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

The framework of analysis offered here represents a radical departure from both standard welfare economics and its application in the area of externalities. For reasons discussed at the outset, and reiterated throughout the text, the perfectly competitive general equilibrium (PCGE) has been completely jettisoned as a normative guide for economic analysis. Furthermore, the focus was not switched to some other end-state result. Instead we began from a recognition of the fact that real-world market processes are open-ended, and that real-world human actors necessarily pursue goals within an open-ended framework of trial and error. In other words, knowledge of means are neither perfect nor “given” to anyone in the system-not market participants, not policy makers, and certainly not economists.

This is a world that differs very significantly from the one that is typically assessed by economists. Following the distinction emphasized by Mises, Hayek, and later, Buchanan, it is a world that is best described as a “catallaxy” not an “economy.” It is a setting where individuals, through the process of exchange, pursue goals that are ranked on individually determined value scales. Because these rankings cannot exogenously be fused together or even observed, there is no perspective from which to make value objective. This means that concepts such as social costs and social benefits, and distinctions such as those that are made between private and social costs or benefits, are not only arbitrary, but simply fabrications of the economist’s mind.

What is there left to orthodox welfare economics when there is no end state to mimic and when the full implications of subjective value are taken seriously? Certainly, in the area of externalities analysis, very little remains. The orthodox approach to efficiency is wholly dependent on these concepts. As a consequence, most of the market failure-based approaches to public policy, which are derived from considerations of “economic” efficiency as traditionally defined, are totally dependent on social cost-benefit analysis and a general equilibrium benchmark.

The Pigouvian approach to both defining and resolving externality problems is completely undermined when the foundation provided by a perfectly competitive general equilibrium is withdrawn. Outside of this framework the orthodox tax and subsidy approach to such issues is vacuous. It becomes clear that economic efficiency-based arguments for pollution taxes, energy taxes, effluent charges, etc., crumble without the PCGE touchstone. The same is true for the standard market failure arguments that are made for the subsidization or government provision of so-called public goods, such as education, roads, parks, or even police and national defense. Without the benchmark of a PCGE these excise taxes and subsidies are stripped of their alleged efficiency properties.

As was noted in the last chapter, the same assessment applies to Coasean type property rights analysis and its policy prescriptions in the field of law and economics. While Coase presented his analysis of harmful effects as both a criticism of and alternative to Pigouvian analysis, its policy prescriptions are no less dependent on the results associated with a PCGE. It is only an alternative to standard analysis within the general equilibrium framework. Our attempt here has been to break free of this paradigm.

The primary question that has been addressed here is, what should welfare economics and, in particular, externalities analysis look like when the full implications of an open-ended market process are considered. This should not be viewed as an attempt to formulate the last word on either welfare economics or externalities theory from this perspective. Quite the contrary. The purpose has been to lay the groundwork for research in the entire range of areas that have typically fallen under the rubric of externalities. In this sense, the purpose here has been to open doors, not to close them, although I emphatically believe that the door should be closed on the entire concept of perfect competition as a meaningful guide for normative questions in economics.

While I see the scope for economic analysis in this area to be much more narrow than is acknowledged in the standard literature, the idea that externalities is a subject area that is completely beyond the range of efficiency analysis is incorrect, although, as in the area of competition, the meaning of efficiency has had to be reconstructed to fit the realities of an open-ended world.

UNRESOLVED ISSUES

Opportunities for further research in this area are without limit. As already emphasized, the purpose here has been to open a door--to provide an alternative framework of analysis for interpreting not only externality problems, but other areas in welfare economics, including competition and monopoly.

There are vast numbers of issues, both theoretical and empirical that one can begin to address. On a theoretical level it is clear that the relationship between normative economics and ethics in general needs to be explored more thoroughly. As we have pursued our analysis here the limits of economic science were continuously being felt as a binding constraint, particularly when it came to the issue of establishing initial entitlements. This suggests that ethics will have to play a significant role if we expect to offer a complete normative analysis of the externalities question, particularly if we are to proceed within the methodological constraints imposed by Austrian economics. As argued here, those are nothing more than the same constraints imposed by reality. To ignore them, as is done in Pigouvian welfare economics, does not make them any less binding. It simply makes the analysis less meaningful and, therefore, less relevant.

It was argued that in dealing with certain issues in tort that economics could inform judges and juries in some instances where property rights are not clearly delineated. Hence we argued that a rule of “coming to the nuisance” would promote catallactic efficiency in certain cases where title to resources under conflict were not clear. But this may not be relevant in all or even most situations where property titles are ambiguously defined. It may not be clear who actually made use of the property first and, furthermore, non-economic considerations may override the first-use principle. My own feeling is that, as particular kinds of externality problems are explored in light of catallactic efficiency, different ways in which efficiency analysis can inform the ethical decisions concerning initial entitlements will be discovered. No doubt though, there will always be unexplored questions concerning the relationship between economic analysis and ethical analysis.

By invoking Hayek’s rule that normative economic analysis must remain “ends independent,” we have at least helped to sharpen what has become a very blurred boundary between the disciplines of ethics and economics. Once Hayek’s constraint is imposed on normative economic analysis it becomes clear that the border between economics and ethics is crossed regularly by economists-typically without them even recognizing the transgression. Every time an economist views policy analysis in terms of social costs and benefits, the ends of different actors are being compared to determine their relative “value” to society. From the perspective taken in this book, this is inherently an ethical question, the answer to which cannot be grounded in economics.

On both a theoretical and practical level, it would be important to explore the issue of “second best” within a framework of catallactic efficiency. Certainly there are and will be many cases where the IIS, for technological or political reasons, cannot be conformed to. In these situations it would be important to develop alternative approaches to the problem that would minimize the damage done to the market process.

A second, but related, problem occurs when there are large numbers of people generating an externality, each contributing an imperceptible amount to the problem. An example of this is urban smog caused by auto emissions. Here again, the kind of specific identification that would be necessary in order to implement a solution that is completely consistent with the IIS might be impossible. The problem here though may be more political than technological. Rothbard (1982A) has suggested that this particular problem is exacerbated by the fact that the roads are publicly owned. If the roads were privately owned, the owners, not the drivers, would be held responsible for damage caused by any pollutants emitted from the authorized use of their property. This would encourage the road owners to set emission control standards for automobiles that use their roads. Clearly a major stumbling block to such an approach is that the electorate is unlikely to be willing to accept the wholesale privatization of roads.

Politically acceptable second best solutions that move in the direction suggested here can be developed. A promising approach has been noted by Anderson and Leal. They suggest a “system of tradable pollution permits:”

The point here is that this kind of innovative thinking will be necessary if the Austrian approach to externalities is to become a relevant part of public policy debates.

... economists have moved to the position of advocating effluent charges as a means of meeting politically determined environmental standards at minimum cost. (Orr, p. 57)

That is a far cry from the claim that pollution taxes can be used in a way that will maximize social efficiency. Economists have simply relegated themselves to the role of telling politicians the cheapest way to achieve politically determined goals. As the study of public choice suggests, this becomes advice not on how to maximize “social welfare” but advice on how to maximize the welfare of the politicians, bureaucrats, and special interests that win out in the political decisions-making process.

An issue that has been left, in large part, open in this book concerns the origins of institutions, such as police and courts, that are necessary for the establishment and maintenance of the IIS. In other words, the analysis presented here does not automatically lead to a justification of the state-even a minimal state. As discussed in Chapter 4, orthodox market failure and public goods theory, while purporting to provide such a justification, actually does not. Standard public goods theory and the analysis of free’ rider problems implicitly must assume that property rights and the right to make contracts exist, but for certain other reasons-free riders, non-excludability, etc.--some exchanges that “should” take place do not. In other words, while claiming to provide a justification for the state, some institutions with the capability of establishing property rights must already exist for analysis to proceed. In order to talk about transaction-cost problems, which are at the root of all public goods issues, if not all externalities problems (see Coase, 1960), one must assume that people have the right to transact.

Whether a coercive state should or should not exist to set up, maintain, and enforce the IIS is not a question that a theory of externalities or even efficiency can answer. One can only talk about catallactic efficiency within the context of a catallaxy. Therefore, some sense of private property and some form of rights and contract enforcement are necessary pre-conditions of the analysis.

Surely, economists have not proven in any empirical sense that institutions such as police and courts, either criminal or civil, would not arise without coercive state intervention. Recent work by Bruce L. Benson (1990) suggests that the standard arguments are, in fact, not borne out historically. Benson researches and reveals case after case where everything from the establishment of property rights to their enforcement and adjudication have arisen completely from voluntary cooperation, without the presence of state intervention or even the existence of a state.

Benson’s research has profound implications from the perspective of the theory presented in this book. Catallactic efficiency does not necessarily provide a starting point from which one can argue for or against the existence of a state. On the other hand, this notion of efficiency only becomes relevant within the context of a market-oriented society. If a society decides, through whatever process, to invoke catallactic efficiency and the achievement of individually determined goals as a welfare norm, it must also be concerned about establishing the institutions that are necessary for a catallaxy to exist. In fact, this is the issue currently facing citizens in the predominantly non-market societies of Eastern Europe. Certainly the analysis here suggests that the most consistent means of establishing such institutions would be through totally voluntary efforts. What Benson has shown is that the traditional economic theory, which suggests that such voluntary solutions could not come about, does not hold up when measured against the historical evidence.

FINAL REMARKS

Modern welfare economics has been developed in such away as to ultimately have very little relevance for real-world policy making. In constructing their model of efficiency economists have abstracted almost completely from the real-world efficiency problem faced by individual human actors. In the market process there are real human beings, not the robot-like “agents” in most economic models, who must cope with the world as it actually exists. To be relevant, welfare economics must take into account the fact that human activity takes place through time. Therefore the pursuit of ends and the formulation and execution of plans is strictly an open-ended process of trial and error. New information is always being revealed. This new information may help to reaffirm our existing set of plans or it may be cause for either minor or radical revision. This is the efficiency problem facing us all, and any theory of social efficiency must spring from a recognition of this fact.

Unfortunately, modern theories of economic welfare, which are based on notions of perfect competition and general equilibrium, completely abstract from the fundamental efficiency problem. What economists have done is constructed a parallel universe that looks very little like the one with which we must cope, and assessed the efficiency problem that would exist in that universe. It is an efficiency problem that can be formalized and mathematized relatively easily. Within the context of this “other world,” neat and unambiguous solutions can be derived for any problem that might arise. Unfortunately, the economist insists that this entire analysis is something more than a mental exercise, and pretends that his parallel universe is actually the world in which we live. Taxes, subsidies, antitrust laws, public utility regulations, etc., all of which very neatly solve problems that arise in the economist’s model, are presented to policy makers without any recognition of the fact that they were developed within a context that bears very little resemblance to the real world.

It is time that economists put an end to this charade. The world of perfect competition has no relevance for real-world policy making, and it should be purged as a foundation for welfare economics. Such a purge would have profound implications for the way economists practice their trade--particularly in public policy-related fields like public finance, law and economics, and industrial organization. The role of mathematics and econometrics would be seriously reduced. The focus of analysis would be taken away from particular market outcomes and placed on the processes and individual activities that have led to those outcomes. As part of this, most public policy analysis would assess the kinds of rules that economic activities must operate under. Even if one does not adopt the particular form of welfare economics that has been presented here, in general this is the nature of the analysis that is appropriate when the “open-endedness” of market activities is fully considered.