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Welfare economics and externalities

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Wheylous Posted: Sun, Dec 11 2011 10:48 AM

We just covered externalities in my Econ class and I am left quite displeased. If you forget the graph involved, here is the positive externality graph:

The conventional wisdom says that for some goods, there are benefits to people who do not participate in the transaction. This is added utility and should be treated as part of the demand curve. Hence, there is some "social benefit" curve which rests above the demand curve and is the "socially optimal" level at which the economy should be running. Therefore, we need subsidies.

I feel that there is something really wrong with this graph, some fundamental assumptions and fuzzy math that make this graph incorrect.

Here is what I've been able to come up with so far:

  • Economic calculation: how exactly do you calculate "social benefit"? If the government can calculate social benefit, why not calculate the entire market? Why have any price system whatsoever? This logical conclusion violates the socialist calculation problem. Hence, we cannot calculate "social benefit." The counter to this first statement, however, would be that there is some level of benefit above what the market includes.
  • Because there is no actual market for this social benefit, we cannot know how much people value it (goes along with the above. Due to the idea of centralized benefits and socialized losses, interest groups may lobby vocally for something which could benefit very few people. Even if it benefits 40% of the public, the other 60% has not had its say to affect the outcome. When there is no market, the whole idea of "willing and able to pay" is thrown out of the window, as anyone can blow hot air claiming he needs roads. There is no normalizing factor (as relative utility valuations need), which means that demand may approach infinity.
  • The social benefit curve is all talk. It's a representation of "it would be nice" and not "I actually want this." Because demand for goods which have a market is essentially infinite, this means that "it would be nice" to have an insane amount of all goods, making all the social benefit curves pointless as the "it would be nice" approaches infinity.
  • The curve makes the assumption of objective value. The actual demand curve tells us what the subjective value of goods is. However, the social benefit curve makes assumptions about inherent value of goods and services which never emerges in the market. Take the example of immunizations (you getting immunized helps your neighbor, as you can't pass diseases onto him) and consider these two scenarios:

This is what a shall analysis shows:

 

In example 1) the black circles are immunized, the white circle with green is sick, and the white circle is not immunized. Because of the immunizations, there is only one attack vector for a virus to take to infect the white circle.

In 2) there are no immunizations, and hence that same last circle may get sick through 3 attack vectors (where the previously-immunized circles are now not immunized and can infect the last white circle if they themselves get sick)

This is what is seen, and it makes sense. Immunizations are good for society (some aggregate) because they decrease chances that any one member gets sick.

However, I contend that this ignores what is not seen. That white circle which chose to not get immunized in 1) has a concrete utility function. Given the information available to it, it has chosen  to not immunize itself. Hence, that means that it gains more utility out of spending money elsewhere than getting immunized. Hence, diverting money from the economy into the immunization of that white circle decreases societal utility. That circle would have used the money elsewhere to gain greater utility.

Here, the bureaucrats assume that they can maximize people's utility better than they can, which is not true, as you cannot measure anyone's utility function - you can only approach it (and that is achieved through the free market).

  • The money for increasing the quantity consumed must come from somewhere. It will probably come from taxes. However, while the benefits of a certain action (immunization) may be more easy to see (and more centralized), the cost of this taxation is unseen (as the alternative, free market actions never get carried out) and is decentralized (the money not spent on immunization could have been spent on thousands of different parts of the economy, which makes cost calculation extremely difficult).
  • When there is a market, it is dynamic and it reflects changing consumer preferences. Subsidies to industries, however, are not dynamic and ever-changing. The market allows for a different amount of resources to be diverted into different sectors of the economy, but subsidies lack that inherent characteristic due to being created in the bureaucracy. Hence, keeping a subsidy over any period of time inherently creates inefficiencies due to a lack of market which shows how much subsidies different causes should get across time.

 

Do I make any sense or am I just flailing at an inconvenient truth?

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Wheylous replied on Sun, Dec 11 2011 6:55 PM

Buuump

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An 8 hour bump?  On a Sunday in mid December?  What's the deal?  Give some time.  Did you check into any resources?  These might help...

What is an Externality?

The "Externalities" Argument

Accounting for the Unaccountable: The Case of Externalities

 

If you have any specific questions on those or want to follow up, feel free.

 

As a sidenote, a good video on herd immunity:

 

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Wheylous replied on Sun, Dec 11 2011 9:39 PM

Alright, I read those, thanks. They were nice to have to back up some of my claims, but what abotu the other stuff I mention? Is it valid?

Oh, and about the bump: You've raised my expectations too much :P

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John James replied on Sun, Dec 11 2011 10:58 PM

What specifically?

 

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Wheylous replied on Sun, Dec 11 2011 11:00 PM

... all of them? Are they valid objections?

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claudius replied on Mon, Dec 12 2011 12:13 AM

Your professor can answer each one of these questions.   Why don't you ask him/her?  

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Because the professor has a strong chance of believing in the labor theory of value too.

Wheylous, I'll respond for you tomorrow

 

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Bebob replied on Mon, Dec 12 2011 5:25 AM

I like your explanation and I think you make some valid points. I would like to add something about your following statement:

The money for increasing the quantity consumed must come from somewhere.

You rightly point out a flaw in the model you saw in your Econ class. A flaw that has been recognized by mainstream economics. The model that was used in your class is a partial equilibrium model (see: http://en.wikipedia.org/wiki/Partial_equilibrium for properties and criticism of the model). A partial equilibrium model only takes into account 1 market. All other markets are assumed to be unchanged. Clearly an unrealistic assumption in this case if you would use a tax on labor to subsidize the good with positive externalities. The labor market will not remain unchanged.

Economists have recognized this problem and have consequently expanded the partial equilibrium to the general equilibrium model (http://en.wikipedia.org/wiki/General_equilibrium_theory). The general equilibrium model tries to model the entire economy, instead of a single market. It adds to realism but increases complexity and in turn has its own share of shortcommings. 

Even your professor should recognize the shortcommings of the partial equilibrium model.

You give another shortcomming of the model here:

Economic calculation: how exactly do you calculate "social benefit"? 

The model uses the concept of utility obtain the marginal cost and benefit functions. However, economists have found several problem with the concept of utility. See for example: http://en.wikipedia.org/wiki/Utility#Discussion_and_criticism and http://en.wikipedia.org/wiki/Utility#Quantifying_utility These critisisms seem to be in accordance to what you are saying.

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Wheylous replied on Mon, Dec 12 2011 8:32 AM

JJ, my econ teacher happens to be an Austrian (which is a miracle), yet he teaches to the curriculum to get us ready for the end-of-year tests. He likes to play the devil's advocate against my arguments, so I wanted to test out my argument here before presenting it to him.

I think that he brought it all down to utility functions, where I pointed out that interpersonal utility comparison is impossible, to which he replied that mainstream economists don't think so and they find utility functions to maximize, which sadly could end the debate right there.

Eagerly awaiting your response, JJ :)

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Student replied on Fri, Dec 16 2011 11:44 PM

Wheylous,

What mainstream economist thinks interpersonal utility comparisons are possible? If your prof mentioned no exmamples, I would be very skeptical of the claim.

But I would like to address one of your points.

Because there is no actual market for this social benefit, we cannot know how much people value it.

This seems like an odd thing to say. There was also no market for the iPad before it was invented. Could Apple have no way to find out how much consumers valued it? I don't see why not. Companies like Apple hire marketers to studies with potential consumers to answer exactly these types of questions. And they have actually come up with clever ways to answer the question. Focus groups, interviews, etc. One technique that has been building in marketing is "discrete choice experiments." These are essentilly surveys that show respondents sets of hypothetical products that differ based on a number of attributes. Based on their responses, the marketers can then estimate how much the respondents would be willing to pay for improvements in each of the attributes.

I see no reson the govt couldn't use this technique to value non-market goods. And hey wait a minute!! That is exactly what has happened. Discrete Choice Experiments have proved so successful in marketing they re fast becomming adopted as *the* way to evaluate the external benefits/costs of environmental and other policies (over more traditional "contingent valution" surveys).

http://ekopol.org/descargas/ecological69.pdf

Are these methods perfect? No. But they are partial solutions to problems that are not unique to government policy. It seems to me the same "problems" you identify here could easily be applied to most companies developing new or improved products.

The real value of a market (in this context) is that it provides businessmen with quick feedback on whether they guess the "value" of the new product or not (if the iPad was prices at $1 million per unit, I'm sure Apple would learn quickly they could maximize profits at lower prices...or competitors would let them know.) That same type of feedback is not there for command-and-control govt intervention. But that is not a new or uniquely Austrian insight. Indeed, bringing market forces to bear on government policy is exactly the point of things like emissions markets.

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Student replied on Sat, Dec 17 2011 2:19 AM

Just one more follow up on this post. After re-reading, it sounds like you are skeptical of the idea of positive externalities in general. But let me put your fears to rest that they do exist with a simple example--bees.

Imagine a honey producer. He needs bees to make honey for him so he can put it in jars and sell it at the market for people to put on toast. In a sense, the only "benefit", the honey producer gets from the bees is the honey they make for him that he can sell. So as a profit maximizing honey producer, he will only raise honey bees until the cost of keep the last hive equals the revenue he would get from the additional honey sales.

However, bees don't just stay on the bee keeper's property. they wonder off, pollinating flowering plants all over the neighborhood. If you're a farmer that gets visited by these bees, they are doing you a valuable service by polinating your crops. In fact, you may be willing to pay the bees to visit your property more often to increase your crop yields. Unfortunately, bees make bad nagotiators. So the bee-keeper may not know he could have a side line in selling "bee pollination services". And as a result, we won't include that additional benefit into his calculation of how many bees to raise. In other words, there is a "positive externality" to producing honey that isn't being reflected in the price. And as a result, "too little" honey will be produced.

Of course, in the real world, problems like these can be sorted out by enterprising people. Indeed, there is a thriving bee pollination market in the US:

http://heinonline.org/HOL/LandingPage?collection=journals&handle=hein.journals/jlecono16&div=6&id=&page=

That is one of the central insights of Coase's paper on the Problem of Social Costs. When transaction costs are low and property rights are set, externality problems tend to work themselves out.

But, in the real world, transaction costs are not always low. And that is where the argument for intervention begins.

Hope that helps.

 

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Of course, in the real world, problems like these can be sorted out by enterprising people. Indeed, there is a thriving bee pollination market in the US:

 

 

I wonder if the bee business is thriving because we have done a pretty good job on killing the poor bastards off - hence creating a rise in demand.

 Anyway, I always kind of thought about starting a bee colony, as it looks like it would be a fun thing to do, and it would probably be good for my garden.

 

http://www.currentresults.com/Wildlife/Endangered-Species/bumblebees-802141.php

"As in a kaleidoscope, the constellation of forces operating in the system as a whole is ever changing." - Ludwig Lachmann

"When A Man Dies A World Goes Out of Existence"  - GLS Shackle

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Wheylous replied on Sat, Dec 17 2011 10:34 AM

What mainstream economist thinks interpersonal utility comparisons are possible? If your prof mentioned no exmamples, I would be very skeptical of the claim.

Well, he said that economists come up with utility curves that they then maximize. For example, there is the common claim that "a dollar for a poor man means more than a dollar for the rich man", which comes down to "poor people get more utility than rich people out of a marginal dollar." This is completely unjustified, because although marginal utility is downwards sloping, we don't know either the y-intercept or the actual slope. In fact, we cannot know them.

Do economists still believe in this?

It appears so:

Murphy addresses it (snapshot of page because his website is down): http://webcache.googleusercontent.com/search?q=cache:Xjky0pCt5c0J:consultingbyrpm.com/blog/2011/11/modern-utility-theory-and-interpersonal-utility-comparisons.html+krugman+interpersonal+utilty&cd=2&hl=en&ct=clnk&gl=us

Also, I point out the flaw here: http://mises.org/Community/forums/t/27306.aspx

Furthermore, Krugman makes the same mistake (another Murphy post).

This seems like an odd thing to say. There was also no market for the iPad before it was invented. Could Apple have no way to find out how much consumers valued it? I don't see why not. Companies like Apple hire marketers to studies with potential consumers to answer exactly these types of questions.

Then the problem of socialist calculation goes away! Horraaay!

No. It is not possible to know how much customers value this. What companies do is guess the value. Now, it's interesting that you bring up Apple. Why not consider Microsoft's Zune instead? What about the standard MP3 players? Do you think they didn't do any market research? Why suppose that government can be as efficient as Apple? It could very well turn out to be a Zune maker, could it not?

While customer surveys are useful to plan ahead, they're useless unless the market actually is forced to put its money where it's mouth is.

Furthermore, the market, as you point out, is dynamic and constantly adjusting. Do you really expect a bureaucracy to do the same?

 It seems to me the same "problems" you identify here could easily be applied to most companies developing new or improved products.

Sure, but government implementing a policy across the board can result in the entrepreneurial failures that happen so often in individual firms. That's why there's competition in the free market. This doesn't exist in government.

But that is not a new or uniquely Austrian insight. Indeed, bringing market forces to bear on government policy is exactly the point of things like emissions markets.
And how can we be sure that the cap is the "right amount"? It again makes some assumption that you know people's utility better than they do, because if a free market exists then this is a de-facto demonstration of relative utilities for individuals.
it sounds like you are skeptical of the idea of positive externalities in general

Oh, I obviously see that there are benefits which aren't necessarily taken into account. I'm just pointing out that we're looking at what is seen and not what is not seen.

But, in the real world, transaction costs are not always low. And that is where the argument for intervention begins.

If I remember correctly, Coase's idea is that the parties get together and "bribe" each other to get their policy instituted, right? If so, then transaction costs are simply part of the cost calculations.

 

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Student replied on Sat, Dec 17 2011 3:05 PM

Thanks for the link to Delong. I am very suprised he would make such a statement, but he is also a bit of provocetour. So I always take what he says with a grain of salt. In terms of how I view the mainstream attitude, I prefer to go to the textbooks instead of blog posts. For example, Varian's Microeconoic Analysis. B

This is a PhD text, but, contrary to Murphy's claim, you don't have to go to PhD level textbooks anymore to find discussions about cardinal v. ordinal utility. For example, see Hirshleifer's  Price Theory and Applications. They hve an excellent discussion on the subject.

http://www.pricetheoryapplications.com/

Why suppose that government can be as efficient as Apple? It could very well turn out to be a Zune maker, could it not?

While customer surveys are useful to plan ahead, they're useless unless the market actually is forced to put its money where it's mouth is.

Furthermore, the market, as you point out, is dynamic and constantly adjusting. Do you really expect a bureaucracy to do the same?

Hence the need for feedback mechanisms in policy as previously stated.

And how can we be sure that the cap is the "right amount"?

We can't be sure, but who said we had to be? Thankfully, we don't live in a country of unaccountable central planners. Hopefully, our representitive government would react to citizen complaints if the cap was too high or too low and hopefully that would get us close to the right amount. That is a lot of hopefullys, but I am not offering perfect policy solutions. I am describing ways we can (and have) improve policy making.

But this is getting us off topic. This doesn't change my central point, which is that many of the "criticisms" you offer don't seem unique to government policy makers or are even unique to the Austrian school. EVERYONE realizes these issues. But I am now a little lost on what you are actually criticizing. You say you acknowledge the possibility of positive externalities and you acknowledge that the information problems you mention are not unique. If that is the case, I don't think we have anything more to disagree on that is economic. The rest is just political. And I dislike politics.

If I remember correctly, Coase's idea is that the parties get together and "bribe" each other to get their policy instituted, right? If so, then transaction costs are simply part of the cost calculations.

You remember VERY incorrectly. The central point of Coase is that if transaction costs are high, the transaction won't take place and externality problems will remain. I suggest re-reading the Problem of Social Cost.

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Autolykos replied on Sun, Dec 18 2011 7:50 PM

Student:
This seems like an odd thing to say. There was also no market for the iPad before it was invented. Could Apple have no way to find out how much consumers valued it? I don't see why not.

Apple indeed had no way to find out how much "consumers" valued the iPad before it was invented or even marketed. (I put "consumers" in quotes because there's no necessary reason for the numerous individuals making up "consumers" to share the same valuation of the iPad or anything else.) All Apple could do is guess. Entrepreneurship is basically guessing - no matter how much research is done. You yourself seem to recognize this later in your post:

Student:
The real value of a market (in this context) is that it provides businessmen with quick feedback on whether they guess the "value" of the new product or not [...] [Emphasis added.]

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Student replied on Sun, Dec 18 2011 9:41 PM

Obviously, not all guesses are created equal. 

 

If you are asserting that businesses could improve profits by firing their marketing teams and choosing prices at random, then you are crazy and we have no need to continue this conversation.

 

If you are asserting that even an educated guess isn't perfect and that prices will ultimately be determined by the interaction of producers AND consumers, then we agree on supply and demand 101 and have no need to continue this conversation.

 

And judging from the 3 other posts you have written about me recently (calling me a liar, a coward, and worst of all not amusing) it seems you are in the mood to troll and thus we have no need to...well you see where this is going.

 

But I have no time for dark energy during the holidays. So let me just say Happy Christmas. :) I hold no hard feelings. 

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Wheylous replied on Sun, Dec 18 2011 9:44 PM

You neglected my argument about the negative externalities of taxation.

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Student replied on Sun, Dec 18 2011 9:56 PM

You mean in your original post? About how funds to close the positive externality have to come from somewhere (like taxation)? And that the opportunity cost of raising taxes (the "unseen" impact of spendingmoney on immunization instead of other things) would have to be accounted for? I didn't neglect it. I agree with it.

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Wheylous replied on Sun, Dec 18 2011 10:36 PM

Yet you believe that policy makers can calculate this cost effectively?

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Autolykos replied on Mon, Dec 19 2011 6:14 PM

Student:
Obviously, not all guesses are created equal.

That's not what you seemed to be saying before. From my reading of your earlier post, you seemed to be saying that Apple somehow knew just how much "consumers" valued the iPad before it was invented and/or marketed. But how can anyone know anything about the future? After all, the future hasn't happened yet. In other words, I was challenging your apparent claim that there can be certainty about the future. If that's not what you were claiming, then I think it's up to you to clarify - assuming you actually want me to understand what you mean.

Student:
If you are asserting that businesses could improve profits by firing their marketing teams and choosing prices at random, then you are crazy and we have no need to continue this conversation.

I'm not asserting that, and I think you know that already. But I could be wrong.

Student:
If you are asserting that even an educated guess isn't perfect and that prices will ultimately be determined by the interaction of producers AND consumers, then we agree on supply and demand 101 and have no need to continue this conversation.

I'm asserting that it's impossible to know the future before it happens. As I mentioned above, you seemed to be asserting the opposite. Here it seems like you're by and large agreeing with me - but I think a better way of putting "even an educated guess isn't perfect" is "even an educated guess isn't knowledge."

Student:
And judging from the 3 other posts you have written about me recently (calling me a liar, a coward, and worst of all not amusing) it seems you are in the mood to troll and thus we have no need to...well you see where this is going.

In no way am I even attempting to troll you. Somehow I think you already know that. But I will call people out when I perceive intellectual dishonesty from them. If you really want to call that "trolling", then I'll gladly stand "guilty".

Student:
But I have no time for dark energy during the holidays. So let me just say Happy Christmas. :) I hold no hard feelings.

Don't expect to see any change in my behavior. I couldn't care less what you call it - "dark energy", "trolling", whatever.

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Student replied on Mon, Dec 19 2011 9:04 PM

Yet you believe that policy makers can calculate this cost effectively?

It depends what you mean by "effectively".

But the last thing I want to make this thread about is what *I* think policy makers are capable of. I just wanted to lay out my thoughts on your original criticisms, and I think I've done that. So we can probably pack this in.

But if you are really interested in the topic and want to read more about it, here are some parting thoughts and links for further reading that you might find interesting.

Throughout this thread, it seems like you are framming your questions as if this was the 70-year-old calculation debate--with "central planners" on one side and "markets" on the other. But I really don't think that a discussion about U.S. policy can be framed in those terms. Namely because not all "government intervention" could accurately be described as being led by "central planners."

Specificlly, I would say that many (if not most) of the disputes that arise over conflicts created by externality problems are not settled by the market or bureaucrats, but judges (as I remember Coase presents several examples of relevant cases). Yet, even though judges are "central" decision makers working for the state (whose decisions are in turn enforced by the state), they are not at all the type of central planners that Hayek or Mises was talking about in the 30s/40s. This is because, in a common law system, the rulings of judges are subject to "feedback" in subsequent court cases. That way, even if the one judge makes a ruling that doesn't allocate resources to their highest valued uses, future judges will eventually reverse it.

It isn't obvious why this should be the case, but a number of papers in the field of Law and Economics have been written trying to make the case. Here is one good example if you would like to read more on the subject:

http://business.baylor.edu/Charles_North/4318Files/4318Rubin1977.pdf

(Note:  this line of research is relly a continuation of Hayek's assessment of common law v. statute law in Law, Legislation, and Liberty--also worth reading).

Similarly, even the decisions of executive branch "planners" are not made in a vacuum--they are directly subject to legal action (the EPA is routinely sued by both industrialists and environmentalists for example) and indirectly scrutinized by the electorate. It is harder to make the case that these pressures tend toward "efficient" policy decisions, but it is also harder to pretend we can treat these "planners" like Soviet Commissars.

Anyways, those are just some thoughts and a few things worth reading. Thanks for the discussion and have a Happy Christmas. 

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Well, that wasn't very convincing.

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MrSchnapps replied on Tue, Dec 20 2011 12:34 AM

Good posts, Student + others. This is a solid thread.

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