Welfare Economics and Externalities in an Open Ended Universe: A Modern Austrian Perspective.

Ford, George S.

The author's stated goal is to develop, within the bounds of Austrian theory, a welfare criterion that can be used to judge and possibly improve economic efficiency when market failure, i.e., externality, exists. The basic tenets of Austrian theory are that a) competition is a dynamic, disequilibrium process, b) utility and costs are subjective and unmeasureable and c) information is always imperfect. Within this framework there can be no useful definition of social costs; there are only individual costs that are purely subjective in nature. Also, any notions of orthodox price-cost deviations are senseless as both value and cost are subjective and interpersonal utility comparisons are not acceptable. One can easily see how the standard Pigouvian and Coasian approaches to externality and welfare are senseless within this framework.

The book begins with an unequivocal denial of orthodox theories of externality and welfare. The first two chapters are devoted to summary and critique of orthodox and earlier Austrian positions on the topic. Cordato adopts theories of economic efficiency (individual) from those of Rothbard and Kirzner. Rather than viewing man as a utility maximizer, the Austrian approach sees man as a goal seeker; efficiency then is judged on the market's ability to disseminate information and allow individuals to better allocate resources to attain their goals. Voluntary exchange, in that it provides information, is viewed as efficient allowing market participants to better pursue their goals. On a grander scale, the welfare criterion, catallactic efficiency, is judged by the extent to which market activity encourages economic efficiency, i.e. the dissemination of information. Rather than searching for a set of optimal conditions there is no end-state to be reached; the process is "open-ended." The author defines an ideal institutional setting (IIS), the cornerstone of which is private property, which best facilitates the discovery of information. Within this IIS framework, individuals are best able to employ resources as they pursue goals. In summary, welfare is enhanced when individuals are allowed to use private property to pursue their goals via voluntary market exchange. The IIS is the ideal state in which this activity can occur. Therefore, policy that moves society toward the IIS is efficient and welfare enhancing. So, deviations from efficient conditions are measured at the institutional level rather than by non-optimal prices and quantities. Public policy need only improve the institutional setting to increase welfare and not make judgments based on inappropriately measured values and costs.

With efficiency and welfare defined, what action is recommended when externalities occur? To illustrate consider Coase's scenario of wandering cattle destroying neighboring crops. The Coasian approach, which is seemingly firmly rooted in property rights, ignores who actually has property rights and instead posits a bargained solution based on the social value of the outputs produced by the two parties. This approach, however, does not enhance catallactic efficiency in that is creates uncertainty as to what rights one has to his or her property--hindering economic exchange by distorting and impeding information dissemination. Cordato's solution merely requires the policy maker to stop the activity creating the externality, i.e., forcing the cattle owner to keep his cows from trampling his neighbors' fields. This solution confirms the property owners' beliefs concerning the delineation of property rights and the ability to use the property to attain his or her goals without interference.

The conclusion that follows is that if property rights are clearly defined policy relevant externalities do not exist. External costs in this environment are corrected simply by stopping the activity generating the externality. Policy relevant externalities only arise when property rights are not clearly defined or transactions costs are high. Interestingly, the author argues that when these policy relevant externalities do exist analysis is beyond the scope of economic theory. Rather, entitlements are an ethical question more than an economic one. This conclusion is somewhat disappointing in that the interesting cases of externalities, for example air pollution, most always result from poorly delineated property rights and/or high transactions costs. Even in Coase's world of defined property rights and zero transactions costs policy relevant externalities would be scarce as they will theoretically be bargained away. Externalities are a property rights-transactions cost problem; any theory incapable of evaluating them as such is a leap backward. In various parts of the book the author suggests that in an Austrian framework transactions cost are inappropriate, public goods are non-policy relevant and free-riding is irrational behavior--an idea which completely disregards the fact that most real-word externalities have public goods characteristics and usually involve high transactions cost preventing effective bargaining. Cordato's approach leaves the economist's contribution to externalities, at least policy relevant ones, void.

While the book is not, and was likely not intended to be, the final word on welfare and externality in an Austrian framework it does provide a good general overview of the Austrian approach to economics. It is an especially useful illustration of how difficult it is to apply such an approach to real world problems in a meaningful and rigorous way. Also, the theoretical and practical shortcomings of orthodox welfare economics are worth an occasional reminder and the Austrians seem determined to provide that valued service. However, Baumol |1~ notes that despite the imperfections of orthodox approaches to externalities they are still "the most promising means available to regulate many of our externalities problems." Even after Cordato's notable attempt to improve externality theory, Baumol is, most likely, still correct.

References

1. Baumol, William. Review of Buchanan (1969) Cost and Choice, in The Journal of Economic Literature, 1970, p. 1211.