The Game of Telephone: The Knowledge Problem in Regulation

Why do economists who accept a theory oppose putting it into practice?  For example, I believe global warming is a rather significant problem.  I agree that it is internally consistent that carbon taxes (or some other variation like cap & trade) can reduce carbon emissions to a socially optimal level.  So, why then do I oppose carbon tax regulation?

There are many reasons why I (and many other GMU-style economists) oppose regulation even though a logical argument can be made, it could improve a given situation.  We tend to focus on public choice reasons (such as rent-seeking and agency capture).  The knowledge problem, most famously discussed by F.A. Hayek, is also often cited: government agents can too seldom possess all information and knowledge necessary to regulate desirably and much less “optimally.”

There is an element of the knowledge problem that warrants further attention, an element highlighted by Don Lavoie in his 1985 book National Economic Planning: What is Left? In this book, Lavoie greatly expands our understanding of the knowledge problem and its relevance for assessing central planning and more mundane government regulation.  He discusses Hayek’s formulation of knowledge as mostly tacit, but Lavoie also emphasizes that knowledge is built upon inarticulable foundations.  Attempts to articulate the inarticulate foundations are doomed to fail as each person carries with him or her different nuanced understandings of the language used in legislation authorizing regulations.

Consider, for example, the phrase “2+2=4.”  Understanding the phrase’s meaning requires a tacit, inarticulable understanding of the elements: 2, +, =, and 4.  If one were to try to rigorously define every element in that phrase, he would eventually fall into a problem of recursivity.  As children, when we first encounter mathematics, it may seem weird and arbitrary.  We just learn that 2+2=4 by rote.  It is only through repeated interactions with mathematics do we start to understand it.  To paraphrase the great mathematician John von Neumann, you never really learn mathematics.  You just get used to it.

The problem of inarticulable understandings of knowledge comes into play in the field of regulation.  The economist has a foundation of knowledge.  When he tries to convert that knowledge into policy, we run into a game of telephone.  At each step along the way, the knowledge and information get a little distorted. Each person has different foundations from which they understand the message the economist is delivering.  As such, the end policy would deviate considerably from theory, even if we assume away public choice issues.  In other words, the policy will look considerably different from the theory because of a sort-of language barrier.

Consider, for example, the word “cost” in economics.  We define “cost” to mean what one gives up to take a particular action (it is sometimes called “opportunity cost” for this reason).  Cost is inseparable from choice.  Yet, “cost” takes on a very different meaning for the general public, as it usually refers to a negative consequence (“the cost of reading is a headache”) or the monetary price of something (“the coffee cost me $2”).  Thus, the economist already faces a problem communicating his theory to policymakers.  But even within the field of economics, “cost” has different understandings.  James Buchanan’s excellent short 1969 book, Cost and Choice, discusses how “cost” has changed understandings among the various schools of thought.

I oppose regulation even when I understand the argument because argument and policy are not the same things.  When communicating, experts run into the telephone problem: the theory is misunderstood, misapplied, or miscommunicated.  Competition among experts helps solve these problems, yes, as experts become incentivized to be less wizardly and more like teachers.  But the knowledge problem remains, and regulation can only enhance the communication problems.

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Joe Stiglitz on Taxes

Taxation is unlike most transfers of money from one individual to another: while most other transfers are entered into voluntarily, taxation is compulsory. In Chapter 5 we saw some of the reasons why the contributions to support public services need to be compulsory: because of the free rider problem, unless support for public goods is made compulsory no one will have an incentive to contribute. We showed, in particular, that all individuals might be made better off by voluntarily agreeing to be compelled to contribute to the support of public goods. Yet the ability to compel individuals to contribute to the support of public goods may also provide the government with the ability to compel individuals to contribute to support some special-interest group: the government has the power to force one group to give up its resources to another group. This forced transfer has been likened to theft, with one major difference: while both are involuntary transfers, transfers through the government wear the mantle of legality and respectability conferred upon them by the political process. In some countries and at some times, the distinction becomes, at best, blurred. The political process becomes detached from the citizenry and is used to transfer resources to the groups in power.

This is from Joseph E. Stiglitz, Economics of the Public Sector, Second Edition, 1988. I used the textbook in a policy analysis course at the Naval Postgraduate School in the mid to late 1990s.

I find the order of his reasoning in the above fascinating.

The first sentence makes clear, in no uncertain terms, that taxation is compulsory.

The second sentence is the typical case for taxation to finance public goods, something that he might have learned (if he hadn’t already known and he probably did know) at the knee of his mentor, the late Paul Samuelson. It also contains the standard exaggeration: no one would have the incentive to contribute? I don’t know of any such examples. Even for the economist’s typical example of national defense, if some foreign invader is coming at me, I’m going to defend myself. Is the amount of defense enough? Probably not. But my incentive is not zero.

The third sentence reminds me of James Buchanan when he channeled Knut Wicksell. Buchanan took seriously Wicksell’s idea that the only way to be sure everyone benefited from government spending is to require unanimous consent for every tax/spending program. Of course, in practice this is unworkable, but it’s a good reminder.

The fourth sentence lays out the huge downside of relying on taxes: taxes can be used to redistribute wealth. Indeed, that is the main thing they do in most countries. Here Stiglitz is channelling Public Choice theory.

In the fifth through seventh sentences, Stiglitz is way more radical in an anti-government direction than I ever would have expected.

There’s so much I like about this textbook. I don’t think he would write it even close to the same way today.

 

 

 

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The Role of Sympathy in Policy

It is no great revelation to say that the policy responses to the COVID pandemic varies considerably between Republicans, liberals, and Democrats.  A charitable interpretation of the differences are that Republicans and (classical) liberals are concerned about government overreach, undermining the rule of law, and that the costs of policies far exceed the benefits.  Democrats may be seen as concerned with saving as many lives as possible even if the costs of the policies exceed the benefits.  A less charitable interpretation is that Republicans and Liberals are simply anti-science and that liberty is the only virtue that matters whereas Democrats are merely trying to sneak in socialism on a fearful public.

The split, however, can be understood much more cleanly without trying to speculate on people’s virtues and vices.  According to a recent study, vast differences exist between people’s perception of the COVID virus.  In general, people overestimate the risk of the virus on young people and underestimate the risk on older people (see the first chart in the link).  Democrats tend to overestimate its risk to a greater extent than Republicans do.

Perceptions of the virus filter into people’s evaluations of the costs and benefits of a given policy.  Since economic costs are ephemeral, forward-looking, and subjective, our personal perceptions will shape what we consider the costs to be.  Democrats support more stringent policies and slower re-openings because they perceive the costs to be considerably higher than Republicans.  They likewise overestimate the net benefits of the proposed policies.

 

This is where the role of sympathy comes into play.  Sympathy is a 4-step process.  For the sake of example, consider two people Jim and Mary.  Mary is an observer of Jim’s behavior, but she wants to try to sympathize with him:

  1. First, Mary imagines herself in Jim’s situation as best as she can
  2. She imaginatively experiences sentiments arising from the situation
  3. She then compares her sentiments (what she is feeling from the imagined situation) with the sentiment that Jim appears to be experiencing
  4. She comes to a new sentiment about the agreement or disagreement between the two sentiments (hers and Jim’s). If they coincide, there is agreeableness.  If they do not coincide, there is disagreeableness and disapproval of Jim’s sentiment.

 

Disagreeableness, however, is not a good feeling.  Mary, to improve herself, will examine more closely Jim’s situation.  She may endeavor to learn more about his frame of mind, his perceptions- in short, his local knowledge.  In this effort to sympathize more fully with Jim, Mary may learn new key facts, as well as Jim’s perceptions of those facts, which may bring their sentiments closer into alignment.  Mary may still disapprove of Jim’s sentiments, but she will have a clearer understanding of them and could engage with Jim more fruitfully to shift his perceptions, too.

To bring the story of Mary and Jim from the abstract to reality, Mary may observe Jim opposing COVID lockdowns.  In her initial sympathetic process, she may reject Jim’s opposition.  But, upon further reflection, she may see her own sentiments are based on an incorrect perception of the virus.  She, in turn, alters her sentiments, but can now also engage Jim with sympathy to his concerns about the policy.

The late, great James Buchanan described democracy as “government by discussion.”  Discussion, for it to be fruitful and not simply be a tyranny of majority, must involve sympathy.  A government without sympathy, even if it has the trappings of democracy like majority voting and dispersion of powers, cannot be a liberal democracy.  Legislation without sympathy deserves not the august description of “law.”  We must make efforts to understand the positions, the sentiments, and the perceptions of those whom we disagree with.  We just might find it is us who err.

 

 


Jon Murphy is a Ph.D. student at George Mason University, where he specializes in Law & Economics and Smithian Political Economy. He previously was an economic consultant in New Hampshire.

For more articles by Jon Murphy, see the Archive.

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Ronald H. Coase: Chicago School or Virginia School Economist?

It is not uncommon for Ronald Coase to be identified as a “Chicago School” Economist. For several reasons, this would not be an unfair characterization. First, Coase joined the faculty of the University of Chicago Law School in 1964, and remained there until his retirement in the early 1980s, during which time he had also been the Editor of The Journal of Law and Economics until 1982. Secondly, as a student at the London School of Economics, Coase, like other economists of the Chicago School, had been greatly influenced by the work of Frank Knight, particularly Risk, Uncertainty, and Profit (1921). Although Coase had regarded himself as a socialist in his youth, his training at the LSE under Arnold Plant and his study of the workings of the operation of markets in public utilities, postal services, and lighthouses solidified his free-market convictions, as is often identified with Chicago School economists, such as Milton Friedman, George Stigler, or Gary Becker. Moreover, the tendency for government regulation to serve special interests, rather than the public interest, also affirmed his skepticism of government intervention. It would seem, then, that Coase carried all the trappings of a Chicago economist.

However, as economist Steve Medema has argued, the “relationship between Coase and the Chicago School could be considered a case study in the dangers of assuming some sort of Chicago homogeneity” (Medema 2010, p. 262). Indeed, Coase shared similar public policy conclusions as his contemporaries at Chicago. But to identify an economist by his or her free-market policy conclusions, instead of the methodology by which they arrive at such conclusions, renders indistinguishable the distinction between the Chicago School and the Austrian School, or between Chicago and its intellectual cousins at the University of California, Los Angeles (UCLA), University of Washington, or the University of Virginia (UVA) for that matter.

 

In terms of methodology, I would argue that Coase would be better identified as an economist of the Virginia School, from which Public Choice theory was born at the Thomas Jefferson Center for Studies in Political Economy and Social Philosophy (TJC) at the University of Virginia (UVA) under James Buchanan and Gordon Tullock. Though Buchanan, Tullock, and other faculty members, such as Rutledge Vining and G. Warren Nutter, had been trained at the University of Chicago, what distinction, if any, exists between the “Virginia School” and the Chicago School? Moreover, how can we attribute the distinction of “Virginia School” to Coase?

Though Coase’s own work shares many policy conclusions with that of public choice theorists, particularly skepticism of government intervention to mitigate supposed market failures, the relationship between Coase and Public Choice introduces another danger of homogeneity, since other branches of Public Choice have emerged as well, besides that which emerged at UVA (and later Virginia Tech and George Mason University). These include the “Bloomington School” of Vincent and Elinor Ostrom and the “Rochester School” of William Riker. Moreover, Public Choice was also developed by economists at the University of Chicago, including Gary Becker, Sam Peltzman, and George Stigler (see Mitchell 1988 and Mueller 1976).

 

What I wish to highlight here is a point that Peter Boettke and I have made in paper recently published in Public Choice, titled “Where Chicago Meets London: James M. Buchanan, Virginia Political Economy, and Cost Theory” (2020), in which we argue that the Virginia School of Political Economy emerged from the marriage of subjective cost theory that had been developed at the London School of Economics (LSE) under F.A. Hayek and Lionel Robbins, and price theory from the University of Chicago.

 

The work of Frank Knight had been a cornerstone of the education of students at the University of Chicago and the LSE alike in the pre-WWII era, and Knight had been highly influential in Coase’s education. But whereas price theory at Chicago had been primarily Marshallian, in which costs are taken to be objective, price theory at the LSE had been primarily Wicksteedian, in which supply curves are simply the demand curve of suppliers, and therefore part of the total demand curve for a good or service, the value of which is subjective. In his own recollection of the LSE of the 1930s, Coase remarks that, unlike at Chicago, at the LSE, “Marshall was in the calendar of saints but few of us prayed exclusively to him. Marshall was one among many economists studied”, and goes further to state that, “[i]n fact, we thought his views on cost confused” rather than clarified the analysis of market processes (1982, p. 34).

 

Therefore, what Coase shared with Buchanan and other economists of the Virginia School, which made them distinct from their intellectual cousins at Chicago (see Wagner 2017, 2020), is the fact that they saw opportunity costs not as constraints to which economic actors passively respond, but as variables defined by the act of choice itself. Because of this, Virginia School economists, such as Coase, directed their analytic attention to choice among constraints, and thus saw institutions, organizations, and other contractual arrangements as a by-product of individuals striving to realize the gains from exchange. Virginia School economists therefore took a constitutional perspective, which focuses on analyzing “the rules of game” and how the modification of institutions could generate positive-sum forms of interaction. Therefore, whereas their contemporaries of the post-WWII Chicago School took Pareto-optimality as an assumption that characterizes real-world market outcomes, Coase and the Virginia School understood the conditions of Pareto-optimality to be a by-product of individuals devising institutional arrangements, not only to reduce transaction costs, but also to exhaust the gains from trade.

 

This distinction is best highlighted not only by how economists at the University of Chicago first reacted to what later became known as the “Coase Theorem,” but also how the Coase Theorem is still interpreted today. “The Problem of Social Cost” (Coase 1960) had been written in response to what Friedman, Stigler, Harberger, and other economists at the University of Chicago had perceived as a fundamental error in Coase’s analysis of Pigovian welfare economics, as had been first argued in the “The Federal Communications Commission” (Coase 1959). However, what needs constant reminding is not only that both of these papers were written when Coase was a faculty member at UVA, but also that, at UVA, his ideas were regarded as an evolution of the common knowledge that he, Buchanan, Nutter, and Vining had inherited from Frank Knight. Surprisingly, as George Stigler (1988) recounts in his autobiography, it was among Knight’s former pupils, including Friedman and himself, at the University of Chicago that Coase’s ideas were considered a revolution that overturned Pigovian welfare economics.

 

Though the Coase Theorem has become a cornerstone of law and economics and institutional economics generally, Coase’s central message cannot be fully understood unless we first realize how he understands the nature of costs. As he recounted repeatedly, the Coase Theorem was never meant to direct our attention to a world in which transaction costs are zero. In such a world, markets will have already exhausted all the gains from trade, and institutions are therefore redundant. Rather, what Coase was trying to stress is how positive transaction costs represent future profit opportunities for their reduction, and how entrepreneurs will profit from perceiving a way to reduce transaction costs by devising institutional arrangements, thereby creating the gains from trade.

 

As Coase has highlighted throughout his work, from seminal paper “The Nature of the Firm” (Coase 1937), to his last book, How China Became Capitalist (Coase and Wang 2012), the benefit of institutional and organizational arrangements, such as contracts, firms, money and property rights, are that they reduce the costs of making an exchange (i.e. transaction costs). Costs are not a constraint independent of human choice, but are an artifact of human choice, and therefore can be manipulated by restructuring the payoff structure embodied in institutions through human creativity. It is this understanding of market processes that Coase shared with his colleagues at UVA, and distinguished him from his colleagues that he would later join at the University of Chicago. It is in this respect that Coase should be considered economist of the Virginia School.

 

 

 

 

References

Candela, Rosolino A., and Peter J. Boettke. 2020. “Where Chicago Meets London: James Buchanan, Virginia Political Economy, and Cost Theory.” Public Choice 183(3-4): 287– 302.

Coase, Ronald H. 1937. “The Nature of the Firm.” Economica 4(16): 386–405.

Coase, Ronald H. 1959. “The Federal Communications Commission.” The Journal of Law and          Economics 2: 1–40.

Coase, Ronald H. 1960. “The Problem of Social Cost.” The Journal of Law and Economics 3: 1–44.

Coase, Ronald H. 1982. “Economics at LSE in the 1930s: A Personal View.” Atlantic Economic      Journal 10(1): 31–34.

Coase, Ronald H. and Ning Wang. 2012. How China Became Capitalist. New York: Palgrave Macmillan.

Knight, Frank H. 1921. Risk, Uncertainty and Profit. Boston, MA: Houghton Mifflin.

Medema, Steven G. 2010. “Ronald Harry Coase.” In Ross B, Emmett, ed. The Elgar Companion to the Chicago School of Economics (pp. 259–264). Northampton, MA: Edward Elgar.

Mitchell, William C. 1988. “Virginia, Rochester, and Bloomington: Twenty-Five Years of Public Choice and Political Science.” Public Choice 56(2): 101–119.

Mueller, Dennis C. 1976. “Public choice: A Survey.” Journal of Economic Literature 14(2): 395–       433.

Stigler, George J. 1988. Memoirs of an Unregulated Economist. New York: Basic Books.

Wagner, Richard E. 2017. James M. Buchanan and Liberal Political Economy. Lanham, MD:         Lexington Books.

Wagner, Richard E. 2020. “Chicago Political Economy, and Its Virginia Cousin.” GMU Working       Paper in Economics No. 20-11. Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3597754

 

 


Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and Associate Director of Academic and Student Programs  at the Mercatus Center at George Mason University

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The Opportunity Costs of J. Alfred Prufock

Steve Horwitz and I have been teaching an online class about economics and literature, pairing core economic concepts with literary works that demonstrate those concepts. This past week, we talked with the students about opportunity cost (see Steve’s thoughts on Buchanan’s Cost and Choice here), using Thomas Grey’s “Ode on the Death of a Favorite Cat, Drowned in a Tub of Goldfishes” and T.S. Eliot’s “Love Song of J. Alfred Prufrock” as our literary texts.

Using poetry, I told the students, helps us think about opportunity costs in ways that travel alongside, but are not the same, as the ways that economists think about them. For economists, the important thing is that a choice is made. In the most reductive version of this, the moment of choice, the moment where opportunity costs are weighed, disappears into something called “revealed preference.” A choice is made. Results follow. The economist moves on. For poets, particularly for Eliot, and particularly in “Prufrock,” the moment of choice, the weighing of opportunity cost, is everything.

 

“The Love Song of J. Alfred Prufrock” is five pages of glorious poetry about the moment when we decide that a choice must be made, but we are caught on the tenterhooks of opportunity cost. The poem begins with the speaker inviting himself and us to walk out into the evening with him as he contemplates a life-altering decision. Although the nature of the decision is never directly stated, most readers agree that he is debating whether or not to ask someone to marry him. He decides not to, and the poem ends. The most reductive economic reading of the poem would be to say “Revealed preference. He never wanted to propose marriage anyway. He obviously got what he wanted, because otherwise he would have chosen something different. End of story.”

Horwitz describes James Buchanan as seeing, not “homo economicus” but “richly understood humans who experience that agony of choice and face uncertainty about the future.” This is certainly true when one contrasts Buchanan to the simple predictive choice economics models. But when one has the expansive playing field poetry offers for thought and exploration, there can be even more to the story than Buchanan gives us.

With “Prufrock,” we are invited to travel “you and I” alongside one particular human as he grapples with one particular decision. While Prufock is absolutely considering opportunity costs, his decision process is no sterile totting up of pros and cons followed by a simple choice of the least costly option. 

There will be time, there will be time

To prepare a face to meet the faces that you meet;

There will be time to murder and create,

And time for all the works and days of hands

That lift and drop a question on your plate;

Time for you and time for me,

And time yet for a hundred indecisions,

And for a hundred visions and revisions,

Before the taking of a toast and tea.

 

Opportunity cost, for Prufrock, means a torturous understanding that choices define who we are. Every choice requires that we remake ourselves and “prepare a face” that goes with whatever choice we make. Choices “murder and create” different selves we might be and different lives we might lead. With all that hanging in the balance, no wonder Prufrock finds time “for a hundred indecisions/ And for a hundred visions and revisions.” 

The unrelenting “should I/shall I” constructions of Eliot’s verse help us feel each of those individual moments that make up this thing we call a “choice.” And for Prufock, the actual choice passes almost unnoticed amidst all this debate. “I have seen the moment of my greatness flicker…in short, I was afraid.”

But while most economists would say “That’s the end of the story. Choice made. Preference revealed, moving on,” and while even Buchanan would say “A choice has been made and that experience will carry forward into Prufrock’s future choices,” Eliot shows us that–despite the fact that a choice has been made–the moment of choice is not over for Prufrock. Prufrock, human that he is, cannot stop thinking about it. Indeed, he still seems to be living in that moment of choice.

The poem’s “should I/ shall I” constructions transform into the phrase “would it have been worth it” as Prufrock returns obsessively to the moment of choice, thinking over what he could have done, might have done, did not do. The choice is made, but Prufrock is still endlessly, obsessively making it. The pain of Eliot’s poem comes not only from his obsessive titivating, but from his final realization that he has trapped himself in a world of unending “decisions and revisions,” growing ever older, but never wiser, and cutting himself off from the wonder and beauty he might have found through other choices.

Economists aren’t wrong to shrink the moment of choice to near invisibility. Poets aren’t wrong to expand it until it is so large it might “disturb the universe.” They are using different sets of tools to explore the same questions. We are wrong to think that using only one set–whichever set it is–gives us the real story. 

 

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