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

In 1978 I was taking a microeconomics course in my masters program at the University of Hartford and we were covering the issues of perfect competition and economic efficiency. At this same time I had begun to familiarize myself with some of the Austrian school economists particularly Hayek, Kirzner, and Rothbard and I was having many very enlightening conversations with Professor Armentano, who was also on the U of H faculty. In the micro class discussions I began to raise all of the arguments against the perfect competition model that I had been reading about in the Austrian literature. The professor in the class, a very patient and tolerant man (in addition to being a fine economist), Professor Bharat Kolluri, listened to my arguments against the standard view of efficiency and then asked, “but what do you have to offer in its place?” I hemmed and hawed and babbled something, but I realized that I had no answer. In a real sense it was Professor Kolluri’s question that ultimately led to this book.

The following semester I took an excellent course in public finance with Professor John Sullivan where this situation repeated itself. This time it was with respect to discussions of externalities and public goods. I realized that, given my developing Austrian perspective, the standard arguments regarding these issues broke every rule in the book, especially those regarding the subjective nature of costs and benefits. On the other hand all my responses were in the form of criticism, I had no alternative to offer.

At that time the only place in the Austrian literature that I could find an alternative theory of efficiency specifically discussed was in a little known and out of print book by Israel Kirzner, Market Theory and the Price System (1963). Here, invoking a strictly Misesian perspective, Kirzner carefully laid out definitions for both individual and social efficiency. I was amazed that this was the only place in the Austrian economics literature that the notion of efficiency was specifically defined (in a way that completely rejected perfect competition I might add) and no one (Austrian or not) seemed to have noticed. Certainly the theory had not been applied to the traditional areas where efficiency is a concern for economists in general. How do we define competition and monopoly? How would externalities, free rider problems, and public goods be viewed in light of Kirzner’s “Austrian” theory of efficiency? These questions inspired me to write a paper for a seminar class in public finance, under the direction of Professor Sullivan, titled “The Austrian Theory of Efficiency and the Role of Government,” which went on to be published in the Journal of Libertarian Studies (1980) and was my first published article. In retrospect, it is clear that this paper was an attempt to respond to Professor Kolluri’s original question.

In my naivete I thought that this article would bring to light Kirzner’s neglected theory and that suddenly Austrians would start invoking the theory everywhere when talking about public policy. As it turned out, the only person who seemed to notice was Professor Armentano who explicitly invoked the theory, citing both my paper and Kirzner’s original 1963 discussion, in his book, Antitrust and Monopoly, which appeared in 1982 (2nd ed., 1990).

As I went on to work on my Ph.D. at George Mason University I continued my interest in efficiency theory and was anxious to take every opportunity to talk about the concept with my professors. At GMU it was Professor Jack High who was most interested in the issue. At the time he was concerned about Kirzner’s concept of coordination which forms the foundation for Kirzner’s theory of social efficiency. It was Professor High who first inspired me to think critically about Professor Kirzner’s approach to efficiency. Many of the issues that I raise in chapter 2 of this book concerning Kirzner’s coordination standard have their roots in these discussions with Jack High. They were also significantly influenced by a paper that Jack had just written for a volume in honor of Ludwig Lachmann, titled “Equilibrium and Disequilibrium in the Market Process” (1986). But while Jack was taking the Rothbardian position that efficiency should be jettisoned from policy analysis, I was still convinced that it was an important concept for Austrians to develop.

From the perspective of this book the penultimate project for me was my dissertation, An Analysis of Externalities in Austrian Economics (1987). Primarily an exercise in the history of economic thought on the issue, this allowed me to sort through the entire issue of efficiency and externalities analysis from an Austrian perspective. The dissertation forced me to identify exactly what Austrians were saying on these issues and more importantly it allowed me to pinpoint the gaps in the analysis. I realized that while Austrians had offered alternative visions of efficiency and welfare economics (Kirzner and Rothbard respectively) and an alternative assessment of externalities, (in Mises and Rothbard) there was no attempt to connect the two. Also, that project made me realize that the concept of efficiency, which must form the foundation of any normative economic analysis of externalities, needed to be reconsidered and overhauled.

All of this has led to this book, especially the theory of catallactic efficiency presented in chapter 3. My hope is that Austrian economists in general reconsider the value of having a strong theory of efficiency as part of their analytical tool kit. I not only hope that, ultimately, we can persuade the economics profession that the perfectly competitive general equilibrium presents a fundamentally flawed perspective on efficiency, but that the disequilibrium world view of Austrian economics offers a more fruitful and relevant context for judging social welfare.