Chapter 4: The Nature of Inefficiency
4. The nature of inefﬁciency 4.1 THE DEFINITION OF INEFFICIENCY I will say that economic inefﬁciency occurs when there is some hypothetical new rule that would pass a KHZ efﬁciency test, not counting the costs of changing the rule, but counting other transactions costs.1 By not counting the costs of changing a rule, the economic analyst is saved the difﬁcult job of estimating the political costs associated with rule change. I call this efﬁciency or economic efﬁciency. With this deﬁnition a paradox arises in so far as an economist may then label some rule inefﬁcient, when the costs of enacting the rule are sufﬁciently great that society would lose were the rule to be enacted. If, however, to deﬁne efﬁciency to include the costs rule change then every society is always completely efﬁcient as a tautology. I will call this sort of efﬁciency tautological efﬁciency. Inefﬁciency incurs then because transactions costs are higher than they need to be, or because property rights do not correspond to psychological rights. By this deﬁnition, inefﬁciency lies solely within institutions with rule-making authority. That is, given rational, wealth-maximizing behavior on the part of individuals, inefﬁciency arises only from inefﬁcient rules, which arise from institutions. Here, I view the role of institutions as setting rules of property and liability, by which I mean rules of transactions. That is, inefﬁciency occurs only when an efﬁcient...
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