Applied Economics

Introduction to Applied Economics: Resource allocation, production, and human choices

A. Overview: Scarcity and the price system
Economics is the study of allocation of scarce resources in society. Without scarcity there is nothing to study. Every individual would satiate their ``wants.''  Such an environment may characterized as a ``Garden of Eden'' economy, in which resources are unlimited (except of course for apples), and people live forever. For all practical purposes, scarcity always exists.  Among the most important of these resources, our time, is scarce because we live lives of finite length. When resources are scarce, the problem faced by individuals, firms, and society becomes how do we allocate those resources among their most ``valued'' uses? 
This question beckons another important question: as ``valued'' by whom? By individuals? By the managers of multinational corporations? By government policy makers? In a market-oriented economy, these values are determined largely by consumers and workers. Consumers base their purchases on their assessments of the alternative values of goods or services in consumption. Workers decide whether to ``supply their labor'' to a firm based on their assessments of the value of alternative uses of their time.  Notice that in both of these instances there is no explicit dollar amount placed on these values.  For example, the value of homes is almost certainly larger than the price paid by homeowners or more precisely the price that homeowners could receive if they sold their homes. Similarly, if parents decide not to work, but instead to stay home and care for their children, we only know that the value to parents of raising their own children must be at least as large as the wage or salary less the cost of child care that they would have received from working. These consumption and labor supply decisions result from individuals' values and ultimately determine the allocation of resources in society.  They determine who works, what is produced, and how the output of society is distributed among its members.
At its most fundamental level economics is the study of human choices.  In a market-oriented economy, the functioning of the price system reflect these choices.  A price is the value placed on a good or service by those consumers who are just indifferent between buying that good or service or some other alternative. Even in situation in which a producer ``sets'' or ``fixes'' a price for the product, there exists some consumer who is approximately indifferent about purchasing the product and buys it,  and another who also is just indifferent about buying the product and does not buy it.  If this producer were to reduce its price, additional consumers would buy the product. But what does the price system have to do with resource allocation?  Because when these additional consumers purchase the producers' product, they are now NOT buying the products of other producers. This change in consumption changes how resources such as labor, materials, natural resources, and entrepenerial skills are allocated among producers.
The price system, therefore, signals to economic ``agents'' how their resources (ie. their time, their natural resources, their capital) are valued by others who have used the marketplace.  If the transmission of information were costless, we would know that the current (market) price represents the highest value of a particular resource by an alternative user.  When the price rises above an individual's own value for a product, that individual should sell it.
A striking example of this choice facing individuals has arisen recently in the wine market for fine Bordeaux wines. In recent years average wine prices have approximately doubled and the prices of some wines have gone up by even more.  Wine connoisseurs are now faced with the dilemma that $30 bottles of wine that they had purchased as their ``pizza'' wine is sometimes selling at auction for nearly $100 a bottle. The question is what is the cost of drinking this wine with their Domino's Pizza or a plate of spaghetti? Is it the $30 that they paid for the wine in the first place (the historical cost) or is it the $100 that it is currently fetching at auction (the replacement cost)? Some wine connoisseurs report that they no longer can afford to drink the wine stored in their own cellars!
Because of the central role that the price system plays in allocating resources in industrialized economies, this course amounts to a course in ``price theory.''  The objective of this course is that you understand (i) the important role of a well functioning price system in allocating resources in a market economy; (ii) how to use the analytical tools developed in this course to examine broader questions of economic policy; and (iii) how to apply these tools to problems facing the firm.

B. A Historical Perspective:
The problem of resource allocation is an old problem that has attracted the attention of philosophers for at least three millennia.  Economic and political writings from ancient China document early interest in the role that production and exchange play in the ``wealth of nations.''  Consider the following excerpts from two different ancient texts.  

            When Duke Tai (ca. 1122 - 1078 B.C.E.) arrived in his country [Qi], he improved government, conformed to the [local] customs, simplified the rites, extended the work of merchants and artisans throughout the country, and facilitated the making of profit from fish and salt. Thus, people came to Qi in large numbers and the Qi became a great country.

                                                                                   Author unknown, from the Shi ji 32/3a

            The marketplace determines the value of goods. Hence, if goods are kept cheap, there will be no [exorbitant] profits. If there are no [exorbitant] profits, production will be well organized, and if it is well organized, expenditures will be properly controlled. Now production materializes through planning, succeeds through diligent attention, but fails through negligence. Without planning it will never materialize, without diligent attention it will never succeed. However, unless there is negligence, it will not fail. Therefore it is said that the marketplace may know order or disorder, abundance or scarcity [on its own]. There is a proper way to manage [markets and production].

                                                                                   Attributed to Guan Zhong, ca. 645 B.C.E.,

In particular in the second excerpt notice the author's view of how ``value'' is determined. Economists today would be comfortable with this proposition. However it is important to recognize that the ancients' understanding of economics differed considerably from our own. This point can be understood from the origins of the word itself. ``The word 'economics,' Greek in origin, is compounded from oikos, a household, and the semantically complex root, nem-, here its sense of `regulate, administer, organize.' '' (A simpler translation of these words might be ``household management.'')  For more approximately two millennia the standard work on economics, Oikonomikos, was written by the Greek philosopher, Xenophon during the 4th century B.C.E. ``In Xenophon, however, there is not one sentence that expresses an economic principle or offers any economic analysis, nothing on efficiency of production, ``rational'' choice, the marketing of crops.''   By our understanding today, his was a work on ethnics, and not economics.  This emphasis continued into the 18th century and is seen even in the work of Francis Hutcheson, Adam Smith's teacher, in his book entitled Short Introduction to Moral Philosophy.
During the 18th century, the subject of economics as we understand it today began to take form culminating in the publication of the Wealth of Nations in 1776. This important book was part of a growing body of literature characterized by the French as l'economie politique which dealt with issues such as money, trade, national income, and economic policy.  For more than a century the term political economy was understood to refer to the ``science of the wealth of nations.'' The term ``economics'' did not come into common use until after the publication in 1890 of the Principles of Economics, by the British economist, Alfred Marshall.
The important contribution of Smith and others and their intellectual departure from the work of previous scholars is that they developed a conceptual framework for understanding a wide range of economic activities such as farming, manufacturing, labor, finance, taxation, money, and so on.  More recently, the ``economic'' activities examined using by this framework have been expanded to include marriage, addiction, suicide, fertility, the forming of firms, organizations, associations, or clubs.  This framework is what is often referred to today as microeconomics.

C. The Modern Economy in a Dangerous World:
Given the historical roots of the subject as the science of the wealth of nations, it is appropriate to begin our examination of price theory or microeconomics looking at the national economy. A useful fact to take away from this course is that the U.S. economy produces approximately $8 trillion worth of goods and services each year. This figure known as the ``gross domestic product'' or ``GDP'' is a measure of the value of all goods and services produced and sold in the market place each year.  To appreciate the relative size of this output, 25 percent of world output is produced in the United States.  As shown by the pie chart, Japan and Germany generate 13 and 8 percent of world output, respectively. Thus, together these three countries generate approximately 45 percent of world output. (By contrast, they constitute less than 10 percent of the world's population.)
But why is this $8 trillion figure so useful? One way think about this figure is to recognize that it approximates the productive capacity of the economy. Consider the graph discussed in lecture that sometimes is referred to as the ``production possibility frontier.'' Individuals in a society have choices about how to employ their resources to produce final products. In the simplest of cases we can think of the economy as producing two types of goods ``guns'' and ``butter.''  At some point if existing technology is being used effectively, decisions must be made that involve trading off guns and butter. In the graph, we can think of the slope of the line as representing the relative price of guns and butter: an extra gun costs so many sticks of butter.
In the first graph, this (relative) price is treated as a constant. But it is easy to imagine that a more realistic characterization of technology is to assume that there are diminishing returns associated with this tradeoff, so that extra guns ``cost'' an increasing number of sticks of butter. We can also characterize the impact of technological change on an economy's productive capacity by a rightward shift in the production possibility frontier. The implication of this shift is that the economy can have both more guns and more butter. Because technological change allows individuals to produce and consume more of all goods using the same resources,  it is sometimes referred to as the true ``free lunch'' in economics.
As the United States dramatically demonstrated to the rest of the world during World War II, an economy can quickly shift along its production possibility frontier.  Indeed, one can argue that the Japanese decision to bomb Pearl Harbor in 1941 was one of the great military miscalculations of the century. Why? Because the decision appears to ignore the implications of the industrial capacity of the United States. True enough at the time the U.S. military was small in size compared to other world powers and destroying the Pacific Fleet would seem likely to deliver a crippling blow to the United States' ability to fight a war. However, the implications of the diagram are that such an analysis was misguided because in the long run the bombing of Pearl Harbor would have little consequence to the outcome of the war. What the Axis Powers needed in order to achieve victory was to destroy the U.S.'s industrial capacity.
By contrast Winston Churchill appears to have understood completely the consequences of the U.S.'s entry into the war. He recognized the economic impact that the U.S. would have on war despite it having a relatively weak military. A story from the invasion of Normandy serves to illustrate the point. During the initial hours of the invasion a U.S. navel intelligence officer reported asking a colonel ``how things were going?'' The colonel replied, ``we are screwing up so badly that you would not believe it, but you know we have so many ships, and so many tanks, and so many airplanes, that it won't make any difference. The invasion will still be successful anyway.'' The economic impact of the U.S. participation in the war was decisive. Indeed, the outcome became clear once the U.S. gained air superiority and was in a position to systematically destroy not simply the military installations, but the industrial capacity of Germany and Japan.
Saddam Hussian provides  a more recent example of a military ``strategist'' who probably knew but could not comprehend what it meant for an economy to have an $8 trillion GDP. After he invaded and occupied Kuwait,  Hussian asserted that  U.S. ground troops would not stand much of a chance against his battle tested troops who had spent nearly a decade fighting a bloody war with Iran. As evidence, he asserted that whereas his troops could live off the desert and endure many hardships, ``soft'' American troops could never get by without their ``bottles of Evian water.'' Of course Saddam may well have been right, but more importantly what he failed to appreciate was that an $8 trillion economy can supply a 1/2 million troops with a bottle of Evian each day and no one will notice! Similarly, an economy this size also can fly 2,000 ``sorties'' per day over Baghdad without this activity measurably affecting day to day civilian life.
Finally, we can consider the economic lessons of the Cold War. Much has been written about the consistent resolve of the U.S. and its allies during the decades long struggle with the former Soviet Union having been an important factor in determining the outcome of the Cold War. But clearly the most important factor was the substantial and growing difference between the economic capacity of the U.S. and Western Europe and of the U.S.S.R and its allies. ``Glasnost'' and the fall of the Soviet Union revealed the reason for the Cold War's outcome. As shown by the graph the industrial capacity of the U.S. economy meant that despite substantial expenditures on the military, U.S. citizens could still enjoy an affluent lifestyle. The same could not be said of citizens of the Eastern Block. Indeed as the Cold War dragged on the disparity grew, even during the 1980s as the U.S. substantially increased its miliary expenditures.

Discussion Questions:

1. Suppose technological change affected only the production of butter. In other words a chemical engineer designs a new process that yields more sticks of butter with the same resources. By contrast, guns continued to be produced the same old fashion way. Given this form of unbalanced technological change, would it still be possible for society to ``consume'' both more guns and more butter?

2. One of the U.S. Congress's favorite activities is to prevent the closing of domestic military bases and installations that the U.S. military has determined serve no strategic value. Congressmen (and Congresswomen) argue that critics of their behavior ignore the beneficial impact that these bases have on the number of jobs in their communities. Without these jobs, the economy would weaken because fewer people would be working.  Evaluate this argument of U.S. Congressmen.

D. The Role of the Market, the Firm, and the Household
To be sure, the $8 trillion GDP figure understates the true output of the U.S. economy because it does not include the value of output and services produced and consumed by households.  For example, the value of meals prepared at home, child care by parents, house cleaning, or home and appliance repair are not included in official statistics unless the household hires or contracts others to perform these tasks. The implication of this accounting of GDP is that as two earner couples become more common, GDP necessarily rises because households stop producing these services on their own, and employ others to perform these tasks for them.
A simple way of thinking about the economy is to think of it consisting of two institutions: firms and households; and two markets: final product and factor markets. It is useful to think of the household as an enterprise or firm. Households consume final products, but they also supply the factors used by firms to produce products. The most important factor is labor, but households also own (either directly or indirectly)  all capital, land, and other resources used in production. GDP measures the value of those final products purchased by households.
In his book entitled Price Theory, Milton Friedman describes the market sector as the place in which the use and purchase of final products and of factors of production ``organize the use of resources'' in a society.  He goes on to explain that

            (i)n its simplest form, ... an economy consists of a number of individual households, a collection of Robinson Crusoes, as it were. Each household uses the resources it controls to produce goods and services that it exchanges for goods and services produced by other households, on terms that are mutually acceptable to the two parties to the bargain. It is thereby enabled to satisfy its wants indirectly by producing goods and services for others, rather than directly by producing goods for its own immediate use. The incentive for adopting this indirect route is, of course, the increased product made possible by division of labor and specialization of function. Since the household always has the alternative of producing directly for itself, it need not enter into any exchange unless it benefits from it. Hence, no exchange will take place unless both parties do benefit from it. Cooperation is thereby achieved without coercion.

            Specialization of function and division of labor would not go far if the ultimate productive unit were the household. In an modern society, we have gone much further. We have introduced enterprises that serve as intermediaries between individuals in their capacities as suppliers of services and as purchasers of goods. We have introduced money to facilitate exchange and avoid barter, thereby enabling the acts of purchase and sale to be separated into different parts.

 

E. The price system and the allocation of resources.
How does the market sector allocate resources? What are the dynamics that cause resources in a market oriented economy to be allocated to their highest ``valued'' user? A dramatic illustration of how this process works is seen in the aftermath of a natural disaster. The historic flooding of the Red River in North Dakota during the spring of 1997 demonstrated how quickly nature can affect both the level and allocation of resources in a community. Goods that one day seemed ``plentiful'' such as drinkable water, the next were suddenly scarce.  Did North Dakotan's demand for drinkable water suddenly increase as a consequence of the flood? A common mistake is to assert that it did, when it fact it probably declined to the extent that some members of the community choose to leave the area and ``wait out'' the flood by staying with relatives and friends. 
However, how does an economy provide drinkable water to those individuals who decide to stay behind? There are essentially two approaches: (i) call in the National Guard and provide every individual with a daily ``ration'' of water; or (ii) do nothing and allow market forces to operate. But what do market forces have to do with floods? If drinkable water in an area suddenly becomes scarce and demand for water stays constant what should happen to its price? The higher price provides incentives to providers of drinkable water to ship water to the flood victims. Of course, unlike the National Guard, providers of drinkable water are not likely to ship water for ``free.'' The flood victims must pay the higher price for their water.
Both approaches described above result in North Dakotan flood victims having fresh drinking water.  But do these two approaches result in the same outcomes? Experience suggests that the public actually prefers the non-market approach to addressing the problem of scarcity following a natural disaster. For example, long time residents of Northern climates know the likely consequences for retailers who raise the price of their snow shovels following a blizzard.  In principle, such behavior makes sense from the point of view of both the retailer and society, because it ensures that following a blizzard show shovels are allocated their highest valued users.   The price system ensures that those persons or businesses who are willing to pay the most to begin digging out from the snow storm receive the relatively scare resource.
Nevertheless, the public often refers to such pricing behavior in the aftermath of a natural disaster as ``price gouging.'' Sometimes businesses that are alleged to practice such behavior are threatened with law suits. Application 8 - 1 on pages 285 - 286 in the text illustrates this point using the experience of Hurricane Andrew in 1992.  But, if ``price gouging'' leads  to an ``efficient'' allocation of resources, why does the public often object to it? The reason is that the outcome - how the snow shovels are allocated in the aftermath of a snowstorm - does not seem ``fair.'' Some would assert that relying on the price system to allocate resources following a natural disaster is ``crass'' and ``hard hearted.'' Critics of the market system correctly point out that during these times of exceptional hardship the most vulnerable in society are least likely to receive ``needed'' resources such as drinkable water and snow shovels. Individuals perceive that the non-market solution - calling the National Guard - yields a fairer outcome.  From a normative standpoint, the non-market solution may be a ``good'' or the socially ``preferred ''outcome.  Economic analysis does not help us understand ``right '' from ``wrong'' or ``good'' and ``evil.'' None the less,  some economists might suggest that a more ``efficient'' way allocate resources following a natural disaster is to allow market forces to operate and to ``subsidizes'' the poor and needy so they can buy drinkable water or snow shovels.

 Discussion Questions:

1. Since 1981 in the United States, labor productivity has grown at historically unprecedented rates in the manufacturing sector. (By contrast, labor productivity as measured in the services sector has grown very slowly.) Starting in the 1920s and continuing until the 1980s, U.S. labor unions have argued that wage increases for workers should be tied to productivity gains in the industry.  In the absence of unionization, would you expect that workers wage gains would be proportional to gains in labor productivity? What would happen if manufacturing wages began to rise relative to wages paid in the service sector? How are wages helping to allocated labor resources? Is the union wage policy sustainable?

2. The United States often is on the front lines advocating ``free trade,'' especially in agricultural products among other industrialized nations. French farmers, notorious opponents of free trade, sometimes are signaled out as an example of an impediment to lower world prices for agricultural products.  At the same time, the United States has engaged in some inefficient and ``protectionist'' agricultural policies of its own.  A good example, are laws governing the trading and pricing of water rights in many western U.S. states.  In California water is relatively cheap if used for farming, but is expensive when used by urban residents for personal use.   Could this outcome result from market forces? In general what should be the price difference between water used for farming and water used for residential consumption? Given the existing price differential between water used by farmers and urban residents, what are the consequences of the resulting allocation of resources for the prices of agricultural products?  For housing prices in Los Angeles? Why did I refer to these water rights laws as ``protectionist?''

3. Interest in the benefits of ``free trade'' dates back at least to the 18th century and indeed this issue was one of the central purposes of the Wealth of Nations.  More than 150 years ago, economist David Ricardo rigorously analyzed the economic consequences of the British ``corn laws.'' These laws amounted to significant import restrictions on agricultural imports into Great Britain. The crux of Ricardo's analysis was that these laws had lowered national income and had reduced growth.  The question to be resolved was similar to that facing North American policy makers today with NAFTA.  The ``North-South'' question during Ricardo's time was the industrialized United Kingdom and the relatively land rich Baltic countries.  Ricardo successfully argued that the corn laws distorted the allocation of British land and human resources and as a consequence had hindered growth. Given the low cost of land in the Baltic countries, too much British land was used for farming and too many British subjects were farmers.
Although the economy of Ricardo's time was much different that ours today, the issues that he addressed in his influential work on free trade are essentially the same as those encountered with NAFTA and other ``free trade'' arrangements. That the debate still rages about this topic after more than 200 years since the publication of the Wealth of Nations demonstrates in part how difficult these issues are to understand and the point that not everyone benefits from free trade.
The question arises is why do trade agreements generate such heated opposition? Would the nations of the world be better off with more protection? One way to understand protection is that it prevents voluntary exchange among individuals who reside in different countries.  In other words, there are two individuals who would both be better off if they could trade.  If two citizens of the same country wanted to engage in a similar transaction most would agree that it would be inefficient to prevent the exchange. (But see water rights discussion above.)
If Country A can not successfully negotiate a free trade agreement with Country B, would it still make sense for it to allow ``unfair'' trade between the countries?  Consider the following definitions:

            Fair Trade:

                        Country A can sell its products to country B without barriers.
Country A can buy products from country B without barriers.

Unfair Trade:

                        Country A cannot sell its products to country B.
Country A can buy products from country B without barriers.

            No Trade:

                        Country A cannot sell its products to country B.
Country A cannot buy products from country B.

How would you rank each of these regimes? Why?

4. During the late 1980s, the U.S. and Canada successfully negotiated a free-trade agreement.  President Bush intended that the agreement would become a model that would subsequently become the basis for NAFTA.  An interesting obstacle arose during the negotiations when the U.S. objected because the Canadians wanted to continue to subsidize their beer industry.  The U.S. argued that it would not be ``fair'' for  Canadian producers to be subsidized after tariffs were eliminated under the agreement.  Disputes over a ``level playing field'' often arise in trade negotiations. But the question is ``fair'' to who?

F. Tools of the trade: Supply and demand
In the previous section, we developed the tools of economic analysis without using any explicit quantitative framework or apparatus.  Now we turn to putting our discussion of these economic concepts into the context of the familiar supply and demand framework.  One of the best places to start any analysis of prices is with agricultural markets. One reason for this is that they often conform most closely to an economy consisting of many producers (suppliers) and consumers (demanders).  Under these conditions, the framework that we develop in this course is the easiest to use and makes the strongest predictions.
Consider the graph showing the relationship between the quarterly demand for turkeys and their price.  Since scientific studies revealed the health benefits of eating turkey as opposed to red meat, turkey is now consumed year round in the United States. However, the greatest demand is during the fourth quarter of the year when American families often eat turkey during the Thanksgiving and Christmas holidays. What  appears to be the relationship between the quantity consumed and the price of turkey? Once one understands that the consumption patterns differ during the year, it is easy to see that there are two demand curves for turkey: (i) the fourth quarter demand curve is ``shifted'' out to the right and is steeper; and (ii) the rest of the year demand curve which is flatter.  The data plotted in the graph appear to tell us something that makes a lot of sense: the demand for turkey is greatest in the fourth quarter and consumers exhibit less sensitivity to price during that period.
The demand curve for turkey represents the amount of turkey that consumers are willing to purchase at any given price. Therefore, the area under the demand curve would be the total revenue that turkey producers would receive if they could price discriminate and charge each consumer the maximum price he/she would be willing to pay for a ``unit'' of turkey.   If consumers value turkey more, then the demand curve shifts to the right. Notice that this shift implies that at any given quantity of turkey, the value placed on it by consumers has increased. The ``slope'' of the demand curve tells us how sensitive consumers are to changes in price. A steep demand curve means consumers behave as if price is NOT an important determinant of their consumption decisions. By contrast, a flat demand curve, means consumers behave as if price is a very important determinate of their consumption decisions.  In this case, a modest rise in the price of turkey would lead consumers to stopping purchasing turkey and instead purchase a ``substitute'' such as chicken.
As  we will discuss in the next lecture, the demand curve represents the values that consumers place on a good or service. By contrast, the supply curve represents the costs to producers of producing a product. These costs reflect both the market prices for different factors of production, and also the available technology for combining these factors and producing a final product.  Lets consider two supply curves: (i) the first represents a firm that buys factors in competitive markets and uses a technology that exhibits constant returns to scale; and (ii) the second supply curve represents either a firm buying factors in noncompetitive markets and/or uses a technology that exhibits decreasing returns to scale.  The first supply curve is flat: it says that firms can produce an unlimited amount of turkey at a constant (marginal) cost. The second supply curve is increasing: it says that firms can produce more turkey but only at a rising cost per unit.  Lower factor prices or technological change shifts the first supply curve down and the second curve to the right.
The prevailing competitive price is characterized by the intersection of the demand and supply curve. At this point, the value placed on the turkey by the ``marginal'' consumer exactly equals the cost of production.  If a rare disease were to ``hit'' turkey farms, the cost of supplying turkey would rise. (The first supply curve shifts up; the second shifts back to the left.) As a consequence, the price rises: turkey producers are not willing to produce turkeys at the low pre-disease price, but some consumers continue to buy turkeys at higher prices.  Notice that consumers do not value turkey any more as a result of the ``supply shock'' on the turkey farm. But the price has risen. The higher price tells us that the ``marginal'' turkey consumer values turkey more than previously.
This framework helps us to understand questions of economic value that often puzzle individuals without any economics training. Consider the following three questions:

            (i) Everyone knows that water is essential to life and diamonds are frivolous. But why is the price of water low and the price of diamonds high? Does this outcome mean that something is wrong with the free market?

            (ii) Everyone knows that teachers and police perform essential work, yet they are relatively low paid. By contrast, Michael Jordan is an entertainer engaged in a frivolous or non-essential activity and yet makes $36 million per year.  Does this outcome mean that something is wrong with the free market?

            (iii)  In April 1992, child care workers in Seattle, Washington went on strike for one day protesting their low wages and poor benefits.  They noted that while their hourly wages ranged between $5 and $6 per hour, the wages of zookeepers in the Seattle zoo averaged $12 per hour.  Because care givers of children were being paid less than 1/2 the pay received by care givers of monkeys and tigers, they argued that the ``free market'' was not functioning in the child care industry.  Does this outcome mean that something is wrong with the free market?

In each case comment on the argument that the ``market does not work.''  These three questions all ask the same thing. What do they have in common?

G. Economic v. technical efficiency
One confusing aspect about economics is that it uses an alternative definition of efficiency than the one commonly used by the general public. To most people, efficiency refers to technical efficiency: how much output a person or firm can generate from a fixed set of resources. An alternative definition of efficiency is based on the answer to the question are these resources allocated to their highest valued user? If yes, then the outcome is efficient.
To understand this distinction more clearly consider our discussion above of water rights laws. We could research the use of water by California farmers and determine that they make efficient use of their water.  However, from an economic standpoint, unless they sell their water to urban users, their use of water is inefficient.  Laws and regulatory practice prevent water from moving to its most valued user!  Because urban consumers are willing to pay more for water ``on the margin'' it would be socially more efficient for them to consume more water. Such an allocation means that it would be more efficient for Southern Californian homeowners to pay less to fill their swimming pools or water their lawns and for everyone else to pay more for agricultural products!
Now consider an example that contrasts the labor intensity of hotel or commercial construction in the United States compared with Mexico.  In the United States, building contractors construct multi-storied hotels with relatively little labor. Instead, they save on labor costs by employing modern capital equipment.  By contrast, their counterparts in Mexico use relatively less capital and make heavy use of labor.  Labor productivity is much higher in U.S. construction firms.  But are the U.S. firms more efficient? The answer is probably not.  The difference in labor intensity or the capital-labor ratio used in U.S. compared with Mexican construction results from the differences in relative wages.  U.S. workers are more expensive because they have higher valued alternatives. As a result, it makes economic sense to employ building (ie. production) technology that relies heavily on capital. The point is that even if a Mexican construction firm were given the capital equipment, it would still be more ``efficient'' (and profit maximizing!) for it to continue to use the labor intensive mode of production and rent the capital equipment to a construction firm in the United States!
The idea underlying the notion of economic efficiency is that all resources, whether they be labor, capital, land, mineral resources, etc., have an alternative use. Thus, the real cost of employing these resources to produce one good or service equals the value of the good or service that would have been produced had these resources gone to that use. If the price system functions well, this cost should equal the prevailing price for these resources. So if clerical workers in a community  receive $12.00 per hour, this wage implies that the alternative use of their time is worth $12.00 per hour. In other words, if a clerical worker quit or was laid off from his/her job, he or she would expect to find another job paying approximately $12.00 per hour.

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Footnote
See Guanzi: Political, Economic, and Philosophical Essays from Early China, W. Allyn Rickett, translator, Princeton, NJ: Princeton University Press, pp. 9, 118. (The Guanzi is believed to have been written or compiled around 250 B.C.E. Italics are added for emphasis).
2 see M.I. Finley, The Ancient Economy, Berkeley, CA: University of California Press, 1973, pp, 17 - 19.
3 For those who are following the debate on granting ``fast track authority'' to President Clinton in order to extend NAFTA, approximately 2.5 percent of world output is produced in Canada, and 5 percent of world output is produced by all of the remaining countries in the Western Hemisphere. See Latin American View, Citicorp Securities, Inc., Global Research Emerging Markets, September 1997, Issue 8.
4 In reality there are two other important sectors: the government and the nonprofit sectors. The government plays three roles: (i) it redistributes ``income'' among households; (ii) it produces or supplies final products (ie. education or electricity) and (iii) it ``consumes'' final products (ie. provision of national defense, or highways).
5 See Friedman, Milton, Price Theory, Chicago:Adline Publishing Company, 1976, pp. 5 - 6.
6 Notice that the nature of the scarcity is different. By contrast to drinking water following a flood, the ``supply'' of show shovels has remained the same. Instead the ``demand'' for snow shovels has increased.
7 For a more technical treatment of this example see Application 18-2 in the text, pp. 679 - 681.
8 See Kouparitsas, Michael. ``Economic Gains From Trade Liberalization-NAFTA's Impact,'' Chicago Fed Letter, Chicago:The Federal Reserve Bank of Chicago, 122, October 1997.
9 A multi-country poll, conducted just prior to the 1997 G-7 conference in Denver, which was hosted by President Clinton, revealed somewhat ironically that the greatest support for free trade was among Russian citizens! In most of the G-7 countries substantial numbers if not majorities opposed freer trade.
10 In the United States, the ``interstate commerce'' clause of the U.S. Constitution prohibits states from establishing trade barriers. However, as a result of the repeal of prohibition in the 1930s, alcohol is exempt from this clause and states have in fact erected significant barriers to trade. For example, Michigan has a state-owned monopoly on the wholesale liquor business. Pennsylvania has a state-owned monopoly on the retail liquor business. (If you can imagine such a thing wine made in Pennsylvania is exempt!) This year the Florida state legislator enacted a law (allegedly to protect minors) making it a felony for individuals to receive liquor that they have had shipped across state lines.
11 Thinking back to your time with Professor Rubin, how would you use your knowledge of regression analysis to estimate the relationship between quantity and price?
12 This statement is approximately true if the good involved constitues a small portion of a consumers' expenditures. More generally, this amount overstates the actual amount that consumers are willing to pay for a good.  For a technical treatment of this question see the discussion in the text on pages 110 - 119, 134 - 136.
13 To make matters worse, statisticians have another important definition of efficiency.