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

2 EXTERNALITIES AND MODERN AUSTRIAN THEORIES OF ECONOMIC WELFARE: PROBLEMS AND PROMISES

In Austria, economics has never had direct political aims in spite of the close connection of the Austrian marginal utility theory with utilitarian philosophy. The Austrians were preoccupied with value theory and never elaborated a detailed theory of welfare economics. (Myrdal, 1955)

Although modern Austrians have moved away from the preoccupation with value theory attributed by Myrdal to the early Austrians, little attention has been devoted to developing an Austrian theory of welfare economics. In the case of externalities, the Austrian approach discussed in Chapter 1 is not explicitly based on any clearly defined efficiency or welfare criteria.

Once it is realized that most Austrians have not accepted the Pigouvian welfare standard, the Austrian approach to positive externalities becomes partially intelligible, at least in a negative sense. Specifically, in the absence of Pigouvian marginal analysis there is no reason to interpret external benefits differently, for normative purposes, than any other type of benefit. But the relationship between the normative effects of externalities and property rights, as is primarily emphasized in the Austrian analysis of negative externalities, is not quite so easily interpreted. With no clearly defined normative benchmark the conclusion--that only externalities involving a conflict in property usage have policy implications--cannot be completely understood or justified.

Since the criticism of orthodox externalities theory presented here centers around fundamental disagreements with neoclassical welfare economics, it is incumbent upon Austrians to present a coherent alternative. Indeed, no credible assessment of externalities from an economics perspective can be made without such an alternative.

The purpose of this chapter is to critically assess the current state of Austrian efficiency theory and welfare economics. There are two normative standards that have been explicitly proposed, if not completely developed. It is important to assess the strengths and weaknesses of these approaches in order to lay the groundwork for further refinements and the establishment of a sound normative foundation for externalities analysis. Furthermore, in order to round out the discussion from the previous chapter we will investigate here the extent to which these different standards can be used as a justification for the Austrian approach to externalities as it has developed.

In the literature of modern Austrian economics there are primarily two distinct, although related, economic welfare standards that have been suggested as a backdrop for policy. Each of these, when used as a standard for normative analysis, would give rise to the approach to externalities discussed in chapter 1. One of these standards was introduced by and is primarily associated with Rothbard while the second has been most extensively detailed by Israel Kirzner. Although neither of these approaches have been developed to the extent that neoclassical welfare economics has, one of the two, that discussed by Kirzner, has been developed much more extensively. Consequently, this approach or some variation of it, has been widely adopted among Austrians involved in normative analysis (Armentano, 1990, pp. 29-30; Rizzo and O’Driscoll, 1985, pp. 113-119; O’Driscoll 1977; Lavoie, 1985, pp. 34-39; Cordato, 1989). In addition, it can be viewed as an ex post efficiency rationalization for much of Hayek’s analysis. [1967 (1935); 1948 (1935A, 1945A)]

ROTHBARD’S CRITERIA OF DEMONSTRATED PREFERENCE

... the scale of values or wants manifests itself only in the reality of action. These scales have no independent existence apart from the actual behavior of individuals ... Every action is always in perfect agreement with the scale of values or wants ... (Mises, 1966, p. 95)

From this starting point both Mises, Rothbard, and most other Austrian economists, argue that a person’s highest valued alternative can be deduced from the actions that are taken. In other words people reveal their preferences through action.

This concept, which Rothbard calls “demonstrated preference,” serves as the foundation for his economic welfare analysis. He argues that voluntary action will always, ex ante, be viewed as welfare enhancing from the point of view of the individual taking the action. Rothbard then concludes that “if we define an increase in social utility in the Paretian manner” (1976, p. 98) evaluations and proclamations about social welfare can be made without the use of interpersonal utility comparisons. But Rothbard adopts a strict individualist, non-equilibrium interpretation of the standard Paretian rule. It allows for no social welfare functions and is not dependent on the attainment of any equilibrium or Pareto optimal state. In Rothbard’s view, an economist can claim that there has been an increase in social utility only when “one or more persons gain in utility while nobody loses” (1976, p. 98). By coupling this rule with “demonstrated preference,” he reasons that all free market activity is welfare enhancing. Rothbard states that:

[a free market exchange] is voluntarily undertaken by both parties. Therefore, the very fact that an exchange takes place demonstrates that both parties benefit (or more strictly, expect to benefit) from the exchange. The fact that both parties choose the exchange demonstrates that they both benefit. The free market is the name for all the voluntary exchanges that take place in the world. Since every exchange demonstrates unanimity of benefit for both parties concerned, we must conclude that the free market benefits all its participants. In other words, welfare economics can make the statement that the free market increases social utility ... (Rothbard, 1977, p. 27, emphasis added).

The normative principle I am suggesting ... is simply this: No action should be considered illicit or illegal unless it invades, agresses against, the person or just property of another. (Rothbard, 1982A, p. 60)

With this approach to voluntary action in mind, Rothbard’s welfare criteria can be applied to externalities in a straight forward manner. Any use of one’s property by another without the former’s permission would be considered a coerced exchange. It would violate the Paretian rule and therefore reduce social welfare. This gives rise to Rothbard’s and Mises’ normative conclusion regarding negative externalities. A pollution externality is a social problem because the pollution interferes with the use of property by its “legitimate” owner, i.e., it represents a coerced exchange (Rothbard, 1982A). In generating the pollution the polluter is being made better off at the expense of the recipient of the externality.

External benefits, to the extent that they are actually generated, as in the case of a type 1 externality, would have to be considered welfare enhancing from Rothbard’s perspective. It involves no violation of property rights and makes one or more persons better off without making anyone worse off. The generation of positive externalities represents a Pareto superior move. The fact that the result may be inconsistent with a hypothetically derived state of Pareto optimality for that moment in time would be irrelevant in Rothbard’s disequilibrium framework. He makes no reference to a “welfare maximized” state of the world when developing his Paretian criteria.

Neither would the results associated with a type 2 externality have negative connotations from the perspective of demonstrated preference. The fact that the good in question does not get produced results from a demonstrated preference not to make certain exchanges. From Rothbard’s perspective, the reason’s behind that action, or in this case inaction, would be beyond the scope of economic analysis. In other words, the fact that the exchange is not being made because one of the parties is attempting to obtain the good for free or because transactions costs are too high, will have no role in any normative analysis made from the perspective of demonstrated preference. From Rothbard’s point of view it must be concluded that, given Mises’ type 2 externalities result, at the very least, social welfare has not been reduced.

While Rothbard never examines externalities in light of his theory of welfare economics, it could easily serve as a normative backdrop for the conclusions that were reached by Mises and most subsequent Austrian economists. With external benefits, the argument that exchanges are not made because of “excessive” transaction costs is irrelevant. As has traditionally been the case in Austrian economics, there is no basis for a normative distinction between transaction costs and other costs. The preferences being demonstrated are consistent will all perceived costs and benefits.

The most common criticism of demonstrated preference as a welfare guide is that Rothbard does not allow for any consideration of harm that is not demonstrated, i.e., psychic harm. The welfare effects of envy, trauma, etc. are ruled out of his model. The voluntary activities of some people may have negative psychic effects on others, causing a decline in their level of satisfaction. To the extent that this occurs, some people will be made better off at the expense of others and there will not be an unambiguous increase in “social utility.”

Once this criticism is recognized other problems become readily apparent. One implication is that interpersonal utility comparisons cannot, as Rothbard claims, be avoided. In order to conclude that a market exchange unambiguously increases “social utility,” the effects on everyone’s satisfaction must be considered and compared; even those whose preferences are not being demonstrated. Rothbard’s approach does not eliminate this problem, but simply ignores it. Oddly enough, in a different context, Rothbard admits this point. He argues that given a free market exchange by two parties, A and B, “there might be one or more people in existence who dislike and envy A or B, and who therefore experience pain and psychic loss because the object of their envy has improved his lot. We cannot conclude from the mere fact of exchange that ’everyone’ is better off, and we can therefore not leap to the valuational idea of social utility” (1973B, p. 36). While this statement implies a recantation of his earlier welfare theory, Rothbard has not acknowledged the contradiction.

But there are even more damaging criticisms to be made of Rothbard’s approach. By focussing strictly on demonstrated preferences and ex ante evaluations, he rules out all consideration of costs and therefore the possibility of utility loss. Cost is the foregone satisfaction associated with activities that are not undertaken. By definition costs cannot be demonstrated. Therefore, in Rothbard’s model only benefits, that is, utility gains, are recognized. The narrow focus on ex ante action restricts the analysis to a consideration of expectations about the rewards from activities that are being pursued. By definition, though, people always expect to benefit, relative to the alternatives, from every action that is undertaken. This is true under any institutional arrangement. An action taken at the point of a gun is expected to result in an increase in utility relative to the available alternatives.

It can only be determined ex post whether or not the desired goal was reached and an increase or loss in utility was experienced. Clearly, even in a free market, if an individual expends a large amount of resources in pursuit of a goal and then finds out that the services or satisfaction that he anticipated receiving were not forthcoming, his efforts would have been in vain. Clearly he would have experienced a loss in utility.

The point is that the economist must wait for the ex post results of action in order to determine whether utility has been increased or decreased. Rothbard’s conclusions would only hold in an error free world of perfect knowledge, where expectations necessarily coincide with results. It is not surprising, then, that Rothbard comes to the conclusion that all free market activities imply increases in social utility. He rules out any possibility of utility loss in constructing his model.

Another fundamental problem with Rothbard’s welfare economics is that it ignores the fact that preferences are expressed sequentially through time, as part of a general set of goal oriented activities. The actor in Rothbard’s framework is operating in a static world where actions are undertaken in isolation from one another. The fact that all preferences are “demonstrated” within the context of a means-ends framework is missed. This emphasis on static, unconnected action has led to conclusions with regard to both individual and social welfare that are obviously incorrect.

For example, one analyst, in a strict application of Rothbard’s social utility theory, argues that, given two individuals pursuing an employment opportunity, the individual whose offer is rejected suffers no loss in utility (Osterfeld). In Rothbard’s framework, the person whose salary request was rejected is no worse off for the failed attempt. “He did not have the job before he made the offer; he does not have the job after his offer was rejected. Thus his ... real world utility plane is unchanged” (Osterfeld, p. 81). But, consistent with Rothbard’s theory, this analysis ignores the fact that the rejection was the culmination of an attempt to obtain a particular goal, i.e., the job. The attainment of goals are associated with utility gains while the employment of means are associated with opportunity costs or disutility. If certain means are employed in order to attain an end that is never achieved then opportunities are forgone without a resulting payoff, and the actor will have suffered a net reduction in utility. Given the typical costs associated with a job search--preparing a resume, going to an employment agency, filling out an application--the individual in the example above would have to have suffered a net loss in utility. This obvious conclusion is avoided by separating out particular actions of individuals from their overall means-ends framework.

These criticisms have implications that relate directly to externalities analysis. If only external effects that are demonstrated can be evaluated by Rothbard’s normative criteria, a strict interpretation of his approach would have to conclude that any harms or benefits that are not demonstrated do not actually exist. For instance, an example of a negative externality that does not involve a violation of property rights was discussed in chapter 1. In this example, individual A imposed psychic harm on his neighbor, individual B, by storing junk cars on his front lawn. As was pointed out, the standard Austrian conclusion with respect to this type of situation is that a non-voluntary remedy to this problem could not unambiguously improve social welfare. But if Rothbard’s welfare criteria was guiding the analysis the fact that an externality was even being generated would have to be denied.

In light of these criticisms, Rothbard’s welfare economics does not offer much promise as a general guide for externalities theory or policy. His approach begs many of the questions that would have to be answered if an analysis of externalities were to be considered complete. The problems noted above could also explain why Rothbard’s normative standard has not been widely adopted by other Austrian economists in discussions of appropriate approaches to welfare economics. While Rothbard, along with Mises, has established the standard assessment of externalities from an Austrian perspective, we must look elsewhere for a coherent welfare economics to serve as a backdrop for that assessment.

KIRZNER: EFFICIENCY AS PLAN COORDINATION

To the extent that Austrian economists have discussed issues in terms of efficiency, it has been the concept of plan coordination, as made explicit and elaborated by Kirzner, that has been commonly used. Most often it has been invoked as a backdrop for defining and discussing the normative implications of competition and monopoly (Armentano, 1990; Kirzner, 1973). It has also been argued that monetary theory and policy is best seen in light of this type of efficiency standard (Garrison, 1978, p. 169). Kirzner’s theory is clearly the most well developed and thought out conception of welfare economics in modern Austrian economics.

Individual Efficiency and Social Efficiency

Kirzner’s approach is distinguished by the fact that it is primarily developed in a disequilibrium or market process setting. But it does not completely avoid equilibrium theorizing and the notion of general equilibrium does play a role. In defining perfect efficiency, he describes an equilibrium world where there is complete plan coordination. At any given point in time, with preference scales held constant, an ideal market process will move towards this state. But unlike Pigouvian welfare analysis, Kirzner sees the particular end-state pattern of resource allocation as hypothetical and irrelevant for real world appraisals of social efficiency (1963, p. 298). Instead of dwelling on the perfectly efficient equilibrium, Kirzner focuses on the relative efficiency of any given disequilibrium market process that might be taking place. He describes the purpose of his analysis this way:

... it is the market process that is being judged rather than the state of equilibrium the process leads toward ... After all, in a changing world, a state of market equilibrium, as we have seen is hardly an attainable goal. The precise degree in which the state of market equilibrium deviates from the conditions of optimality is therefore ... a distinctly academic question. (Kirzner, 1963, p. 299)

A second distinction of this efficiency standard is that, consistent with methodological individualism and like Rothbard’s theory, individual and social efficiency are seen as mutually consistent. If particular actions are efficient from the perspective of the individuals making up society they will also be considered socially efficient. This can be compared to standard Pigouvian analysis where actions deemed to be efficient from the perspective of individual market participants may lead to distinctly inefficient outcomes when viewed from “society’s perspective.” This is seen most clearly in the case of positive externalities. An activity generating positive externalities that are not either internalized or compensated for is judged to be socially inefficient, even though all of the relevant market participants are, from their own perspective, acting rationally and experiencing positive gains in utility. This kind of clash between individual and social welfare is not only inconsistent with Kirzner’s, and Rothbard’s, welfare economics, but could not be sustained by any theory of social efficiency developed from a strictly Austrian perspective.

Kirzner begins his analysis by focusing on the determinants of efficient activity from the perspective of the individual’s means-ends framework. (A more elaborate discussion of individual efficiency will be pursued in the following chapter.) Since all action is seen as purposeful, i.e., goal seeking, efficiency for an individual is viewed in terms of the extent to which his activities, the means employed, are consistent with the goals or ends that are hoped to be accomplished (1963, pp. 33-34). This will depend upon the extent to which the individual has knowledge of the means available and the extent to which they are suitable for achieving the desired goal or program of goals. The efficiency of the individual’s activities will improve as he obtains more knowledge that is relevant to those activities.

It is important to note that the individual in Kirzner’s model is not presented in terms of the utility maximizing framework of neoclassical economics, where individual efficiency is achieved by equalizing given marginal rates of substitution. Kirzner postulates an individual that is making decisions through time. This individual is more akin to Buchanan’s “artifactual man” (1979A), where some future state of affairs (the goal) is imagined and, under conditions of uncertainty, attempts are made to achieve it. According to Kirzner:

... in making plans, individuals have in mind given sets of goals. With respect to this set of goals, they seek a consistent, efficient course of action. (Kirzner, 1963, p. 34)

In Kirzner’s framework social efficiency is derived directly from individual efficiency. Once individuals find it advantageous to pursue their goals in a cooperative setting, through exchange and the division of labor, the concern is with the basis upon which the cooperative setting, i.e., the economic process, can be judged efficient. Kirzner suggests the following criteria:

... the efficiency of the social system ... depends on the degree of coordination with which the separate activities of the participants are carried on. (Kirzner, 1963, p. 36)

By coordination Kirzner is referring to the mutual compatibility of plans among market participants (1963, p. 36). Therefore an economic process is judged efficient to the extent that it harmonizes the plans of individuals in the pursuit of their goals. As with efficiency for the individual, social efficiency depends on knowledge. In this case, it is the knowledge held by market participants of relative scarcities and the desires of their fellow market participants (1963, pp. 301-302). To the extent that this type of knowledge exists, people will be able to exploit a greater number of opportunities for mutually beneficial exchange. Given that exchange of this nature implies the coordination of plans on the part of the traders, Kirzner reasons that an economic system can be judged efficient to the extent that it generates knowledge of mutually beneficial exchange possibilities.

For Kirzner, improvements in knowledge are synonymous with increased plan coordination among market participants. As the market process brings new information to light, the plans of market participants become more closely coordinated and social efficiency is improved. He argues that,

... the movement from disequilibrium to equilibrium is at once a movement from imperfect knowledge to perfect knowledge and from uncoordination to coordination ... [the] learning process ... nudges individual plans into closer and closer coordination. (Kirzner, 1973, pp. 218-219)

Knowledge, Coordination, and Equilibrium

As noted above, a state of perfect efficiency is associated with a world of complete coordination of plans, which, in turn, is synonymous with general equilibrium and a world of perfect knowledge. Kirzner makes the connection as follows:

The state of equilibrium is the state in which all actions are perfectly coordinated, each market participant dovetailing his decisions with those which he (with complete accuracy) anticipates other participants will make. The perfection of knowledge which defines the state of equilibrium ensures complete coordination of individual plans. (Kirzner, 1973, p. 218).

In Kirzner’s framework, knowledge, coordination, equilibration, and efficiency always move in the same direction. Improvements in knowledge will always be equilibrating and lead to increased plan coordination. By definition, this implies an improvement in social efficiency. Furthermore, with preferences held constant, the market process will generate improvements in information and coordination until a perfect knowledge, perfectly coordinated, and therefore, perfectly efficient end state is reached.

The role of the entrepreneur in this process is crucial. The social function of the entrepreneur is to facilitate plan coordination by exploiting profit opportunities. Price discrepancies, i.e., the existence of two prices in the same market for the same good, indicate a lack of plan coordination. Because of a lack of information concerning alternative trading partners, some consumers are paying higher prices and buying smaller quantities of the good than is necessary while presumably some marginal consumers are going without the good completely. Discoordination exists, then, between certain potential buyers and sellers. In exploiting the profit opportunities that arise from this incomplete knowledge the alert entrepreneur brings new and improved exchange opportunities to market participants. The result, according to Kirzner’s theory, is always an increase in plan coordination and therefore an increase in social efficiency. Because of this, all successful entrepreneurial activity, where profit opportunities are accurately perceived and exploited, is seen as “equilibrating,” i.e., as a movement in the direction of general equilibrium and “perfect efficiency.” As Kirzner concludes:

Each entrepreneurial discovery represents alertness to a hitherto unperceived interpersonal opportunity--an opportunity that depends on the coordinated plans of two separate individuals. As this “general” equilibrating process proceeds by competitive-entrepreneurial alertness, it identifies more and more uncoordinated situations, at the same time spreading the information perceived by entrepreneurial alertness among wider and wider circles in the market. (Kirzner, 1973, p. 222)

The use of general equilibrium in Kirzner’s approach can be contrasted to the standard analysis of social efficiency. As already noted, Kirzner does not consider general equilibrium as an attainable goal and would never use as a starting point, particularly in normative discussions of efficiency, the assumption of general equilibrium prices or outputs. While invoking general equilibrium as a mental construct in order to delineate a world of perfect efficiency and to draw out the logical conclusion of a market process, Kirzner considers the efficiency problem itself under a “state of the world” that is always in disequilibrium. This is distinctly different from orthodox analysis of allocative efficiency, where a level of knowledge is given to the individual or society, and most of the time that level of knowledge is considered to be perfect. The knowledge problem, and therefore the coordination problem, is already solved in the standard efficiency framework. The assumption that all relevant means and ends are known in the Pigouvian model eliminates the coordination problem. The efficiency problem then becomes one of determining the precise pattern, or set of precise patterns, of resource usage that will maximize social welfare.

An internal consistency can be recognized between the normative analysis of externalities typically associated with the Austrian school and Austrian welfare economics as presented by Kirzner. For Kirzner, if an activity leads to an improvement in knowledge and, hence, coordinates previously uncoordinated plans, that activity can be deemed efficient. Contrariwise, if an activity leads to the disruption and discoordination of plans then that activity would have to be considered inefficient.

Different kinds of externalities can be assessed with Kirzner’s criteria in mind. Only those externalities that lead to a disruption of plans and/or the discoordination of plans among market participants should be considered inefficient. In a general sense, the traditional Austrian perspective on externalities follows from Kirzner’s standard. But there are some areas of vagueness that suggest underlying problems with the use of plan coordination as a general standard for efficiency and social welfare.

The assessment of external benefits, from this perspective is quite clear. Positive externalities, per se, will have no adverse consequences. In other words, there is nothing discoordinating with respect to market participants’ plans.

We can examine Mises’ two types of positive externalities, discussed in chapter 1, in light of Kirzner’s theory. To recall, a type 1 external benefit in Mises’ framework is one that does not prevent the production of the good in question: it is analogous to a situation where the good is less than purely public. In the Kirznerian framework the equilibrium benchmark against which the actual market outcome is typically judged is considered unattainable. Furthermore, the actual equilibrium price and level of output is considered to be unspecifiable. Any equilibrium state in Kirzner’s analysis, must be the result of the market process that has led up to it. Therefore, it cannot be argued that less than the efficient quantity is being produced. In fact, from Kirzner’s perspective, this type of externality can only be considered efficiency enhancing. The production of this type of good not only furthers the goals of the producer and those who are participating directly in the market for this product but also furthers the interests of third parties who are not participating in the market. In this framework, Mises’ type 1 externality can correctly be viewed as an unintended fringe benefit of the market process--one that is both coordinating and efficiency enhancing.

Mises’ second type of externality is analogous to a pure public good where no one is willing to bear the costs of production, resulting in the good not being produced. For the reasons just discussed, there is no framework from which to argue that too little of the good is being produced. In other words, Kirzner’s standard does not suggest that a production level of zero is any less optimal than any positive level of production.

At first glance it may appear that the potential presence of positive externalities, in this case, may be discoordinating given that certain opportunities for beneficial exchange are kept from materializing. In other words, because of potential positive external effects, transactions costs were increased, and what otherwise would have been an opportunity for mutually beneficial exchange did not come to fruition. But there is nothing in Kirzner’s analysis that suggests transaction costs should be treated differently, for normative purposes, from other types of costs, i.e., transportation costs or labor costs. If an opportunity for exchange doesn’t exist because transactions costs are too high then, given all the costs and benefits of making the exchange, it must be concluded that there simply is no opportunity for mutually beneficial exchange.

When applied to negative externalities, the implications of Kirzner’s efficiency standard are less certain. There is no question that Kirzner’s standard implies Mises’ and Rothbard’s normative assessment that externalities involving the conflicting use of property will give rise to market inefficiency. For example, if pollutants from a factory end up on property that is owned by someone other than the factory owner, and assuming that the externality disrupts the execution of at least some plans that person might have with respect to the use of his property, the existence of the externality must be deemed inefficient. If the externality involves the conflicting use of property where rights are not clearly defined, such as “publicly” owned waterways, forests, etc., then the lack of clearly defined rights will give rise to interpersonal conflicts and discoordination. This is consistent with what Kirzner sees as the “ideal” institutional setting for the operation of a market system (to be discussed at length in Chapters 3 and 4). He argues essentially that in order for a market system to flourish, property rights need to be clearly defined and strictly enforced (1963, p. 13).

This type of discoordination is explained within Kirzner’s framework of analysis, but the explanation itself implies that the coordination standard cannot be strictly applied in every circumstance. As was discussed above, Kirzner’s view of efficiency starts with the individual and the extent to which his means are consistent with the attainment of the sought after goal or set of goals. In the example above the discoordination was caused by the fact that B’s original means were inconsistent with his ends. B’s goal was to produce widgets in such a way that he could sell them for a profit. As the market process unfolded it became clear that his chosen course of action was based on erroneous expectations. Viewed from this perspective, the discoordination and therefore inefficiency was inherent in B’s original means ends framework. B’s failure was due to the fact that he did not accurately perceive the new conditions brought about by the activities of entrepreneur A. As the market process unfolded this misperception was revealed to B.

For Kirzner, this type of plan discoordination is inherent in a disequilibrium market process and is the result of errors in assessing markets, i.e., imperfect knowledge. He argues that, because of the incentives that are created by the system of profits and losses, even this type of plan discoordination will tend to be minimized in a competitive process. Entrepreneur B will be encouraged to revise his plans as his errors are exposed and losses are incurred (Kirzner, 1963, p. 304 and 1973 pp. 212-242). In other words, there would be no reason to make this type of plan discoordination the object of public policy.

This explanation, although consistent with Kirzner’s framework of analysis, does not negate High’s criticism. The fact remains that the activities of entrepreneur A had third-party effects that were discoordinating, i.e., that disrupted what otherwise would have been the coordinated plans of B with respect to his customers. Clearly, this kind of discoordinating activity is generally considered beneficial.

The Kirznerian explanation of this phenomenon itself suggests that the emphasis on coordination as an appropriate welfare standard may be misplaced. The elimination of error may be a more appropriate focus for our attention. While Kirzner has argued that the two are completely consistent, High’s arguments imply that this is not the case.

Coordination vs. Improvements in Knowledge

While knowledge and coordination go hand in hand in general equilibrium, they are not as neatly correlated in the disequilibrium world of the market process. In other words, while knowledge improvements may be equilibrating, in that, ceteris paribus, they move us closer to a world of “perfect knowledge,” they may not always be strictly coordinating. Stories concerning an entrepreneurial process where general improvements in knowledge will take markets through different stages of discoordination and coordination can easily be told.

Imagine that widget entrepreneurs A and B from above are trading in a perfectly coordinated fashion in two separate markets. A is selling quantity Qa at price Pa and this combination is completely consistent with A’s plans and the plans of his customers. Widget seller B faces a similarly coordinated situation in his market at Pb, selling Qb. But due to the lack of any knowledge that might connect the two markets Pa<Pb. Clearly gains from trade could be exploited if either A, a third entrepreneur, C, or the consumers in B’s market gained knowledge of the price discrepancy. But this new knowledge and the exploitation of these gains would lead to at least a period of discoordination. This would be particularly true for entrepreneur B. But it may also be true for some of B’s customers and for entrepreneur A, as output plans must be adjusted upward. Clearly, as market participants adjust to the new information, plans and goals will be reassessed and market activities will ultimately be recoordinated. But we cannot necessarily say that the newly coordinated environment is better than the old one.

A second criticism of Kirzner’s framework that deserves mention here, has been made, indirectly, by O’Driscoll and Rizzo (1985). Their focus is on the end state equilibrium that is implied by Kirzner’s analysis. They have argued that Hayek’s notion of coordination, which has been explicitly adopted by Kirzner (1988A), implies an equilibrium state that is both too restrictive to be useful in real world economic analysis and logically flawed. They argue that the level of coordination that is necessary for a general equilibrium end state requires not only ex ante plan coordination but also that all expectations concerning future events be consistent. They cite an example where one person sells an umbrella expecting that it will not rain tomorrow to a person who is expecting that it will. Ex ante, the plans of the buyer and seller are compatible and this is what gives rise to the exchange. But it is “logically impossible” for both parties to have their expectations fulfilled (O’Driscoll and Rizzo, p. 80).

Generally speaking, they argue that the perfect knowledge which is required if all exchanges were to be made on the basis of mutually consistent expectations is a logical impossibility (O’Driscoll and Rizzo, p. 84). But O’Driscoll and Rizzo go beyond the arguments being made here concerning the usefulness of general equilibrium as a tool of normative economics. They further question its usefulness for most predictive and explanatory purposes in economics (p. 114).

The extent to which O’Driscoll and Rizzo’s arguments constitute a case against Kirzner’s welfare economics is questionable. Kirzner himself has argued, on the one hand, that he considers comparisons between real world coordinating processes and nonreal-world end states to be irrelevant. On the other hand he has argued that a “perfectly efficient” world would be characterized by the end state equilibrium that O’Driscoll and Rizzo criticize (Kirzner, 1973, p. 218). Furthermore, O’Driscoll and Rizzo do not argue against the usefulness of some notion of relative plan coordination as a normative welfare standard. They do not challenge the notion that coordinating economic processes are always to be desired over discoordinating processes. They argue that the desirability of an economic system can be judged by the extent to which it allows individuals to adjust to the information changes that are inherent in the passage of time. With Kirzner, they relate this directly to the coordination of plans in arguing that:

... we can assess [] the performance of an economic system on the basis of its adjustment to change. Here the criterion is the relative amount of coordination consistent with the system’s exogenous change (O’Driscoll and Rizzo, p. 115).

O’Driscoll and Rizzo identify a coordination standard that is less restrictive than Kirzner’s; they call it “pattern coordination.” This standard allows them to focus on the likelihood, i.e., probability, of plans being fulfilled rather than on whether specific plans of specific individuals can be carried out. They conclude by arguing that “maximal possible [as opposed to complete] plan coordination is the most straightforward adaptation of the plan coordination concept to dynamic problems” (p. 118). Unfortunately, their discussion of “pattern coordination” is preliminary with no discussion of how it can be directly applied to concrete issues in welfare economics or how it would lead to analyses, either positive or normative, that are qualitatively different from a more Kirznerian approach to plan coordination.

Although Kirzner’s coordination standard of efficiency has not been perfected, it is the most highly developed welfare standard in the Austrian literature. Unlike the criticisms leveled against Rothbard’s demonstrated preference, most of those that have been made of Kirzner’s standard are not so fundamental as to undermine the use of plan coordination as, at least, a partial benchmark for normative analysis. In light of this, Kirzner’s standard offers a logical starting point from which to develop a more complete Austrian alternative to standard welfare economics.