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Book Review: Welfare Economics and Externalities in an Open Ended Universe

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Welfare Economics and Externalities in an Open Ended Universe: A Modern Austrian Perspective
by Roy E. Cordato (Boston: Kluwer Academic Press, 1992); 140 pages.

Classical liberals and libertarians have traditionally argued that government should be limited to certain essential functions for the sake of social order: police protection against domestic criminals, military force for security against foreign aggression, and a court system for adjudication of disputes and enforcement of justice under rule of law. When the state goes beyond these activities, friends of liberty have argued, it threatens to become an oppressor of freedom rather than its guarantor.

But practically every economist participating in policy debates says that government must do more than just keep the peace and administer justice. The problem, they say, is that a totally unregulated economy can suffer from “market failure.” A free-market economy, the argument goes, often produces antisocial “externalities.” Pollution, for example, would be a negative externality in which one or more producers reduce the quality of clean air for others, but do not take into consideration the costs and effects upon others when they make their production and trading decisions.

A positive externality, on the other hand, is a situation in which producers supply something that creates desirable spillover effects for others for which they do not pay. Because these others get a “free ride,” the producer supplies a smaller amount of the commodity or service than would be the case if all those who benefited had to pay some price for the improvement in their circumstances. In the extreme case of what is called a “public good” — since practically everyone can get away with being a “free rider” and not pay for a service rendered — either the state collects tax money and supplies it, or it doesn’t get supplied at all.

Dr. Roy Cordato, in his recent book Welfare Economics and Externalities in an Open Ended Universe, explains the fundamental weaknesses in the premises and logic of the standard “externalities” argument. Dr. Cordato approaches his task from the point of view of the Austrian economists, in particular building upon the writings of Ludwig von Mises, Friedrich Hayek, Murray Rothbard and Israel Kirzner.

He starts by demonstrating that most economists are able to reach their conclusions about externalities because they reason on the basis of what is called the “perfect competition” model. In this model, the economic system is examined from the perspective of a perfect and complete equilibrium in which every market participant in doing just the right thing, every good is produced in just the right way in the “optimal” amount. And there are neither errors nor mistakes by anyone because everyone is endowed with perfect knowledge. This then becomes the benchmark from which the real economy is looked at and evaluated. And since in the real world, at any moment in time, the market economy is never in such a perfect equilibrium, it is fairly easy to find “market failures.”

Rather than looking at the economy from the perspective of this imaginary perfect equilibrium, Dr. Cordato explains the Austrian view that a market economy should be studied as an ongoing process in which the actors in the market never possess perfect knowledge; and in which competition and changing market prices supply constantly changing information to better coordinate the actions and plans of a multitude of people who are interdependent in their activities in the social division of labor.

If the actions of some people are having negative spillover effects on others, we need to ask, what prevents people from knowing and bearing the full costs for all their actions? The failure is not in the market, Dr. Cordato argues, but in the failure to clearly specify and enforce private-property rights that would make every producer take into consideration the effects of his actions on others and require him to “internalize” into his decisions the full costs of his own activities.

In the case of positive externalities, the problem is that since the knowledge of the economist is no less perfect than that of the market actors he is trying to study — and indeed is more imperfect, since he can never know all the special and specific knowledge that only individuals possess about their own particular circumstances — he has no way of knowing if some commodity is not being supplied in some larger “optimal” amount because of a free-rider effect.

If a good is not supplied in larger quantities, it is because it is just not worth the cost to suppliers and demanders to devise ways to overcome the difficulties of “internalizing” the benefits from its provision at a particular moment in time. What is certain is that in a competitive market process, there are always ongoing incentives for people to discover ways to capture profits by providing people with the things they desire. And these incentives will be more efficiently and continuously at work than if these problems are placed in the hands of the state to solve.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).