Measurement Costs and Economic Calculation

In a previous post, I attempted to demonstrate how transaction costs—the costs of defining and enforcing property rights—modify and enrich the standard (and important!) Econ 101 analysis. In this post, I want to show how transaction cost analysis benefits from incorporating the most important Austrian contribution to economic science: economic calculation. What follows provides a practical example of how Austrian and transaction cost analysis can complement one another, as many scholars have argued they ought.

 

Measurement Costs and the Organization of Markets

Transaction costs arise when exchanging parties take steps to mitigate the threat of opportunistic behavior. As Barzel notes, a buyer has an interest in inspecting a good’s “attributes”—its size, quality, freshness, color, or similarity to other units—in order to verify that what is given up in exchange is perceived as less valuable than what is gained. (Resources that consumers perceive as having different attributes are different goods in the Mengerian approach). However, “measurement” of a good’s attributes is costly. The “problem” with measurement is that its costliness, unlike the money price, does not accrue to the exchange partner’s benefit. Relative to a perfect, Nirvana world where measurement is unneeded, measurement costs are pure waste! This suggests that buyers and sellers could affect exchanges at a higher net price if they could agree to a low-cost means of rendering measurement activity superfluous. Sellers would gain by receiving a higher money price; buyers would gain if the increase in the money price is less than the reduction in measurement costs. How then can exchange partners reduce measurement costs and enjoy these gains?

One possibility is for sellers to do something which makes it in the buyers’ best interests to refrain from expending resources on measurement. Perhaps counterintuitively, one way to achieve this goal is to raise a buyer’s cost of measuring, so that less of it is undertaken. Barzel offers a few illuminating examples. DeBeers, once the owner of a large majority of the world’s diamonds, interacts with its distributors only on a somewhat curious, “take-it-or-leave-us” basis. After having assessed a potential diamond dealer’s request, DeBeers will present the distributor with a package of diamonds that roughly matches the description. Next, the buyer is asked to make a choice: Make the purchase or forgo dealing with DeBeers ever again. Instead of seeing nefarious market power inherent in the “take-it-or-leave-us” offer, Barzel argues that this practice reduces the sorting and negotiation costs that buyers would otherwise incur. To convince buyers to consent to such seemingly slanted terms, sellers invest in brand name capital which they forfeit should they behave opportunistically toward buyers. The discipline of continuous dealings therefore constraints potential opportunism. Similar arguments can make sense of the way that perishable food items, such as tomatoes, are packaged and sold.

Barzel extends this analysis by noting that, in some markets, sellers will tend to be the least cost “measurers,” while buyers will tend to be so in other contexts. Under large-scale production of durable goods, for example, buyers will tend to be the least-cost inspectors, since each unit tends to be examined only once—by the buyer when he attempts to use it. In such contexts, sellers usually offer warranties, which reduce the costs associated with each buyer being forced to measure separate units at the point of sale. This lowers the overall costs stemming from measurement and allows the seller to receive a higher money price.

Calculation and the Organization of Markets

During the Socialist Calculation Debate, first Ludwig von Mises and then F.A. Hayek convincingly demonstrated that a consumer-satisfying allocation of resources is impossible under pure socialism, a system where the state owns all factors of production. Without the exchange of productive factors, there are no market prices for them, and without market prices, there is no way to perform profit and loss calculations. Lacking measures of profit and loss, there is no non-arbitrary means of assessing whether a production process has created or destroyed value. According to this argument, an institutional environment characterized by private property rights is necessary and sufficient for capital goods to be continuously re-allocated to their highest valued uses.

Since the original contributions of Mises and Hayek, the calculation argument has been extended (including by Mises himself), most notably to argue that interventionism’s fundamental flaw is that it causes “false” prices to inform economic calculation. More recently, Piano and Rouanet have extended the calculation argument into the organization of markets themselves. Without re-hashing their argument, they show that “primary calculation” occurs within a given set of institutional rules, but that “secondary calculation” governs the decision of what institutional arrangement to adopt. For example, the fundamental Coasean question about whether to use a market or a firm is regulated by secondary calculation.

Along the same lines, in free markets, the decision about whether to implement a measurement cost reducing arrangement is also subject to economic calculation. Certainly, the opportunity to participate in exchanges where the distribution of goods’ attributes is narrower is a benefit to buyers who can spend less time and fewer resources inspecting. Just because something is a benefit, however, does not mean the benefit exceeds associated costs. You may consider an anti-theft device to be a beneficial ad-on when purchasing a car. But if you live in a low-theft region and rarely drive your car into other areas, you may view the benefit of the ad-on to be less than the cost.

Private versus Public

The most important implication of integrating economic calculation with a theory of market organization is that transaction cost arguments do not apply with equal weight to both private and public institutional arrangements. To illustrate this point, I draw on an example that Barzel offers in his 1985 paper, “Transaction Costs: Are They Just Costs?” In discussing institutions which serve to reduce the variance of goods’ attributes and therefore to reduce measurement costs, Barzel writes: “Occupational licensing may serve a similar purpose. Consumers will view licensed professionals as more uniform when some minimum qualifying criteria are imposed. They would spend less on search and would be willing to spend more on the service itself,” (p. 15).

Barzel is contending that licensing necessarily reduces the quality variance among sellers. Buyers, knowing this, expend fewer resources sorting between labor sellers, and therefore pay higher prices for the laborer’s service. Of course, virtually all economists believe that licensing leads to a higher money price, but Barzel here argues that it is lower than the full price, inclusive of measurement costs, that would be incurred without licensing. In Barzel’s approach, the higher price is a boon to consumers because they are simply paying a premium to avoid sorting. Elsewhere in the paper, Barzel makes similar remarks about government interventions which would force grocery stores to remove expired milk from the shelve. Similarly, for Barzel, the American Medical Association’s regulation of doctors reduces physician variance and thus may confer net benefits on consumers.

However, we might wonder if there is there truly symmetry between private institutional arrangements that reduce measurement costs and public institutional arrangements purported to do the same. Barzel moves seamlessly from examples of sellers voluntarily suppressing expiration dates to government occupational licensing. A key difference between the two cases, though, is that private institutions designed to lower measurement costs are subject to profit-and-loss discipline, while publicly imposed constraints are not.

The reduction of measurement costs is itself a goal that demands someone expend resources to achieve it. When resources are devoted to this task, we must ask whether the resources used to achieve this goal might have been used to satisfy other, more intensely desired ends. For example, suppose that the measurement costs associated with buying tomatoes are minimized when they are sold in a specialized plastic carton. Further, suppose the benefits that exchange partners receive from this reduction in measurement costs are trivial, but that the plastic used to make the cartons is intensely demanded in some other use. The profit-and-loss system assures that the plastic is bid away from its measurement cost reducing role to satisfy some other end.

This logic is also applicable to the labor market example that Barzel supplies. In an unhampered labor market, there would likely be a larger range of quality among labor sellers than in a market restricted by licensing. Yet, an entrepreneur who perceives gains from reducing measurement costs could introduce a new institutional configuration in the form of (say) an association which certifies the quality of its members’ work. Another solution is individual certification by a third-party. In both cases, measurement costs are reduced, as buyers can come to rely on the brand name of the association or the third-party certifier. However, such arrangements will only arise if consumers value the reduced variance in seller quality sufficiently to pay the higher price that comes with “association” or “certified” labor.

Additionally, the reduction of measurement costs is clearly not the singular objective of exchange parties. Yes, some sellers may find it profitable to suppress information about expiration dates, while relying on reputation to assuage suspicions of their opportunism. Other sellers, of course, find that the benefits consumers derive from knowing this information outweigh the gains associated with reducing measurement costs. Which consideration ultimately prevails in any given context can only be determined in the presence of profit and loss feedback.

It follows that a persistent private institutional arrangement that reduces measurement costs can be taken as evidence that it confers net benefits. If it did not, firms employing this technique would earn losses and be forced to implement an alternative arrangement. The same cannot be said of public policies that reduce measurement costs. They may confer net losses on market participants yet persist because the public agency operates in the absence of disciplining losses. For examples of persistent public institutions, which nonetheless failed to achieve even their stated ends, see here.

Ultimately, the notion that occupational licensing works to benefit consumers by shrinking labor market variance is a subset of the idea that the state’s primary role is to reduce a society’s transaction costs. Certainly, more exchanges will occur should the state depress transaction costs. This is because transaction costs are a “brake” on the number of mutually beneficial exchanges which can occur. To point this out, however, is only to note that transaction costs are like all costs in this regard. Costs are barriers to action. If the state subsidized steel production, we would doubtless consume more steel, yet no economist reasons from this fact alone to conclude that steel subsidies are therefore justified. By the same token, transaction cost reducing innovations ought themselves to be left to the realm of economic calculation—if our goal is the most efficient use of society’s scarce resources.

 


Caleb Fuller is an assistant professor of economics at Grove City College and a faculty affiliate at the Program on Economics and Privacy.

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Zico and Ammo under Price Controls

In the current shortage economy, why are some goods are in shortage (in the economic sense: none available at the on-going price), others are simply not produced (intensifying the shortage), and some others (I’ll consider the case of ammunition) are produced as needed and sold at higher prices in violation of the states’ “price gouging” laws or the federal Defense Production Act?

To answer this question, it is necessary to understand the economic concept of shortage, as opposed to a blob intuition (I call it “smurfage”) encompassing all situations where somebody does not have something that he would like to have, but not necessarily more than something else.

In another post, I mentioned many ways in which producers—incentivized by consumers who bid up prices instead of having nothing—can stealthily increase prices (see “Why Shortages Are Not More Widespread,” August 17, 2020). One way is for producers to limit the diversity of their offerings, reallocating production to higher-margin products. Another example of that was provided by the Wall Street Journal a few days ago (“Coca-Cola to Discontinue Zico, May Drop Coke Life,” October 4, 2020).

Like many social planners at heart, Bernie Sanders and Donald Trump don’t understand how product diversity is efficient when it corresponds to consumer demand backed with money. Sanders declared:

You don’t necessarily need a choice of 23 underarm spray deodorants or of 18 different pairs of sneakers…

In the same mode but for other reasons, Trump said, in his typical baby talk:

I see people buying five dolls for their daughters, maybe buy two dolls for their daughters…

Ways of satisfying consumer demand when government edicts (price controls or political allocation of available supplies) interfere include the black market or, when repression is haphazard and irregular, the grey market. This appears to be the current situation in the retail market for ammunition. As one can easily check online, established ammo retailers charge prices close to pre-control levels but, most of the time, the products are “out of stock” and the shelves, even online shelves, are bare. This market, however, is very competitive with many online competitors who are apparently willing to risk government suits or prosecutions, don’t have a politically-correct reputation to maintain, and charge what the market will bear. Consumers who need ammo for self-defense, shooting, or hunting can thus get some at higher prices—but, needless to say, they remain free to benefit from low government-capped prices and have nothing to buy.

To give an example of the phenomenon, take 9mm cartridges, the most popular caliber for semi-auto pistols. You can easily check at any large retailer that 9mm ammo is still priced at roughly (or discreetly more than) pre-control prices: around $12 for a box of 50 cartridges used mainly for target shooting and twice that price for 20 premium self-defense cartridges. You can also check that on the grey online market, these prices are now much higher—typically about five times more, when they do have the ammo in stock. It is not perfect but it’s better than to have no choice at all.

Note that there is less diversity on this grey market than there used to be on the white market. One reason is that the established manufacturers of ammo are still forbidden to “price-gouge” the retailers and thus have presumably reduced the diversity of their production.

One interesting question is, Why do government prosecutors close their eyes to gray-market suppliers who offer ammunition at market-clearing and illegal prices? One hypothesis would that the government loves gun owners and rednecks, on whom the electoral fortune of the current administration may hinge. By allowing ammo prices to rise up to their market-clearing level, government prosecutors at least allow gun owners (and hunters) who need ammo more urgently to bid up prices; otherwise, long and haphazard queues would be the only hope. Of course, this hypothesis does not make sense as these same governments claim that laws against “price gouging” favor the consumers! Moreover, there are more than 40 state attorney generals who are supposed to enforce “price gouging” laws, a sizeable proportion of whom don’t like private gun owners at all.

The opposite hypothesis—that governments hate private ammo buyers and do not mind throwing them in the jaws of price gougers—does not make more sense.

One explanation of this strange government tolerance for the grey ammo market is consistent with what classical liberal and libertarian theorists have demonstrated. When a government tries to control prices and allocate goods (like in the current emergency), it cannot respect the abstract and impartial rule of law; it has to arbitrarily discriminate among people and treat them unequally. Moreover, government planners are seldom efficient because they have little incentives to be and because they lack the knowledge necessary to control a vast, diversified, and complex economy. Arbitrary interventions and prosecutions also come from the difficulty and cost of going after everybody breaking the law: the personnel of state attorney generals is not infinite and their employers are broke.

We are getting a glimpse at why, in a government-controlled economy, nothing works. The less government-controlled the economy is, the better things work.

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Zico and Ammo under Price Controls

In the current shortage economy, why are some goods are in shortage (in the economic sense: none available at the on-going price), others are simply not produced (intensifying the shortage), and some others (I’ll consider the case of ammunition) are produced as needed and sold at higher prices in violation of the states’ “price gouging” laws or the federal Defense Production Act?

To answer this question, it is necessary to understand the economic concept of shortage, as opposed to a blob intuition (I call it “smurfage”) encompassing all situations where somebody does not have something that he would like to have, but not necessarily more than something else.

In another post, I mentioned many ways in which producers—incentivized by consumers who bid up prices instead of having nothing—can stealthily increase prices (see “Why Shortages Are Not More Widespread,” August 17, 2020). One way is for producers to limit the diversity of their offerings, reallocating production to higher-margin products. Another example of that was provided by the Wall Street Journal a few days ago (“Coca-Cola to Discontinue Zico, May Drop Coke Life,” October 4, 2020).

Like many social planners at heart, Bernie Sanders and Donald Trump don’t understand how product diversity is efficient when it corresponds to consumer demand backed with money. Sanders declared:

You don’t necessarily need a choice of 23 underarm spray deodorants or of 18 different pairs of sneakers…

In the same mode but for other reasons, Trump said, in his typical baby talk:

I see people buying five dolls for their daughters, maybe buy two dolls for their daughters…

Ways of satisfying consumer demand when government edicts (price controls or political allocation of available supplies) interfere include the black market or, when repression is mild or irregular, the grey market. This appears to be the current situation in the retail market for ammunition. As one can easily check online, established ammo retailers charge prices close to pre-control levels but, most of the time, the products are “out of stock” and the shelves, even online shelves, are bare. This market, however, is very competitive with many online competitors who are apparently willing to risk government suits or prosecutions, don’t have a politically-correct reputation to maintain, and charge what the market will bear. Consumers who need ammo for self-defense, shooting, or hunting can thus get some at higher prices—but, needless to say, they remain free to benefit from low government-capped prices and have nothing to buy.

To give an example of the phenomenon, take 9mm cartridges, the most popular caliber for semi-auto pistols. You can easily check at any large retailer that 9mm ammo is still priced at roughly (or discreetly more than) pre-control prices: around $12 for a box of 50 cartridges used mainly for target shooting and twice that price for 20 premium self-defense cartridges. You can also check that on the grey online market, these prices are now much higher—typically about five times more, when they do have the ammo in stock. It is not perfect but it’s better than to have no choice at all.

Note that there is less diversity on this grey market than there used to be on the white market. One reason is that the established manufacturers of ammo are still forbidden to “price-gouge” the retailers and thus have presumably reduced the diversity of their production.

One interesting question is, Why do government prosecutors close their eyes to gray-market suppliers who offer ammunition at market-clearing and illegal prices? One hypothesis would that the government loves gun owners and rednecks, on whom the electoral fortune of the current administration may hinge. By allowing ammo prices to rise up to their market-clearing level, government prosecutors at least allow gun owners (and hunters) who need ammo more urgently to bid up prices; otherwise, long and haphazard queues would be the only hope. Of course, this hypothesis does not make sense as these same governments claim that laws against “price gouging” favor the consumers! Moreover, there are more than 40 state attorney generals who are supposed to enforce “price gouging” laws, a sizeable proportion of whom don’t like private gun owners at all.

The opposite hypothesis—that governments hate private ammo buyers and do not mind throwing them in the paws of price gougers—does not make more sense.

One explanation of this strange government tolerance for the grey ammo market is consistent with what classical liberal and libertarian theorists have demonstrated. When a government tries to control prices and allocate goods (like in the current emergency), it cannot respect the abstract and impartial rule of law; it has to arbitrarily discriminate among people and treat them unequally. Moreover, government planners are seldom efficient because they have little incentives to be and because they lack the knowledge necessary to control a vast, diversified, and complex economy. Arbitrary interventions and prosecutions also come from the difficulty and cost of going after everybody breaking the law: the personnel of state attorney generals is not infinite and their employers are broke.

We are getting a glimpse at why, in a government-controlled economy, nothing works. The less government-controlled the economy is, the better things work.

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Impoverishing Economic Illiteracy

Last week, for the Nth time, the Wall Street Journal had a story about shortages of Covid-19 tests ( “Covid-19 Testing Is Hampered by Shortages of Critical Ingredient,” September 25). An important topic. The journalist notes:

According to a survey last month by the American Association for Clinical Chemistry, which represents commercial, hospital and public-health laboratories, 67% of labs are having issues getting both reagents and test kits—the highest level since the group started querying labs in May.

Shortages of test kits have persisted for seven months. And there is apparently no explanation in sight. The president of the Riverside Health System in Virginia, Dr. Michael Dicey, echoes the general puzzlement:

This is a big country, and we still haven’t been able to settle the testing issue. It doesn’t make any sense.

In fact, it makes a lot of sense for anybody who knows something about economics—and does not push it under the rug for ideological reasons. During these seven months, prices of most goods produced in America have been under the legal threat of states’ “price gouging” laws and of the federal Defense Production Act. The latter does not formally control the prices of testing supplies, but the federal government has been doing it indirectly through the FDA, the CDC, and a few commissars who control the allocation of many Covid-19 related products. Among them are Peter Navarro, the so-called “equipment czar” (“‘This Is War’: President’s Equipment Czar to Use Full Powers to Fight Coronavirus,” Wall Street Journal, March 28, 2020), Admiral Brett Giroir, the “testing czar” (“Trump’s Covid-19 Testing Czar Claims Administration Is Doing ‘Everything That We Can Do’ to Increase Testing Capacity,” CNN, August 14, 2020), and Moncef Slaoui, the “vaccine czar” (“Trump Vaccine Czar Will Not Be Required to Disclose Pharma Ties, IG Rules,” The Hill, July 17, 2020).

The Soviet Union was also a big country and they too were unable to settle similar issues, such as shortage of automobiles, pharmaceutical products, or bread. It took between 8 and 12 years for an ordinary citizen to take delivery of a car after he ordered it. Shortages also hit pharmaceutical products; a New York Times story of 1977 (“Soviet Medicine Mixes Inconsistency with Diversity”) gives many examples. Another New York Times story, published a few years later, focussed on food shortages (“Soviet Food Shortages: Grumbling and Excuses,” January 15, 1982; OCR errors corrected):

The situation in late summer looked so bleak that the Kremlin began a nationwide campaign for the conservation of bread, and there are many cities and towns where bread purchases are restricted. …

In Moscow there is de facto rationing, limits set by store managers on the quantities that shoppers can buy. …

For years, top Soviet officials have attributed the nation’s poor agricultural performance to bad weather, and the leadership’s official New Year greeting to the people this year again stressed the climatic blight.

Legion of examples are available.

Strangely—for those who ignore standard price theory—shortages persisted until the whole system crashed. It was not because of a lack of commissars. Could the situation, by any chance, have something to do with the substitution of government allocation for free-market prices? And is it possible that what does not work in the United States right now is also, on a lower scale, the consequence of government interference in prices and allocation? Economic theory and observations strongly point to a positive answer.

The efficiency of decentralized markets and free prices in the allocation of resources was first clearly demonstrated by Adam Smith in his 1776 classic The Wealth of Nations. The invisible hand of voluntary cooperation works better than the visible fist of the state. (The featured image of this post shows Smith’s statue in Edinburgh.)

The well-known story reported by Philip Coggan in his recent book More (which I review in the current issue of Regulation) illustrates the incapacity of the collectivist mind to understand or to acknowledge that decentralized and free markets are more efficient than government price controls and allocation:

In the aftermath of the Soviet Union’s break-up, the economist Paul Seabright was contacted by a Russian official who was keen to learn about the workings of the markets. “Tell me, for example,” he asked “Who is in charge of the supply of bread to the population of London?”

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Do Externalities Matter for Economic Analysis?

In the analysis of market processes, the concept of externalities has long invoked strong public policy implications among economists regarding the role of government in addressing their alleged presence, or lack thereof.

It is for this reason that analyses of externalities have preoccupied economists, at least since A.C. Pigou. The more important question, however, is how do they matter for economics?

 

In an excellent and thought-provoking article recently written by Don Boudreaux and Roger Meiners (2019), they provide a comprehensive overview of the origins of the concept of externality, its evolution, and its classifications. Boudreaux and Meiners put forth a subtle though sophisticated argument that transcends how economists generally arrive at particular public policy implications regarding externalities. My goal here is not simply to summarize their point, but also to provide my own interpretation of their argument.

To summarize the concept briefly, an externality refers to a spillover cost borne by third parties to an exchange. Externalities arise when the market price at which a good is exchanged fails to account for the full cost (in the case of a negative externality) or benefits (in the case of a positive externality) of producing a good. Such costs or benefits are, therefore, not only involuntary, but more importantly, unexpected by third parties to the exchange. Externalities are indicative of a deviation from the ideal of perfectly competitive equilibrium, in which all potential gains from trade have been exhausted. Thus, the resulting “market failure” associated with externalities arises from the fact that “there exists a reallocation of resources, such as a change in the structure of market activities that will enrich society” (Boudreaux and Meiners, 2019, p. 21). This restructuring not only includes an adjustment in market prices to more fully concentrate the costs and benefits of exchange upon the relevant trading partners, but also, more importantly, an adjustment in the assignment of property rights, the exchange of which gives rise to exchange ratios, or market prices, in the first place. I will return to this last point later.

 

The fundamental aspect on which Boudreaux and Meiners focus is not the involuntary nature of externalities, but the degree to which they are expected or not. As they put it, “Externalities exist only when another party’s actions create unexpected spillover effects” (emphasis in original, 2019, p. 29).

Building on Alchian (1965) and Demsetz (1967), Boudreaux and Meiners make clear that property rights “are a bundle of expectations” (emphasis in original, Boudreaux and Meiners 2019, p. 31) about how individuals can choose to use, exclude, and exchange resources. The expectation in a market economy is that property rights allow “harm” to the exchange value of a good or service, but not to its physical characteristics.

Consider a barber who sets up shop in midtown Manhattan, assuming well-defined and enforced property rights, physical impediments to his expected ability to utilize his physical and human capital for providing haircuts constitutes an externality. For example, theft or other physical damage to the barber’s property rights are assumed to be prohibited. But, under these assumptions, he also has – or, as a reasonable person, should have – the expectation that a competing barber may “steal” away his clientele by providing a better haircut, thus reducing his income and the resale value of the capital he employs.

Here is where the concept of externality gets a bit tricky, and why “the term has become nearly meaningless due to its ubiquity,” according to Boudreaux and Meiners (2019, p. 3). Returning to the previous example, suppose that building construction is taking place on 5th Avenue, requiring the use of jackhammers. These jackhammers, no doubt, are a nuisance to the barber, and therefore might impede his ability to provide haircuts in a safe and productive manner. A bad haircut or the slip of a razor blade while shaving a client will result in a misallocation of resources in terms of “too much” building construction and “too few” haircuts and shaves than would otherwise be optimal. Is this indicative of a negative externality? Does this example prove that building construction should be taxed in order for contractors to take into account the noise pollution resulting from construction?

Not necessarily.

The key here is the role of expectations. No doubt, incurring the noise pollution from jackhammering was involuntary if the building contractors did not get the barber’s consent beforehand. However, we can reasonably conclude that when the barber chose to locate his shop in midtown Manhattan, one of the most densely populated islands on earth, he would have expected and anticipated such occurrences. The fact that he nevertheless located there implies that he expects the cost to him of this particular “externality” to be sufficiently low as to not overwhelm the prospect of greater expected monetary income derived from serving a larger and wealthier clientele than if he located in a less populated area outside the city.

 

What does this way of looking at externalities reveal about the welfare implications of the market process?

The fundamental point that Boudreaux and Meiners raise, as I understand it, is twofold. First, market processes are imperfect, meaning always in disequilibrium, and therefore imply that the expectations of individuals will never fully mutually coincide. If economists start in a world of disequilibrium as their analytic point of departure, then expectations about the costs and benefits of individual decision-making are never perfect (see Hayek 1937), in which case the concept of externalities, in an abstract sense, means everything and nothing. This implies, I would argue, that if the concept of externalities is to have any meaning and tractability, it must be grounded in an analysis of the particular expectations that individuals have in time and place. In doing so, it will provide the economist with a richer understanding of the public policy implications that follow from his or her analysis.

Secondly, to admit or to deny the presence of externalities is not analogous to admitting or denying the presence of market imperfection. Admitting the presence of externalities does not necessarily imply the necessity of government intervention. But, the absence of externalities does not necessarily imply Pareto efficiency in the allocation of resources either. It therefore does not follow that embracing one analytical point of departure or the other implies the dismissal of or appeal to government intervention as a corrective.

 

As I’ve written elsewhere, imperfect markets do not imply suboptimality or an inherent flaw as compared to the ideal of equilibrium. Rather, imperfection implies “incompleteness” and therefore that markets are processes incessantly moving towards completion. That completion process is facilitated by greater mutual coordination of expectations, requiring corrections in expectations, which makes market processes necessary to addresses misallocations of resources in the first place! As Boudreaux and Meiners make clear, “nothing said here suggests that the absence of spillovers implies a Pareto-optimal allocation of resources” (2019, p. 30). It simply implies the failure of the conditions of the market process to exist, not the existence of market failure (see Candela and Geloso 2020). “The problem, if one asserts there is a problem, is the structure of property rights” (Boudreaux and Meiners 2019, p. 30).

If I have correctly interpreted Boudreaux and Meiners, the question is not whether or not externalities matter for economists, but when they matter for economics, and how they matter for our analysis.

 

As an example to illustrate and conclude this point, let’s take the example of the solution devised by Julian Simon to the problem of airline overbooking (see Simon 1968). Generally speaking, airlines tend to overbook flights on the expectation that there will be a certain number of cancellations. Airline overbooking can then be reframed as problem of assigning property rights, since it creates a situation in which more than one individual has a claim on an assigned seat. When an airline involuntarily “bumps” an individual to another flight, can we conclude that represents an externality? Again, we must take into the context of time and place.

Indeed, the airline has generated a misallocation of resources through its decision-making. It exchanges a claim to a seat for money with a customer, but by assigning more than one customer to the same seat, there is a potential spillover cost on an individual bumped to a future flight, the full cost of which is not borne by the airline. However, we must conclude in this case that though bumping individuals to a future flight may be involuntary, it is not completely unexpected. Prior to the introduction of Simon’s auction proposal, an individual booking a flight could not rule out the possibility that a flight is overbooked. The anticipation of this possibility by individuals implies that this is not an example of an externality. However, to conclude this is not an externality does not imply this is a Pareto-optimal situation. There is indeed a misallocation of resources, since there are too many claimants to the available seats on a flight. Therefore, there is a profit opportunity to devise an institutional innovation to realize such potential Pareto improvements.

The introduction of the auction solution to the problem of airline overbooking can be understood as private property right solution, and therefore introduces new expectations between the airline and its customers about allocation of property rights. Given the transaction costs associated with correctly estimating the number of cancellations by customers, the introduction of the auction system (whether through a voucher or cash payment) grants all existing claimants to airline seats the ability to exchange, in effect creating private property rights in seats (Alchian 1965). Customers, in effect, not only become buyers of seats, but the auction system allows them to become potential sellers back to the airline in the case of overbooking. This exemplifies the point made by Phillip Wicksteed, namely that the supply curve for a good or service (in this airline seats) is part of the total demand curve for a good or service (see Wicksteed 1914, p. 13). More importantly, the exchange process generated through the auction system not only reduces the transaction costs associated with discovering the individuals with the lowest opportunity cost of moving to another flight (at a particular price that reflects such opportunity cost), it also reduces the transaction cost of economically calculating the minimum price necessary to pay an individual to be moved to a future flight. Such knowledge only arises in the context of the exchange of property rights (see Mises 1920 [1975]), which creates more consistent dovetailing of expectations between individuals.

Thus, the ability to assign private property rights in seats with the introduction of the auction system thereafter creates an expectation that individuals will be compensated if an airline mistakenly overbooks a flight. This brings me to the case of the United Airlines 3411 incident that took place on April 9, 2017, in which a passenger, Dr. Dao Duy Anh, was involuntarily dragged off the flight for refusal to give up his seat. This would seem to be a case of an externality, since the situation represents not only an involuntary cost borne unfortunately by the individual, but also because it was unexpected. Given the expectation that, through the auction system, an individual more willing to give up his or seat could likely have been discovered and paid a lower price than what Dr. Anh would have probably demanded as compensation for the airline’s error in overbooking.

 

Connecting this example back to Boudreaux and Meiners, the point here is that however one approaches this analysis, the existence or non-existence of externalities does not eliminate the fact that airline overbooking was representative of a misallocation of resources. And, the fact that this imperfection in the market process facilitated an institutional innovation to erode an existing inefficiency in the allocation of airline seats did not depend upon whether or not there existed an externality. And yet, the presence of an externality does not automatically presume a market failure, requiring government intervention, but a failure to secure the conditions of the market process, namely the voluntary exchange of property rights, due to government intervention. We can therefore conclude that the unfortunate circumstances that transpired during the United Airlines 3411 incident indicated the presence of a negative externality, but that this was a result of government failing to provide clear expectations about the security and enforcement property rights in airline seats, not a market failure.

 

The focus of analyses for economists, therefore, should not be to look backward at a presumed consistency or inconsistency in expectations between individuals, and then to pass normative judgment on it in terms of its conformity with Pareto-optimality or an efficient allocation of resources. Rather, the economist must always approach each analysis of any state of affairs as “nothing but a seething mass of unexploited maladjustments waiting to be corrected” (Kirzner 1979, p. 119), and focus on the constant adjustments that market processes facilitate in an open-ended world of uncertainty.


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

 

Further References

Candela, Rosolino A., and Vincent J. Geloso. 2020. “The Lighthouse Debate and the Dynamics of Interventionism.” The Review of Austrian Economics 33(3): 289–314.

Hayek, F.A. 1937. “Economics and Knowledge.” Economica 4(13): 33–54.

Kirzner, Israel M. 1979. Perception, Opportunity, and Profit. Chicago, IL: University of Chicago Press.

Mises, Ludwig von. 1920 [1975]. “Economic Calculation in the Socialist Commonwealth.” In F.A. Hayek, ed. Collectivist Economic Planning (pp. 87–130). Clifton, NJ: August M. Kelley.

 

 

 

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Repression of Economic Freedom: The Case of Eggs

There exist some people, usually called “economists,” who have a theory that explains why price ceilings create shortages. Most other people believe that there is no relation between prices and whether shelves are bare or fully stocked. Within this last category, there are those who insist that prices should be prevented from rising when supply decreases or demand increases.

In a recent post (“Why Shortages Are Not More Widespread,” August 17), I wondered why, despite the “price gouging” laws on the books in more than two-thirds of American states (including virtually all the largest ones), shortages were not more widespread; and why prices of meat, poultry, fish, and eggs had been allowed to rise, thereby preventing shortages of them. I wondered if farmers are more immune to the heavy and arbitrary hand of the state.

An article in the Wall Street Journal by agricultural economists Richard Sexton and Daniel Sumner, both at the University of California at Davis, just shed more light on this issue (“New York AG Lays a Rotten Egg,” August 30). At least one large egg producer has been sued. Small farmers, even if they are official favorites of the state, may now yield before the threat they may have thus far ignored.

On August 11, New York Attorney General Letitia James sued Hillandale Farms, a large producer and supplier of eggs based in Ohio, for having “exploited hardworking New Yorkers” and “made millions by cheating our most vulnerable communities and service members.” It committed these horrible sins by letting consumers bid up the price of eggs instead of finding none on what would otherwise have been bare grocery shelves.

New York State’s “price-gouging” law (General Business Law, Section 396-R) states:

During any abnormal disruption of the market for goods and services vital and necessary for the health, safety and welfare of consumers or the general public, no party within the chain of distribution of such goods or services or both shall sell or offer to sell any such goods or services or both for an amount which represents an unconscionably excessive price. …

This prohibition shall apply to all parties within the chain of distribution, including any manufacturer, supplier, wholesaler, distributor or retail seller of goods or services or both sold by one party to another when the product sold was located in the state prior to the sale.

The was amended in June and, as the astute reader may guess, not in order to make it less liberticidal but instead to extend its reach. In the quote above, “or services or both” was added after “goods.”

The petition against Hillandale Farms is presented to the Supreme Court of the State of New York on behalf of “the People,” as if it were some sort of super individual à la Jean-Jacques Rousseau. A few quotes:

The People of the State of New York (“the People”) …

The NYAG [New York Attorney General] on behalf of the People, alleges upon information and belief …

The People repeat and re-allege paragraphs 1 through 67.

In their Wall Street Journal piece, Sexton and Sumner report that “price gouging”—which is part of the economic freedom to respond to price signals—motivated egg suppliers to expand their production capacity, with the result that by late-April, “though demand remained high, prices in New York and nationally returned to pre-pandemic levels.” According to the Bureau of Labor Statistics, egg prices at the retail level are still about 6% higher than in February, but they are down 11% from their April peak. This is what we would expect: if prices are not effectively capped, they will soar in an emergency and, as suppliers try to profit from these higher prices, more production will be forthcoming, which will eventually push prices back down—although not necessarily to their original level if demand remains higher and long-term marginal production cost increases.

The efficiency of letting prices respond to conditions of supply and demand is involuntarily confirmed by the Attorney General’s own charts, one of which is reproduced below, representing the invoice prices of eggs sold by Hillandale to Stop & Go.

One would think that, in “the country of free enterprise” as we used to say, the president would give the Medal of Freedom to Hillandale Farms and other egg producers who made this happen by increasing their production to profit from high prices. (Let’s keep our dreams under control. The current president understands economics as little as the framers of price-gouging laws: he invoked the Defense Production Act precisely to be able to cap the prices of medical goods and PPE, which is why they remain in shortage, contrary to eggs.) The New York Attorney General shows that economics was not her strong field in college or that she has an illiberal conception of the state or that she is willing to say anything—as can be double-checked in two sections of her petition:

50. Hillandale informed the NYAG that its customers have “agreed to” [sic] Hillandale’s pricing practices.

51. To the extent that any such agreements with its customers purport to allow Hillandale to charge unconscionably excessive prices for eggs during an abnormal market disruption, such provisions are illegal, in violation of public policy, and unenforceable under New York law.

The Attorney General might reply that the New York price-gouging law does not forbid a supplier to charge higher prices if his own suppliers charge him more. She claims that Hillandale faced no such higher cost and she is asking the court to force the company to pay her office all egg sales revenues in New York State over and above what they would have been at the prices prevailing in the 30 days preceding its “price gouging.” She is also asking the court to force the company to “disgorge all profits” (among other penalties). How any profit could be left if her first request is granted is another mystery.

She obviously ignores there is always a cost of doing something, which is the opportunity cost of not doing the next most profitable thing instead. The farmer who caters to more hens could instead work elsewhere or take more leisure. And consider that if everybody is forbidden to charge higher market prices (what purchasers are willing to pay) except those who are faced with higher accounting cost, the ones at the beginning of the supply chain—the farmers in our case—will not increase production and shortages will appear and move the chain up to the final consumer. Finally, who trusts government bureaucrats to calculate a private producer’s costs?

Except to those who prefer allocation by government instead of by the market (despite the experience of Venezuela or the Soviet Union), price controls make no sense. (See also my Econlog post “Good Government Greed, Bad Economic Freedom,” August 12.)

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Economics: Prices, Pri-ces, P.R.I.C.E.S.

It is impossible to understand the economy—that is, the economic consequences of individual actions—without understanding the role that prices play or are prevented from playing. This was a crucial scientific discovery of modern times. For that very reason, microeconomic theory used to be called “price theory.” So it is troubling to observe that many of our contemporaries and even many financial journalists ignore that discovery. Even economists tend to forget it when their moral values or virtue signaling is at stake.

An illustration of the problem was given by a Wall Street Journal feature of August 21 titled “Why Are There Still Not Enough Paper Towels?” The role of prices and price controls is nowhere mentioned. The very word “price” only appears twice, mainly from a management perspective: the competition of “Japan’s low-price cars” in the 1970s and the fact that overcapacity “would not allow you to price in a way that meets customer needs.” This last phrase, from P&G’s chief executive, could be read as referring to prices established on free markets, but it is as close as the story comes to prices. Not surprisingly, the report cannot explain why a shortage of paper towels persists:

The United States of America, heralded as the land of plenty, still doesn’t have enough paper towels. … An average of 21% of household paper products were out of stock at U.S. stores as of Aug. 9

The story’s “economic” explanation is essentially that

[t]he scarcity is rooted in a decadeslong quest by businesses at all levels, handling many different products, to eke out more profit by operating with almost no slack.

In other words, the culprits are bad capitalists who are trying to maximize profits with tricks such as lean manufacturing and just-in-time delivery. The authors do not conclude, but they could as well have concluded, that this is why so few shortages exist under communism and socialism, in Cuba or Venezuela, not to mention the former Soviet Union.

The real reason for persistent shortages, as I explained in many recent Econlog posts (including “Why Shortages Are Not More Widespread,” August 17), is that prices are capped under the threat of government prosecution. It is that consumers are forbidden to bid up prices. It is that bad capitalists are forbidden to maximize profits to respond to consumer demand, except sometimes stealthily. Being an obedient government crony is becoming an easier path than serving consumers.

The featured image of the present post is a photograph I took last week of the gun counter at a major retailer in Maine. It illustrates what a “land of plenty” looks like when price adjustments along supply and demand curves are forbidden.

The Wall Street Journal story has some feebly redeeming value. It provides many examples of why marginal cost increases with production. It hints at the fact that reducing product diversity has been a stealth way of responding to consumer demand despite price controls. But as a purported explanation of why shortages persist, it is at best misleading.

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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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Cost and the Agony of Choice

I recently had cause to re-read part of James Buchanan’s Cost and Choice, which remains one of the most important treatments of the idea of cost in the history of economics. Chapter 3 of the book is the core of his argument and it lays out an important distinction that is often overlooked in other treatments of cost.

 

Buchanan starts with a methodological distinction between what he calls the “predictive theory” of orthodox economics and the “more general theory of choice.” In a move that can be found elsewhere in his work, Buchanan understands the predictive theory to be the equilibrium models that populate much of formal economics. Those are based on two key assumptions. First, humans are homo economicus, concerned with maximizing utility or profits. Second, they have all of the relevant knowledge necessary to engage in that maximization process. That is, meaningful uncertainty is absent.

If all of the conditions of the predictive theory hold, we can, indeed, predict what people will do facing a particular set of data. As Buchanan notes, in this world, “Individuals do not choose; they behave predictably in response to objectively measurable changes in their environment.” Another way to put this is that if an actor is assumed to maximize utility and that person knows all that is necessary to fill in their utility function, what they will “do” is not a choice. It is simply implied by the maximization assumption combined with those particular data. As we teach in intro, when you know your cost curves and your revenue curves, and are assumed to maximize profits, you don’t “choose” the price and output combination in any meaningful sense of the word. That combination is the logical implication of the location of those curves. Utility and profit maximizers in the predictive theory stand there and can do no other.

The simplest way to see the distinction between the predictive theory and the more general theory of choice is a bit of introspection. When real humans actually make choices, we feel the “agony of choice” that is utterly absent from the predictive theory. Which entrée should I order at the restaurant? Which college should I attend? Which medical treatment should I adopt? All of these choices involve an internal struggle over assessing the costs and benefits and thinking through alternatives, and imagining future regret. The discomfort we experience when facing genuine choice is the result of conflicting goals we might have and the structural uncertainty that is the human condition. Those are all absent in the predictive theory where there are no alternatives to the outcome implied by the data given the maximization and knowledge assumptions.

In the more general theory of choice, human actors are not assumed to only care about pecuniary concerns and they face genuine uncertainty about the future. As Buchanan puts it, in the predictive theory, “cost is reckoned in a commodity dimension” while in the theory of choice it is “reckoned in a utility dimension.” The assumptions of orthodox theory allow us to attach a financial or physical dimension to our understanding of cost, as represented by the marginal cost curves of basic microeconomics. But once we put those assumptions aside, we can only understand cost in utility terms.

This is where Buchanan’s core contribution comes in. What does cost look like in a world where people have multiple goals and are dealing with true uncertainty? Cost in such a world is the actor’s “own evaluation of the enjoyment or utility that he anticipates having to forego as a result of selection among alternative courses of action.” (I would note that it would be more precise to say “want satisfaction” rather than “enjoyment or utility,” especially if “utility” is understood in hedonic terms.) He lays out six implications of what he calls the “choice-bound conception of cost:”

  1. Most importantly, cost must be borne exclusively by the decision-maker; it is not possible for cost to be shifted to or imposed on others.
  2. Cost is subjective; it exists in the mind of the decision-maker and nowhere else.
  3. Cost is based on anticipations; it is necessarily a forward-looking or ex ante concept.
  4. Cost can never be realized because of the fact of choice itself: that which is given up cannot be enjoyed.
  5. Cost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed.
  6. Finally, cost can be dated at the moment of decision or choice.

 

I don’t want to walk through each of these, as I’ve covered many of them in a previous contribution. What I do want to note is that all of these implications derive from the absence of homo economicus and the presence of real uncertainty. This combination makes cost subjective and anticipation-driven. We don’t know for sure whether the steak will be better than the salmon, or whether standard drugs will be better than chemotherapy. Cost is the hurdle we must get over in order to choose. We have to decide that the want we anticipate satisfying by one option is more valuable than what we anticipate from the next best option. That process of weighing those anticipated outcomes is the agony of choice, and it is what is absent from the predictive theory and the standard neoclassical models that emerge from it.

Standard theory might allow us to make predictions about behavior, given its assumptions, but it fails us as a way to understand choice.

Another way to see Buchanan’s contribution is to think in terms of the Austrian idea of discovery and markets as processes of social learning. In the predictive model, there is nothing to discover and there can be no regret. Behavior is implied by the assumptions and the data, and the maximizing combination is always chosen. There is nothing to learn. In the theory of choice, we are always in a process of discovering whether or not the various options in front of us can satisfy our wants in the ways we anticipate. If we choose the steak and it’s not very good, we have learned something for next time we eat at that restaurant. We can experience regret and it can inform future decision making. We learn from our choices and we improve ourselves in the process.

The relationship between cost and real choice Buchanan outlines in his description of the general theory of choice depicts humans who are much closer to the kind of people who inhabit the world of the humanities, and especially the creative arts. They are richly understood humans who experience that agony of choice and face uncertainty about the future. And they are humans who are capable of regret, learning, and improvement. In his essay “Natural and Artifactual Man,” Buchanan writes that “Man wants liberty to become the man he wants to become.” This is a description of the choosing person who inhabits the general theory of choice. The automaton in the predictive theory cannot be understood in those terms.

Whatever the value of the predictive theory, and it certainly has value as a preliminary exercise for understanding economic relationships, it cannot help us to understand genuine choice in a world of uncertainty. And it therefore cannot help us understand the very human experience of the agony of choice, the regret of error, and the joy of learning.

 

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Transaction Costs are the Costs of Engaging in Economic Calculation

This year marks the 100th anniversary of the publication of Ludwig von Mises’s seminal article, “Economic Calculation in the Socialist Commonwealth,” which marked the first salvo in what later became the socialist calculation debate. Though the contributions of F.A. Hayek to that debate, and to economic science more broadly, have been well recognized, what is somewhat forgotten today is that the fundamental contributions of another economist were also born out of the socialist calculation debate. I am referring to none other than Ronald Coase.

 

As Coase outlines in his Nobel Prize Address, he had been a student of Arnold Plant in the Department of Commerce at the LSE, who introduced him to Adam Smith’s invisible hand, and the role that the price system plays in coordinating the allocation of resources to their most valued uses without central direction. The insights of Coase, like Mises, were both motivated from the attempt by the Bolsheviks to implement central planning in Soviet Russia. As Coase writes, “Lenin had said that the economic system in Russia would be run as one big factory. However, many economists in the West maintained that this was an impossibility,” a claim first put forth by Mises in his 1920 article. “And yet there were factories in the West, and some of them were extremely large. How did one reconcile the views expressed by economists on the role of the pricing system and the impossibility of successful central economic planning with the existence of management and of these apparently planned societies, firms, operating within our own economy?” The answer put forth to this puzzle was what Coase referred to as the “costs of using the price mechanism,” (Coase 1992, 715). This concept, which later came to be known as “transaction costs,” was first expounded in his seminal article, “The Nature of the Firm” (1937) and later developed in subsequent articles, “The Federal Communications Commission” (1959) and “The Problem of Social Cost” (1960). But, it is interesting to note that Coase also states that “a large part of what we think of as economic activity is designed to accomplish what high transaction costs would otherwise prevent or to reduce transaction costs so that individuals can freely negotiate and we can take advantage of that diffused knowledge of which Hayek has told us” (1992: 716).

My point here is not to trace the historical origins of the parallel insights drawn by Mises and Coase, or other economists working in the Austrian tradition and the transaction-cost tradition for that matter. Rather what I wish to suggest here is that what Coase (not just Hayek) had been stressing in his insights learned from the socialist calculation debate cannot be fully appreciated without placing his contributions in the context of what Mises had claimed regarding the problem of economic calculation. Reframed within this context, I would argue that the concept of transaction costs can also be understood as the costs of engaging in economic calculation. However controversial my claim may seem, this reframing of transaction costs as the costs of associated with economic calculation has a precedent that can be found not only in Coase, but also in more recent insights made by economists working in the Austrian tradition (see Baird 2000; Piano and Rouanet 2018).

How do transaction costs relate to the problem of economic calculation? According to Coase, the most “obvious” transaction cost is “that of discovering what the relevant prices are” (1937: 390). The costs of pricing a good (i.e. transaction costs) are based, fundamentally, on the costs of defining and enforcing property rights in order to create the institutional conditions necessary for establishing exchange ratios, hence prices, in the first place. This also entails not only cost of negotiation and drawing up contracts between trading partners, but also discovering who are the relevant traders partners are, as well as discovering what are the actual attributes, such as quality, of the good or service being exchanged.

Carl Dalhman (1979) argues that all such transaction costs can be subsumed under the umbrella of information costs, but the nature of such information is not one that can be obtained only through active search per se, as if all such information is already “out there” and therefore acontextual. Rather, the very nature of such information is not just tacit and dispersed (Hayek 1945), but contextual (see Boettke 1998). The discovery of relevant trading partners, the valuable attributes of a good being exchanged, and the price to which trading partners agree, emerges only within a context of exchangeable and enforceable private property rights. This last point is precisely the argument that Ludwig von Mises had meant in his claim that economic calculation under socialism is impossible! Outside the context of private property, subjectively held knowledge cannot be communicated as publicly held information without first establishing the terms of exchange in money prices to allocate resources to their most valued uses.

In his Presidential Address to the Society for the Development of Austrian Economics, published in The Review of Austrian Economics as “Alchian and Menger on Money,” Charles Baird (2000) best illustrates the point I’m making here. Carl Menger (1892) and Armen Alchian (1977) had made distinct, though complementary stories as to why money emerges spontaneously, namely to reduce transaction costs. Menger argued that money emerges to avoid the costs associated with the double coincidence of wants between exchange partners. On the other hand, Alchian emphasized that money emerges to reduce the costs of calculating and pricing the value of the various attributes of a good, such as in comparing the quality of different diamonds. Money prices reduce the costs of pricing the quality of diamonds, thereby providing information, discovered by middlemen, to non-specialists about what kind of diamond they are purchasing (i.e. higher quality or lower quality). As Baird writes, “Menger’s story is incomplete. But so, too, is Alchian’s. On the other hand, both stories are complete on their own terms. Clearly what is needed is someone to put these two stories together” (2000: 119). Thus, reframing transaction costs from an Austrian perspective, money, firms and other institutional arrangements emerge to reduce the costs associated with economic calculation.

In a lecture written to honor F.A. Hayek in 1979, later published posthumously in The Review of Austrian Economics, James Buchanan boldly declared the following: “The diverse approaches of the intersecting schools [of economics] must be the bases for conciliation, not conflict. We must marry the property-rights, law-and-economics, public-choice, Austrian subjectivist approaches” (Buchanan 2015: 260). The link that “marries” these distinct schools, including the Austrian School, is the notion of transaction costs. However, this underlying link cannot be understood without first reframing, I would argue, the concept of transaction costs as the costs of engaging in economic calculation. The “marriage” of these intersecting schools, as Buchanan and others have suggested, highlights distinct aspects of the economic forces at work in the market process, as well as the alternative institutional arrangements that emerge to reduce the cost of transacting and thereby exploit the gains from productive specialization and exchange.

 

 


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

 

 

References

Alchian, Armen A. 1977. “Why Money?” Journal of Money, Credit and Banking 9(1): 133–140.

 

Boettke, Peter J. 1998. “Economic Calculation: The Austrian Contribution to Political Economy.”  Advances in Austrian Economics 5: 131–158.

Buchanan, James M. 2015. “NOTES ON HAYEK–Miami, 15 February, 1979.” The Review of         Austrian Economics 28(3): 257–260.

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 & Economics 2: 1–40.

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

Dahlman, Carl J. 1979. “The Problem of Externality.” The Journal of Law & Economics 22(1): 141–162.

Hayek, F.A. 1945. “The Use of Knowledge in Society.”

Menger, Karl. 1892. “On the Origin of Money.” The Economic Journal 2(6): 239–255.

Mises, Ludwig von. [1920] 1975. “Economic Calculation in the Socialist Commonwealth.” In F.A.     Hayek  (Ed.), Collectivist Economic Planning (pp. 87–130). Clifton, NJ: August M. Kelley.

Piano, Ennio E., and Louis Rouanet. 2018. “Economic Calculation and the Organization of     Markets.” The Review of Austrian Economics, https://doi.org/10.1007/s11138-018-0425-4

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