Abundance, Generosity, and the State

7

THE EQUIVALENCE POSTULATE

Side-effect goods are an essential feature of all exchanges. Side-effect goods are fueled by economic growth. They are built into the DNA of a market economy, which can be understood as one great organism geared toward the spontaneous production of manifold gratuitous services.

Real-world markets therefore fulfill Pope Benedict XVI’s postulate that “in commercial relationships the principle of gratuitousness and the logic of gift as an expression of fraternity can and must find their place within normal economic activity” (2009, sec. 36, emphasis added). Indeed, the spontaneous production of economic goods is a principle of the market economy. It has a place. Actually, it is so much entrenched in markets that it could not possibly be separated from them. It is there for everybody with eyes to see.

Then why was it overlooked? Why did so many economists fail to see it? After all, it was their job to study the side effects of market exchange. Why did so few of them follow in the footsteps of Bastiat? Why did they satisfy themselves with the meager theory of “positive external effects”—as a corollary of the equally pitiable theory of “pure and perfect competition”?

In what follows, we will focus on an important root of this failure. It is to be seen in the fallacious conception according to which market exchange is, tends to be, or ideally should be an exchange of equivalent values. If this equivalence postulate were correct, then, indeed, there would be no gratuitous goods to be received in ideal exchanges. It would also be difficult to see any advantage when competition, capital accumulation, and technological progress bring about goods without due compensation.

As we have stated before, the fallacious equivalence postulate goes back to Aristotle. The philosopher paved the way for Western thinking in virtually all fields of intellectual inquiry. The theory of exchange, too, was strongly influenced by his writings, most notably by the famous book five of the Nicomachean Ethics, where he deals with the virtue of justice. Let us therefore now consider his argument in more detail and then retrace its influence on subsequent economic thought.

ARISTOTELIAN ORIGINS

In Aristotle’s conception, each virtue is a sound middle ground, or meson, between two opposing vices. For example, the virtue of generosity is the meson between profligacy and stinginess; the virtue of courage is the meson between recklessness and cowardice. This characteristic feature of all virtues is particularly pronounced in the case of justice, if justice is understood in a larger sense than abiding by the law. The reason is that a just or fair man strikes the sound middle ground in all of his actions. He is not merely just when he abstains from robbing other people. He is also just when he is not being stingy, cowardly, reckless, or extravagant. In short, he is just whenever he does not deviate from the narrow right path in all of his ventures. Justice in this larger sense is therefore “identical with complete virtue” (Nicomachean Ethics, bk. 5, chap. 2, sec. 7).

Now, while it is straightforward to tell what just conduct is in the context of all other virtues, it is much more difficult to do so in the case of justice itself. What are the two opposing vices relative to which justice would be the meson? Aristotle answers that this sound middle ground must be conceived of as a quantitative equality between different terms.A just action is one that brings about such equality. This is the equivalence postulate, or equivalence criterion.

Aristotle argues that two cases need to be distinguished. In the first case, a “stock of good things” that hitherto had been held in common by the members of a community needs to be distributed among them. Here the just distribution is the one that respects a proportional equality of the members (see Nicomachean Ethics, bk. 5, chap. 3, secs. 5–17). The more important person should receive more than the less important one, so that the proportion between the importance of all persons be left the same as before. Aristotle uses the example of the distribution of dividends among the members of a joint-stock company: “When it is a common fund that has to be divided, the sums which the several participants take must bear the same ratio to one another as the sums they have put in” (bk. 5, chap. 4, sec. 2).

The second case is a market exchange. Here the relevant criterion is the equality of the value of the goods that are exchanged. The social standing of the partners to the exchange does not come into play. Let us quote this passage more fully:

For it makes no difference whether a good man defrauds a bad one, or a bad man a good one, nor whether a man who commits an adultery be a good or a bad man; the law looks only to the difference created by the injury, treating the parties themselves as equal, and only asking whether the one has done, and the other suffered, injury or damage.

That which is unjust, then, is here something unequal [or unfair] which the judge tries to make equal [or fair]. For even when one party is struck and the other strikes, or one kills and the other is killed, that which is suffered and that which is done may be said to be unequally or unfairly divided; the judge then tries to restore equality by the penalty or loss which he inflicts upon the offender, subtracting it from his gain.

What is fair or equal, then, is a mean between more or too much and less or too little; but gain and loss are both more or too much and less or too little in opposite ways, i.e. gain is more or too much good and less or too little evil, and loss the opposite of this.

And in the mean between them, as we found, lies that which is equal or fair, which we say is just. (ibid., bk. 5, chap. 4, sec. 3–6)

He concludes his argument as follows:

But these terms, “loss” and “gain,” are borrowed from voluntary exchange. For in voluntary exchange having more than your own is called gaining, and having less than you started with is called losing (in buying and selling, I mean, and in the other transactions in which the law allows free play); but when the result to each is neither more nor less but the very same amount with which he started, then they say that they have their own, and are neither losers nor gainers. That which is just, then, is a mean between a gain and a loss, which are both contrary to the intention, and consists in having after the transaction the equivalent of that which you had before it. (ibid., bk. 5, chap. 4, sec. 13)

To sum up, justice, whether in a distributive or in a market-exchange context, is always and everywhere a (quantitative) equality between different terms. This conception has a momentous consequence for the interpretation of markets. It implies that market exchanges ideally should be zero sum. An exchange is just if the two goods that are exchanged have exactly the same value. Otherwise, one of the partners gains and the other loses; and the gain of the former is then exactly equal to the loss of the latter.

Notice that Aristotle does not make the slightest effort to explain or demonstrate his contention. In his eyes, it seems to be obvious that the sound middle ground of justice itself is a quantitative equality between different terms and that a just exchange is therefore an exchange of equal values. In any case, he seems to take it for granted that his readers do not need an explanation of any sort.And indeed one may very well argue that the case is obvious with respect to gains and losses. What one person gains in excess of the just price is necessarily equal to the loss of his partner in trade. Say the just price of a haircut is three apples. Then if Mark exchanges two apples against a haircut from barber Joe, he unjustly gains one apple, and the value of his gain is exactly equal to Joe’s loss; namely, one apple. But this sort of demonstration skips over the main difficulty. The problem is to know what the just price is. How do we know, how is it possible to know, that the just haircut price is three apples? As we shall see, Aristotle provides no answer.

The equivalence postulate is not as obvious as Aristotle claims. But then what are the roots of his conviction? Let us venture a hypothetical answer in light of the writings of Plato, which provided the foundation and context for Aristotle’s philosophy. In his Laws, Plato had presented a blueprint for the good society.This blueprint was static—the good society was supposed to be permanent. In order to preserve the ideal society, it was therefore necessary to eliminate any kind of change. Now, market activity is a dynamic factor that might enrich some and impoverish others. It is likely to undermine the social and intellectual equilibria necessary to preserve the ideal state of affairs. Plato therefore considered that market activity should be reduced to an absolute minimum and that all exchanges with the outside world should be strictly controlled.

While Aristotle did not share Plato’s totalitarian outlook, we may surmise that he nevertheless adopted the idea that market exchanges could be disruptive unless they were neutral in regard to economic power. The Aristotelian “just exchange” fulfills precisely this requirement. By all intents it is neutral with regard to the distribution of wealth.

This is not more than a hypothesis. The curious fact remains that Aristotle does not demonstrate his foundational equivalence postulate. In the Nicomachean Ethics, he simply proceeds to discuss his theory of justice in more detail. He argues that it is “the rule of justice that holds society together.” More precisely, justice is the foundation of free societies. “For the very existence of a state depends upon proportionate return. If men have suffered evil, they seek to return it; if not, if they cannot requite an injury, we count their condition slavish.”He also mentions that the members of society are held together by common needs: “The need for each other’s services . . . holds the members of a society together; for if men had no needs, or no common needs, there would either be no exchange, or a different sort of exchange from that which we know” (Nicomachean Ethics, bk. 5, chap. 11; see also bk. 5, chap. 13). Thus, there are two social bonds: justice and needs. Needs are more general, since they also hold together societies that are not just, and therefore not free.

Aristotle then zooms in on the precise meaning of the aforesaid “terms” that should be brought to equality in a market exchange. In which sense should the goods that are exchanged be equivalent? Clearly, this cannot refer to their physical characteristics. When apples are exchanged for a haircut, it makes no sense to argue that the apples are in any sense “more” or “less” than the haircut. They have different physical dimensions. In order to establish whether there is equality or inequality between three apples and a haircut, it is necessary to appraise these goods in terms of a common measure. But this measure cannot be found in the things themselves. The apples and the haircut do not share any common physical feature that could be used as a meaningful measure.

Would it not be a solution to argue that apples and haircuts both satisfy human needs? Indeed, as we have seen, Aristotle argues that “the need for each other’s services . . . holds the members of a society together” and that this need is a common measure of value for all things that are exchanged (ibid., bk. 5, chap. 11). But this solution fails, too, and it fails for the same reason that we encountered before. Needs are diverse. Haircuts and apples provide very different satisfactions that do not have much in common besides satisfying someone.

Hence, the problem of reducing diverse goods and diverse needs to a common measure remains. This standard cannot be found in the nature of the things to be exchanged. It cannot be found in human needs. According to Aristotle, it has to be specially created by an act of human ingenuity. Human beings invented and instituted money for the express purpose of reducing all goods to a common standard. In his words:

All things or services, then, which are to be exchanged must be in some way reducible to a common measure. For this purpose money was invented, and serves as a medium of exchange; for by it we can measure everything, and so can measure the superiority and inferiority of different kinds of work—the number of shoes, for instance, that is equivalent to a house or to a certain quantity of food. (ibid., bk. 5, chap. 10)

He goes on:

Money has been introduced by convention as a kind of substitute for need or demand; and this is why we call it because its value is derived, not from nature, but from law and can be altered or abolished at will. (ibid., bk. 5, chap. 11)

Aristotle is fully aware that this solution is not perfect. He highlights two problems.

The first one is that the value of money is not constant. It fluctuates in the course of time. It is different from one place to another. It is merely more constant “than the value of anything else” (ibid., bk. 5, chap. 5, sec. 14). This seems to be just a little practical nuisance, but in truth it is a big problem from the point of view of Aristotle’s conception of a free society. How can there be justice, in his conception, with a vacillating measuring rod?

The second problem is even more momentous. Aristotle admits that money is not a common measure at all. He writes: “In strictness, indeed, it is impossible to find any common measure for things so extremely diverse; but our needs give a standard which is sufficiently accurate for practical purposes” (Nicomachean Ethics, bk. 5, chap. 5, sec. 14). Crucially, there is no common measure for the things that are exchanged. The same problem that plagues the comparison between apples and haircuts also upsets the comparison between apples and money, as well as between money and haircuts. And it also spoils the comparison between apple and haircut prices. It makes no sense to assert that three dollars are—more or less—equal to seven apples. It is no less meaningless to state that the apple price is—more or less— equal to the price of haircuts. There simply is no common denominator. The money price of apples is dollars per kilo of apples, whereas the money price of haircuts is dollars per haircut. These dimensions are different and the two prices therefore incomparable (see Hülsmann 1996, 1999). Using them—or “needs”—to measure the value of haircuts or apples in terms of a common unit is not a rule of thumb or a “standard which is sufficiently accurate for practical purposes.” Contra Aristotle, such a rule of thumb is a logical impossibility. It is nonsense.

Then why do standard textbooks, even today, represent money as a standard of value? This has to do with the long shadow of Aristotle, about which we shall have to say a few words below. Here we merely need to stress the fallaciousness of Aristotle’s conception of the meson of justice. The equivalence postulate cannot be this meson. It leads to absurd results, as Aristotle himself coyly admitted.

Money and monetary exchange prices are of the utmost practical importance. But this is not so because money prices measure the values of other goods. Rather, it is because the money flows that result from exchange allow for a comparison of costs and revenues, which in turn allows for a comparison of alternative courses of action. While different activities do not have a physical common denominator, they become comparable in terms of monetary revenue and monetary costs. For example, by knowing, or rather appraising, the money prices of all the equipment and labor that I might need to start a barber shop, and by appraising the monetary revenue that such a shop might generate, I am in a position to assess whether this activity will generate a net revenue for me. Similarly, I might calculate the expected return on the investment in the barber shop and compare this percentage to the expected returns of other investment alternatives.

Calculations of this sort are the most precious devices to orient human action. They are essential tools of entrepreneurial decision-making within the market economy, as Ludwig von Mises ([1949] 1998], pt. 3) has brilliantly argued in his magnum opus. None of these intellectual operations are concerned with measuring the monetary value of nonmonetary goods, but with comparing monetary costs and monetary revenues springing from human action. Estimating whether a barber shop will generate net revenue, or whether it will generate more or less revenue than alternative investments, is not the same thing as assessing “the value” of razor blades and haircuts.

TOWARD A NEW MESON

The foregoing remarks do not purport to refute Aristotle’s theory of justice in general. We do not take issue with the definition of virtue as a sound middle ground, a meson, between opposing vices. We do not contest that the virtue of justice is the foundation of a free society. Quite to the contrary, we fully subscribe to these notions.

Our critical remarks solely concern Aristotle’s conception of “justice itself ” as a numerical equality between different terms. We have seen that this conception is wrong and has to be rejected. However, this does not mean that there is no such thing as justice itself, and neither does it mean that justice itself is not a sound middle ground, a meson, between opposite excesses. The error is to see the meson in the equivalence of the traded goods. But the meson could be something else. An alternative candidate that might serve as an Aristotelian meson is Rothbard’s nonaggression principle.

This principle is the foundation of Rothbard’s ([1982] 1998, chap. 8) theory of justice. The principle says that property rights can be legitimately acquired only when the acquisition activities do not involve violating (“aggressing” or “invading”) the legitimate property rights of other persons.For example, he who homesteads a virgin piece of nature is not invading the rights of other. He therefore becomes the legitimate owner of that piece of nature which he transforms through his labor. Similarly, gifts and exchanges do not per se invade the rights of others. Therefore, the goods that are acquired through gifts and exchanges become one’s legitimate property.

The nonaggression principle provides a coherent meson. It is rooted in the theory of property, not in the theory of value. Acquiring property rights under the principle of noninvasion is a meson between too much and too little. He who acquires property only through homesteading, gifts, and exchanges walks on the narrow middle ground of justice itself. He who acquires property through violence or fraud obtains too much, and thereby deprives other persons of their due. Hence, we see that property rights provide a solid starting point to reflect on market exchange and justice. This is a starting point that has served jurists well at least since Roman times.It is also the starting point for the modern economic theory of the market. Exchange is not about shuffling objects through space from left to right. It is about acquiring and ceding property rights.

The nonaggression principle elegantly sidesteps the fatal problems of the Aristotelian conception of the meson of justice. As we have seen, Aristotle’s error was to look for the meson in the theory of value, rather than in the theory of property. He compounded this error by inventing a flawed theory of value, the equivalence postulate, which vitiated his theories of exchange and of justice.

To the present day, this wrong approach spoils normative propositions in law, welfare economics, and similar fields. The fallacious equivalence postulate leads to the idea that property rights should be arranged in such a way as to respect the equivalence criterion in distributive and commutative justice. In other words, property rights appear to be a dependent variable, whereas subjective value (utility, ophelimity) and market prices are portrayed as independent ones. But this turns reality on its head. Both subjective value and market prices presuppose a framework of property rights and appropriation rules. It is impossible to invert this logical dependence. Property rights cannot be derived from the subjective values of economic goods or from the market prices of such goods. Any attempt of this sort involves an inescapable contradiction. It is one of the great tragedies of twentieth-century economic thought that many of its most illustrious representatives have fallen prey to this fallacy.

ARISTOTLE’S LONG SHADOW

Mises once lamented that one of the great philosophers of his time, Henri Bergson, did not understand the most basic element of modern value theory. Mises ([1949] 1998, p. 33, footnote 2) wrote: “Hardly any philosopher had a more universal familiarity with various branches of contemporary knowledge than Bergson. Yet a casual remark in his last great book clearly proves that Bergson was completely ignorant of the fundamental theorem of the modern theory of value and exchange.” In The Two Sources of Morals and Religion, Bergson ([1932] 1935, pp. 54–55) had stated that “however rudimentary a community may be, it barters, and it cannot barter without first finding out if the objects exchanged are really equal in value, that is to say, both exchangeable for a definite third object.”

As we have seen, Bergson’s shortcoming goes way back to Aristotle and Plato. Very probably, it is even older, but with Aristotle’s backing, the equivalence postulate has spread into modern times. It has cast a long shadow on social philosophy and economics and, by implication, on the analysis of gratuitousness within the market economy. Indeed, if Aristotle’s conception of “justice itself ” were correct, then by definition there would be no gratuitous element in just market exchanges. A just exchange would be an exchange of equivalent values. Each trading partner would receive the exact same value that he pays. There would be no gain and no loss, no gratuitous benefit and no gratuitous harm. Gratuitousness would vanish from the intellectual radar screen.

In what follows, we will trace some of the Aristotelian influence on the theory of exchange. As we shall see, the Aristotelian equivalence postulate is alive and thriving, even in present-day economics, which in many other respects has repudiated Aristotle’s conceptions root and branch.

Saint Thomas Aquinas and the Scholastics

Nobody has done more to popularize Aristotle’s thought in the Western world than Aquinas. This holds true in particular for the Aristotelian conception of justice and exchange. Aquinas turned this conception into a comprehensive theory of just prices and just revenues. He applied the notion that the equivalence criterion is the just middle ground in any exchange to the case of fraud, where such equivalence does not hold, and thereby argued that fraud is unjust (Aquinas 1948, II-II, q. 61, art. 2). Similarly, in money lending at interest, Aquinas argued that there is no equivalence between the sum initially lent and the payments made by the borrower. The borrower does not just reimburse the principal, but also pays interest, ostensibly for using the principal (which is why interest is also called “usury”). Since payment of the usury destroys the equivalence of the lending operation, usury is unjust.

But the equivalence criterion, or equivalence postulate, has even broader implications. In its light, any commercial activity appears to be problematic from a moral point of view (Aquinas 1948, II-II, q. 77). Selling a good for a higher price than it was bought for is wrong per se. It can only be justified by extenuating circumstances—that is, by conditions extrinsic to the trade itself. For example, trading involves human services (transport, packaging, informational services, etc.) whose costs need to be compensated for. Similarly, interest revenues gained by lending money are wrong as such, since the creditor eventually receives more than he has lent. Yet the money lender may legitimately be compensated for accepting the risks (periculum sortis) and the opportunity costs (damnum emergens) that come with lending.

This way of arguing has remained central to Western economic thought. In its pure form it has been well preserved into the present day, most notably in the writings of various Catholic economists. In the early twentieth century, Heinrich Pesch updated the equivalence postulate and applied it to entrepreneurial revenues. He argued that while it was intrinsically unjust to sell products at prices above their production costs, such practices may be warranted in the light of extrinsic circumstances such as entrepreneurial labor and responsibility for losses. Just like Aristotle and Saint Thomas, Pesch (1923, p. 721) insisted on the equivalence criterion. In his conception, as in theirs, there is no trace of gratuitousness in a just exchange. What you get is what you paid for.

In our day, Stefano Zamagni (2005; 2010, p. 84), the president of the Pontifical Academy of Social Sciences, follows in Aristotle’s footsteps. It is therefore not surprising that both Pope Benedict XVI and Pope Francis have made the equivalence postulate the central element of their interpretation of markets.

But the Aristotelian-Scholastic conception also influenced economists outside of the Catholic intellectual orbit, some of whom rejected Scholasticism outright. This concerns most notably the classical economists and Marx.

Classical and Marxist Economics

Writing more than a century before Pesch, Smith developed a price theory that can be interpreted as a vindication of the equivalence criterion. According to the opening sentence of The Wealth of Nations, all commodities originate from labor, and labor is there-fore “the real measure of the exchangeable value of all commodities” (Smith [1776] 1994, p. 33).Elaborating on this idea, Ricardo then went on to claim that the value of reproducible commodities is wholly determined by the amount of labor that was—directly or indirectly—employed in the production process.This leads, again, to the conclusion that there is no gratuitous element in ordinary market exchange. All commodities “naturally” trade at prices that correspond to their cost of production.

Marx’s position is somewhat different. Like Ricardo, he considers that the value of a commodity is exclusively determined by the amount of labor time that under given social conditions is necessary to produce it (see Marx 1867, p. 5). And he was perfectly aware that this conception is a variant of the Aristotelian equivalence criterion. In a just exchange, there could not be any gratuitous element. Nevertheless, he acknowledged two forms of gratuitous human services.

The first one is an unintentional service of value preservation. Marx (1867, pp. 173–75, 595) argues that when a worker transforms a means of production into a product, then the value of that means is preserved in the product. For example, when a cotton spinner spends a day transforming raw cotton into cotton yarn, the total value of the yarn becomes equal to the sum of the values of the labor and of the raw cotton. As a consequence, the exchange value of the yarn (its market price) is equal to the sum of the prices of raw cotton and labor. According to Marx, the “soul hike” (p. 173) of the exchange value from a means of production to its product is unintended. It is a gift of nature (Naturgabe) or a free gift (Gratisgabe) “which does not involve any cost for the worker, but which yields a lot to the capitalist, namely, the preservation of the existing capital value” (p. 173).

Secondly, Marx argues that under capitalism, workers constantly provide gratuitous services to their employers because they are cheated out of the full compensation for their services. This is Marx’s famous exploitation thesis, the central piece of his economic thought. He contends that entrepreneurial profits by their very nature result from exploitative labor relations. Since the value of commodities springs—directly or indirectly—only from labor, the workers should receive the exact equivalent of the exchange value of their products. But in a profit economy they receive less than this amount. To realize a profit means to sell commodities at a higher exchange value than the combined exchange values of the factors of production that brought them into being (Marx 1867, p. 112). It means not paying the laborers the full exchange value of their services. In short, under capitalism, exchange is not just. The capitalists enrich themselves at the expense of the workers. The latter have to work gratuitously some of the time, whether they like it or not (pp. 184, 198ff.). In other words, the only gratuitousness that can be found in capitalist exchange is the abusive gratuitousness obtained by some at the expense of others.

Neoclassical Economics

The equivalence criterion also echoes through various elements of the neoclassical price theory that goes back to Jevons, Walras, Marshall, and Knight. It is manifest in the microeconomic model of perfect competition, which revolves around the idea that in market equilibrium, the price of any product is equal to both its average and its marginal costs of production. Each firm receives (from its customers) exactly the same amount of money that it pays (to its employees and suppliers). Similarly, in the Walrasian macroeconomic model of pure and perfect competition, each market participant pays the auctioneer—a.k.a. Mr. Market—the exact amount that he receives from him. And all payments received are the exact equivalent of all goods provided. No production of any good remains uncompensated.

Classical price theory derives commodities prices from costs of production (amounts of labor), whereas the marginalist approach derives them from consumer choices. But both approaches hold that, in equilibrium, market prices are equal to costs. Moreover, as in the case of Scholastic reasoning and as in Marx, this equivalence does not just have a descriptive bearing, but also a normative one. Marx claimed that profit making (a deviation from the equivalence norm) amounted to exploiting the laborers. Walras, Pareto, and Knight asserted that the market equilibrium that would result if all agents were endowed with perfect knowledge and perfect foresight was some sort of ideal state, a situation of maximal consumer satisfaction. From their point of view, it appeared to be desirable that the market resemble a perfect market, that it reach equilibrium, most notably because in equilibrium all good deeds are compensated by equivalent payments. In marginalist thought as in Scholastic thought, then, the exchange of equivalents serves as a normative benchmark. Ideally, all economic goods that are not gifts should be duly compensated. There should be markets for all of them (this is the postulate of complete markets). Ideally, everyone should pay the equivalent of what he receives, unless he receives a gift. In the economics jargon fashionable today, this is ideal is called “the first fundamental theorem of welfare economics.”

Now, most economic goods are provided or received above or below cost most of the time. But this was not a fatal problem for the pioneers of the neoclassical approach as long as the deviation of product prices from product cost was just temporary. Profits and losses oscillated around the long-run equivalences of costs and revenues. They were not problematic. They were just frictions that would wane in time.

Things are very different in the case of the value effects, wealth effects, and other positive externalities of exchange. These are permanent elements of a market economy, a fact that did not escape the attention of the champions of the neoclassical approach How did they incorporate these ostensibly gratuitous benefits into their theory without abandoning the idea that all services should be remunerated unless they are gifts? In two ways. On the one hand, they obfuscated the gratuitous nature of these benefits with technical jargon like “consumer surplus,” “income effect,” and similar expressions. On the other hand, they acknowledged such deviations from the norm of complete markets as a matter of fact, but then proceeded to recommend that the government intervene to rectify them—to internalize the externalities. The best known case in point is the technological externalities of the market process, which we highlighted in the previous chapter and which we will discuss in more detail below. The pervasiveness of such externalities seems to imply that some services remain permanently without pay and some damage without compensation. Positive externalities are therefore not mere accidental imperfections. They are market failures.

More than any other element of modern economic thought, this conception has blinded economists to one of the greatest benefits of the market process. Rather than appreciating the fact that market exchanges generate numerous and significant unpaid benefits, both for the exchanging partners and for third parties, economists have denigrated this feature, and they have even sought to “rectify” it with the coercive powers of the state.

External effects did not play a significant role in classical economics. They were furtively considered by Mill (1848) and then formally introduced into economic science by Sidgwick (1883, pp. 412ff.) and Marshall. The latter distinguished between external and internal “economies.” The standard conception of our own day was developed in the interwar period. Pigou asserted, in much more detail than Sidgwick, that market externalities should be rectified by government interventions (see Marshall [1890] 1920, bk. 4, chap. 9, sec. 7, and passim; Pigou [1920] 1932, pt. 2, chaps. 9–11). This line of argument would be further developed in the first three decades after World War II. It has since become a staple in economics classes dealing with microeconomics and public policy.We will therefore deal with this important theory in more detail below.

The Austrian School

The adjective “neoclassical” is often used to describe all schools of thought that propelled the marginalist revolution of the 1870s, even though it was used initially only to refer to Marshall’s theories. In any case, as far as the equivalence criterion is concerned, we have to exempt Menger and the Austrian School.

Within the Austrian School, we find a mixed picture. On the one hand, important figures such Böhm-Bawerk and Wieser make various concessions to the equivalence postulate. Röpke ([1937] 1963, pp. 21, 236–37), too, believed it was a foundational element of economics, calling it the “business principle.” But on the other hand, in the conceptions of Menger and Mises, the equivalence postulate plays virtually no role. Under their influence, the standard Austrian approach was not focused on market equilibrium, and neither did the Austrians elaborate any fictitious models of perfect markets. It is true that they, too, held that costs tended to equal product prices in final equilibrium—that is, at the end of a long, winding process of adjustments. But most of them did not consider this end result of the competitive process to be an ideal or a suitable objective for public policy.They were primarily interested in the process itself, not in its final state. They understood that “the market” is the process rather than the equilibrium toward which it tends. From the Austrian perspective, it was therefore possible to think of gratuitous goods as part and parcel of the market.Most notably, Mises ([1949] 1998, pp. 654–56) and his present-day followers do not consider positive externalities to be market failures (see Block 1983; Cordato [1992] 2007). They are part and parcel of the ordinary operation of the market economy. They do not need to be rectified.

POSITIVE EXTERNALITIES AS MARKET FAILURES

The Aristotelian equivalence postulate has prevented a proper understanding of the pervasive presence of gratuitous goods within a market economy. On the preceding pages, we have seen to what extent it has infused economic thought from antiquity to the present day. In what follows, we will take a closer look at one of its offshoots, the theory of positive externalities, which plays an important role in contemporary economic thought.

Most economists ignore the Aristotelian lineage of the theory of positive external effects. They ignore that this theory is built on the postulate that all goods resulting from human action should be paid for unless they are intended as gifts. Students are given the impression that the theory describes the real world as it is, whereas in fact it explains how the world appears to be deficient, and how its short-comings could be mended, in light of the Aristotelian postulate on which the theory is built. The consequence is an abysmal underappreciation of the role gratuitous goods play within the human economy and of the stupendous fact that for-profit activities are powerful vehicles for the generation of gratuitous benefits. It is therefore necessary to take a closer and critical look at this theory. It may be stated as follows.

When a person A does not pay for the benefits that he receives from the activities of B, and if B does not wish to donate these benefits to A, then A “free rides” on the work of B. This is not just a private problem concerning parasites like A and their victims. It is also a social problem because the victims, who are not fully paid as they should be, do not—in fact, cannot—produce quite as much as they would if they were paid properly. In other words, free riding goes hand in hand with underproduction. Gratuitous benefits are not a charming and potentially salutary aspect of the market economy. They are the symptom of malfunctioning markets, of market failures.

Fortunately, there is a remedy. It is true that private citizens are more often than not unable to provide relief, but the government has the wherewithal to step in and do the job. It can tax the beneficiaries and subsidize the producers, or produce the good.

We have taken some liberty in choosing our vocabulary to make the argument vivid and clear. But except for the word “parasite,” we have remained very faithful to the typical textbook presentation of the theory of positive externalities. And speaking of parasites merely served to emphasize the value judgment that underlies the entire theory and is also echoed in the expression “free riding.” This value judgment posits that all goods that are not gifts should be paid for. We have seen that this postulate has a distinguished intellectual history, running from Aristotle to modern times. But it is a postulate, rooted not in fact, but in wishful thinking.

Positive Externalities in Free Markets

What is wrong with the contention that external benefits are to be considered as market failures? To answer this question, we must first think unreservedly about how market participants deal with external benefits in the absence of any state intervention.

In a free society, all economic goods are produced by voluntary decisions. The choices of the producers depend on the proceeds that they can expect from sales. Higher proceeds facilitate a larger production volume. Moreover, there is a tendency for all profit-oriented activities to align on the same return on investment. If higher profits can be earned by producing honey than by producing computer screens, then monetary capital will be withdrawn from screen production and more monetary capital will be invested in the fabrication of honey. Through such arbitrage processes the return on capital in both lines of activity will tend to equalize.

Now, honey production would be increased even further if beekeepers were not only paid by honey consumers, but also by apple farmers who benefit from the bees’ pollination. Ordinarily, apple farmers do not pay for this benefit. They “free ride” on the work of the beekeepers. If they somehow had to pay for the services of beekeepers, then the revenue of the beekeepers would increase, along with the costs of the apple farmers. The production of honey would expand, and the production of apples would be curtailed. But, again, this typically does not happen. The apple farmers know that they will obtain the bees’ services even without payment, and therefore they do not pay.

There are only two ways out of this impasse, if an impasse it is. There is the political way and there is the voluntary way. The beekeepers may call on the government to tax the apple farmers and hand the tax money over to the beekeepers. This is the political solution. The power of the state would then “internalize” the positive externality—that is, transform it into a payment. It would become revenue for some and production cost for others. While this political solution is interesting in its own right and merits careful examination, it does not concern the basic question of whether external benefits are in fact market failures. We will therefore leave this topic aside for the moment and revert back to it in part three.

Let us rather consider the voluntary way. Suppose someone develops a technology that allows the beekeepers to steer the flight of their bees to a specific field. In this case, they could make the apple farmers pay, and the latter would pay voluntarily, because this would be the only way to obtain the needed bees’ services. Today, such a technology does not exist. Neither does there seem to be any other economically viable way to make the apple farmers pay. The emphasis here is on economically viable,for there are already technically viable ways to restrict the pollination services of the bees. For example, the beekeepers might contain their bees with extensive netting over the surrounding acreage. Why does no beekeeper do this? Because it is not economically viable. No beekeeper thinks that the extra revenue that he could expect to obtain from the apple farmers or other beneficiaries would justify the extra cost of this bee-containment technique.

It appears that this is also the reason why there are very often no attempts to restrict the external benefits of technological progress. It is simply not worth the while. And the same reason again is at stake in all other cases that we have discussed in the previous chapter. There is nothing wrong with trying to privatize the external benefits of money hoarding or of capital accumulation. In the next chapter we will examine the possibilities and limits of such privatization in more detail. But one thing is clear. In all cases, the prospects of privatizing external benefits depend on the associated costs and revenues.

To sum up, in the context of purely voluntary social relations, there are perfectly intelligible and good reasons why certain benefits come and remain free. There simply is, under present conditions, no economical way to make the beneficiaries pay for them. But then it seems to be wrong to portray external benefits as market failures. If the apple farmers believe that there are not enough bees around, they are free to pay the beekeepers to do a better job, or to start their own beehives. If the beekeepers think that they do not earn enough from selling honey, they are free to look for something else to do. Either way, there is no market failure.

The Coasian Approach to Externalities

Ronald Coase (1960) has come up with a variant of the market-failure argument that we should briefly consider. Coase focuses on external costs rather than on external benefits, but his argument can be extended to the latter as well. He concedes that while external costs such as air pollution can be internalized into market exchanges in many cases, there are other cases in which this is not economically possible because of transaction costs. In these cases, the government should intervene as the least costly solution. It should tax the polluters and thereby make the pollution economically unviable.

Now, adapting this argument to the case of external benefits, it may be contended that the government should intervene if the presence of transaction costs prevents external benefits from being made payable.

The problem with this approach lies in the foundational concept of transaction costs. Coase uses this term to designate all human activities which would not exist in an ideal world of perfect foresight and competition. Holding cash on hand, inspecting a factory, verifying that payments have arrived in bank accounts—all such activities are costly in the sense that they would not occur if human beings were endowed with perfect knowledge and foreknowledge. Hence, if some external benefit cannot be made payable because of the presence of such transaction costs, then in Coase’s mind this is an inefficient outcome that could and should be rectified by government interventions.

Clearly, this way of thinking is out of tune with world in which we live. As the present author stated a few years back: “The costs of real-world behavior are the values of . . . real alternatives. But transaction costs as Coase understands them can only be defined in terms of ‘alternatives’ that have never been open to human beings and which never will. To be a human being means to act under uncertainty. This fact permeates all aspects of human behavior. It is there-fore meaningless to hold up perfect foresight as a standard in terms of which real-world human action appears to be costly” (Hülsmann 2004, p. 4; see pp. 46–50, and also North 1992, for a detailed discussion and critique of Coase’s transaction-cost concept).

The General-Equilibrium Perspective on Positive Externalities

There seems to be another, very simple and very straightforward, way to criticize the theory of external benefits. One might point out that from an overall point of view, free riding does not entail underproduction. It is a sectoral problem, not an overall problem.

Honey production might very well remain relatively small scale because apple farmers and others do not pay for the pollination services of bees. But this makes resources available for other activities. All the human labor that could be used to make more honey is now available for other sectors of the economy. It can be used to make more bags, skateboards, machines, tools, and other things. And similarly, all the raw materials and nonspecific intermediate goods that could be used to make more honey—but are not under current circumstances—are now available to be used in other lines of business.

In short, if external benefits are problematic at all, then they are problematic only for some people—in our example, for honey producers and honey consumers—but these disadvantages necessarily go hand in hand with advantages for other people. In the worst of all cases, external benefits are a sectoral problem, not an aggregate one. If the government steps in to internalize them via taxation and subsidies, then, at best, it merely redistributes wealth within society and rechannels productive activities. It does not mend an underproduction problem because there is no such problem from an overall point of view to begin with.

This brings us to the Walrasian or Arrow-Debreu general-equilibrium perspective on external benefits. Indeed, the standard response to the argument that we have just presented goes as follows: It is true that external benefits entail sectoral advantages and disadvantages. But it is not true that they make no difference from an overall point of view. Indeed, to stay in our example, honey is now underproduced, whereas other goods are overproduced. There is not enough honey, while there are too many other goods. In comparison to what? In comparison to the general-equilibrium world à la Walras. This is a world in which all agents choose with perfect foresight and in which all benefits are paid for. Relative to this ideal bench-mark, external benefits make the real world inefficient from an overall point of view. Resources are wasted and society is impoverished.

Now, this macroeconomic version of the theory of external benefits is just as untenable as its microeconomic cousin. Five main points merit our attention.

First, as we have seen in discussing Coase’s argument, the fictitious image of a world inhabited by agents with perfect foresight is an unsuitable benchmark for real-world human action. No man, no society, could possibly attain perfect foresight.

It follows, secondly, that even if this fictitious benchmark is accepted for the sake of argument, it entails a paramount problem of a very practical sort. There is simply no way to determine what a perfect-foresight world would look like, other than with a system of purely formal, fictitious, and tautological equations à la Walras. As a consequence, it is similarly impossible to assess any quantitative deviations from this ideal. In the present case, how could the external gains of the apple farmers and the opportunity loss of the beekeepers be quantified?

It is impossible to measure and compare the subjective values, or the personal utilities, associated with these gains and losses, for these subjective values do not have a quantitative dimension. They are ordinal—they have dimensions such as more important / less important or more urgent / less urgent. What is more, as we saw at the beginning of this chapter, this ordinal dimension is idiosyncratic. It depends on the context in which decision-making takes place.

Similarly, it would be impossible to compare the monetary gains and losses within a general-equilibrium framework. On the one hand, this criterion is perfectly arbitrary—why should monetary income be the decisive criterion rather than, say, calorie consumption, consumer longevity, or CO2 emissions? On the other hand, while the monetary externalities of the real world (the world without perfect foresight) might conceivably be estimated, though within certain margins of error, no reasonable estimate of any sort would be possible for a hypothetical perfect-foresight world. The apple farmer could estimate the monetary value of additional pollination services. The beekeeper could estimate the monetary cost of additional hives. The reason is that they only have to assess one variable while supposing that all other variables will not change. But the issue is to estimate the monetary gains and losses relative to a perfect-foresight world. In such a world, all variables would be different because all variables are interdependent. They would therefore all have to be estimated at the same time.

Now, economists might contend that it is necessary to have some conception of general equilibrium. This is true, and it brings us to our third point. There is no necessity to resort to the fallacious neoclassical conception of general equilibrium based on the fictitious assumption that all agents enjoy perfect knowledge and perfect foresight. As we have shown in Hülsmann (2000), it is possible to derive realistic general-equilibrium analysis from the basic dichotomy of success and error. The binary pair of success and error is a universal feature of all human actions. A general-equilibrium analysis that is derived from it does not involve any stipulations about the knowledge or foresight of the agents. And it does not imply that all goods that are not gifts are or should be paid for. In the framework of this conception, external benefits are neither frictions nor failures. They are natural elements of the market process.

This leads us to point four. As we have seen, the perfect-foresight framework is needed to make sense of the assertion that external benefits are market failures. But this assertion relies even more fundamentally on the normative premise that all people who provide goods to others without intending to make a gift should be paid. But why should all such benefits be paid for? Why should the gains of apple farmers and the losses of beekeepers be balanced? If Mary takes a shower in the morning, all people around her will benefit. Does this mean she should be paid for taking showers?

Fifth, the portrayal of external benefits as market failures is completely absurd when we turn to the case of the virtues. Clearly, virtuous behavior more often than not entails material benefits for others. But such behavior cannot be compensated by definition. If you get paid for telling the truth, then it is no longer virtuous for you to tell the truth. It is therefore a logical impossibility to remunerate virtues. And if it is not possible in the case of such vitally important goods—if, on the contrary, there are positive externalities that should remain unpaid—then the entire idea that positive externalities are per se market failures collapses lock, stock, and barrel.

To sum up, the neoclassical theory of positive externalities is an outgrowth of the Aristotelian conception of a just exchange. It posits that all goods that are received, unless they are received as gifts, should be paid for—that there is no justice unless a benefit received is compensated. The “inefficiency” resulting from positive external effects appears only by reference to this postulate. But this normative premise is arbitrary, as we have argued at length. Positive externalities and various other unintended benefits are omnipresent in markets. Yet they are not failures—not of markets, nor of anything or anyone. They are goods that are voluntarily provided and gratuitously received. They are important and beneficial elements of a free economy.

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“The unjust man, we say, is unfair, and that which is unjust is unfair. Now, it is plain that there must be a mean which lies between what is unfair on this side and on that. And this is that which is fair or equal; for any act that admits of a too much and a too little admits also of that which is fair. If then that which is unjust be unfair, that which is just will be fair, which indeed is admitted by all without further proof. But since that which is fair or equal is a mean between two extremes, it follows that what is just will be a mean. But equality or fairness implies two terms at least. It follows, then, that which is just is both a mean quantity and also a fair amount relatively to something else and to certain persons—in other words, that, on the one hand, as a mean quantity it implies certain other quantities, i.e. a more and a less; and, on the other hand, as an equal or fair amount it involves two quantities, and as a just amount it involves certain persons” (ibid., bk. 5, chap. 3, secs. 1–45).

Bruni and Zamagni ([2004] 2007, pp. 42–43) argue that the equivalence postulate must be interpreted as being qualitative rather than quantitative. In their eyes, it generally connotes reciprocity, and only in the case of market exchange does it imply a strict quantitative equality.

Let us quote him again: “If then that which is unjust be unfair [unequal], that which is just will be fair [equal], which indeed is admitted by all without further proof” (Nicomachean Ethics, bk. 5, chap. 3, sec. 3; emphasis added).

Plato presents a theoretical study of justice most notably in the Republic (Politeia). For a recent in-depth discussion of Plato’s conception of justice starting with the dialogue between Socrates and Thrasymachus in the Republic, see Batthyany (2021).

Nicomachean Ethics, bk. 5, chap. 6. He goes on: “And again, if men have received good, they seek to repay it: for otherwise there is no exchange of services; but it is by this exchange that we are bound together in society” (ibid.). And then further: “This is the reason why we set up a temple of the graces [charities, χάριτες] in sight of all men, to remind them to repay that which they receive; for this is the special characteristic of charity or grace. We ought to return the good offices of those who have been gracious to us, and then again to take the lead in good offices towards them” (bk. 5, chap. 7).

Fundamentally, the whole idea of measuring the value of goods is ill conceived. The value of an economic good is not a substance or an extended quality of that good, but an idiosyncratic preference relation. For a good to have value means that it is more (or less) important than some other good, at some point in time and at some place, for some human being. In other words, the value of a good is a relation in which it stands by virtue of the fact that it is subject to human choice, in an ever-changing context. See Hülsmann (2003).

On p. 200, we highlighted that the late Scholastic Luis de Molina ([1597] 1981), argued that exchange was just if property rights were respected. This is essentially the same line of argument that we find in Rothbard’s nonaggression theorem. The historical origin of this argument merits more detailed investigation.

See Hoppe (2021, pp. 19–21) on what he calls the classical tradition of interpreting the social and political significance of private-property rights.

For a full discussion of this fallacy, see Hoppe ([1987] 2005, chap. 2; [1993] 2006, chap. 12). For a critique of Ronald Coase’s approach to law and economics, which is squarely built on this fallacy, see Hülsmann (2004).

For a discussion and critique of the Aristotelian-Scholastic theory of usury, see Hülsmann (2017).

We glance over this important subject very rapidly. For a fuller discussion, see Rothbard (1995, vol. 1, chap. 16) and Dooley (2005, chaps. 8–10). Dooley underscores that historical labor-value theories variously considered human labor to be the origin of commodities’ values, the measure of their values, and the factor determining their relative values (regulation of value).

“The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it” (Smith [1776] 1994, p. 30). “The real value of all the different component parts of price, it must be observed, is measured by the quantity of labour which they can, each of them, purchase or command. Labour measures the value not only of that part of price which resolves itself into labour, but of that which resolves itself into rent, and of that which resolves itself into profit” (p. 52).

“Possessing utility, commodities derive their exchangeable value from two sources: from their scarcity, and from the quantity of labour required to obtain them” (Ricardo [1817] 2004, p. 12). Notice that this contention only concerned reproducible commodities, not rare books, unique paintings, and similar goods.

See Böhm-Bawerk (1896), Mises ([1922] 1981), and Reisman (1996) for a full discussion and critique of Marxist economics.

The same point of view is apparent in the writings of the advocates of social enterprise, who uphold nonprofit ventures—that is, the equality of revenue and costs—as an ethical ideal.

See Bator (1957, 1958); Baumol (1965); Buchanan (1969); Arrow (1969); Laffont (1977, 2008); and more recently Berta (2017). Overview in Papandreou (1994).

The main exceptions were the “verbal Walrasians,” Friedrich von Wieser and Joseph Schumpeter. The latter is usually not counted as a member of the Austrian School at all. See Salerno (2002) and Hülsmann (2007, pp. 469–74).

One might argue that the Austrian approach to rent had occasional elements of retrogression in comparison to Marshall’s conception. For Marshall, rent denoted the gratuitous revenue resulting from the ownership of natural resources. By contrast, the Austrian authors Frank Fetter and Rothbard redefined the concept in such a way that it covered all revenues.

In the standard literature on positive external effects, to which we have referred above, this problem is typically neglected (an exception is Mises 1949, pp. 650–59). The general assumption is that some goods are by their very nature excludable, whereas others are by their very nature non-excludable. But this assumption is wrong. Technically, it is very often possible to exclude potential beneficiaries in order to concentrate all of a good’s benefits on a select group of effective beneficiaries and to make the latter pay. However, economically such exclusion is not always viable.