Value and the Method of the Free Market Ion Lucian Sterpan , May 2005
Introduction
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The common question
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Different starting points concerning value and cost
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The Marshall criterion for efficiency
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Utility of money as an approximation to utility as such
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The subjectivist approach to value
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Indifference: no definition of action from the 3rd person perspective
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The neoclassical argument for the market
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The public goods problem
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The problem of externalities
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Subjectivism all the way
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Austrian view of efficiency
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The critical method to tackle the problem of knowledge
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Knowledge at the center
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The open-ended character of our valuations
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Power and freedom
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The open-ended character of resources
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3rd order goods
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Introduction The concern of the present essay is the efficiency of the free market and its different conceptualizations. Different approaches to the economic activity will be referred to in the course of the discussion: the neoclassical school, the Austrian approach, the property rights paradigm initiated by Coase at the Chicago School, and some elements of public choice. Some arguments for the free market coming from different schools are construed so differently that an advocate of the market cannot afford listing them without paying attention to the extent to which these different arguments exclude or support one other. A major source of difference between economic schools is the underlying conception about value and valuation. A first concern in this essay is to argue for a subjectivist theory of value and a Popperian view about the nature of knowledge. These two elements incline the balance in favor of the Austrian view. A subjectivist theory if taken by itself also leads to interesting consequences in the field of law.
The common question In order to compare different answers or views, one needs to understand the common question they answer differently, question that should be in principle possible to conceptualize in an unbiased fashion. It might be useful for a moment to imagine the following picture: envision on the one hand our ends or wants, whose fulfillment is a benefit, and on the other, a pool of resources (knowledge, time, money, effort) whose use is a cost. Using our knowledge may be often a pleasant thing to do, but since we might have used it for another purpose at that particular point, the leaving out of that purpose makes it a cost. The common question these views are trying to answer is “What is the task of the economy?”. The problem to be solved by economics has two sides: employ as few resources as possible for the attainment of a given end on the one hand, and on the other, given a certain amount of resources, satisfy as many wants as possible in the order of their preference. The objective is efficiency. The question “How much of what should be produced by whom and to whom should it go?” cannot really pass for a neutral formulation, since the focus on production is more an ingredient of the neoclassical economics, just as “exchange” and “knowledge” are the key elements in an Austrian and market process discourse, and “transaction cost” for the Chicago School.
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Different starting points concerning value and cost That the value of X is the same thing as the valuation of X 1 and that the cost of X is the same as the value of the opportunity cost are assumptions shared by all economists. Thinking about the cost of production of an additional unit of X, the cost equals the value of the most valuable alternative product that could have been produced with the same resources employed in the production of that unit of good X. The cost is the greatest sum that would have been paid by a consumer for an alternative use of those resources. Prices are the best guide for appraising other people’s valuations. For the neoclassic, valuations are taken to be equal with the prices paid for X (this is the principle of revealed preference). The value (for a consumer) of an additional loaf of bread equals the price paid for it by that consumer. For an Austrian however, this equality is inconsistent with the assumption of individual rationality: there is no such thing as an equality of value in an exchange, a voluntary exchange is an evidence for a “double inequality” in valuations: the partners of exchange happen to prefer what the other has to what he has himself, and this is the only reason why they make the exchange. For each of them the cost must be perceived at smaller than the prospected benefit. If this is rationality, then how come the neoclassics did not feel the tension between their assumptions? Actually they did, this is why they have another understanding of rationality than. [Friedman 90] starts his book with the following definition Economics is that way of understanding behavior that starts from the assumption that people have objectives and tend to choose the correct way to achieve them, while Mises starts from “People act.” 2 , without saying anything more about the “correct” means. There is a world of a difference hidden under these two formulations: A subjectivist like Mises cannot say that the means to an end or the cost paid for its attainment is a “correct” one. Once it is a conscious and voluntary affair 3 we are dealing with, then the cost must have been perceived as worth incurring, this is the only acceptable meaning “correct”. That perhaps other people wouldn’t have done it, tells nothing about the “correctness” of these costs.
This is the subjectivity of value. Mises and Rothbard start his treatises by the “axiom of action” No treatment of economic problems proper can avoid starting from acts of choice; economics becomes a part, although the hitherto best elaborated part, of a more universal science, praxeology. [MISES 1949], 3 3 “Action” in the technical Austrian sense is conscious and voluntary. 1
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Meanwhile, the neoclassical reasoning follows these lines: If efficiency is a function of valuations and money prices translate valuations then efficiency can be translated into a function of money prices. In other words, perhaps with the help of some additional assumptions, interpersonal comparisons of utility are easy in principle.
The Marshall criterion for efficiency Marshall’s idea is the classical utilitarian idea made operational by using utility of money to approximate aggregate utility: In principle we could price all of the gains and losses. We could ask each person who was against the change how much money he would have to be given so that on net the money plus the (undesirable) effect of the change would leave him exactly as well off as before. Similarly we could ask each gainer what would be the largest amount he would pay to get that gain, if he had to. We could, assuming everyone was telling us the truth, sum all of the gains and losses, reduced in this way to a common measure. If the sum was a net gain, we would say that the change was a Marshall improvement. If we had a situation where no further (Marshall) improvement was possible, we would describe it as efficient. 4 Valuation of something in terms of money is valuation in terms of other things that can be bought against money. People want different things with different intensities, but since things that can be bought against money are of so many different kinds, there is always something there to be desired that can be bought against money. So, if people possess the same capacity to desire things in general, and there will always be something they would desire, they will always desire more money with about the same intensity. So, the valuation of money or “utility” of money could work as an approximation of utility as such. This approximation could be our best way to achieve the overall good:
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The concept of efficiency is intended as a workable approximation of our intuitions about what is good 5 . The Marshall criterion needs to assume that differences in the valuation of the dollar are negligible. Intuitively, the assumption is false. The principle of diminishing marginal utility - the more you have something the less you value it - seems to imply that the poor value a dollar more than the rich. The unacceptability of the assumption that individuals have the same utility for the dollar made many people favor the idea of redistribution, and, as a terminological consequence, resist the idea that “efficiency” comprises other values such as justice: so much with the Marshall criterion for what is good. But actually, the principle of marginal utility doesn’t say anything about rich versus poor: its predicament is for one and the same person. Any argument for redistribution is based on an interpersonal comparison of utility, a line incompatible with subjectivism.
Utility of money as an approximation to utility as such Marshallian Approach can be an approximation of utility only if there is something to be approximated. What could mean “utility as such”? Could utility be some kind of psychic dimension, some sort of a substance? Positing stuff is the easy way to picture reality: “Utility” might be the name of a substance: a metaphysical dimension capable of translating all kinds of values. Any amount of any kind of value could in principle be said to measure a certain number of units of this underlying dimension. Things would be wanted for the utility they are capable of producing in us. Such an objective scale would easily allow for interpersonal comparison of utility, the most straightforward way to speak about overall utility. Think of utility as of a kind of ‘psychic mercury’, each individual’s mind having some mercury column. The level of this stuff is accessible to the 1st person, and although normally concealed from others, it is in principle open to a 3rd person observer. Why so? Once it is the same kind of stuff – say, “mercury” – then why couldn’t it be observed by an ideal observer? A perfectly objective instrument could in principle measure John’s mercury column, then mine, and make interpersonal comparisons of utility. Like a lie detector operating at the psychic level it could also measure valuations regarding imagined changes: a doctor 5
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would ask John and then me: “How bad would it be for you if you lost 20 dollars?” The instrument would compare our columns. It might find out how much a dollar is worth for each of us in “utiles”, a gradation of utility. The problem with the psychic instrument is that it must itself have a psychic mercury column, a yardstick against which it would measure the height of other columns; but this means either: (a) that it would have feelings itself; and then, it would never get to measure “how is it like for this bat to be a bat” but “how is it like for it to be a bat, not the same thing at all. Psychic entities are private in principle. If God himself is someone else than me, then God himself would encounter this problem. He would never know how is it like for me to feel my feeling F, but how it is like for him to feel my feeling F. The idea of a single psychic kind – “psychic mercury” – collapses. Anyone could have very different psychic qualities and interpersonal comparisons would be measuring cows against horses, without resorting to one single public scale like weight, or volume. The problem of interpersonal comparisons sounds now like: which one is more pig? John’s cow, or Mary’s horse? There is no semantic (public) means of expressing private object other than more or less sophisticated analogies. (b) or, the psychic instrument wouldn’t feel anything, it would be just a numb scaled empty column. But then, we are committed to say that psychic quantities, would somehow “be there” open for the public, waiting for someone to feel them and measure them. This is not to say that they could endure outside columns, independently of personal minds capable to feel them. It means that the 1st person would be merely a contingent instrument of detecting valuation; that in principle there could be better instruments, so much better that they could disagree with our own natural instrument in matters of our own felt good. They would feel our pain more clearly than us. They would be more us than ourselves. The mercury column picture has one more difficulty: suppose the personal instrument perceiving the utilities of the blue T-shirt and of the red T-shirt reflected in him. The utility of the blue shirt is higher. If the instrument is the 1st person, then why would she choose the higher utility? We can’t say “because it would be more valuable to her” since we would sink into an infinite regress. The alternative would be to think that the columns do all the work for you, in a deterministic mechanism. The higher column simply generates action towards its corresponding external object. But then we end up renouncing to free action for the sake of psychic mercury a trade off unacceptable for an economist: where would the scales of preference be if not in our minds?
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The subjectivist approach to Value The conclusion seems is the confinement of value in subjectivity. Popper baptized the world of sensations the 2nd world, but in accordance with the subjectivity of value and for the sake of clarity we should not talk about one 2nd world but many 2nd type worlds or separate dimensions, as many 2nd type worlds as sentient beings. The argument from analogy to the 1st person perspective to sensations is our only reason we have for saying they are of the same type. We can use the concept of intensity only confining ourselves to one such dimension. There is no measurement possible between 2 intensities felt by two sentient beings, no inter-2nd type dimensions criterion of intensity. Austrians commit themselves to the idea that valuations are transparent only in human choices. Choice or action is the ultimate given. 6 Action does not measure utility or value; it chooses between alternatives. To prefer and to set aside and the choices and decisions in which they result are not acts of measurement. A would be better off with X”, or “X would give her more satisfaction or more utility that Y” are mere synonymous expressions for “given the alternative, she would choose X”. Let us explore the following chain of equivalences, and see how far they can take us. “Utility” is only a means to express in one word “whatever people value”; and people value whatever they act towards. More precisely: “X yielded utility to A at time t” means “A valued X at time t” which in turn means “A chose X at time t”. The first part of the equivalence reduces all talk of utility to subjective valuations; this is subjectivism. The practical conclusion of subjectivism is that no one can tell anyone what would be best for her. One’s best is a private matter. The second part is a commitment to action as an ultimate given. It reduces valuations to actions. For an Austrian “man” is “acting man”. It would be contradictory to say that someone chose to buy the red T-shirt instead of the blue T-shirt, although she valued the blue one more. Action – the revealed preference - is the ultimate given. This is because action, preferring A to B, or sorting and setting aside, cannot be analyzed in some further components. 7 Our attention is now focused on actions at successive points in time. Action opens a field for application of ordinal numbers, but it is not Human action …cannot be traced back to its causes, it must be considered as an ultimate given and must be studied as such. [MISES 1949], 17 6
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open to application of cardinal numbers... 8 The question is not “how intensely do I want X?” but “which choice from my opportunity set is most expedient at this point?” The difference between these questions is obvious, and is due mostly to the idea of marginal utility: the question of valuation arises only among possible choices available in the opportunity set at present. The question “what do you value most?” reiterates for every successive moment in time, it is re-posed at every “choice point”. If “more” means “more at that particular time”, then “more” means “more urgent”. It doesn’t make any sense to say that I want X less urgently than Y but I want it more nevertheless. “More intense” is replaced by “more urgent” in the hierarchy of urgency / opportunity set. 9 Does this mean that any free action is a step towards efficiency, and every constraint is a set back to it? “Two people engage in an exchange only because they expect to be better off from making it” is in Austrian language an analytic truth. Voluntariness (absence of coercion) is part of the concept “exchange”, where coerciveness is the reduction from the top in someone’s opportunity set or private action space. Combined with the clause “I am the best judge of what is best for me”, we are lead to a simple argument for the free market. Too simple in fact. There is something empirical about this, and the method of interpreting empirical phenomena is fallible: how do we recognize an exchange when we see it? Could charity be a counterexample? Something that looks like an exchange, but in fact benefits only one side? Charity, if it is voluntary, is indeed an exchange, because ultimately, benefit is psychic for both parts. It is the case of the “white elephant” that can bring light into this 10 , the embarrassing gift that cannot be refused. Imagine that you are offered embarrassing gift, but refusing it would put you in an even more embarrassing state. The key is to split the phenomenon we referred to as “the deal” in two stages. 1) coercion: Your “friend” puts you into a worse position, he reduces your opportunity set at stage zero. 2) voluntariness: you accept it with a smile trying to conceal that there was a first stage to this a worsening of statee zero. Some people would be fooled, while perhaps some would interpret the situation correctly. Stage two is worse than stage zero, but since it is [MISES, 49], 122 People stemming from the Chicago School took over the metaphysical picture of the opportunity set while slowly abandoning the neoclassic tools. Steve Pejovich said that innovation is the engine of progress since it offers the community a new choice. [PEJOVICH 1998], 10 [Radnitzky, G. and Bouillon, H., eds. 1995], 189-194 8 9
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voluntary you necessarily thought it to be better than stage 1, defined as the stage perceived to be immediately before. The example of the white elephant took us one step further into subjectivism: not only intensities are opaque to 3rd person knowledge, but it seems the definition of action itself is subjective. What the deal really was, is known only by the actor from the 1st person perspective. The Austrian solution to the problem of indifference leads to the same conclusion. At first sight, indifference is a problem for the Austrians: the reality of human action is only proof for ordering, the reality of interaction (exchange) is evidence for a double inequality. There seems to be no place for equality of value in the Austrian paradigm.
Indifference: no definition of action from the 3rd person perspective Austrians allow for indifference as an interpretation across value scales at different points in time, but insist that human action refutes indifference at the top of the scale: Suppose that a man, Jones, chooses each of two alternatives A and B about 50 percent of the time, upon repeated opportunities. This shifting is alleged to be a demonstration that Jones is really indifferent as between the two alternatives. Yet what is the reasonable inference? Clearly, that in some cases, A was preferred to B on Jones’ value scale, and that in the others, the positions were shifted so that B was preferred to A. In no case was there indifference between the two alternatives. The shift of choice indicates a shift in the preference scale, and not indifference on a constant value scale. Of course, if we were dealing with psychology, we could enter into a discussion of intensities of preferences and opine that the man, with respect to his underlying personality, was relatively indifferent rather than intensely biased, as between the two alternatives. 11 As regards the indifference present in one single scale at a given point, Austrians started an ingenious solution; take the indifference of Buridan’s ass. If an ass is just as hungry as it is thirsty, it would starve out of rationality, said Buridan, because he would value equally the pile of hay and the pool of water before his muzzle. The solution starts by the discovery of a third option in the ass’s opportunity set: starvation. Since this is at the bottom, then Non-starvation, the other options, are at the top. A rational ass would choose not to starve by either: (A) drinking and then eating or by (B) eating and then drinking. The rational choice is the disjunction itself as soon as possible. If the fastest 11
[ROTHBARD 62], 311
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mechanism to decide between A and B is flipping an “internal” coin 12 , then the ass would flip it. Assume the coin decided in favor of A. The ass drinks first. What does this prove? Does this prove that the preference at the top – A is just as urgently felt than the second option B? This would be bad for an Austrian. Rothbard does not pay enough attention to the difficulty. He starts by putting between brackets the psychological mechanisms saying that a praxeologist may restrict to talk about choices and valuations as they are revealed by action; he then jumps to conclude that if the ass drinks first – option A - then A was on top of the donkey’s scale of preference. If the flipped coin indicated the left water hole, then the left water hole was finally placed higher on the actor’s value scale, as was revealed when he went towards it. 13 But this conclusion (the ass preferred A to B) contradicts the premise (the donkey was indifferent between A and B). Rothbard insists that praxeology may ignore psychological mechanisms because its scope is the logic of action, not the content. Flipping the coin in my mind is indeed a psychological fact. But so is indifference; and the concept of indifference happens to belong to both praxeology and psychology. “Action” starts to fade to its homonym: behavior. No wonder Rothbard rushes to set behaviorism apart from praxeology, since ignoring mental events to the point of behaviorism is not an option for an Austrian 14 . The flipping of a coin is by hypothesis the proof of a lack of motivation, lack of a choice, and consequently lack of action in the technical Austrian sense. There is no middle: either drinking the water was not an action in the technical Austrian sense or if it was, then it was motivated towards A as opposed to anything else including B. Since by hypothesis the donkey was indifferent then drinking the water was not an action. And indeed it was not. It was only part of one: Let’s say that I am buying apples from the marketplace. The marketer invites me to pick up the apples I want; but since I am in a hurry I ignore the difference between the individual apples, and decide that they are all the same; the physical descriptions of the various apples may contain many differences. But it was certainly rational on my part The idea is that an individual might generate a random sequence. [SOLCAN 2003], 26 [ROTHBARD 62], 310 14 Praxeology is based on a fundamental distinction between human action and the motion of inorganic matter, namely, that human action is motivated toward the achievement of certain ends. [ROTHBARD 62], 308 12 13
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not to take them all into consideration and made them all the object of choices, because I was an a hurry. That all the apples are increments of the same good for me was not obvious for the marketer, who thought that maybe I see more than one kind of thing in the heap. He waited for my decision. My decision was that they are all increments of the same kind, or good – Apple. and I let him choose for me. This is analogous to generating a random sequence: I want a kilogram of apples, and I ignore the difference between the apples in my kilogram and the apples left in the heap. More precisely, they are all increments of the good “MeEating-Apples” because it is this which I buy, without this, the kind Apple would be no good anymore, all the apples would be worthless. The generation of the random sequence is inside the action as I defined it: buying a kilogram of apples. I chose not to split this action in as many small actions as apples in a kilo. There is one single action. And picking up some apples instead of others is just an automatic part of its content. Just as the marketer waited for my decision as regards my action, we must wait for the donkey to define its own action. We cannot define the donkey’s options from outside: one is water, the other is hay. Perhaps the ass sees two kinds of hay where we see one, perhaps there are more hidden options. Or perhaps it doesn’t even see a difference between water and hay: to him, water and hay may be just increments of the same good, Non-Starvation; after defining its action the donkey might generate the sequence inside the action. His drinking is just part of his choice and action: not to starve, just as the first apple put in the basket (by the marketer or by myself without paying attention) is not an action for me, but the first part of an action’s content: buying a basket of apples. We have just solved the Problem of Buridan’s ass, and found a proper scope for indifference: not between choices, but among increments of the same good. The key to the solution was the opacity or privacy of the opportunity set, its closure in subjectivity. The behavior is public, while the action itself bears a subjective definition. At this point, as the difference between subjectivism and its opposite is fully spelled out, it would be interesting to see what kind of pro-market arguments could be built starting from each of these conceptions.
The Neoclassical Argument for the Market Marshall’s Principles of Economics introduced the idea of equilibrium between the supply and the demand; from then on, his followers continued to equate efficiency with equilibrium, and replaced the
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Marshall criterion with Pareto, leaving unchanged the big strategy: a find a criterion of the efficient state, b) find ways to reach it. The neoclassical argument for the free market is the following: 1. Efficiency is translated in the Pareto optimum. 2. The Pareto optimum is achieved only in conditions of equilibrium 3. Equilibrium needs perfect competition. 3. The market is the best method to approximate perfect competition. 4. Therefore the market is efficient. Let us take the premises one by one. 1. What could look better than the Pareto criterion for efficiency? The clause that no one must be made better off at the expense of someone else’s being made worse off looks respectable; this criterion seems not to involve interpersonal comparisons of utility. However, a serious problem rushes in: If simple dissent were enough to block a change, few changes would be made at all. Could Marshall plus some appropriate transfers do the trick? If we take into account valuations only insofar as they are translated in corresponding payments, then the dissenters would pay amount X in the pool labeled “against the change” only to take it back afterwards. This might work as a measurement, but only in a world of zero transaction costs; we need either a world in which nobody exaggerates his preferences, or a world in which the process of raising money from everybody, measuring the pros and cons for every possible change, the giving the money back would be completely costless. In the real world however, when transaction costs exist and cannot be measured and set aside from the “main” valuation, one simply cannot calculate who dissents and how much, apart from the transaction or measurement costs themselves. This matter turns out to be no other than the old one. We are back talking about measuring costs. We are back to Marshall. No wonder Friedman prefers the Marshall criterion to the Pareto due to its honesty in making interpersonal comparisons of utility. 15 2. Equilibrium means the equation of cost and price. The marginal value of good X (the value to the consumer of an additional unit of good X translated in the price paid) must equal the marginal cost (the cost of producing an additional unit of good); otherwise there is no optimum. Why? a) Assume for a moment that the cost was lower than the price. The cost of X was $ 0.9 and the price is $1.If price equals value, then it’s bad, A subchapter of Friedman’s Price Theory is called: “Marshall disguised as Pareto”: http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_15/PThy_Ch ap_15.html 15
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because a greater value has been given up for a smaller. No equilibrium, no efficiency attained, because a greater value (1) has been given up for a smaller one (.9). With one dollar, that consumer could have bought X and something else, a Y, in addition to it, or perhaps more of X. b) Assume now that the cost is higher than the price. The cost of X is $ 1.1 and the price is $1. This clearly involves giving up a higher value – the 1.1 dollars that could have been used for producing some Y worth 1.1. for the sake of a lower, namely the 1 dollar. The consumer who would have paid 1.1 for the un-produced product (that could have been produced with the 1.1, but it wasn’t) is worse off. This crazy exchange has been made on this person’s expense. Without equilibrium, the Pareto optimum has not been achieved. 3. A perfect competition would ascertain that no product is sold at a higher price than its cost, and nothing is produced unless there is someone who values it at its ‘true’ worth. 4. A free market - defined as free entry into any sector plus private property - would provide the necessary framework and incentives to achieve this; take the example at 3.b. A free market would be the proper mechanism to divert resources from X towards Y, and this would be fine because the value for Y ($1.1) is greater than the value for X ($1), and the market will have all chances to produce the Y. For the state of equilibrium to be attained, the notorious assumption of no transaction costs is needed: any transaction mutually advantageous to the parties involved can be arranged at no cost. Within this framework, the critics of the market would have to show that there are cases of market failure – chronic disequilibrium – for which an institution such as the state could do better than private arrangement on the market to solve. They would have to show that a state could reduce transaction costs and help the process of production towards equilibrium at a faster pace than the market, while the defenders of the market would have to come up with a scary theory of governmental behavior. This is the battleground over the best (equilibrium tending) structure of incentives, one with more state, or one with less state. The two types of market failure are public goods and externalities. There is no one to deny that there are situations of chronic disequilibrium. And if one wishes to call them “market failures”, this is no problem with anybody, since simple baptisement does not take one
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closer to proving the expediency of the state in correcting the failure 16 . The Chicago School defenders of the market together with Coasians show that the market could find its way to equilibrium alone, while the Austrians are even praising disequilibrium 17 .
The Public Goods Problem Non-excludability means no additional costs for the producer if there is an additional consumer of that good. Take national defense for example: Because the marginal cost of producing additional "defense" is assumed to be zero, price would have to equal zero for the market to work "efficiently" in a neoclassical sense. Since no one in the private market would provide this type of good at the "efficient" price, it is argued that the government's responsibility is to step in and provide such outputs. 18 In the absence of a coercive institution, the incentives for every consumer are to wait until others pay for the good to the point where she herself would enjoy the free ride. This postpones the actual production indefinitely. The larger the number of people whose agreement is needed and the less obvious it is how much each values what he is getting, the harder it will be to get agreement 19 . The solution to the public good problem, the free rider problem, or the tragedy of the Commons has two steps: 1. detecting the intensity of the desire for good X, 2. providing it at that proper cost . In what ways could this be done my a market? a) Sometimes the cost of voluntary negotiation would be lower than the cost of setting up a state department: b) An entrepreneur could convert the public good temporarily into a private good. Suppose the public good is flood control; building a dam will reduce floods in the valley below, increasing the value of farm It is one thing to show that there is something government could do that would improve on the outcome of the unregulated market; it is an entirely different, and much more difficult, thing to show that what government would do, given the power, would improve on that outcome. www.daviddfriedman.com/Academic/Medicine_Commodity/Medicine_Commodity.ht ml 17 [KIRZNER 1982] passim 18 [CORDATO 1980], 394 16
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land there. One way to pay for the dam is for the entrepreneur to buy up as much as possible of the land in the valley …, build the dam, then sell the land back …at a higher price than he paid. c) Another ingenious solution… is to combine two public goods and give away the package. The first public good has a positive cost of production and a positive value to the customer; the second has a negative cost of production and a negative value to the customer. The package has zero or negative cost of production and positive value to the consumer. This is how radio and television broadcasts are produced; the first good is the program and the second the commercial. 20 What if no entrepreneur is “perceptive” enough to do any of these? An Austrian, while having no objection to this classification whatsoever would say that Friedman set the problem upside down in the first place. Have a look at the following formulation: Suppose that the total cost of the defense is $149 million. It is still worth having--the top five landowners alone value it at more than its cost…. If the entrepreneur asks the Big 5 to each put up the same proportion of the value of their land (just under 10 percent), Howard Johnson will refuse. Unfortunately for Hawaii, the Howard Johnson firm is run by an optimist who believes the chance of an attack is only 5 percent and therefore is willing to pay only 5 percent of his land value to protect against the attack. We are lead to think that Howard Johnson is wrong to be optimistic. It is as if we knew from the outset not only that the cost is $ 149 million, but also that the value is at least that much. How on earth could one establish that? Arbitrarily, would a subjectivist say. The entrepreneur’s job is not to perceive valuations, but to “speculate” as Mises would say, or to hypothesize. And since she may be wrong, anyone could, including an altruistic state agency. The same difficulty appears in the analysis of externalities:
The problem of externalities The subjective view and the Austrians push for the exclusivity of one single criterion for valuation: actual exchange. Since all exchanges presuppose an accepted distribution of property rights, there can be no talk of efficiency outside defined property rights. Sometimes however, 20
http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_18/PThy_C hap_18.html
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people compete in Courts for property titles over the same bundles of rights. The traditional Austrian criterion for allocation of property rights is homesteading: whoever was there first. Coasians famously argue however, that it is precisely judgment of efficiency that should lead to a proper allocation of property rights: An external cost is not simply a cost produced by one person and born by another. In almost all cases, the existence and size of external costs depend on decisions by both parties. I would not be coughing if your steel mill were not pouring out sulfur dioxide. But your steel mill would do no damage to me if I did not happen to live downwind from it. It is the joint decision, yours to pollute and mine to live where you are polluting, that produces the cost. If you are not liable to me for the damage done by your pollution, your decision to pollute imposes a cost on me. If you are liable, my decision to live downwind imposes a cost, in liability or pollution control, on you. For some people, this looks morally outrageous. It is not our concern here to judge these institutions against our own. The tool of moral intuition is precisely what we want to avoid if we are to stick to the subjectivist line of argument. A subjectivist would observe that the situation is presented upside down once again: Suppose pollution from a steel mill does $200,000 a year worth of damage and could be eliminated at a cost of $100,000 a year (from here on, all costs are per year). Further assume that the cost of shifting all of the land downwind to a new use unaffected by the pollution, timber instead of summer resorts, is only $50,000. If we impose an emission fee of $200,000 a year, the steel mill stops polluting and the damage is eliminated at a cost of $100,000. If we impose no emission fee, the mill keeps polluting, the owners of the land stop advertising for summer visitors and plant trees instead, and the problem is again solved, this time at a cost of $50,000. The result without Pigouvian taxes is efficient. The problem is eliminated at the lowest possible cost and the result with Pigouvian taxes is inefficient. ... Next suppose we change our assumptions, lowering the cost of pollution control to $20,000… 21 Friedman’s main business in this is to discredit Pigouvian or governmental taxes and build a case for the free market. Our worry is as usual, presuppositions about value: How can we know in the absence of an exchange that the damage is worth 200,000?
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www.daviddfriedman.com/Academic/Course_Pages/L_and_E_LS_98/Why_Is_Law/ Why_Is_Law_Chapter_4.html
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Coase’s first point is that since external costs are jointly produced by polluter and victim a legal rule that assigns blame to one of the parties gives the right result only if that party happens to be the one who can avoid the problem at the lower cost. 22 How are we to know who avoids it at a lower cost? Considered from the standpoint of a court, there are at least two different ways in which these insights might be applied. Courts could follow a policy of deciding, in each case, whether plaintiff or defendant was the lowest cost avoider, awarding damages for pollution only if it concluded that the polluter could solve the problem more cheaply than the victim. Alternatively, courts could try to establish general rules, assigning liability to the party that was usually the lower cost avoider. The first alternative sounds profoundly unsatisfying for the subjectivist. If the argument is “If A values X more than B does, then A has the right to A.”, how are we to determine the antecedent? This presupposes that the costs and valuations involved are transparent to the Court, an entity in possession of method of reading 1st person data. The second alternative is in fact identical extensionally both to the Lockean natural law of homesteading and common law. As long as the term efficiency in this matter is not taken to be a matter of monetary calculation, Austrians and Coasians agree on this. Once the problem of establishing guilt and how big the guilt is (proportionality of punishment) is not a matter of monetary calculation, there is no problem with Mises. It is nonsensical to evaluate in money objects which are not negotiated on the market and to employ in calculations arbitrary items which do not refer to reality. The law determines the amount which ought to be paid as indemnification for having caused a man’s death. But the statute enacted for the determination of the amends due does not mean that there is a price for human life. Where there is slavery, there are market prices of slaves. Where there is no slavery man, human life, and health are res extra commercium. In a society of free men the preservation of life and health are ends, not means. They do not enter into any process of accounting means. 23
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www.daviddfriedman.com/Academic/Course_Pages/L_and_E_LS_98/Why_Is_Law/ Why_Is_Law_Chapter_4.html 23 [MISES 1949], 216
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Subjectivism all the way One idea or another about the correct cost or the correct “price to be paid” is inevitable in the field of law, if one has a traditional idea about order. Suppose one were to commit herself to subjectivism in all matters of law, and have no care about traditional “order”. This sort of person would not accept common law because common law would be just another sophisticated form of judgment from analogy. Once we can’t know how badly it was for the victim, and let the victim be the only judge, then the victim has the right to retaliate in any way. One could argue that a widespread conception of such a nature, would not necessarily lead to chaos. If we reject this however, then we must be aware that we reject subjectivism as a full theory of value. If we don’t reject subjectivism we can only think of the Court’s decisions as a systematic form of social pressure, that has nothing to do with objective value, but has everything to do with social order, order being the upshot of the large number of subjects who agree to it.
Austrian view of efficiency Looking for equilibrium between supply and demand is exclusively an allocative matter, a problem of matching together pieces of puzzle. The picture of resources and benefits should not look like a puzzle, says the Austrian, because the problem is not that of allocation between resources and objectives whose value is known. The main difficulty is in identifying the elements not in matching them together. We are not facing a technological problem of allocation between given terms, but that of allocating known and unknown resources to known and unknown wants. 24 Both sides, resources on the one hand, wants on the other, are open-ended sets, that is, neither is possible to list completely. If knowledge is a resource and there is such a thing as knowledge advancement, or knowledge-not-yet-discovered 25 , then there are always unused resources because unknown. The set of preferences is not even known from a 1st person perspective: many surprises are unexpectedly pleasant. Once we realize that it is pleasant surprises that we are If we possess all the relevant information, if we can start out from a given system of preferences and if we command complete knowledge of available means, the problem which remains is purely one of logic. [Hayek 45], 519 24
Following Hayek, Kirzner uses the term “discovery” for entrepreneurial activity. Since the discoveries we are talking about (matches between resources and consumers’ wants) are not made to last due to the changing of preferences, the term “discovery” does not collide with Popper’s bucket theory. There is no obstruction to a Popperian reading of the market process. 25
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looking for when we go shopping, we are able to see more clearly the problem that our economy is meant to solve: it is a knowledge problem. If the set of resources is open-ended, then there is always a benign innovation possible, and consequently, equilibrium is not an ideal. The market is a method of knowledge management, along the two sides of the matter: an allocative process towards the market clearing level or what we have been calling “equilibrium” all along, and the entrepreneurial discovery process 26 . We have a certain idea about the first kind of process, since we have been talking quite a bit about how competition presses for equilibrium; let us have a look at the second, which is more risky and maverick.
The critical method to tackle the problem of knowledge All conscious action is a problem-solving process. Adaptation takes place in a continuous sequence of trial and error, following Popper’s three-stage model: 1. I have a problem; 2. I attempt a solution; 3. The proposed solution is eliminated after failing the test of severe critical discussion. The Misesian terminology fits in perfectly: The starter of human action, the problem, is the uneasiness of an unfulfilled want, while the action itself - the attempted hypothesis - is the adjustment of means to ends. This methodology becomes expedient once we realize that the future is open and that all empirical knowledge is of a tentative character. The three-stage model of action is in fact the structure of experiments. An experiment is a means of acquiring knowledge by comparing the results obtained with the results expected… A grocer who opens a shop is conducting a social experiment; and even a man who joins a queue before the theater gains experimental technological knowledge which
There are two sorts of processes: the process of entrepreneurial competition responsible, in the short run, for the tendencies for the market price of each commodity or input to move toward the respective market-clearing level, for the array of outputs to reflect the pattern of consumer preferences in the light of currently available technological possibilities, and for pure profit opportunities to be ground down to zero; and 2) the process of entrepreneurial discovery, invention, and innovation through which long-run economic growth is stimulated and nourished. [KIRZNER 1984] 41 26
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he may utilize by having his seat reserved next time which again is a social experiment. 27 Any entrepreneurial idea is a hypothesis of the form “Good X will be valued at least this much in this place.” These hypotheses are subjected to the empirical test of targeted consumers. They are the ones who perform the tests by buying or ignoring the new products. Entrepreneurs are the operators of backtracking. They have to keep on adjusting the supply to the ever-changing valuation conditions. Keeping on experimenting is the only way to learn both the transitory social knowledge of valuations, and the technical knowledge of the least costly way to satisfy consumers’ desires. Since all knowledge is hypothetical, the rational method for allocating resources is the application of the method of trial and error for as many times as possible and as often as necessary. Once we are assured that the trials are serious (by internalizing both profit and loss, the institution of private property makes entrepreneurship as serious as it gets) the secret is in the numbers of its application, or in the actual amount of criticism. This is because the process of selection of the most valued goods and services is a process of selection from goods that are already on the market, just like the intellectual process is a process of selection from ideas already formed. The rational way of tackling with the problem “How much of what should be produced?” is to break it into a collection of smaller local problems; its solution will be an ever changing collection of individual smaller solutions continuously attempted by everyone, and tested by everyone. This is rational because under conditions of uncertainty the only option is to assure serious critical activity in the highest degree possible. Under conditions of uncertainty, competition becomes the best procedure of discovering the better results, both about our valuations and about the least costly means to produce the valued goods.
Knowledge at the center The open-endedness of resources and valuations (think in the first place of future intellectual resources, and then think of our desire of being pleasantly surprised) is a different matter from their dispersed character. If this was merely a problem of actual dispersed knowledge, the only difficulty faced by the central planner would be that of speed. There is however a deeper problem, independent of the Hayekian argument of non-collectible practical knowledge; it is still about the 27
[POPPER 57], 85
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non-manifest character of knowledge but in the sense of its being hypothetical. Popper’s main idea is that under conditions of uncertainty all knowledge is tentative, or fallible. Since there is no manifest knowledge to be gathered all knowledge is based on experiment rather than observation. The central planning team must conduct experiments (let’s assume that it could do it faster than a myriad of potential entrepreneurs working simultaneously each in his place at their bits of the great economic problem). The conducted experiments would have to yield information about both sides of the matter, resources and valuations.
The open-ended character of our valuations But what sort of experiments would be needed in order to gather the information about valuations? The assumption of any central-planning thought experiment is that a certain amount of material resources is available at the center. The distribution center has something to distribute, such that the more property to allocate by the center, the less private property manageable by private entrepreneurs. In Austrian terms this is the problem of calculation: The less private property, the lesser the number of free exchanges. But the smaller the number of exchanges the lesser information about valuations or true prices available. And in the absence of information about intensities of valuation, allocation is doomed to be arbitrary. This brings the necessary failure in completing the economic task, rational allocation. The most important thing to note here is the wide scope of the argument. One can imagine an axis depicting the amount of centralized resources that are prerequisite for conducting economic and social experiments from the center. At one end, all resources are centralized, the state being the only entrepreneur; at the other, there is no public ownership and agents are using their resources to conduct experiments on their own. It is only at the right end of the axis that full information about valuations can be used. The rest of the axis falls prey to the argument: the less private property the more disturbed the calculation of the intensities of our preferences. The impossibility of calculating value (intensities of preference) in the absence of a market where values are made transparent is due to the essentially experimental character of our social knowledge.
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The same argument we used against the Coasian Courts of Law, finds a use now against regulators, and governmental agencies: how ca they know the preferences if not by observing free exchanges?
Power and freedom We can try to depict the situation in terms of “power” and “freedom”. That the situation is unchanged should come as no surprise; after all, words are mere substitutable vehicles for ideas. The intuition is of course that the political power and social knowledge are complementary in the sense that the more we make use of one, the less we can use the other. Why is it so? The experiments of the center (one can give any example of state intervention in a mixed economy) do not add to the experiments that are and would be conducted anyway by economic agents. This is not only to say that the operation of tests by market and state may mess with each other and change the input or the conditions of the test in unknown ways. This sort of interference of tests and plans exists in any free market. The difference is that in a mixed economy agents are deprived of the capacity to conduct those experiments they would have conducted in the absence of centralization of those particular resources that are at the center’s disposal. Fewer experiments are performed by individuals. And since they could have used and produced knowledge we arrive at the Hayekian conclusion: public experiments lead to underused knowledge. The intellectual conceit of those in power blocks potential hypotheses-testing, it blocks entrepreneurial ideas in an uncritical manner. The careful pursuit of the argument that the rational method is the critical method shows that power and knowledge are complementary in the sense of being exclusive of each other. Ironically, even though insisting that the more critical the method employed, the more rational it is, Popper himself fell prey to the intellectual trap of taking the state to be an additional agent performing additional tests and producing additional social knowledge. He starts his section about piecemeal technology by making a distinction between the public and private areas of activity assuming that the public area is reserved to state action. Technological problems in the field of social science may be of private or a public character. For example, investigations into the technique of business administration, or into the effects of improved working conditions upon output, belong to the first group. Investigations into
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the effects of prison reform or universal health insurance, or the stabilization of prices by means of tribunals…or the possibility of controlling trade cycles…belong to the second. 28 Starting from given distinctions is simply presenting observed data and taking it to be necessary. Postulating classifications of problems is incompatible with the structure of the Popperian epistemology. This is a violation of the three-stage model of scientific method because it starts with step two. A problem is never by itself “public” nor is it “private”, problems are simply problems. The classification public vs. private comes at the level of solutions. The original problems are always the individual feelings of uneasiness with respect to administration, working conditions, security, health, fear of bankruptcy. They are not ab initio classified as public or private. It is the proposed solution that employs private or public means. This arbitrary distinction leads Popper to reject anti-interventionism as a sort of passivism or inactivity: refraining from performing tests in the areas conceptually reserved to the state. Actually this is just another example of tyranny of the statusquo: this is how it is, therefore this is how things should be. The deeper structure of his epistemology however is calling for maximization of competition and precludes the existence of monopoly over any area of any service.
The open-ended character of resources The naïve way of conceiving economic growth is to make a list of the available known resources (like oil, coal, cars, soap), measure their actual magnitude and imagine their growth. But if the unknown resources are ignored (taken as inexistent), increasing all known elements at once is a logical impossibility. If resources are given, there is but one move left to make: allocation by carrying out shifts between known resources. This is the growth of certain elements at the expense of others. Once we conceive our resources as comprising known and unknown elements, the interesting part of growth becomes the acquiring of new kinds of elements, resources of which we are not yet aware that they are resources. Creativity is the advancement of new entrepreneurial hypotheses corroborated by experience, i.e. proved to be successful by consumers. One can understand the meaning of resource discovery which Schumpeter, Hayek or Kirzner 29 spoke of, by visualizing an example. Someone is putting together two known elements each valued 28 29
[POPPER 57],59 [KIRZNER 84], 46
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at $1 that were never associated in that manner before and transforms them into a new product. If she / he is selling this new combination to the highest bidder at the price of $12, this entrepreneurial profit of $10 is the mark of fulfilling a want. Pure growth is pure growth in desirefulfillment. The answer to the question why growth is a good thing is conceptual: it creates worth.
3rd order goods Planning today a particular discovery of tomorrow is of the same tentative character and strength as the launching of a new hypothesis by a common entrepreneur. The amount of rationality dwelling in this sort activity rests only in the capacity of backtracking, of repeating the guess. The argument from critical debate showed that we can plan for the advancement of knowledge in an unknown direction by maximizing the actual amount of backtracking in the world, that is, by ensuring the conditions for critical debate. It is said sometimes that freedom of action is as important as freedom of thought. But they are just as important because they are part of the same tree, whose root rests in practical problems. They can be treated as if they were the same thing. Planning for freedom entails outlawing any restriction on conducting experiments. This activity must be twofold: (1) Ensure maximum freedom for advancing new hypotheses, be it the maximization of (1.1) innovating entrepreneurial activity or of (1.2) market clearing entrepreneurial activity (the adjustive process of taking over a ready-made hypothesis and replicating it for test in some other part of the world). (2) Ensure maximum consumer freedom, the liberty to test hypotheses by consuming or abstaining from the consumption of any product. In this light any sort of taxation and restraint of private property, is seen as an arbitrary restraint on resources that could be employed in entrepreneurial (wealth-creating) activity. Any sort of limit on free entry in any market sector is seen as an arbitrary obstruction of empirical testing of hypotheses. We can think of national borders and unions as restrictions on free entry. Looking from the consumer side of the matter, tariffs and trade control trammel consumption of “foreign” goods. The problem with blocking free entry or suppressing tests by consumers is the hampering of net gains in value or of desire-fulfillment since the entry may be blocked for potential higher bidders. No such display of power is compatible with the rational method of creating wealth.
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Because we value them, institutions themselves can be treated as goods. We could name them “third order goods”, one layer above the capital goods. Their value is simply transferred from the amount of lower-order goods whose production they foster. Inventing names is no impressive project of course unless it helps in identifying an idea: What is the methodology for developing the best rules in detail? If the case for liberty stays in its being a method of discovery of new goods, and institutions are goods, then the argument from the critical method pushes for the continuous trial and error in the production and test of institution, and rules out any sort of artificial monopoly for wealth-creating hypotheses.
References: [CORDATO 1980] The Austrian Theory of Efficiency and the Role of Government, Journal of Libertarian Studies Vol IV, No.4, http://www.mises.org/journals/jls/4_4/4_4_6.pdf [FRIEDMAN, David 1986] Price Theory, www.daviddfriedman.com/Academic/Price_Theory, accessed May 16, 2005 [FRIEDMAN, David 2000] Law’s Order, www.daviddfriedman.com/Academic/Course_Pages/L_and_E_LS_98/Why_ Is_Law, accessed May 16, 2005 [HAYEK, Friedrich 1945] The Use of Knowledge in Society, The American Economic Review, Vol. XXXV, No. 4 [KIRZNER, 1982] Competition, Regulation, and the Market Process: An Austrian Perspective, Cato Policy Analysis No. 18, September 30 [KIRZNER, Israel 1984] The Entrepreneurial Process, in The Environment for Entrepreneurship, ed. Calvin A. Kent (Lexington Books) [MISES, Ludwig 1949] Human Action, San Francisco, Fox & Wilkes, 1996 [PEJOVICH, Svetozar 1998] Economic Analysis of Institutions and Systems, Kluwer Academic Publishers [POPPER, Karl 1957] The Poverty of Historicism, Routledge, 1961 [RADNITZKY, Gerard and BOUILLON, Hardy, eds., 1995] Value and the Social Order, Value and Society, Vol 1. [ROTHBARD, Murray 1962] Man, Economy and State, Ludwig von Mises Institute, scholar’s edition, 2004 [SCHUMPETER, Joseph 1934] Entrepreneurship as Innovation, in [SWEDBERG Richard ed. 2000] Entrepreneurship – The Social Science View Oxford U. Press Oxford: Oxford University Press, 2000, pp. 51 -75 [SOLCAN, Mihail-Radu 2003] Freedom, Minds and Institutions, Bucharest University Press
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