Sit in any time beyond the first month of a typical ECON 101 class and here’s what you’ll be taught: free markets work well, but only under conditions that seldom prevail in reality – a regrettable fact that requires the state to intervene to correct each of the many market failures.
The apparent science on display seems impressive. Curves are drawn on the whiteboard to portray the difference left by free markets between marginal private cost and marginal social cost, between marginal private benefit and marginal social benefit, and the resulting failure of markets to produce socially optimal quantities of outputs and to attach to these outputs socially optimal prices.
Gazing at the curves – or, if the class is especially mathematical, studying the equations – reveals the remedial action that must be taken if society’s welfare is to be optimized. Shift this curve upward, or that one downward – or in the equations modify this coefficient that way or that coefficient this way – and, voila!, society is engineered to optimality with the aid of Scientific Economics.
It all seems to be so objective and free of any taint of ideology. After all, you can see it right there in the graph, in black and white: the marginal private cost of operating the oil refinery is lower than is the marginal social cost of doing so. Only a libertarian ideologue objects to using government to bring marginal private cost into equality with marginal social cost. This libertarian stubbornly elevates his ideology over the public good, for, as the graphs and equations make clear, bringing marginal private costs into equality with marginal social costs yields net social gains. Such engineering is Kaldor-Hicks-Scitovsky efficient. (It’s impressive to have scientific terms that non-specialists must google.)
It’s a Scientific Fact: Economic Reality is Highly Complex and Often Unobservable
But the reality is that this allegedly scientific case for intervention is not close to being as scientific as it is widely believed to be, especially by economists.
Curves and equations are often very useful tools for helping us to think clearly about reality. But these curves and equations are seldom realities on which researchers can gather actual data. While Jones does incur particular costs by increasing her factory’s output, those costs are not observable to outsiders. Nor are Jones’s costs the same as the costs to Smith who increases his factory’s output by the same amount as does Jones.
Also not observable are the marginal social costs of these factories’ operations. The factory across town might indeed spew pollutants into the air that my neighbors and I breathe. But I challenge anyone to objectively quantify the cost that each of us experiences as a result of a one-percent increase in the factory’s output – then of a two-percent increase – then of a three-percent increase… and then to add these costs together in order to construct a genuinely objective marginal-social-cost schedule.
This challenge cannot be met, although meeting it can be faked. The best that can possibly be done is for a fair-minded researcher to estimate – inevitably using her own subjective evaluations – the costs that I and each of my neighbors individually bear. But how does this researcher know my discount rate – or, rather, know the length of time over which I regard as relevant my exposure to the factory’s emissions? She doesn’t. She can’t possibly know such a thing. And what’s true for her knowledge of my discount rate is true for her knowledge of my evaluation of the precise degree to which the factory’s emissions negatively affect my present well-being.
This researcher – assumed here to stick as closely as possible to the scientific tenets of economics – knows that the preferences, risk tolerances, and discount rates of all individuals affected by the factory’s output differ from each other. Therefore, to scientifically quantify “marginal social costs,” this researcher must get not only such ungettable information about me; she must also get such ungettable information for each of the many individuals who is or who might become affected by the factory’s emissions.
Even ignoring the fact that preferences, risk tolerances, and discount rates can and do change in unpredictable ways, this researcher’s task is undoable.
This impossibility is no small matter. If the researcher overestimates the social costs of the factory’s emissions, she – in league with government officials – imposes her own “social” cost on others. She obliges the factory to reduce output to a level below that which is textbook optimal. The cost to society of this suboptimal level of output might well be as large as, or even larger than, the cost to society of simply leaving the factory free to operate without government attempts to “internalize” on it the social costs of its emissions.
The Scientific Appearance Is a Mirage
At this point the mainstream economist pushes back. He doesn’t deny (How could he?!) that, as a technical matter, getting precise information on marginal social costs is practically impossible. But he insists that such an ideal standard is inappropriate. “We can estimate the divergence between private and social costs closely enough,” the mainstream economist assures us, “and then have government act on those estimates. It’s better than doing nothing.”
While it’s true that the perfect should never be allowed to obstruct the good, there are at least two looming problems with this mainstream-economics approach – problems that warn against trusting it to serve as a reliable guide to government policy.
First, as explained above, there’s no good reason to think that estimates made of social costs by even well-intentioned and sparklingly brilliant government officials will be close-enough to accurate to trust that a government empowered to correct market failures will, on the whole, raise social welfare. The assumption that such officials will typically perform well enough on this front is based on no science; it’s merely an assumption – or, rather, an aspiration.
Second, there’s no good reason to think that government officials in reality face incentives that prompt them to behave as their doppelgängers in textbooks behave. The entire case for using government to correct alleged market failures is built on the belief that self-interested actions of private decision-makers lead them to seek private benefits at the greater expense of the public. But if we assume that people act self-interestedly in their private spheres we must make the same assumption about people’s motivations in public spheres.
Yet despite more than a half-century of warnings from public-choice economists, mainstream economists continue to assume, without much apparent thought, that government officials act in a way that is categorically different from the way these same persons would act were they in the private sector: private persons are assumed to act to promote their own self-interests, while government officials are assumed to act to promote the public interest.
What, however, could be more unscientific than this assumption of dual motivations? It is justified neither by science nor by common sense, but it is crucial to the “scientific” case for government action to correct market failures.
My argument is not that markets are perfect. (They certainly are not.) Nor is my argument that a highly informed and well-meaning deity could not intervene in markets in ways that improve their performance. (Such a splendid creature certainly could.) My argument is that because economists advise government officials rather than deities, the economic case for using government to correct market failures is scientific only in the most superficial sense. Deep down it’s mostly superstition.
Donald J. Boudreaux
Donald J. Boudreaux is a senior fellow with American Institute for Economic Research and with the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University; a Mercatus Center Board Member; and a professor of economics and former economics-department chair at George Mason University. He is the author of the books The Essential Hayek, Globalization, Hypocrites and Half-Wits, and his articles appear in such publications as the Wall Street Journal, New York Times, US News & World Report as well as numerous scholarly journals. He writes a blog called Cafe Hayek and a regular column on economics for the Pittsburgh Tribune-Review. Boudreaux earned a PhD in economics from Auburn University and a law degree from the University of Virginia.
