Externalities

My last post on Social Planning did not address the issue of externalities as well as I would have liked so I decided to write some more on it.

For the first part of the arguement, consider the example of a lighthouse from George Reisman’s book Capitalism: A Treatise on Economics (pdf version available here. Note: I have not read it fully). A lighthouse benefits all the ships that use its light whether their owners have paid for the construction and maintenance of the lighthouse or not. So there is no immediate incentive for any individual shipowner to pay. In such cases, it is claimed that lighthouses will be under produced. Reisman writes that ship owners could make their payments contingent on the payment of a sufficient number of other ship owners’ payments thus creating an incentive for everyone who wants a lighthouse to pay for it. These kinds of solutions do not figure in economic models based on the assumption that individuals act to maximize their utility, with no consideration for what effect their acts have in a wider context. This is simply not true. How would such a model explain the existence of this blog, activist groups, charities etc? Man is not homo-economicus. He is capable of a wider understanding of the world. Stripped of all the mathematics, the externalities arguement is essentially a claim that men are too short-sighted to act for their long term good. It is ironic that proponents of social planning use economic models based on short-sighted decision making to “prove” that the free market must fail and then use this “proof” to argue that people should elect a government which will magically not be hampered by short-sightedness. How do the votes of millions of short-sighted men result in an elite group that is not short-sighted? The fact is that governments voted into power by short-sighted men are far more short-sighted than any of the voters. Witness the incredible spending sprees that governments around the world are indulging in, with no thought of who, when and how will create the goods to support all the extra money being created and what will happen to the economy when the money is finally presented for consumption. Witness the fact that the liabilities of all social support programmes keep on increasing.

Secondly, as I mentioned briefly in my previous post, the solution suggested by the proponents of social planning – taxing/subsidizing – necessarily violates the property rights of individuals. Once the government has the power to violate property rights, a different kind of “externality” sets in. Henry Hazlitt describes the process

Special interests, as the history of tariffs reminds us, can think of the most ingenious reasons why they should be the objects of special solicitude. Their spokesmen present a plan in their favor; and it seems at first so absurd that disinterested writers do not trouble to expose it. But the special interests keep on insisting on the scheme. Its enactment would make so much difference to their own immediate welfare that they can afford to hire trained economists and public relations experts to propagate it in their behalf. The public hears the argument so often repeated, and accompanied by such a wealth of imposing statistics, charts, curves and pie-slices, that it is soon taken in. When at last disinterested writers recognize that the danger of the scheme’s enactment is real, they are usually too late. They cannot in a few weeks acquaint themselves with the subject as thoroughly as the hired brains who have been devoting their full time to it for years; they are accused of being uninformed, and they have the air of men who presume to dispute axioms.

Each time such a project gets through, it establishes a further precedent for the violation of rights. This leads to ever increasing government interference until government becomes nothing more than an unstable coalition of special interest groups. The proposed cure for economic “externalities” ends up creating a political “externality”.

Social planning

In a response to a forwarded post, a friend made the following argument (I am putting only its essence and in my own words, since I have not taken permission to make it public)

Market forces can produce outcomes that are worse off for everyone in the system. A social planner can, (in some cases at least) improve on the efficiency of the market. Pigouvian tax is an example.

In his response, he acknowledges that it might be difficult in practice for the social planner to obtain all the information required, but says that it would be very surprising if the social planners actions could never lead to efficiency improvement.

Consider the crux of the argument (emphasized above). There are three aspects to it that should be considered.

1) What are market forces? They are an abstraction that refers to all the judgements made by individuals interacting with each other under some conditions. If one is talking of a free market, these conditions are the absence of any coercion. Note that for the concept of coercion to be clear, a system of property rights (at the very least) needs to be in place (More on this in 3). If one is to prove the statement above (in a mathematical sense, which is what my friend meant), these market forces need to be modeled. This leads to 2.

2) How are choices evaluated? In actuality, every individual evaluates and weighs choices in a unique manner depending on the context of his knowledge, his hierarchy of values etc. This evaluation is neither necessarily rational nor quantitative. Yet if a mathematical result is to be obtained, both the evaluations and the decisions based on these evaluations need to be quantified. The evaluation (sometimes called “utility”) is quantified by assigning a monetary value to every “variable”. The decision making process is quantified by assuming that each individual acts to maximize utility (the sum of the monetary values of the results of all his choices).

3) What is the system? In actuality, the system is the set of laws that determine the kind of interactions that occur among individuals. In the model, this translates to assumptions that certain factors will remain constant over time.

Once these three aspects are modeled, one ends up with a set of equations that can be solved to determine what utility each individual will be able to achieve. The solution represents an outcome. In certain cases, feasible outcomes may exist that are better for each individual. (This usually happens when there are “externalities” which can be considered mathematically as non-linear effects). The most obvious problem with this argument is that it involves a huge number of variables, so man variables that no human (or computer) can solve the set of equations in any meaningful time. That however, is not my argument. My friend already acknowledges this fact and claims (plausibly) that in certain cases, a social planner may find an approximate solution that is still better than the free market one. My arguement is that: The fact that a (mathematically) feasible better solution exists, does not mean that it is possible to achieve in actuality. The reason is that the sort of actions required to achieve the feasible solution change the system (point 3) that was analyzed. In actual terms, such actions necessarily involve violating the property rights of individuals, thus changing the interactions between people, the monetary values they attach to different choices and the strategies they adopt to maximize their values. In plain language, attempts to achieve the “optimum” solution are lost in a host of unintended consequences. The information that says a better solution is feasible exists not with any single individual but with a vast number of individuals. To put that information to use, even if a social planner is able to approximate it, he needs to communicate it to all the people who will need to act on it. But force (and social planning is all about force) is a very destructive way of communicating. Successful communication is done with persuation and persuation is what the free market is all about.

Now consider a much simpler moral argument. Every value that man achieves is a result of using his mind. And the essential requirement for the mind to work is freedom. When man is free to act as his mind instructs him to do and is responsible for the consequences of his actions, his mind works the best. When he is forced to act against the judgement of his mind, his mind becomes passive and he loses the motivation to use his mind (something that never figures in a mathematical model). In the most fundamental sense of the word good, force can never be good for man.

In his response, following my post on propaganda, my friend clarified that what he meant by propaganda was a one-sided presentation of an idea that does not consider all sides of an issue. The moral idea (in the paragraph above) when supplemented with the practical arguments and all the evidence of the past century becomes a fundamental political principle. And there is no other side to the issue left. As I wrote in this post, as long as one is unsure of something and has not integrated ideas into principles, it is good to be circumspect and consider all pros/cons of all sides of an issue. But on issues on which it is possible to have relevant principles, there is only one side. Fundamental principles do not allow any evaluation in shades of gray. Whether I should be free to act on my own judgement or whether I should allow a social planner to force his whims on me or whether I should become a social planner myself is not an issue where I will weigh the pros/cons of the alternatives.

Finally for the sake of completeness, consider the Pigouvian tax/subsidy to correct for externalities. The first point to be noted is that most externalities go away when property rights are properly defined and implemented. And in fact a tax on pollution is actually quite close to what a property-rights solution to the “problem” of pollution would be. As for the subsidy on education, one can just look at the state of subsidised public education in the U.S. to see how it works. Externalities cause problems in model-based economics because they are non linear effects and most models are linear (eg, price = marginal utility) (for the simple reason that non-linear models are untractable). Man’s mind is not a linear device however, and a linear model does it no justice. Just think of the salesman who negotiates a price (= marginal utility?) or the investor who depends on a virtuous cycle where increase in supply creates a non-existant demand to recover his investment.

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