficient. Dynamic Efficiency and the Low and
High-Roads of Competition
Bangladesh
is currently most competitive in price sensitive, low-value, low-priced items7. Bangladesh has two options to compete after
2005, raising productivity or reducing costs.
Bangladesh
could react to intensified competition by trying to enhance it price
competitiveness within its existing niche by extending hours, reducing
overheads (subcontracting) and intensifying work conditions (a low-road of
competition). There is some evidence
this path has already been pursued in the Indian textile industry. The
fragmentation, ruralisation and casualisation
consistent with a low-road of competition has already had a profound impact
in India. As early as the 1960s
textile mills in Ahmedabad and Bombay began putting
out weaving work to decentralised power-loom units. Pharmaceutical firms in Bombay passed on
work to smaller units located away from the high-wage industrial belt. From the 1970s there was a general increase
in the use of contract, temporary and casual workers. The share of casual workers in large
factory employment rose from 4.6% in 1980/81 to more than 12% in 1993/948. Subcontracting was not a significant
activity prior to 1970, by 1978 it was a prominent activity in large
factories with a share of 21% of total employment9. In India especially sharp has been decline
of large urban cotton mills and ruralisation of the
industry10. This ruralisation of labour is reflected in the fall in the
average size of industrial units from 3.2 to 2.5 workers between 1961 and
1991. The fall in average employees
per factory is true for most industries and has persisted throughout the
1970s and 80s11. b) The High-Road of
Competition A
high-road of competition could consist of remaining in an existing production
niche and raising productivity, or upgrading to a less (price) competitive
market niche to capture rents. In the RMG sector Bangladesh may compete by capacity building to
enhance skills in fashion, design, cutting and technology upgrading,
developing backward linkages to suppliers to shorten lead times, and
improving the skills and training of management and workers. Good
policy can be defined as that which helps achieve a high-road response to
competition. Dynamic efficiency is a
situation characterised by a virtuous circle of higher productivity, output
growth and higher wages rather than having a rigorous mathematical
definition. Dynamic Efficiency,
Rents and Learning Dynamic
efficiency is an alternative paradigm to neoclassical efficiency. In fact there is likely for various reasons
to be trade-offs between static and dynamic efficiency. When we are
considering dynamic efficiency good policy cannot be mechanically judged in
terms of whether it liberalises the economy, encourages competition or
expands the freedom of decision making.
Policy is a far more nuanced process that has to be carefully
evaluated in terms of its effect on the dynamics of investment, growth and
competition.
One neoclassical assumption
immediately disposed of when we consider dynamic efficiency is that no
allocation or industrial structure is preferable to any other. In fact, while many allocations may be
efficient, some are more (dynamically) efficient than others. Neoclassical theory argues
that export structures are simply a product of comparative advantage and
factor prices. The composition of
exports does not matter; no set of activities are more desirable than any
other. There are no externalities, so
returns are equalised at the margin (efficient allocation). Lall (1999,
p1775) notes that spill-over benefits for the whole economy are positively
related and ease of market entry of competitors negatively related to the
technological complexity of a product.
The consideration of dynamic efficiency is, much more than market or
information failures, what creates the potential for industrial policy by the
government. We can broadly define
industrial policy as a deliberate action by the state to shift the structure
of the economy away from its static comparative advantage to a structure
offering more dynamic potential. We
generate the first strong implication of our alternative paradigm: there may
exist a trade-off between static and dynamic efficiency. b) Profits and Efficiency Profits
in the neoclassical model are a temporary aberration of the market. Profits may exist temporarily before
resources and factors flow into a sector and compete them away. In a dynamic world profits (or more
correctly rents) are useful to induce and reward learning in order to raise
productivity or upgrade to higher value-added and less price sensitive
sectors. Learning is much like patents
that reward innovation in a developed country. Neoclassical economics assumes innovations take
place in advanced countries and learning in less developed countries (LDC) is no more difficult than selecting the most
appropriate. Innovation (shifting the
production frontier) is distinct from mastering/ adapting technology13. In truth, though much technology is tacit,
experimentation and learning are necessary to understand the tacit elements
and adapt them to local conditions. In
practise there is less difference between innovation in developed countries
and industrialisation based on learning already commercialised technology. Investment in learning by
one entrepreneur in discovering a commercial niche that can be profitably
exploited is likely to lead to rapid imitation14. If such learning requires investment, the
returns to which cannot be fully appropriated, entrepreneurs in LDC’s face similar problems to innovators in developed
countries. While neoclassical
economics subscribes to the need for patent protection to generate an
incentive for innovation, it advocates complete freedom of market entry in
all other scenarios. LDC investors should not get patent protection no matter
how high the (external) social return.
Entrepreneurial learning is likely to be under-supplied. Profits / rents that reward and motivate
learning may lead to a more dynamically efficient economy even if they are a
sign of resource misallocation according to considerations of static allocative efficiency. c) How do we Evaluate Policy? The
analysis of policy intervention in the static neoclassical model is easy,
anything that increases the scope of the free market and free decision making
is a good thing. When we consider our
alternative paradigm, that of dynamic efficiency, the analysis of policy is
much less clear. Policy needs to
increase the expected payoff to learning, hence it is important to
distinguish firms that are engaged in costly learning and those who simply
imitate the results of others’ learning.
The parallels with innovation and patent protection are evident. Temporary trade protection
may increase profits from learning but only for firms producing for the
domestic market14. Trade
protection does not discriminate between innovators and imitators. This will promote early entry and lower the
expected return to learning. Export
subsidies avoid the anti-export bias of trade protection but likewise do not
discriminate between learners and imitators.
Export subsidies can be relatively good at discriminating between
successful and unsuccessful performers ex-post. Providing subsidies or government credit
contingent on exporting can allow policy makers to discriminate between
firms. d) Dynamic Efficiency and Liberalisation Neoclassical
analysis of efficiency pre-supposes that good economic policy consists of
removing constraints on the operation of the free market. Individuals are rational, so any
constraints on voluntary options and mutual exchange can only reduce welfare
and efficiency. One exception is that
of game theory, or more precisely the ‘Prisoners Dilemma’. This illustrates a situation in which
individuals acting in their own self-interest generate a socially sub-optimal
outcome. Some sort of constraint is
necessary to prevent individuals rationally defecting to maximise the social
return. The literature has typically analysed this in terms of extra-economic
factors such as trust, culture or coercion.
For example: “an
economy can perform well only to the extent that it is embedded in a well
integrated society, and that a society exists only to the extent that it is
capable of imposing normative constraints, or social obligations, on the
pursuit of individual interest.”15
This question is of
immediate relevance to Bangladesh.
Currently unions are forbidden from operating and organising in
Export-Promotion-Zones where many of the RMG
factories are located. Japanese and
Korean foreign investors are threatening to withhold FDI
should the law be amended. Concerned
institutions in the US motivated by ‘fair trade’ rhetoric are pressing for
this to happen under threat of countervailing import duties. Placing a floor under the process of
cost-cutting, longer hours and intensified working conditions may force
producers to pursue a high-road to international competition. Conclusion
Successful policy cannot
simply be judged in terms of the degree to which markets are
liberalised. Once we consider
economies as dynamic rather than static entities and evaluate policy in terms
of achieving dynamic not static efficiency, what we conceive of as good policy
becomes far more nuanced. The impact
of policy on learning and imitation is relatively clear, but the relative
merits of trade protection, export and government subsidies are more subtle
and complex. Certainly we can say
liberalisation has to be carefully compared and evaluated against other
possible policies; certainly liberalisation can only ever be a policy means
to achieve a given end; it certainly cannot be judged an end in itself. Beginning with a benchmark of ‘dynamic
efficiency’ we have arrived at the theory of the developmental state, this is
the archetype of a dynamically efficient economy. The developmental state is an alternative
to neoclassical efficiency, not an occasional aberration and second
best-solution to allocative inefficiency16. Notes 1. A.Wood and M.Calandrino, ‘When
the Other Giant Awakes: Trade and Human Resources in India’ (2000),
University of Sussex, IDS Mimeo. 2. Which were prominent
parts of the domestic industrial structure in India especially before
liberalisation.
4. These are H.Gravelle and R.Rees (1992), Microeconomics
(2nd Edition) (London, Longman, 1992), H.R.Varian,
Microeconomic Analysis, (Third Edition) (London, W.W.Norton
and Co, 1992), D.M.Kreps, A Course in
Microeconomic Theory, (London, Harvester Wheatsheaf,
1990), A.Mas-Colell, M.D.Whitston
and J.R.Green, Microeconomic Theory,
(Oxford, Oxford University Press, 1995).
8. K.V.Ramaswamy, ‘The Search for
Flexibility in Indian Manufacturing: New Evidence on Outsourcing Activities’, Economic and Political Weekly,
(1999), 34:6, pp. 363-8. 9. B.Harriss-White,
India Working: Essays on Society and
Economy, (Cambridge, Cambridge University Press, 2003).
13. Y.W.Rhee
(1990) notes that the number of export-orientated RMG
factories in Bangladesh exploded after the single firm Desh
proved it was a profitable proposition at the end of the 1970s, by 1985 there
were 700 such firms.
15. W.Streeck in J.R.Hollingsworth
and R.Boyer, Contemporary
Capitalism: The Embeddedness of Institutions,
(Cambridge, Cambridge University Press, 1999) p199.
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