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The Neoclassical Fallacy of Government as Deus ex Machina

Mises Daily: Tuesday, May 19, 2009 by

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Austrian economists have long been critical of the static, unrealistic models of neoclassical economics and instead take a dynamic, causal-realist approach. Similarly, the role of government, while receiving heavy analysis from Austrians, is taken as a given in most neoclassical models and textbooks, used today in almost all university economics courses.

Laying aside the Austrian critique of neoclassical models, an analysis of the role and characteristics of government — within the neoclassical framework — will show that this institution most closely resembles the model viewed as least efficient in terms of production and allocation of scarce resources.

The government is not a deus ex machina. The question of where the government fits into the neoclassical framework demands an answer. It cannot just be assumed that any market "inefficiencies" (in the neoclassical sense) could be limited or eliminated by government, when government itself is arguably the most inefficient of all institutions.

In the neoclassical view, there are four market models that can exist in a society, all of which are described as having degrees of costs and benefits. Based on this analysis, the models could be ranked according to how efficiently goods are produced and allocated. The role of government in such models is usually taken as a given — it is an existing institution, smuggled in with many (false) assumptions, unexamined, and excluded from economic analysis.

In this article, I will (a) briefly review the neoclassical models and (b) apply them to the US government in order to (c) analyze which model — perfect competition, monopolistic competition, oligopoly, or pure monopoly — corresponds most closely with characteristics of the federal government of the United States.

Neoclassical models can be analyzed by looking primarily at the following characteristics of each model: number of firms, control over price, and ease of entry.

The Four Models

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  1. In the neoclassical model of perfect competition, there is a relatively large number of firms offering a standardized product or service with no control over price. Firms are "price takers" and face a horizontal demand curve, by which it follows that price equals marginal revenue. Because of the extreme amount of competition, the rationale is that if an individual firm increases its price, consumers — possessed with perfect information and no switching or transactions costs — will turn to one of its many competitors. The firm that raises its price will lack customers and, therefore, revenues. It is very easy to enter (and exit) the industry, and there is no nonprice competition, e.g., advertising or product differentiation. Firms earn a "normal profit," breaking even, where marginal revenue (and price) equals marginal cost and total revenue equals total cost. This imaginary world may be labeled "ideal" due to its productive and allocative efficiency.

  2. In monopolistic competition, there are also many firms, but with differentiated products (through advertising, location, service, brand name, etc.). Firms possess some control over price, but, unlike perfect competition, firms do face a downward-sloping demand curve. It is relatively easy for new firms to enter and compete in this model. Inefficiencies are typically "allowed" to exist because, although the model is not efficient, consumers benefit from product differentiation and choice.

  3. In the oligopoly model, there are only a few large firms offering standardized or differentiated products. These firms are constrained by mutual interdependence that may lead to collusive behavior, although this is illegal. Collusion of firms may lead to a de facto monopoly, thus charging a monopoly price and producing a monopoly output. In other words, this model, like monopoly, underproduces and overprices relative to pure competition. It is also difficult to enter and compete in an oligopolistic industry.

  4. The final model, pure monopoly, is where only one firm exists and sells a unique product with no close substitutes. The firm is the industry because of its ownership of resources, patents, or economies of scale. The pure monopoly firm has considerable control over price— although not absolute, as it also faces a downward-sloping demand curve — and can restrict product availability. Entry barriers are very high; it is essentially impossible for new firms to enter. One identified failure of the monopoly model is that a monopolist will charge a price in the elastic portion of its demand curve (where marginal revenue is positive). A monopolist underproduces and charges a higher price (relative to perfect competition).

Characteristics of Government

Having briefly explained the models, we can now attempt to answer the question, which model does government most closely fit? While Austrolibertarians knew the answer from the beginning, a review of government's attributes will make the answer — or at least its justification — clearer.

One difficulty with analyzing the US government is that it consists of seemingly endless programs and bodies. Therefore, in order to allocate government to one of the four models, its most-commonly-agreed-upon functions — judicial and military protection — will be used to analyze number of firms and ease of entry. Taxation and control over (monetary) inflation will be used to consider control over price.

Number of Firms and Ease of Entry

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In terms of judicial protection, the US Supreme Court has exclusive judicial power. It is the "final arbiter of the law … [and] functions as guardian and interpreter of the Constitution."Download PDF Competition in law and legislation is not merely difficult — it is illegal. If a citizen has a dispute with the government, it takes place in a government court. Although simplified, it should not be difficult to see the problem with one party holding its own proceedings and deciding the outcome. Rothbard explained this in For a New Liberty:

[W]e turn over all of our powers of ultimate decision-making to this deified group, and then we must jolly well sit back quietly and await the unending stream of justice that will pour forth from these institutions — even though they are basically judging their own case.

Not only does the US government claim ultimate decision-making authority in the court system; it is in complete control of national defense, where it is also illegal to compete. Individuals may not start up National Defense Firm B and attempt to lower costs through diplomacy, since war is costly in terms of lives and money. This is the function Rothbard believed was

reserved most jealously by the State. It is vital to the State's existence, for on its monopoly of force depends its ability to exact taxes from the citizens.

Protection and defense services would surely be in demand in a free society, i.e., without government provision of them. Yet the utilitarian question of whether or not such services would be better provided by the private sector seems to answer itself with the number of YouTube videos exposing police officers abusing their power. The apposite question is more likely to be, could private cops be any worse?

Control Over Price

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To analyze control over price, income tax will suffice as an appropriate measure. According to the Urban Institute and Brookings Institution's Tax Policy Center, "the individual income tax has been the largest single source of federal revenue since 1950, averaging just over 8 percent of GDP." In 2008, 45% of federal tax revenue came from individual income taxes, or over one trillion dollars.

In terms of government's control over "price" through taxation, government cannot necessarily set its price as high as it wants for fear of a potential revolution by the population. However, with self-granted access to the unlimited printing of money through inflation, the less seen price — the hidden tax — may be almost as high as the government wishes. The important point is that government is not a "price taker" as in the perfect-competition model; its price is also not constrained by mutual interdependence as in the oligopolist model. Similar to the pure-monopoly model, government, through tax and access to a printing press, can exercise great control over its "price"; it is a price maker.

However, there is an important difference between government and pure monopoly. Even in the neoclassical pure-monopoly model, individuals are making voluntary exchanges, with each party expecting to benefit. In contrast, government force to extract taxes creates an "exchange" where one party benefits at the expense of the other. This creates a conflict between classes of net taxpayers and net tax consumers. Unlike even pure monopoly — that most dreadful of neoclassical models — it is only the government (and a criminal gang) that obtains its "revenue" through force.

Conclusion

This article sought to analyze the US government and place it into one of the four neoclassical models, leaving aside the Austrian critique of such models. By now the obvious answer should be that government most closely corresponds to the pure-monopoly model, the model viewed as least efficient by neoclassical economists. As demonstrated above, the government is in many cases worse than the pure-monopoly model. There is only one "firm"; it is illegal to compete; and price is controlled through tax and, especially, the ability to print money.

Neoclassical economists would argue that government can correct for (alleged) "inefficiencies" in the market through legislation, subsidies, and taxes. However, government itself cannot be excluded from economic analysis and assumed to be able to remove inefficiencies. As shown above, it is the most inefficient model that exists. Neoclassicals, instead of viewing the government as savior to "inefficient markets," should realize it is the least productive, gaining all of its revenue from others' labor in the private sector. In Man, Economy, and State, Rothbard explains government's monopoly ownership in the following way:

[I]n all countries the State has made sure it owns the vital nerve centers, the command posts of the society. It has acquired compulsory monopoly ownership over these command posts, and it has always tried to convince the populace that private ownership and enterprise in these fields is simply and a priori impossible.

Fortunately, Austrian economists have shown that every product and service can be offered privately, without the use of monopoly force through government.

Typically, neoclassical models assume government as a given, and as a means to step in and overcome "market failure." This amounts to turning a blind eye to one of the most powerful and dangerous institutions in all of history: the state. It is a monopoly in the purest sense.