Efficiency and Externalities in an Open-Ended Universe: A Modern Austrian Perspective
Foreword
by Dominick T. Armentano
University of Hartford
Since Adam Smith, economists have been sympathetic to the idea that the selfish pursuit of profit by individuals can enhance the overall economic welfare of society. The easiest way to understand this notion is to assume that when individuals trade and exchange, they tend to give up resources or goods that they value less for resources or goods that they value more. Thus the process of exchange itself may be able to enhance the net welfare of each participating individual and, generalizing to all exchanges, the welfare of society as a whole.
Externalities and Public Policy
There is still much disagreement and debate concerning this general proposition. One of the most important areas of contention concerns the issue of market externalities. Briefly put, not all of the costs and benefits of individual trades are necessarily internalized by the traders. Some benefits and costs may leak off and affect the behavior of other individuals who are not a direct party to the exchange. Political economy has long been concerned about these so-called “neighborhood effects” or “spillovers.” For example, how should the liability for harmful spillovers be determined? How are private production and consumption decisions altered by positive and negative neighborhood effects? And if specific externalities are determined to be socially inefficient, what is the most appropriate public policy to restore market efficiency?
With regard to these issues, Roy Cordato’s new book is both timely and important. Questions of liability and efficiency with respect to negative spillovers are current, cutting-edge public policy issues. In the area of industrial pollution especially, significant private and taxpayer resources have been committed to schemes to redress the “social costs” of alleged environmental degradation. In addition, government agencies and the courts are increasingly regulating private behavior in this area. Thus it is important to reexamine the economic rationale for regulating externalities and whether existing public policy is appropriate.
Market Failure and Catallactic Efficiency
Aside from the specific issue of externalities, this volume is also important because it attempts to provide an alternative paradigm to the conventional neoclassical welfare analysis. Most economists still “do” efficiency and welfare analysis by comparing existing market conduct and performance to conditions that would exist under perfect competition with perfect information. Markets are said to be efficient if market price and marginal cost are equal; if this equality does not hold, however, then markets are said to “fail” (market failure) and this can rationalize remedial public policy.
Now to be sure, the perfectly competitive benchmark has come in for some extensive criticism over the years, especially from Austrian economists. Yet the paradigm has (somehow) managed to survive all of the criticism. One reason for that survival may be that it has been unclear to economists (even Austrian economists) what alternative approach, if any, could replace the standard Pigouvian methodology.
The truly innovative part of Cordato’s book is a spirited attack on the conventional welfare paradigm (including the Coase theorem) and a serious attempt to recast conventional efficiency and welfare economics along Austrian lines. The foundations of the Austrian methodology are individualism and subjectivism. For Austrians, human action must always be understood in terms of individual purposes, actions and goals. And, importantly, the gains or losses associated with individual action must always be considered personal, non-comparable, and non-additive.
These tenets are clear but they have always created a certain ambiguity in discussions of social efficiency or social welfare. Clearly, Austrians reject the conventional efficiency and welfare benchmark since it assumes perfect information, abstracts from time, and makes the end-state equilibrium condition inevitable. Contrariwise, Austrians tend to see competition as a discovery (of information) process that unfolds through time and is inevitably open-ended. In addition, Austrians reject the social cost/benefit methodology since it is based explicitly on illegitimate inter-personal value comparisons and upon aggregation. Yet having acknowledged that the conventional welfare analysis is inherently faulty, it has never been precisely clear what an economist from a subjectivist perspective could say concerning overall efficiency and welfare.
He might, of course, assume that voluntary trade simply increases everyone’s welfare ex ante: but this logic says nothing about the even more interesting ex post situations. Or he might assume that increasing information leads, necessarily, to an increase in the overall “coordination of individual plans” and, thus, to an increase in overall social welfare. But as Cordato argues, it is not obvious that increasing information always increases overall plan coordination; indeed, as the market process “grinds away,” some previously coordinated plans will inevitably become discoordinated. Is there any appropriate perspective, then, for evaluating the efficiency and welfare of the entire market process?
Cordato attempts to solve the riddle by arguing that the efficiency of the entire social order must focus on the institutional property rights framework rather than on any particular market outcome. Since the market process is inherently open ended and never ending, focusing on an end-state equilibrium condition is irrelevant. And since the acquisition of knowledge is the micro-level efficiency problem, assuming perfect information (as conventional analysis does) must be misleading. Instead, social efficiency--or what Cordato terms “catallactic” efficiency--should focus on the extent to which the overall institutional framework promotes or retards the pursuit of individual plans at the micro-level by the traders involved. And this, in turn, will depend greatly upon whether the legal system is able to clearly define and strictly enforce individual rights to property.
Competition, Monopoly, and Regulation
This alternative approach to social efficiency and welfare analysis has broad applications well beyond the issue of externalities. Its most obvious area of application is to questions of competition, monopoly, and antitrust policy. Industrial organization and public policy have long been dominated by Pigouvian welfare analysis and discussions of “market failure.” The structure, conduct and performance of real world firms are always being compared to structure, conduct and performance under conditions of perfect competition. Markets are said to “fail” when price and marginal cost are not equal; or when products are not homogeneous; or when firms make “extraordinary” profits in the “long run;” or when market output is “restricted” from output under perfectly competitive conditions.
The majority of industrial organization economists implicitly assume that individual costs and benefits are objective, comparable, and capable of aggregation. Monopoly is always said to reduce consumer welfare--as if the utility of individual consumers could be totaled into some meaningful aggregate and compared at different points in time. Monopoly is said to enhance the welfare of the producers--as if the utility of the producers could be totaled both before and after some price increase. And finally overall social welfare is said to be reduced by monopoly power--the so-called “dead weight” welfare loss triangle--again as if we could add together the individual (e)valuations associated with any “lost output.”
Policy analysis in antitrust and in other regulatory areas has been derived explicitly from the efficiency analysis outlined above. The legal restriction of business mergers, price discrimination, tying agreements, and especially price-fixing (collusion) all relate directly to efficiency conditions under perfect competition and to Pigouvian cost/benefit analysis. It is interesting to note that the so-called “antitrust revolution” that modestly slowed federal antitrust enforcement in the 1980’s did not seriously challenge the foundations of the conventional efficiency and welfare analysis itself. Indeed, the currently popular “rule of reason” analysis in antitrust is based explicitly on the Pigouvian paradigm.
Seen from Cordato’s perspective, the bulk of industrial organization analysis and the consequent policy pronouncements are totally without scientific foundation. Catallactic efficiency would require that the legal framework encourage individuals to pursue their own goals as consistently as possible. Catallactic efficiency would require that the legal framework facilitate the discovery and use of physical and intellectual property. Thus it would be socially inefficient to have the legal system interfere with individual plan coordination--as antitrust policy generally does--or interfere with the discovery, dissemination, and use of information.
As an example, take the per se prohibition against horizontal price collusion, the most widely supported antitrust restriction. The traditional Pigouvian rationale for the prohibition is that such agreements, if effective, will reduce consumer and social welfare. Even those few analysts who dissent from this position tend to argue entirely within the Piguovian paradigm. They hold either that collusion will lower “costs” or that price and output agreements between competitors will be unstable and quickly “break down.” Despite their differences, therefore, both sides are in conceptual agreement that a “naked” price and output agreement that does not achieve lower costs or does not “break down” must be inefficient and socially undesirable.
From a catallactic perspective the issue of social efficiency would be seen very differently. In the first place it would be impossible to compare the aggregate welfare of consumers (and producers) before and after any increase in price and, thus, impossible to conclude that business collusion reduces social welfare. Second, and more fundamentally, the act of (price) agreement is explicit evidence of social cooperation and plan coordination. A price agreement, like any contract, is simply a “means” that aims to enhance the individual welfare “ends” of the parties involved. In direct contrast to the Pigouvian position, therefore, a price and output agreement that actually accomplishes its objectives is precisely efficient while an agreement that is unstable or “breaks down” is not efficient. Finally, any government policy that either mandates or prohibits any collusive agreement would, itself, contribute directly to market inefficiency.
A thorough-going catallactic perspective would completely transform industrial organization theory and regulatory policy. For instance, all business mergers and all joint ventures would be seen as socially efficient arrangements aimed at achieving some mutually determined business goal; they no longer could be restricted by law in the name of efficiency. In addition, the long-standing industrial organization anxiety over highly differentiated products would be seen as a thoroughly illegitimate quibbling over ends, not means. Finally, the traditional antitrust concern with market share, concentration, and “entry barriers” would be seen as entirely misplaced. Any market share and any degree of market concentration would simply be the necessary outcome of an open market process of voluntary plan coordination. And the only efficiency-relevant entry barriers would be those associated with legal restrictions that prevent opportunities for additional seller/consumer coordination.
The catallactic theory of efficiency would also (finally) allow an unambiguous definition of the concepts “competition” and “monopoly.” Competition--encompassing both rivalry and cooperation--would be seen as an open-ended process of (information) discovery and (plan) adjustment without any legal prohibition. Monopoly (power), in turn, would then be defined as a situation where legal barriers prevent business organizations from discovering and utilizing information or attempting to coordinate their resource and product plans with those of other firms or consumers. Thus (legal) monopoly would still be socially undesirable because it would (still) lower economic efficiency and social welfare.
Does the catallactic perspective leave any role for government regulation in the antitrust area? Not much. The only application of antitrust policy to promote efficiency might involve the use of antitrust against any federal, state, or local legal restrictions that inhibit opportunities for individual plan making among market participants. (Ending state or local cable t.v. legal monopoly would be an example.) These legal restrictions, in the conventional lexicon, are all “restraints of trade” and they all promote market inefficiency. If the bulk of private and public antitrust regulation, itself so destructive of social efficiency, cannot be immediately repealed--as it should be--then at least it might be employed to remove other legal barriers to trade and exchange.
Conclusion
In conclusion, the efficiency and welfare methodology that Cordato proposes can be usefully applied to an examination of policy issues well beyond the question of market externalities. Indeed, it is to be hoped that this book will inspire additional research programs that critically examine other alleged “market failures” while they expand and deepen our understanding of the relationship between property rights and social efficiency.
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Dominick T. Armentano is a professor of economics at the University of Hartford, West Hartford, Connecticut. He is the author of Antitrust and Monopoly: Anatomy of a Policy Failure, Second Edition, (New York and London: Holmes and Meier, 1990) and Antitrust Policy: The Case for Repeal, (Washington: Cato Institute, 1991).
