Efficiency and Externalities in an Open-Ended Universe: A Modern Austrian Perspective

1 THE GENEALOGY OF THE AUSTRIAN POSITION

In casually surveying the analysis of externality questions among modern Austrian economists one is struck with the fact that most discussions center around externality problems involving conflicts in the use of property, such as pollution. On the other hand, very little is written about the consequences of other external effects such as free-rider or public goods problems. This narrow focus does not arise from any oversight on the part of Austrian writers. It results from a distinctly Austrian perspective on the question of externalities, which, in turn arises from a refusal to view welfare economics in terms of perfectly competitive market outcomes. Typically it has been argued that only those externalities involving a conflict in the use of property will have negative effects on the workings of a market economy. Consequently, the only policy relevant externalities are those that arise because of property rights that are not clearly defined or strictly enforced. In direct contrast, Pigouvian analysis concludes that all non-pecuniary externalities are evidence of market failure, i.e., have negative effects on social welfare, and that all externality problems are at least potentially policy relevant.

This chapter concentrates on the theoretical and normative distinctions that most Austrians have made between different types externalities. No attempt is made here to provide a welfare economics justification for the Austrian school position as it has developed. (This issue is reserved for chapters 2 and 3.) Neither of the two most important figures in the development of this view, Mises and Rothbard, explicitly based their assessment of externalities on a clearly defined theory of economic welfare, although in a separate context Rothbard has elaborated an alternative approach to welfare economics (1977). On the other hand, most of the views discussed in this chapter can be interpreted as simply the result of rejecting the perfectly competitive general equilibrium as a benchmark for normative analysis.

The discussion proceeds as follows. First there is a review of the predominant Austrian attitude toward the issues of negative and positive externalities as represented in the writings of Mises and Rothbard. The Mises-Rothbard approach has clearly had the most influence among Austrian economists in general. As is pointed out below, Hayek’s position on the question of external benefits is essentially different from that of other modern Austrians. His view is analyzed separately. To obtain a better understanding of the Mises-Rothbard position we will examine the views of those early Austrian economists whose writings are relevant to this issue; primarily Menger, Böhm-Bawerk, and to a lesser extent, Wieser. Clearly there are elements of the more modern position in the writings of the Austrian school’s founders.

MISES AND ROTHBARD ON EXTERNALITIES

Negative Externalities

“The problem of ‘external costs’... is a consequence of failure to enforce fully the rights of property... Hence external costs (e.g., smoke damage) are failures to maintain a fully free market, rather than defects of that market.” (Rothbard, 1962, p. 944)

The notion that policy-relevant negative externalities are exogenous to, rather than an endogenous part of a market economy, is clearly the most distinctive aspect of the Austrian approach to the question of external costs. Both Mises and Rothbard, the two most notable Austrian economists to explicitly define what is meant by an external cost, are clear in linking them directly to the use of property. According to both authors the clear definition and strict enforcement of property rights are essential for the functioning of a market economy. It is concluded, therefore, that any problems associated with what are usually called negative externalities such as air, water, and noise pollution, result from the failure of those legal institutions charged with defining and enforcing property rights and not with the market system itself. For example, Mises argued that all negative externality problems “could be removed by a reform of the laws concerning liability for damages inflicted and by rescinding the institutional barriers preventing the full operation of private ownership” (1966, p. 658). As will be noted below, to the extent that any problems can be associated with positive external effects, there resolution is to be found in similar property rights solutions.

This is not to argue that negative externalities do not cause problems for a market economy which are similar to those discussed in Pigouvian welfare economics. Both specific prices and the economic calculation based on them will be altered in the presence of negative externalities. Mises called these altered prices “deceptive” (1966, p. 658) and pointed out that “some people choose certain modes of want satisfaction merely on account of the fact that a part of the costs incurred are debited not to them but to other people” (1966, p. 656). What is absent from this discussion (and from Rothbard’s) is any reference to an optimal price/output combination that the free market “fails” to produce. This stems from their rejection of the static state of Pareto optimality as a normative benchmark for economic analysis. Problems that arise from external costs do show evidence that the economic system is “failing.” This failure, though, is due to the fact that certain aspects of the system are not consistent with free markets, rather than because they are. If the necessary institutional conditions for a free market process are not present then the market cannot be blamed for the outcome. For Mises and Rothbard these conditions include both clearly defined and strictly enforced property rights.

The view that negative externality problems are not the result of market failure but are the result of the circumvention of markets continues to be emphasized in the more recent contributions to the Austrian literature. Rizzo and O’Driscoll blame the presence of external costs on the “absence of markets and improperly specified property rights” (p. 142). And they suggest that the associated problems should be solved in the way property rights disputes are typically solved, through the courts.

Much of this can be explained by the traditional Austrian emphasis on dynamic market processes. What makes a free market process desirable is that it gives rise to prices and outputs that reflect the ongoing allocational decisions of resource owners, not that it results in a Pareto optimal, general equilibrium end state. For Mises and Rothbard negative externalities result in resources being allocated by non-owners, either because ownership rights are not being enforced or because they are not clearly defined.

This raises some questions about externalities that do not involve the conflicting use of property. For example, what if neighbor A keeps junk cars in his back yard and neighbor B considers this unsightly? How would this be viewed from the Mises/Rothbard perspective? Although this type of situation is not addressed directly, the implication is that it is not one that could be improved upon by means other than voluntary market exchange. Mises and Rothbard both concluded that a market system will function as beneficially as possible when the institutional setting is such that all rights to property are clearly defined and strictly enforced (Mises, 1978, pp. 52-59 & 1966, p. 655; Rothbard 1962, chapter 12).

The point here is that both Mises and Rothbard describe institutional settings that they argue will allow markets to function as efficiently as possible. Part of this setting for both authors (see also Kirzner, 1963 p. 13) is that people be allowed to make all decisions with respect to the use of their own property. It is not argued that within this setting all negative externalities will be eliminated. Instead it is clear that Mises and Rothbard would both conclude that this type of institutional setting would maximize the internalization of negative externalities. Like more traditional economic analysis of negative externalities (for an exception see Coase 1960), Austrians view internalization as welfare enhancing. When that internalization can be accomplished by enforcing or more clearly defining property rights, i.e., ensuring the institutional setting mentioned above, it will allow for a more efficiently operating market process. But in the example above, where rights are clearly defined and no one’s property rights are being violated, only a voluntary agreement to internalize the externality would lead to an unambiguous improvement.

External Benefits

The case of external economies is not simply the inversion of external costs. (Mises, 1966, p. 658)

The problem of external costs, usually treated as symmetrical with external benefits, is not really related. (Rothbard, 1962, p. 944)

To reiterate, since most positive external effects are not typically associated with property rights that are either undefined or unenforced, they are not generally deemed problematical. But as will be noted below, Mises has identified certain instances, primarily with respect to inventions and publishing, where, he feels, adverse consequences for social welfare can be associated with positive external effects. But even here the issue is not a problem of external benefits per se but, again, a problem of clearly defining or more strictly enforcing property rights.

Once again among Austrian writers it is primarily Mises and Rothbard who address these issues on a general level, that is, not strictly in terms of particular cases such as education (High 1985), road congestion (Block, 1983), etc. Generally both Mises and Rothbard tend to view external benefits as worthy of discussion at all only because the economics profession has traditionally viewed the issue as important. Mises, for example, after giving only a simple two paragraph definition of external benefits out of his 900-page treatise, Human Action, concludes that:

It would hardly be necessary to say more about external economies if it were not for the fact that this phenomenon is entirely misinterpreted in current [economic] literature. (Mises, 1966, p. 658)

With the elimination of the perfectly competitive end state as the normative benchmark, external benefits per se can be viewed, from a normative perspective, like any other kind of benefit. Since the term benefit under ordinary circumstances implies welfare enhancement, then in the absence of orthodox normative standards any external benefits actually generated would have to imply a gain in social welfare. Certainly there is no basis from which to argue that “not enough” of the good or service is being produced. Not enough compared to what?

On the level of positive analysis it is recognized that the presence of external benefits can be invoked to explain why particular goods or services may go unproduced, or why certain trades may not take place. Mises recognizes two possible outcomes given the presence of external benefits. Neither has special normative significance. For ease of reference they will be referred to as type 1 and type 2 external benefits.

1. The planning actor considers the advantages which he expects for himself so important that he is prepared to defray all the costs required. The fact that his project also benefits other people will not prevent himself from accomplishing what promotes his own well-being.

2. The costs incurred by a project are so great that none of those whom it will benefit is ready to expend them in full. (Mises, 1966, p. 658)

Neither of these results is viewed as a shortcoming of the market. Since the relevant standard of optimality is not the perfectly competitive world, there is no reason to conclude that the resulting price-quantity combination, in either case, is sub-optimal. These outcomes simply reflect the freely made decisions of market participants to trade or not to trade under one of an infinite number of cost-benefit relationships. In the absence of the perfectly competitive welfare standard, there is no reason to single these decisions out relative to others that might be made under different market circumstances.

In the first instance the good is produced in spite of the presence of external benefits. In the standard framework it would be argued that too little of the good is being produced, relative to the Pareto optimal outcome in a perfectly competitive general equilibrium (PCGE). Therefore the market has failed to allocate resources in a socially efficient manner. Austrian analysis of this same situation would argue quite differently. Since there is no optimal outcome apart from that which is generated by the actual interaction of market participants, there is no standard by which to argue that “too little” is being produced. Given this perspective, external benefits of this nature, rather than being viewed as evidence of market failure, are considered to be a fringe benefit of the market process.

Rothbard argues that the market process is filled with such external benefits, and that we all, in some way, benefit from them.

... which one of us would earn anything like our present real income were it not for external benefits that we derive from the actions of others? Specifically, the great modern accumulation of capital goods is an inheritance from all the net savings of our ancestors ... We are all, therefore, free riders on the past. We are also free riders on the present, because we benefit from the continuing investment of our fellow men and from their specialized skills on the market. (1962, p. 888)

Rothbard considers these, and all other external benefits that are actually realized as a result of the market process, to be welfare enhancing. Whether or not the generators of these externalities capture the marginal benefits associated with them has no normative significance in the absence of a PCGE welfare standard. The fact that Mises and Rothbard see all the effects of type 1 externalities as beneficial explains why no corrective policy is necessary. The second result associated with external benefits, i.e., where “the project can be realized only if a sufficient number of those interested in it share in the costs,” is analogous to the standard public goods/free rider dilemma. The standard analysis suggests that if the good fails to get produced on the market, due to excessive transactions costs or a failure on the part of consumers to reveal their “true” preferences, then it is the proper role of government to provide such outputs. This is simply an extension of the argument usually made with respect to type 1 positive externalities, where the good will be provided, but in less than optimal quantities.

Mises generally views the results of this type of externality strictly as an explanation of why certain trades may not take place on an open market. Since these outcomes are consistent with preferences as they have been revealed through market behavior, they are not seen as a failure of the market system to allocate resources efficiently. In fact, Mises argues that it is the government’s rearrangement of the market outcome that would have to result in the misallocation of resources. In response to the standard policy recommendations mentioned above, Mises argues that:

the means which a government needs in order to run a plant... or to subsidize [a] project must be withdrawn either from the taxpayers’ spending and investing power or from the loan market... Public works ... are paid for by funds taken away from the citizens ... the citizens would have employed them for the realization of profit promising projects ... For every unprofitable project that is realized by the aid of the government there is a corresponding project the realization of which is neglected merely on account of the government’s intervention. Yet this nonrealized project would have been profitable, i.e., it would have employed the scarce means of production in accordance with the most urgent needs of consumers. From the point of view of consumers the... unprofitable project is wasteful. (1966, p. 659)

As one analyst has pointed out, the standard approach to these types of external benefits “take[s] an explanation as to why certain trades do not take place and turn[s] this explanation into a normative statement that the trade should have taken place” (Brownstein, 1980). Given the Austrian view of markets and market processes, this approach is wholly illegitimate. There is no way for the economist or policy maker to know the preferences of market participants apart from what the individuals reveal them to be through action (Mises 1966, pp. 94-96). In an unhampered market, assuming clearly defined and strictly enforced property rights, prices and outputs will tend to reflect the preferences of market participants as revealed through decisions to make or not make certain exchanges. The existence of external benefits does not distort this tendency, even in the extreme case where the good is not produced. The standard argument is that good X will not be produced in the presence of an extensive free-rider problem. More specifically, even if the individuals making up the potential market for the good all will benefit from its production, none of those individuals will actually contract for X’s provision, in hopes of receiving the good without bearing the costs. This is the “pure public goods” problem. For Mises and Rothbard the potential consumers of this product have revealed a preference not to pay an amount sufficient enough to induce its production. It is illegitimate for economists, qua economist, to normatively evaluate the motives behind this preference. The actors’ value scales must be taken as given. To suggest that consumers really prefer something other than the market outcome is to substitute the values of the economist for the revealed values of market participants. (Rothbard, 1962, p. 890)

Mises’ discussion diverges slightly from Rothbard’s in that he notes certain problems that he feels can be associated with type 2 externality results that are the consequence of unclearly defined property. The most apparent expression of this is in the “‘production’ of the intellectual groundwork of every kind of processing and constructing” (Mises 1966, p. 661). Mises recognizes that the presence of excessive external economies may hinder new inventions and the publication of new ideas, and argues that these external economies could be internalized through a property rights solution, i.e., by instituting patents and copyrights. Although Mises explicitly refrains from directly endorsing patent and copyright laws (1966, p. 662) he does allow for the possibility that, at least in certain instances, the internalization of external benefits through a more clear definition of property rights may improve social welfare. He argues that “it is unlikely that people would undertake the laborious task of writing [needed textbooks, manuals, handbooks, and other nonfiction works] if everyone were free to reproduce them.” Furthermore he argues that “the extensive experimentation necessary for [technological invention and discovery] is often very expensive.” He concludes that “[i]t is very probable that technological progress would be seriously retarded if, for the inventor and for those who defray the expenses incurred by his experimentation, the results obtained were nothing but external economies” (1966, p. 662).

What should be noted is that to the extent Mises sees a problem arising with external benefits at all, he traces its roots to a more fundamental issue related to “the delimitation of property rights” (1966, p. 662). While Rothbard opposes patent and copyright laws, Mises’ approach does not diverge from Rothbard’s in a fundamental sense. The over-riding theme is consistent: to the extent that economics implies any corrective policy it is in the area of either more clearly defining or strictly enforcing property rights.

The difference between Mises and Rothbard on the issue of patents and copyrights can be found not in their approach to externalities as such, but in their approach to property rights. Rothbard uses as his criterion for defining property rights a Lockean natural-rights ethic. From his perspective, intellectual property rights cannot be derived from principles of natural law and therefore the state has no moral “right” to impose them through the institution of patent and copyright laws. To do so would, from Rothbard’s perspective, violate property rights that already exist. He states that:

... patents actually invade the property rights of those independent discoverers of an idea or an inventor who happen to make the discovery after the patentee ... Patents, therefore invade rather than defend property rights (1970, p. 71).

Mises, on the other hand, rejects all natural law arguments for property rights (1978), adopting a strictly utilitarian approach. This allows him to be more flexible in considering alternative property rights arrangements. The underlying conclusion though, on the part of both authors, is that once property rights are clearly established a policy of strict laissez faire is seen as best promoting social welfare, even in the face of any external benefits or “free rider problems” that might still exist. Both Mises and Rothbard reject standard free rider justifications for either government subsidization or direct provision of any goods or services. Even though Mises is in favor of a minimal state apparatus to provide for the enforcement of property rights, there is no indication in his writings that the justification is based on free rider arguments.

Concluding Remarks on Mises and Rothbard

As a result of this underlying view of the relationship between market efficiency and property rights the Mises/Rothbard position on externalities shows two dominant characteristics, one a derivation of the other. The first is in the area of welfare effects; the second is in the area of policy. First, only externalities involving either the conflicting use or unclear definition of property are necessarily inconsistent with the efficient functioning of a market process. The second characteristic, implied by the first, relates to economic policy. The presence of positive or negative external effects even in the extreme case of Mises’ type 2 externality, is never a sufficient cause for government provision of a good or intervention into a market. Any problems associated with externalities must be the result of ambiguously defined or poorly enforced property rights before they can be considered the subject of policy.

These characteristics dominate the analysis of particular externality problems that is found in the modern Austrian literature. With respect to positive externality issues most of the analysis attempts to show why the presence of a particular external effect is not a sufficient justification for government intervention (High 1985, Block 1983). With respect to negative externalities, nearly all discussions tend to center on situations that involve direct conflicts in property usage, such as air and water pollution problems (Littlechild, 1979; Rizzo and O’Driscoll 1985; Rothbard 1982).

Because these conclusions regarding the welfare effects of externalities and public policy dominate the Austrian literature on externalities, they will be used as a reference point for subsequent analysis in this chapter. The relevant works of both the early Austrians and Hayek, whose analyses can be contrasted with this dominant view, will be assessed in light of the approach established by Mises and Rothbard.

Hayek’s perspective on this issue has emerged as the most notable exception to the Mises/Rothbard analysis. His conclusions with respect to external benefits and “collective goods” tend to be more consistent with neoclassical analysis than with the Mises/Rothbard approach outlined above, even though he explicitly rejects the welfare standards from which the orthodox conclusions are derived.

His analysis of collective goods focuses primarily on the divergence between costs incurred and benefits received rather than on conflicts in property usage. He first asserts that the “effectiveness of the market order ... rests on the fact that in most instances the producers of particular goods and services will be able to determine who will benefit from them and who pay for their costs” (p. 43). He further argues that when externalities are present this is not completely possible. Hayek concludes that under these circumstances there will not be a “balance of costs and benefits” and “the conditions which the market requires in order to perform its ordering function” will not be completely satisfied (p. 43).

Unlike Mises and Rothbard, Hayek argues that the mere presence of external benefits threatens the efficient workings of a market process. From the observation that, due to extensive external benefits “it would be prohibitively costly to confine certain services to particular persons so that these services can be provided only for all” (p. 48), he concludes that “government may have to step in where the market fails to supply a needed service” (p. 49). In this classification, Hayek includes nearly all of the standard cases of public goods including defense, education, roads, and flood protection. He invokes the orthodox “free rider” argument, stating that:

Where large numbers are involved, most individuals, no matter how much they may wish the services in question should be made available, will reasonably believe that it will make no difference to the results whether they themselves agree to contribute to the costs or not. Nor will any individual who consents to contribute have the assurance that the others will also do so ... Indeed wholly rational considerations will lead each individual, while wishing that all the others would contribute, to refuse himself to do so ... [C]ompulsion ... will in many instances be the only way in which collective goods can be provided ... (p. 44)

It is clear that Hayek diverges from the dominant Austrian position with respect to both characteristics outlined above. First positive externalities per se are viewed as impinging upon the efficient operation of the market process whether or not they are associated with poorly defined or enforced property rights. Consequently their presence is viewed, at least with respect to those collective goods he identifies, as a sufficient justification for government provision or subsidization. In addition these are not just pure public goods, or Mises’ type 2 externality goods, but goods that would and do get produced in spite of the associated positive externalities. These include education, park services, quality certification of products and even maps (p. 44).

Hayekian Analysis and Hayek on Externalities

Hayek’s discussions of externalities appears to be inconsistent with much of his own general framework of analysis in other areas. In the same volume where the discussions of collective goods are found, Hayek, in connection with another issue, makes the following statement:

... the whole of the so-called ‘welfare economies’, which pretends to base its arguments on the inter-personal comparisons of ascertainable utilities, lacks all scientific foundation. The fact that most of us believe that they can judge which of the several needs of two or more known persons are more important, does not prove either that there is any objective basis for this, nor [sic] that we can form such a conceptions[sic] about people whom we do not know individually. The idea of basing coercive actions by government on such fantasies is clearly an absurdity, (pp 201-202)

This statement, which invokes a subjectivist approach to questions of policy analysis consistent with that taken by Mises and Rothbard, cannot be reconciled with Hayek’s analysis of the free rider problem and collective goods. On the one hand he rejects the welfare standard used in neoclassical externalities analysis but embraces much of the analysis that is derived from it. His assessment of welfare economics leaves little room for the policy prescriptions that he suggests are appropriate.

In his analysis of collective goods Hayek argues that a person really desires a trade and therefore should be compelled to make it when in fact that person has assessed the market and has decided to abstain from participation. Given his own perspective on welfare economics and subjective value, Hayek’s judgment concerning the person’s true preference cannot be a scientifically made. The fact that the abstention may be due to free rider considerations should not, in and of itself, make a difference. Given Hayek’s rejection of neoclassical welfare economics, it is not evident how he differentiates, for normative consideration, a free rider rationale for refusing to carry out a trade from any other reason for not entering into a market transaction. Hayek freely accepts the implications of rejecting the standard welfare analysis in the area of competition and monopoly, for example, but there is no evidence that he fully recognizes them in the other major area of the market failure literature, externalities analysis.

There are other aspects of Hayek’s general framework that are at odds with his assessment of the externalities question. The knowledge problem that plays such an important role in Hayek’s analysis of economic calculation under socialism [1948 (1935A&B, and 1945B)] and the nature of the competitive market process [(1948, (1945A)] goes unrecognized when he analyzes this issue. Hayek assumes that the authorities can know which goods are not being produced due to excessive external benefits and which goods fail to be produced because of other, non-externality related cost considerations. But given the knowledge problems which Hayek suggests are relevant with respect to nearly all other areas of government intervention, this would be impossible to determine. In Hayek’s own words:

To use a standard by which we measure the actual achievement of competition the hypothetical arrangements made by an omniscient dictator comes naturally to the economist whose analysis must proceed on the fictitious assumption that he knows all the facts which determine the order of the market. But it does not provide us with a valid test which can meaningfully be applied to the achievements of practical policy (p. 67).

Yet Hayek himself seems to fall into this trap. Conceptually, it can be argued that there will be goods that the market will not produce because of excessive external benefits. But Hayek claims to know what many of these goods actually are and proceeds to list them. It would appear that he is playing the part of the economist he criticizes.

A related issue concerns Hayek’s assertion, when discussing externalities, that “the effectiveness of the market order” depends on the ability of market participants to identify who will benefit and who will bear the costs of market activity. The fact that this is true to some extent cannot be denied. For example, in order for a business to be successful it must be able to identify a market for its product and be able to identify the costs incurred by different aspects of its operation. But to state this relationship in an unqualified manner is inconsistent with Hayek’s own emphasis on the beneficial, unintended consequences that he considers essential in generating a market order. Hayek regularly points out that market activity always generates unintended benefits that are not and never could be known fully by the market participants who are generating them. Hayek states that:

It is because in the catallaxy men, while following their own interests, whether wholly egotistical or highly altruistic, will further the aims of many others, most of whom they will never know, that it is an overall order so superior to any deliberate organization ... (1976, p. 110)

The only aspect of Hayek’s analysis where knowledge problems associated with externalities seem to be considered is in the actual provision of collective goods. Hayek argues that while the state should provide certain goods or at least subsidize their production, it should not seize or grant monopoly privileges in this process. Recognizing that new technology could transform a public good into a private good, Hayek states that:

Even if in given circumstances only government is in fact able to supply particular services, this is no reason for prohibiting private agencies from trying to find methods of providing these services without the use of coercive powers ... New methods may be found for making a service saleable which before could not be restricted to those willing to pay for it, and thus make the market method applicable to areas where before it could not be applied. (p. 47)

Here Hayek recognizes that new knowledge could come to bear on the provision of certain collective goods, making it possible to internalize the external benefits. By allowing private firms to compete with the state, the profit motive will encourage the discovery of any new techniques.

Typically, Hayek is also critical of policy prescriptions that are based on states of affairs “that might have been achieved if certain facts which we cannot alter were other that [sic] they in fact are” (p. 67). Yet this is precisely the case with “collective goods.” Because of certain cost considerations facing potential participants in certain markets, namely the cost of organizing markets in the face of extensive free riders, the goods that would otherwise be produced are not. Hayek would have little concern if this result were due to excessive transportation or labor costs. Furthermore, he gives no indication as to why this particular type of cost, i.e., a transactions cost, should be viewed differently. The “collective goods” scenario is consistent with the actual costs that are faced by market participants. If the cost constraints were different, then the results would be different. In the framework of the perfectly competitive model, transactions costs are singled out because they are inconsistent with a perfectly competitive, Pareto optimal outcome. Hayek rejects this welfare standard but offers no alternative justification for normatively evaluating transactions costs differently from other costs. From Hayek’s own perspective, it is not clear how he can legitimately advocate economic policies which attempt to impose outcomes that would have occurred if only actual market conditions had been different.

While Hayekian analysis has traditionally been a beacon for modern Austrian economic analysis, his assessment of the externalities issue is clearly inconsistent with many of his own analytical precepts. Clear evidence of this is that other Austrian economists have not followed Hayek’s lead when analyzing externality problems.

EXTERNALITIES ANALYSIS AND THE EARLY AUSTRIANS

Self-conscious externalities analysis in economics did not come into being until after the 1920’s and the publication of Pigou’s Economics of Welfare (1954, first ed. 1920). For this reason, any observations with respect to the views of the early Austrian writers on this subject must involve a healthy dose of both conjecture and inference. In spite of this, it is possible to trace some of the roots of Mises’ and Rothbard’s approach to externalities to the writings of the school’s founders, Menger, Böhm-Bawerk, and Wieser.

Carl Menger

In Menger’s writing, discussions of specific kinds of externalities appear in the analysis of certain social and economic processes. The approach that Menger takes when assessing these specific external effects is remarkably similar to the approach taken by latter-day Austrians. It is clear that Menger saw the existence of negative externalities that involve the conflicting use of property as a problem that an economic system would need to resolve. On the other hand, Menger views external benefits that are generated within the context of clearly defined property rights as having only positive consequences.

Although the terms “externality,” “external costs” or “external benefits” were not part of the 19th century economist’s vocabulary, Menger does recognize the issue when discussing problems that arise from the conflicting use of property. He argues that because goods are scarce and people’s preferences diverge, different plans with respect to particular units of property will come into conflict. He uses the presence of these conflicts as an explanation for the emergence of the institution of private property. In both Mises and Rothbard, conflicting goals with respect to the use of property is at the heart of problems created by externalities. While they, and other modern Austrians use the existence of these conflicts to derive normative conclusions (i.e., an efficient market process dictates that property rights be defined and enforced) Menger’s motives were primarily positive.

He used the reality of conflicting property usage to explain the observable phenomenon of private property. In the process of his analysis he emphasized the major themes invoked by modern Austrian economists when discussing negative externalities. In particular, he addressed the problem of conflicting property usage and the importance of clearly defining and enforcing property rights as a remedy.

It is clear from Menger’s analysis that he was not thinking strictly of overt acts such as theft, but also of more subtle forms of conflicting property usage as would arise in modern discussions of externalities. Menger argued that private property is only necessary with economic goods, i.e., goods whose quantities are scarce relative to the desires of consumers. A truly non-economic good would not necessitate private ownership. According to Menger, this would include goods such as, in most cases, air for breathing and water for drinking. But he argues that in different circumstances a particular good’s status may be on the borderline between economic and non-economic, and as Menger puts it, “misuse or ignorance on the part of some members of the economy [with respect to the utilization of the good] may easily become injurious to others....” He further concludes that “for these and similar reasons the phenomenon of private property can also be observed in the case of goods that appear to us still, with respect to other aspects of economic life, as non-economic goods” (p. 105).

Although Menger does not give examples, the situations discussed above are clearly analogous to problems of air and water pollution. In the absence of pollution, clean air may be a non-economic or free good and therefore no property rights to the air need be enforced or even in place. Once the air is polluted, or misused as Menger put it, there may be “injurious” effects on others, i.e., a negative externality arises, transforming clean air into an economic good.

It is also clear that he saw the remedy to this type of problem in a property rights solution. In Menger’s analysis, it is these types of negative externalities that explain why, as part of the natural evolution of societies, property rights to some otherwise non-economic goods may evolve. To reiterate, Menger’s analysis was a positive attempt to explain the necessity for and eventual evolution of a property rights structure. But the normative conclusions that seem to automatically derive from Menger’s arguments are similar to the modern Austrian analysis. In light of Menger’s approach it is easy to understand why, for modern Austrians, an externality problem is a problem for property rights analysis not a problem for social cost/benefit analysis. (We will discuss below why, for Menger, like modern Austrians, it could not be the latter.) As Menger concludes, “property, therefore, like human economy, is not an arbitrary invention but rather the only practically possible solution of the problem” (p. 97).

Before looking at Menger’s approach to the issue of external benefits it is important to examine his view of what in modern terms is called social cost/benefit analysis. The subjectivist approach of modern Austrians leads to a rejection of externalities analysis in terms of exact calculations of social costs and benefits. And since, in the standard Pigouvian framework, it is only comparisons of marginal social costs and benefits that gives rise to the conclusion that the presence of external benefits is evidence of market failure, there would be no reason why Austrians would come to similar conclusions. The origins of this modern Austrian position on the question of social welfare analysis, and consequently the social consequences of positive external effects, can clearly be found in Menger’s writings.

In several passages Menger implies that he would have to reject any approach to externalities based strictly on cost-benefit analysis. When discussing the nature of value Menger states that “not only the nature but also the measure of value is subjective. Goods always have value to certain economizing individuals and this value is determined ... only by these individuals” (p. 146). And in a different context Menger explicitly rejects the idea of using objective measures of individual wealth in any attempt to measure social welfare. He states that:

The sum of economic goods at the disposal of individual economizing members of society for the purpose of satisfying their special individual needs obviously does not constitute wealth in the economic sense of the term ... when inferences running from this [measure] to the welfare of the people or when phenomena resulting from contacts between the various economizing individuals, are involved ... [this method] must necessarily lead to frequent errors. (p. 113, emphasis added)

In light of these statements, it would appear that Menger would reject the modern Pigouvian approach which analyzes the effects of externalities, both negative and positive, in terms of concrete measures of social welfare. If we compare Menger’s position on this issue to that of Pigou we get some insight as to why the two economists spawned very different traditions, not only with respect to externalities analysis, but also with respect to welfare economics in general. In contrast to Menger, Pigou argues that economic welfare is objectively measurable. He states that “economic welfare ... can be brought directly or indirectly into a relation with a money measure” (p. 31). Furthermore, Pigou argues that money is an appropriate measure of not only private but also social economic welfare. Arguing directly contrary to Menger, Pigou carries his analysis to its logical conclusion:

... economic welfare and the national dividend are thus coordinate, in such wise as any description of the content of one of them implies a corresponding description of the content of the other. (Pigou, p. 31)

Given the contrast between the positions of Menger and Pigou on measuring economic welfare, it is only logical that modern economists in the Mengerian and Pigouvian traditions would take significantly different approaches to welfare economics and externalities analysis.

It can be shown that, at least in particular instances, Menger himself tended to view production and market processes that generate external benefits as socially beneficial, in that greater benefits are created than are intended by the actors directly participating in the process. The best example of this is Menger’s evolutionary theory of the origin of money.

In his analysis, the fact that actions on the part of certain perceptive individuals generate positive externalities plays a crucial role in transforming a society from one based on barter to one based on monetary exchange. Menger argues that primitive societies naturally evolve through stages of exchange. The typical primitive economy will be transformed from a system based on pure barter, or direct exchange, to first a general recognition that more wants can be satisfied through indirect exchange to, ultimately, the widespread use of some medium of exchange, or money.

The movement from direct to indirect exchange takes place gradually. Relatively astute individuals realize that they can more fully satisfy their wants by exchanging what they have to trade for certain exceptionally marketable items, rather than attempting to trade for what they want to consume directly. These items allow the individuals to facilitate their own exchanges in their attempt to ultimately gain the commodities that are desired for direct consumption. As time passes, this practice becomes more and more widespread until one or a very few extremely marketable commodities become universally accepted in exchange, i.e., evolve into money. In other words certain commodities will be transformed from having only use value, to having both use value and exchange value, to having primarily exchange value.

This evolution takes place, in large part, because of certain positive externalities that are generated throughout the process which facilitates the transformation. Initially, a good’s widespread salability for its use value is what gives it value to some individuals solely for exchange purposes. In other words, each additional individual who demands the product solely for its use value confers a benefit on those who have no direct use for the good by making it more marketable and therefore valuable to them in facilitating exchange. Market exchanges begin to occur that cause marginal private and “social” benefit to diverge. This divergence acts as a catalyst for furthering the process.

Once the good’s exchange value is recognized by some individuals, the process of moving the good toward predominantly having exchange value begins to snowball, again because of positive external effects that are generated as part of the process. An externality which is explicitly recognized by Menger can be called the imitation effect. Once the concept of indirect exchange is recognized by some individuals, light is shed on the process for other individuals who observe the success of the initial transactions. As these people imitate the successful method of facilitating exchange and therefore satisfying their wants, others observe and imitate their successes, etc. As Menger stated it:

Since there is no better way in which men can become enlightened about their economic interests than by observation of the economic success of those who employ the correct means of achieving their ends, it is evident that nothing favored the rise of money so much as the long practiced and economically profitable, acceptance of eminently saleable commodities in exchange for all others by the most discerning and most capable of economizing individuals. (p. 261)

An important point to make is that Menger describes this process, which has as a crucial element the existence of positive externalities, in order to prove that money arises as part of the spontaneous market order and that it “is not an invention of the state” (p. 261). Contrary to Menger’s assessment, modern welfare economics argues that the existence of positive externalities is an explanation of why certain goods will not be produced in private markets and therefore why it is necessary for the state to subsidize, in part or in whole, their production. In Menger’s theory of the origins of money it is obvious that if it weren’t for the existence of positive external effects at each stage of the evolutionary process the good, money would not arise as a natural part of private economies. Ironically, in modern terminology, Menger seems to have been arguing that it is actually certain public goods aspects of money’s evolution that insures that it will be produced in the absence of state intervention. This results from his viewing the generation of the external benefits as part of an ongoing, disequilibrium process rather than in terms of an otherwise fully equilibrated static state of affairs. Menger focuses on the chain of events that the external benefits give rise to, identifying the “unintended consequences” that result (see Butos, 1985).

Eugen von Böhm-Bawerk

Neither Böhm-Bawerk or Wieser addressed the issue of negative externalities or the problem of conflicting uses of property, but both provided some insights into the more contemporary Austrian view of positive externalities. Böhm-Bawerk was clearly the most explicit of the early Austrians in discussing this issue. His relevant work is an 1881 essay entitled “Whether Legal Rights and Relationships are Economic Goods” (1962), which builds on Menger’s earlier discussion of the nature of goods. Böhm-Bawerk explicitly recognizes, as a positive observation, that the goods that are typically produced by the state are also goods that tend to generate positive externalities. It is worth quoting him at length on this issue.

... only a tiny fraction of the total services derived from the state’s institutions impresses itself upon any individual as a direct and positive rendition of service. The individuals comprising the community are the recipients of far greater advantages partly in the form of a far flung system of distribution; and partly in the negative form of protection from harmful disturbances.

Persons for whom wrongs are righted by a judge in a court of law are not the only participants in the benefits of the state activities on behalf of right and justice which are performed by civil and criminal court judges. All others, including those who never see a court of law, share in these benefits too ... because of the respect for law that prevails throughout the land by reason of the activities of those same judges. Every resident of any metropolitan center shares indirectly in the benefits emanating from the activities of the quarantine and sanitation or public health forces that operate at the national borders to prevent the introduction of epidemic diseases; he also shares in the benefits derived from the activities of all teachers and educators who, by giving intellectual and moral training to the entire body of our youth, train all persons to become his useful fellow citizens ... (pp. 132-133)

What is particularly interesting for our purposes is that Böhm-Bawerk emphasizes all of this not in an attempt to place the goods provided by the state in a special category of goods that wouldn’t be produced otherwise, but to show that they are not special. He argues that the state produces a collection of goods that are not unlike goods that are produced in private markets. He states that the person who benefits indirectly from these goods produced by the state also “benefits from the activities of all private ... promoters of industry and from those ... private individuals who contribute to the smooth functioning of traffic and trade ...” (p. 133). In fact he goes even further (unwittingly) toward desanctifying the “public” nature of state produced goods by concluding that the indirect beneficiaries of these goods also “share[] in the benefits arising from the activity of all the individuals in the community who make any direct or indirect contribution to the general welfare” (p. 133).

The direct implication here is that goods and services that generate external benefits are not a special category of goods that cause peculiar problems for a market economy. Böhm-Bawerk points out that these types of goods are produced side by side by both private and public concerns, and in both cases the external benefits themselves are discussed with only positive connotations.

It is true that Böhm-Bawerk did not directly discuss the possibility that a good might be purely public and therefore not be produced at all in private markets. In other words, he did not discuss a situation where the external benefits associated with a good would be so great that they would create insurmountable free rider problems for private producers. There are indications, though, that he would have viewed this problem as simply one of the infinite number of reasons why a good might not end up being produced in certain markets. Thus the modern Austrian view of this aspect of the positive externality issue also may have roots in Böhm-Bawerk’s writings. Böhm-Bawerk argues, in a general discussion about the nature of goods, that whether or not something will be produced depends on the existence of what he calls “positive” and “negative” factors. Unless these positive and negative factors come together in an advantageous way, the good will not be produced. This concept is best understood through Böhm-Bawerk’s own words.

Every economic advantage, if it is to eventuate, requires, on the one hand, a positive causative element that will effect the advantage, but it also requires, on the other hand, a host of negative presuppositions, presuppositions that there will be an absence of elements which would prevent or vitiate the positively useful progress of events.... (p. 130)

Although not specified, it would seem that one of the negative presuppositions that would be necessary for the production of any good is that there is the absence of an insurmountable free rider problem. Furthermore, it is implied that Böhm-Bawerk would not have considered such a “negative presupposition” as something that merits special consideration by economists. He concludes that

it [is] impermissible for us to make any special computation for some selected individual instance out of the entire class of negative factors simply because for some special reason our attention is specially and conspicuously directed to that single factor. (p. 130)

Friedrich von Wieser

In regards to externalities, Friedrich von Wieser is as notable for the arguments that he didn’t make as for the those he did. First, it is important to note that Wieser, along with early Austrian economist Emil Sax, has been included as a precursor of modern public finance economics [Musgrave and Peacock (1958), and Weber (1973)]. This is especially notable because this branch of neoclassical economics is based more than any other on Pigouvian externalities analysis. In his Social Economics (1967: first edition 1914, second edition 1924, English translation 1927.), Wieser discussed at length his view of the role of the state and the principles of taxation. What is interesting for our purposes is that his discussion did not center on the issue of externalities or the public nature of any goods. For Wieser, what defined the state was not the type of goods that it produced but the way it raised and distributed its revenues. Hence, he did not speak of public or collective goods but of, what he called, collective expenditures. In fact, he openly rejected the idea that the distinction between the public and private economies is to be made in terms of the type of good each sector produces. In response to what he saw as the prevalent view of his time, Wieser writes:

Modern theories look upon activities of the state as a special sort of production, an immaterial kind ... [producing] the intangible products of peace and legal security.

Such views only serve to obscure the nature of the public economy. Essentially it is not to be distinguished in concept from the private economy ... both serve the purposes of turning to the greatest possible usefulness the commodities that are found in the economic quantitative relation. (p. 420)

From this Wieser goes on to describe, in his view, what truly distinguishes the public economy.

But the state in its economy has unique means of power placed at its disposal ... [P]ublic economic income [is] ... entirely unknown to private economy and [is] no way related to exchange or production ... the principles observed in levying taxes have nothing in common with the law of price. (p. 420)

As mentioned above, his discussion of the public economy proceeds in terms of collective expenditure not in terms of collective goods. In the midst of defining “collective expenditures” Wieser is especially sensitive to the possibility that the word “collective” might be misapplied and specifically points out that it refers to means (the form of payment) and not ends (the particular goods purchased). He states that:

Collective expenditures are collective in that they employ common means under unified direction ... They are not so much collective in the sense that they serve collective needs... In the main the economy of the state caters to the same [needs] ... to which private economies cater. (p. 422)

The point to be made here is that, although Wieser advocated an extensive role for the state in the provision of economic goods and is often cited in neoclassical public finance literature, there is no evidence that his advocacy is derived from a concern with external benefits and public goods. In fact, his entire discussion of the “Theory of the State Economy” (pp. 419-436) lacks any indication that he felt goods which generate external benefits warrant any special attention by what he called the “public economy.”

Concluding Remarks on Menger, Böhm-Bawerk, and Wieser

This theme can be taken together with Menger’s view of the relationship between what we now call negative externalities and private property. When this is done, the more modern assessments of externalities found in the works of Mises and Rothbard can be viewed as an extension of at least an attitude toward the issue that has existed throughout the school’s history.

CONCLUSION

In this chapter we have examined the analysis of externalities as it has developed in the Austrian school. In doing so, some significant differences between the neoclassical and Austrian analysis have been revealed, particularly when assessing the normative consequences of external effects.

Contrary to the standard Pigouvian approach, which argues that both positive and negative externalities will have adverse consequences for economic welfare, Austrian economists, following the lead of Mises, and later, Rothbard, have dissented from this view. In general they have argued that only those externalities which are the result of ambiguously defined or unenforced property rights can be judged as having negative effects on the efficiency of a market process. Such externality problems are usually associated with negative external effects, leading most Austrians to concentrate their analysis on issues such as air and water pollution. On the other hand, since most positive external effects that are generated do not involve property-rights conflicts, external benefits are generally judged to be welfare enhancing. If an external benefit “problem” arises that is the result of ambiguously defined entitlements, then some form of public policy which focuses on establishing those rights may be advocated. The sole example of this in the literature is Mises’ discussion patent and copyright laws.

The neoclassical approach to externalities theory, and in particular the symmetrical conclusions regarding the welfare effects of positive and negative externalities, are implied by the normative standards described by a perfectly competitive general equilibrium. Thus far we have made no attempt to identify a similar standard of economic welfare that would give rise to the approach advocated by most Austrian economists. We have instead, simply pointed out that the Austrian school has rejected the perfectly competitive welfare standard and has emphasized a market process analysis that is based on a strict interpretation of subjective value theory. This can explain why the Austrian literature contains an approach that is different from the standard analysis, but it cannot explain how the particulars of that approach have been derived.

The following chapter takes up the issue of economic welfare analysis as it has developed in the writings of Austrian economists. No normative economic assessment can be complete without a grounding in a theory of welfare economics or efficiency. To date, few attempts have been made to derive normative conclusions about externalities from any of the alternative notions of efficiency that have been developed by Austrian economists (see Cordato 1980 & 1989). In other words, welfare economics and externalities analysis, to the extent they have developed at all, have been pursued independently of each other. The primary purpose of the chapter that follows is to complete the “stock taking” with respect to the current state of Austrian externalities theory by bringing these two elements together. As part of this exercise, the welfare economics of Murray Rothbard and Israel Kirzner are critically assessed for both internal coherency and relevancy for the evaluation of external effects.