In his paper “Toward a Reconstruction of Utility Theory and Welfare Economics,” Murray Rothbard writes: “We conclude therefore that no government interference with exchanges can ever increase social utility,” (his emphasis).
Joseph Stiglitz shared the Nobel Prize in 2001 partly on the basis of an important paper of his (with Greenwald): “Externalities in Economies with Imperfect Information and Incomplete Markets.” In that paper he says: “There exist government interventions (e.g., taxes and subsidies) that can make everyone better off.”
This article will analyze Stiglitz’s position. The extant Austrian positions on externalities can be found in the work of Walter Block, Hans-Hermann Hoppe, and others. Barnett and Yandle (PDF) provide a useful starting point and references.
The question is very important. If Stiglitz’s view is correct, it provides justification for the state. Even if there is controversy over its correctness, his pro-state view provides a high degree of intellectual cover for all those who wish to enlarge the state’s actions. If the Austrian anti-state view is correct, then it removes the justification for a large set of government activities that come under the general category of externalities. Since a liberal interpretation of this category can be made almost indefinitely large, it is important for freedom’s supporters to eliminate arguments that the state should or can raise social utility by operating on externalities.
I argue that Stiglitz, who is an outstanding spokesman for the pro-government school and who is supposed to have provided the intellectual and analytical foundation for government intervention, completely fails to prove his point. (I’ll refer to Stiglitz and not Greenwald because of Stiglitz’s many other pronouncements on the efficacy of government.)
Austrian economists have examined the issue of externality and government intervention before in various ways, but instead of reviewing them here, I will attack Stiglitz’s views on his home ground, that is, his theorizing or his model. I shall examine the Stiglitz theory in some detail in a way that does not burden the reader with his mathematics but is completely faithful to his equations. At the end of the argument, the reader will understand exactly why we can reject his conclusion.
A good many although not all of my comments are informed by Austrian emphases. But they are all presented in a way that should resonate with economists of all persuasions. My intent in approaching Stiglitz’s theory in this way is to persuade as many non-Austrian economists as possible that they must seriously rethink the facile conclusion that there is a role for government when there are externalities. I do not want to do this on contentious grounds of methodology such as Stiglitz’s use of continuously differentiable utility functions or controversies over a priori economics versus positivism. I want to do this on grounds that most neoclassical economists will recognize, understand, and hopefully agree with.
The Stiglitz Model
The Stiglitz model has no mathematical errors in it that I know of. The equations follow one another correctly. The implications are correctly deduced from the premises. The problems with the model are deeper than mathematical. Barry Smith writes of establishing economic laws: “It is, for example, a matter of certain entities or properties of entities arising in reflection of the existence in appropriate combinations of other sorts of entities.” We have to ask (1) whether Stiglitz has a correct theory of the “other sorts of entities” that lead to properties arising in reflection thereof, and (2) whether the math is capable of properly establishing connections between the two even if the symbols are properly manipulated according to mathematical laws.
We will see that there are fundamental problems with the model that involve the treatment of government and the treatment of externalities. Grafting these onto the standard neoclassical model of exchange and production introduces two “other sorts of entities” with which households and firms interact, thereby giving rise to certain entities. The question is whether the grafting operations make sense and are acceptable theory in which we can place confidence.
The initial model is a standard timeless neoclassical model of general equilibrium under certainty. Part of the paper extends it to situations involving uncertainty. The main innovations in it, which are indeed noteworthy, are (1) a simple formulation or method by which to tell whether in the model there is a set of taxes, subsidies, and lump-sum transfers that indicate a positive net “government” revenue while leaving household utilities unchanged, and (2) showing how the model applies to a number of situations that had previously been treated in disparate fashion. These innovations, which I do not criticize, are responsible for the paper’s fame. The mathematician and physical scientist sides of me that value simplicity and seeing abstract relations among phenomena admire these accomplishments. However, the economist in me does not recognize progress here. I see backward movement.
Model Basics
There are two sectors in the basic model, households and firms. In standard neoclassical fashion, the households maximize utility and the firms maximize profits. Firms are “black boxes,” that is, they process inputs into outputs according to some fixed technology. They do nothing interesting in the model. They are altogether unreal and mechanistic. Nothing in these statements is meant as criticism. I will accept this much of the model in the paper’s context. If the paper were trying to explain how markets work, I’d view the model as failing miserably. I’d view it as perhaps providing some insight into rules of optimizing behavior but that is about all. But the paper’s purpose is otherwise. It is to explore the effects of externalities on the Pareto optimality of household and firm optimizations within a neoclassical model. It is to extend that model.
Stiglitz (and other neoclassical economists) model utility as depending on two sorts of items. One is goods that are produced, traded, and have prices. Later in the model, the “government” will be alleged to do particular things regarding these goods such as tax them. I note here only in passing that although the government may conceivably identify various items and activities and tax them, these may not be the items that ultimately provide utility to the consumer. Consumers produce or obtain utility using various items. They may combine a table with a refrigerator, ham, bread, electricity, a fan, and a TV show to produce something that is difficult to name. Utility does not change directly with consumption of a given item.
The second is items (called externalities) that are not traded and do not have prices in the model. They do not appear in the budget constraints of the households (or firms) as costing anything, but the household utilities are affected by them. Because they do not appear in budgets and cannot be traded but do affect utility, household optimizations leave some possible utility gains on the table. The equilibrium is therefore not Pareto optimal when these externalities are present.
Government in the model is an entity that leaves each household’s utility unchanged while maximizing its excess of tax revenues over lump sum transfers to households. This is its behavior function. The only way that it can have such an excess is when there are externalities. When such an excess occurs, it amounts to money or utility left on the table by households and firms. Of course, the latter has to occur the instant that neither is able to trade goods that affect profits and utility. The implications follow implacably from the assumptions.
Four Main Criticisms
Now, what are the fundamental criticisms of this model? There are four big questions.
In the model, the households and the firms optimize, yet somehow they are still not as well off as they can be. They leave gains on the table that are sopped up by government. Why don’t households and firms fully optimize, that is, take into account the externalities?
In the model, why is government able to recognize the externalities and compensate for them by a series of taxes, subsidies, and transfers while households and firms cannot and do not?
In the model, what sort of entity is this government and how does it relate to the entities that it is taxing?
What does the entity called government have to know in order to effect the taxes, subsidies, and transfers?
Each of these questions occurs in the model. Then there are questions outside the model that have to do with its interpretation by those who use it to justify government. Those questions come later. Let me address these four questions in greater detail.
The actors are optimizing, which is the standard method of neoclassical economic theorizing. We admit there are externalities in this world. Can we simply insert them into utility and production functions without prices and then allow households and firms to optimize? We can do it mathematically, which is what Stiglitz has done, but the procedure is what we call ad hoc. It has no theoretical justification. The externalities in the model do not themselves arise from other optimizing actions. They are simply givens in the model. They could be endogenized and still leave gains on the table by making it too costly for the households and firms to get together to overcome the externalities or too costly for an entrepreneur to internalize them somehow. But that will not do either, because then there will be an ad hoc assumption about costs. Anyway, this was not done here. I do not say that there should never be ad hoc theorizing. There is a cost and benefit to it, and there will be times when it is worth doing. But in a case where the central message is to promote government and downplay markets, it just will not do to introduce the reason for government in an ad hoc manner.
Let us think of externalities as being either trivial or important. If they are trivial, they are not worth worrying about and actors ignore them. But if they are important, then there are incentives for private contracting in order to reap some of the gains being left on the table. The Stiglitz model is an equilibrium model, which means that everyone has already done the best they can possibly do. From that perspective, won’t private parties already have done the best they can do in order to internalize the externalities (create contracts, exchanges, and prices for them)? It’s inconsistent with the spirit of optimizing models and equilibrium models to introduce ad hoc externalities. Where do they come from, and why aren’t they already priced out? The Stiglitz model contains at its core an ad hoc element that drives all the results and that is inconsistent with the optimizing and equilibrium assumptions of the model. It assumes that actors who otherwise are absolutely punctilious about optimizing utility and profits ignore the potentialities of taking externalities into account. The model has inconsistent assumptions.
The paper has a section on optimal taxes. The idea is that when gains are left on the table, the government has a way of realizing them and moving to Pareto optimality. The way is shown via an equation that involves taxes and other parameters. My second question is closely related to my first. Whereas households and firms ignore the externalities, the optimizing government does not. Why is it so perspicacious? In fact, to Stiglitz his equation “provides a simple set of necessary conditions characterizing the optimal level of taxes in the presence of externalities.” And he provides an example, using a tax on alcohol, of just how easy he considers it to accomplish this.
I grant that this equation makes good sense within the model, that is to say, once one grants the existence of externalities and the existence of an entity called government with the properties that the model endows it with. After all, the condition says that the government should push the tax to the point where its marginal cost (in terms of consumption and utility losses) equals it marginal gain (in terms of lowering a negative externality.)
My question at this point, however, is why the government optimizes a measure of profits by taking into account the externalities and the other sectors do not? On the one hand, Stiglitz introduces this optimization merely as a device, a mathematical convenience, a simple way to test for Pareto optimality. But since he also regards it as an entity that interacts with the other entities of the model, we again have an inconsistency and an ad hoc element at the heart of the theorizing. There is no reason or explanation given in the model for why these optimizing behaviors should be different among the three entities, households, firms, and government.
This leads directly into the third issue, which is what government actually is in the model. This issue is very important because there is absolutely no doubt that Stiglitz considers the government in his model to be a basis for government policies and government interventions to improve upon market economies, not only in this paper but in many subsequent writings of his. There is also absolutely no doubt in my mind that this leap from model to reality is totally unjustified in a number of ways, as I shall now argue.
Within the model’s confines, the government is either a creature of the other economic actors (households and firms) or it is not. If it is an institution created and run by the household and firm sectors to rationalize externalities, then (assuming that it can and will do this and that it is the optimal means of doing do), we actually are not dealing with government at all in the usual sense of the word. We are dealing with a voluntary means of negotiating exchanges, a kind of a market, and we are not dealing with coerced taxes. There is in this case no warrant whatever for speaking of the model’s government as representative of real government.
Real government is not an ongoing type of firm created and managed by the private sector to iron out certain problems. If it were, it would not be marked by the extensive power that it has to impose measures. It would not be marked by life and death debates over its every action. It would not be marked by divisions between one part of it and another and between it and society. It would not be marked by what seems to be its creation of conflicts and externalities that rive society. It would hardly be the destroyer of money or of wealth or the inefficient manager of every activity that it touches.
On the other hand, if the government is the coercive institution in the model that we know it to be in reality, then how is this to be explained? What actors in the model create the government? What actors run the government? What are their optimizing behaviors in running it? What are their costs and how are they spread over the other actors?
The fact is that Stiglitz nowhere describes what this government is or how it comes about. He never even describes its basic properties. Government in the model is basically ad hoc. It is motivated to produce taxes, subsidies, and transfers to achieve optimality in a manner that is nowhere described. It simply does it. There is no warrant for making this assumption and there is no warrant for taking it to be characteristic of actual government. I do not see how one can talk about what government should or should not do without a theory of government.
The fourth question I raised was what the model’s government had to know in order to accomplish its task. The list is staggering:
For each and every household, the marginal effect that a tax has on each and every good that that household consumes.
The rate of change of each firm’s profits with a change in each externality (holding all else constant) and the rate of change of each firm externality with a change in tax, all else held constant.
The rate of change of each household’s spending with a change in each externality (all else constant) and the rate of change of each household externality with a change in tax (all else constant.)
If we again stay within the confines of the model itself, there is nothing in it that tells us how the actors who govern are supposed to acquire this information or what the acquisition costs are. If we think of the model as being re-optimized as time passes, then there is variation in the parameters and the governing actors would have to acquire even more information.
In or out of the model, the information requirements present an impossible task. Where does the knowledge of the required rates of change reside? Preferences and production technologies are not self-evident. They are internal to human beings. It is not clear that humans either know them or can communicate them, certainly not in the detail required by a social planner. They possibly learn them over time and they surely alter over time. Under these conditions, the economic actors affected can surely not rely on a set of social planners or engineers to tell them what they, the actors, prefer or how they plan to produce a good, or even what goods they plan to produce. If a government is introduced into the model as a device to tax, subsidize, and make transfers, it is entirely an ad hoc device. There is no economic theory of how it can accomplish these tasks optimally, or how the actors expect it to do so, or empower it to do so.
In sum, in terms of real economic theory the Stiglitz model is about as empty on the issue of externalities and government as it can possibly be. It is simply a mathematical representation of ad hoc assumptions. Not only that, these assumptions conflict with the optimizing and equilibrating that goes on in the rest of the model.
Other Problems
I will now mention a few other serious problems that the Stiglitz model ignores, although my intent is not to provide a complete list.
There is not in reality a fixed set of goods or production technologies. The problem faced by a Stiglitz government is a dynamic one. But it can’t even identify the sets of items that the household and firm sectors are optimizing over at an instant in time.
In or out of the model, it is not at all clear that government, however constituted, is somehow better suited to handling externalities than free markets. The real economic questions concerning externalities are why they arise, how they relate to property rights, what to do about them, or when it pays for interested parties to do something about them. In a sense, they are no different than any other kind of inefficiency. Therefore, the presumption is that free exchanges can address the perceived costs and benefits associated with them whereas government is ill-suited to the task. Stiglitz, by introducing externalities in an ad hoc way, simply assumes that free markets have already failed. This is why the Stiglitz government appears as the promoter of economic efficiency.
In the Stiglitz world, some goods are taxed, others subsidized, everyone adjusts, and then some find themselves better off as a consequence, and no one is worse off. These discoveries are assumed to be impossible or not actuated by the agents themselves. However, the far-seeing if not omniscient government both sees and remedies the problem. This is done continuously as the economy evolves. As prices alter, the pertinent taxes and subsidies alter too. If it is not done continuously, quite possibly an imposed tax will lower welfare when tastes, conditions, and prices shift. So, logically, to assure betterment, it will have to be done continuously. This means an infinite cost of transacting.
Hans-Hermann Hoppe has correctly pointed out that so-called public goods can change their character and become private goods depending on the state of mind of the actor and vice versa. This adds to the burden of the government’s already impossible information requirements.
The model ignores the fact that future opportunities are altered when the government intervenes. With government in the picture preempting action, no private sector actor has an incentive to overcome the reasons for the initial inefficiency by internalizing the externalities. The means have been pre-chosen as the tax, subsidy, and transfer schemes. Therefore innovation is stifled. If a lower cost or superior method could have been found, it will not be if the solution is government.
In an economy with Stiglitz government interference, whenever any new product is invented, there is uncertainty about its relations with other products and processes. The producer has no way of telling what externalities the government will deem important enough to intervene in the markets. The presence of the State will chill many markets and potential markets. The chances are that future production, trade, and original appropriation will all be deterred.
Of course, Stiglitz entirely ignores any malicious acts by government. He ignores any power dynamics. If government is capable of intervening in markets across the entire economy on the basis of externalities, the chances of gains in power are greatly increased.
Stiglitz ignores any error correction mechanism when government makes mistakes in its assessments, that is, government failure. If government were to be the institution to handle externalities, we can be quite sure that its incentive structure would make it inferior to free markets in correcting mistakes.
In sum, there is much that the model ignores that is of vital importance to social welfare. Models always ignore many things. But they cannot appropriately ignore conditions that are central to the phenomena they are analyzing.
Conclusion
Stiglitz believes that his theory (model) demonstrates an economic role for government in principle. Upon this basis he has for years promoted government solutions and denigrated free markets. What he has done is translate his preference for government into mathematical terms that he finds more believable than the verbal. He has done this using inconsistent assumptions and ad hoc theorizing. The theory has severe problems and limitations even within the restricted context of neoclassical modeling. Any policies enacted with this theory as a foundation will ignore a number of important problems that the theory ignores. In doing so, such policies are unlikely to accomplish their objective and likely to decrease social welfare.
We can have no confidence that the Stiglitz model captures the essential aspects of real world economizing that it purports to. We therefore can have no confidence in any belief that rests upon this or similar theories that government has a proper role to play in increasing economic efficiency or social welfare by use of taxes, subsidies, and transfer payments.
Michael S. Rozeff is the Louis M. Jacobs Professor of Finance at the University at Buffalo.
