Kruse Kronicle

Allocation of Limited Resources - Part 9 (The Role of Production)

So far in this series, we have examined several possibilities for the distribution of limited resources. While face-to-face communities have the wherewithal to employ several criteria in allocating limited resources, larger aggregations of people do not. I’ve argued that market exchange is by far the most just and efficient means of allocating limited resources across mass society. (To reiterate, the operative word is “most.” I have not said that markets are some quasi-deity creating a perfect world of shalom, and I’ve spent several posts explaining why markets need regulation.) But there is yet one more issue we need to explore.

If the goal is to have people live in relative prosperity on a sustainable basis, then the title of this series, “Allocation of Limited Resources,” is off the mark. It presumes that there is a fixed set of goods somewhere, say light bulbs, and that our fundamental problem is figuring out how to distribute them. Both presumptions are wrong. It envisions only distribution and consumption. Someone, somewhere, makes light bulbs. If some folks have an insufficient supply of light bulbs, then why not make more light bulbs? What about production?

New Testament scholar Ben Witherington writes in Jesus and Money:

“Scholars of ancient economies often talk about the concept of limited good. In biblical culture there was both low productivity and no notable means of increasing productivity over time (as with, say, the help of modern fertilizers and modern irrigation techniques). Given these realities, ancient peoples tended to believe that the goods of life had been distributed, even distributed by God, and they could not be increased – they were decidedly “limited.” This in turn meant that if a person wanted something he or she did not have, they had to barter for it (or steal it).  It was not a matter of finding some way to make “more,” in order to increase one’s income and spending power. Unlike these pressures, and given the fact that droughts were regular and the land’s fertility could become farmed-out and exhausted, many ancients expected frequent decreases in productivity, thus prosperity on a regular, cyclical basis.” (46)

Production was about human labor. One hour of labor by any healthy individual was understood to be as valuable as any other healthy individual’s. If you wanted more productivity, then you would need more people. Furthermore, you needed land since most labor was in agriculture, even in the sophisticated Roman Empire. There was a fixed amount of land and only a fixed amount of production you get from each parcel of land. Substantial, sustainable increases in production were unthinkable. The land and the population would support the workers and provide enough surplus that elites could siphon off the excess in support of urban affairs and military operations.

This was the state of the world until very recently. It is largely a closed-system, zero-sum game. Whatever advantage someone has is at the expense of someone else. Thus, economic justice for those in need is almost exclusively a question of distribution … the haves not sharing with the have-nots.

But over the past two or three centuries, we have learned something. Production can be radically altered. The keys are division of labor, technology, and trade.

Having each individual produce most of what they consume is a highly inefficient use of labor. No one is efficient at everything. When we add in the complexity of today’s goods … cell phones, pharmaceuticals, construction materials, etc. … there are only a few things we could make on our own at the same quality and price. Therefore, we each specialize in the things we do well. We accept payment from others for the services or goods we provide and then use that money to purchase the other things we are not as good at supplying. Because each individual is concentrating on the work in which they are the most productive, the whole society becomes more productive. That means more and better products per a fixed amount of time.

But when it comes to producing tangible goods, we see a dramatic transition from the past. By analogy, imagine two people on a continuum. First is a caveman with some rocks and knowledge of how to make a fire. The other end is a person standing before a Star Trek replicator, who merely voices what she wants, and the replicator arranges molecules to fulfill her request. The first move along the continuum was tools that directly augment human power … hammers, swords, plows, knives, etc. Animal power in the form of oxen or horses was also eventually employed. Some cultures learned to use water and wind to power some contraptions, but the applications were limited. These were significant improvements over historical standards but were still largely incremental advances, not exponential.

The great change came with the Industrial Revolution. Machines that could do the work of thousands of human beings came into being. Initially, many workers became servants to machines. But as industrialization advanced and public education expanded, manufacturing jobs have become increasingly more skilled, even as the percentage of the economy has shrunk. Service and information sector jobs have risen in their place. The combination of rising incomes for more skilled employees and a reduction in the real price of goods has led to a level of prosperity for the masses that was unimaginable for previous generations. The key has been the emergence of specialized labor, technology, and trade, as well as the social institutions and values that undergird them.

Too much allocation discussion is done by viewing people or societies as buckets of water where we take from some buckets and add to others to ensure they all have the same amount. A better analogy is to view each person or society as a plant. For our recorded history, we have had only sickly plants, but we never knew that until some plants began to thrive radically. The operative question is, what changed that enabled these plants to thrive? Many people ask what causes poverty. But this has it backward. Poverty has been the norm throughout history. Today we have widespread material prosperity in developed nations. That is the aberration. The question is, what causes prosperity?

The specialization of labor and the application of technology has radically altered productivity. Markets have played their role in productivity, but markets have also added something else to distribution that is so subtle we rarely appreciate it. Markets, the auction method of allocation, unlike the other means of allocation we mentioned early in this series (first come, first serve, equal treatment, cronyism, and open conflict), directly link consumption and production. Markets provide a real-time feedback loop that does not and cannot, exist without them. Markets provide unprecedented efficiency in the distribution of goods.

There is no question that there is a place for generosity and aid to others, whether we are talking about individuals or other nations. But unlike throughout history, this is no longer the pressing ethical question. The question is, what inhibits people and nations in poverty from being able to emerge from poverty? How can an ecosystem of sustainable prosperity be developed? These questions have profound theological and ethical implications that need to be wrestled with, but they cannot be addressed from within the ancient worldview of closed-system, zero-sum economics that so many theological specialists and Christian activists inhabit.

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Allocation of Limited Resources - Part 8 (Government Limitations of Ignorance and Vested Interest)

I began this series with the analogy that presented various modes of allocating limited resources. It concluded that auction … markets … is the most efficient and just system we have. In the following post, I explained that we deal with two types of community: Face-to-face and commercial society. Face-to-face communities can often efficiently and justly allocate resources based on non-market criteria. Because people know each other and their circumstances well enough, they can make informed decisions. That is not possible for commercial society. Markets are, therefore, the most efficient and just in coordinating mass society. We then looked at Paul Heynes' analogy of an urban traffic system to illustrate that a "market economy" is not anarchy or an air traffic control system. It is a complex dynamic system where people act on decisions about their own contexts but interact with the larger community according to agreed-upon rules and mores.

With that foundation, I explained that markets have limitations. They need intervention in various ways. We examined the problem of negative externalities where some escape the costs of their actions, and others must absorb them. We explored positive externalities, cases where the broad application of a good or service benefits the common good, but some or all of society will not avail themselves of those goods and services unless the costs are minimized by spreading them across many people. We saw that government regulation is sometimes necessary to facilitate transparency and the flow of information. We saw that government is needed in the case of natural monopolies. We looked at the role of government in stabilizing the economy through monetary and fiscal policies. We noted that some believe there are cases where it may be necessary for government to intervene in businesses or industries for the sake of the public … for instance, by responding to tariffs placed on imports by other countries. We noted the role that non-profit firms play in addressing many societal needs.

Finally, we looked at the issue of redistribution. In our market economy, instead of trying to manage the economy so everyone gets a "fair" outcome … however "fair" is defined … we have generally opted to let the market do its work and then address inequities through progressive taxation and a variety of aid programs. Of course, the big question is how much of which kind of aid? But there is an underlying belief by most that society, through government, has some responsibility to the poor.

So, two things need to be said here about markets. First, markets are the most efficient and just means of allocating limited resources across millions of people that humanity has yet to devise. The benefits of the market system are nothing short of astonishing by historical standards. Combined with the division of labor and technological innovation over the past two centuries, I can think of no other development that has led to such widespread (and rapidly spreading) physical health and material well-being for so many people.

Second, markets do not constitute a quasi-deity, mystically guiding everything to its highest use. They simply do a far better job of guiding things to their highest use than anything else we know. I've identified several ways markets, left to their own devices, would not create the most efficient and just outcome. Markets need intervention.

So maybe we can let markets do their magic while using government to resolve issues like externalities, stabilizing the economies, dealing with natural monopolies, and providing an appropriate social safety net. Will this lead to a more just and efficient society? Not necessarily. There are two very significant constraints on government.

The first limitation is ignorance. While markets require intervention, there is frequently insufficient information to know how to intervene. In Runaway World, sociologist Anthony Giddens looked at the Mad Cow scare in England a few years ago. Government officials were slow to sound a warning. It is believed the delay caused greater harm. Outcries arose about incompetence and conspiracy. And yet, if government overreacts, sounding the alarm too quickly or forcefully, the same cries of incompetence and conspiracy arise if evidence of their warnings is not forthcoming. Ironically, sounding the appropriate level of warning that generates just the right amount of response to confront a problem can reflect negatively on officials because many citizens will view the failure of a disaster to materialize as evidence of alarmism rather than successful aversion. Giddens' primary point is that what we are confronting in so many of these situations is risk management, not certain choices between right and wrong.

Product recalls and epidemic warnings are tricky enough, but when we move to issues like climate change the calculations become enormously complex. We saw earlier that two ways to combat the problem are to tax carbon or implement a cap and trade scheme. But how much tax? How much CO2 should be allowed by cap and trade? The problem is more akin to handicapping horse races than precise economic calculation.

But ignorance bedevils us in other arenas as well. It has long been believed that homeownership makes for better citizens. It was viewed as a positive spillover which government should subsidize. While hardly the only contributing factor, the rising pressure from both Democrat and Republican administrations to take more financial risks in the mortgage lending market contributed to the market's recent collapse. We can point back to the 1960s when government concentrated the poor in high-rise housing projects to centralize services to the poor more effectively. The concentration was one of the worst disasters of aid to the poor in U.S. history. Predicting how people will respond to various incentives interjected into the market is often quite difficult. There is no great oracle who knows all the facts and can give us the policy direction we need.

The second big issue is vested interests. In democratic societies, politicians must get re-elected. That means every decision has a combination of considerations. I'm not as cynical as some in that I believe that many politicians do have noble public service as a part of their vision. But every politician also must weigh the impact of their decisions with the support of campaign donors and voters. Virtually no political decision is the optimal decision that would be made in a perfect world, and some are downright destructive. Most are somewhere in between.

Right now, it is popular to decry the influence of large corporations in the political process. It is believed that large corporations resist regulation. This is true sometimes, but large corporations in many industries embrace regulation. Regulation creates what business analysts call a barrier to entry. Large established corporations are usually more adept at managing regulation than smaller firms. Potential new companies in a regulated industry must go through a learning curve in handling regulatory requirements. The more daunting the regulation is, the more of a deterrent it is to the would-be new competitors. A partnership develops between corporations and politicians. Supportive politicians get sizeable support in their campaigns. Corporations get the ear of politicians in tailoring regulations that benefit the perpetuation of their firms while discouraging competition. Populist efforts to control large corporations frequently have the unintended effect of consolidating corporate power and stifling small business innovation.

Churchill remarked that democracy is the worst form of government except for all the others. We can also say that market economies are the worst economic systems except for all the others. And the two of them together will not yield us the optimal world as seen through the eye of an all-knowing deity … but neither will any other system!

We seem to have a strong need to perceive that someone is in charge … that our world is predictable and safe. When something unpredictable or threatening emerges, that means our "someone" wasn't doing his job; otherwise, these things would not have happened. In our case, that "someone" is usually perceived to be the national government because it is the centralized entity that is "running" the country."

But let's return to traffic analogies. If you let millions of people drive around in their cars at speeds up to 70 mph, there will be accidents. Some people are going to get killed. Many others will be injured. Still, others will suffer financial setbacks from car repairs. In any given accident, we can study events and determine what roles driver error, mechanical failure, or other factors played. We can learn from such studies to minimize contributing variables, but we can't eliminate all collisions if we allow this kind of mobility. We could universally reduce the speed limit to 5 mph, likely dramatically reducing the accident statistics. It would also make the transportation system useless from any practical standpoint, and a load of other miseries would befall us (Think of increased death due to heart attacks from people unable to get to the hospital in a timely way or firefighters getting to fires, much less the way it would end trade.) To paraphrase a popular bumper sticker, "Stuff Happens!" If there is going to be a meaningful transportation system, people are going to get hurt.

Similarly, people are going to get hurt in a market economy. People make seemingly wise investment decisions and lose money. Unscrupulous people do unethical things with their businesses, and others get hurt. Industry dynamics means some businesses rise while others fall. The volatile evolutionary nature of the market means there are times of retraction and loss for the overall economy. And just as with auto accidents, each case can be studied to understand the variables that led to the negative outcome, and we can learn from those variables. But if we are going to have economic freedom, people will get hurt! Stuff happens! There categorically is not a "great mind" or a system somewhere that can make our lives wholly predictable and safe.

Where does that leave us? Markets are a remarkable system for the just and effective distribution of limited resources. Government intervention is critical to both markets' functioning and addressing several limitations markets possess. The deification of the markets as the master of providence and the deification of the state as an all-knowing, benevolent mind guiding the economy with enlightened reason are fantasies. Some combination of the two will not free us from harm, and acting as though changing the system in some direction would free us is a delusion.

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Allocation of Limited Resources - Part 7 (Redistirbution of Income)

Today we come to probably the most controversial role government plays in the market, redistributing income. In the broadest sense, income gets redistributed every time something is taxed, regulated, or subsidized. Here I’m focusing particularly on redistributing income to the poor.

Some believe government has no role to play in alleviating poverty. Others believe government has an enormous role to play. I sense that most folks are somewhere in between. They believe government has at least a prudent interest … if not a moral obligation … to address some aspects of poverty.

And that raises another question. If poverty is simply the bottom X% of the income distribution, there is no way to eliminate poverty. There will always be people in the bottom X%. More typically, I think poverty is understood as insufficient resources to regularly obtain the basics of life (food, shelter, and clothing) as well as being able to partake of some of the basic amenities of contemporary life. The challenge is assigning a dollar value that indicates a poverty threshold.

And still another complicating factor is the persistence and causes of poverty. Our poverty statistics can include relatively well-off people in temporary poverty (Retirees living on savings, grad students, and the temporarily un- or underemployed.) They also include people who are simply unable to provide for themselves economically. They also include people trapped in sub-cultures of poverty. And they include people who make bad choices. However, the stats exclude those just above the poverty level who are at great risk. “Poverty” is frequently a more complex term than it first appears.

From an economic standpoint, having as many economically productive people as possible is desirable. There are positive spillovers to society in reducing the number of poor. That means fewer resources diverted to their care and more productivity by them, leading to more resources for their own care and the care of others. But let’s start with the assumption that society also has moral obligations to help the poor through government redistribution. And let’s also assume that there are personal obligations that each of us individually has for the poor as well. With these assumptions, two externalities present themselves.

If aid to the poor is treated purely as a private affair, many will do much less than their fair share to meet society’s obligations, while a few conscientious folks will be saddled with doing much more. The slackers externalize their obligations. However, it is also possible to take the position that it is government’s responsibility to take care of the poor, and because I have paid my taxes, I am under no further obligation to aid the poor. Aid that government can’t provide (or provide well) is externalized to more conscientious folks. Whether by externalizing personal responsibility to other people or to the government, many will not aid the poor as they should.

The next question is, how much aid is too much aid? There is a deeply held assumption that each member of society should take economic responsibility for themselves and be charitable toward others. For any number of reasons, some will never be able to provide for themselves economically and have limited support networks. There seems to be a widely shared sense that society is responsible for these folks. But others, with education, changes in behavior, and aid, can be highly productive members of society. Then there is a whole continuum of people in between. Which folks are which? There is a measure of triage involved.

Certainly, with enough aid and personal investment, some will be able to excel. Yet, as countless social scientists have noted, too much aid can create a culture of dependency. When aid significantly exceeds what a person might get in the short-run as they pursue a better education and job experience for the long run, most people will never take the initiative to go through the short-run changes. How much aid is the right amount for any given circumstance?

There is an enormous information problem here. Each individual and family is unique. There is no way a vast centralized government can nurture each case in all its particularities. But it is also true that private individuals and agencies require a significant investment of time to know folks at this level as well. The way the poor have become increasingly segregated from the rest of society doesn’t help.

Governments have taken different strategies toward this. Many European nations have more extensive social safety nets. That means a more secure living standard across all of society. But relative to the U.S., this has historically meant higher rates of unemployment, reduced job mobility, less mobility up and down the economic ladder, and lower levels of entrepreneurship and innovation. The U.S. has offered less economic security but usually less unemployment, more mobility, and greater innovation. (One forty-eight month study in the ‘90s showed that half the people that said they were in poverty at any point during the study were in poverty for 2-4 months. Only 7% were in poverty for thirty-six months or more. A Treasury Department study that followed actual individuals from 1996-2005 found that 58% of people who started in the bottom quintile moved to a higher quintile and that 30% moved to the top three quintiles.)

American society has involved government in redistributing income through a variety of means. First, there are direct cash transfers. The Earned Income tax credit is probably the most notable. Second, there are indirect transfers through programs like Aid to Families with Dependent Children, food stamps, Medicare, school lunch programs, and the like. Third, skills development programs like Head Start and job training programs exist. Fourth, there is a progressive tax system. The top 50% of earners pay 97% of federal income taxes. Fifth, wage laws require employers to pay at least a certain base wage. All this is expected to function alongside a strong voluntary aid network for the poor.

I’m not interested in debating the merits of these various strategies at this point. Some think we must do away with all or most of these measures. Others think we ought to do much more. The vast majority seem to be between these two, believing we have some responsibility for the poor through government intervention but are not to subsidize the lives of most impoverished people completely. So while the debate continues, there appears to be a strong consensus that some market intervention is economically and morally necessary. This is another way in which the market is modified with government intervention.

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Allocation of Limited Resources - Part 6 (Other Government Interventions)

So far, we have seen how government sets and enforces rules by which economic transactions occur. Government sometimes intervenes to remedy negative externalities and to leverage positive externalities. What other roles has government played in a market economy?

Information and Transparency

The market economy is based on the presumption that buyers and sellers are well enough informed about products to make an informed decision. If a product or service doesn't meet a customer's satisfaction, the customer goes to a competitor. Multiplied over many customers, good firms will be rewarded, and bad firms will go out of business. If I buy a package of zip-lock bags that don't seal well, I'll buy a different brand next time. This works just fine for the vast majority of products we buy.

But what if, instead of bags, a doctor removes your appendix, or an airline pilot is flying you to your destination? The cost of a bad product here is much more costly. In many cases like these, we regulate the business to ensure practitioners meet certain minimal standards and abide by certain practices. The regulation makes the service more costly but dramatically enhances our chances of avoiding a catastrophic scenario.

Financial markets are another place where regulation is essential. Publicly traded corporations are trading shares. Insiders have considerable knowledge about the company. Reporting financial data in ways that mislead investors would often be quite easy. The failure of regulators to create a transparent environment in the financial markets is, in my opinion, one of the primary reasons for the 2008 economic meltdown. The bigger and more complex the corporations, the greater the need for transparency.

Natural Monopolies

Some services don't lend themselves to competitive models. The sewage system and garbage collection are good examples. In these cases, a monopoly is often granted to a firm, but the firm has direct government oversight with the government approving service fees… usually allowing the firm to cover costs and earn a reasonable profit. As with garbage collection, the service is sometimes outsourced to the lowest bidder on a government contract. That introduces some market discipline to the service being provided. But the bottom line, some industries are simply natural monopolies.

Economic Stabilization

Government also influences the economy by trying to make the endless (and likely unavoidable) swings between boom and bust less severe. One approach is through monetary policy. Through a variety of complex transactions, the government manages the money supply. Too much money in circulation, and you will likely get inflation. Too little money in circulation and credit markets seize up, destroying the economy's dynamism.

Monetary policy is controversial with some. The belief is that the money supply should directly correspond to some precious metal like gold. No more money is printed unless a corresponding amount of gold is produced. It is beyond our purposes to dissect this, but we need to be aware that monetary policy is a significant way government intervenes in the market.

A second method is fiscal policy. Government can affect the economy by raising or lowering taxes. In crises, as we have seen over the last few years, government can increase spending to create more demand for goods and services. Again, there is much controversy about the effectiveness and unintended consequence of such measures, but it is seen as a tool in the government's economic toolbox.

Direct Intervention

Another way government sometimes involves itself in the market is to decide that certain key industries are critical to national survival to be allowed to fail. Decades ago, it was argued that having home-grown food supply capabilities was critical to national security. Farm subsidies and protectionism have given American products a favorable position in the market so that those capabilities would not be lost. Many emerging nations use similar tactics to protect industries they want to nurture as part of their national welfare.

There is spirited debate about the wisdom of such interventions. The recent bailouts of large banks and the auto industry were largely justified on these grounds. These firms were "too big to fail," meaning their collapse would have catastrophic consequences for national security and societal well-being. My point is not to adjudicate whether these actions have merit but rather to simply note that direct intervention in the market is an often-used option.

Non-Profit Corporate Charters

Government also facilitates the formation of legal entities created by citizens to accomplish tasks that might not be well served through a market system. Non-profit corporations are like profit corporations except for two significant features. First, there is no share ownership of the corporation, with shareholders receiving dividends or appreciation in stock value. All assets must be turned over to the state or another non-profit entity when the non-profit is dissolved. Non-profits must still receive more than they spend … make a profit … the distinction is in how the profit is used.

Non-profit corporations are different from profit corporations because they usually have two clients. Some people give the money … donors … and the people who receive the services. While there can be overlap between the two, very frequently, there is no overlap at all. One important function of many non-profits is allowing groups of people to amass wealth to be used to provide goods and services to others who might not otherwise be able to receive those goods and services. The government gives groups willing to live by the restriction of non-profit status favorable tax treatment.

In the next post, we turn to the redistribution of income. In the post after that, we will look at the challenges of government effectively and justly intervening in the markets.

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Allocation of Limited Resources - Part 5 (Positive Externalities)

We saw in the previous post that some types of market exchange involve negative externalities. People not a party to a transaction end up bearing part of the cost … the costs “spill over” onto them. But there are also cases of positive externalities. In these instances, the market exchange benefits not only the parties involved but those who were not a party to the transaction.

James Halteman, in The Clashing Worlds of Economics and Faith, invites us to consider the consumption of a loaf of bread. If I eat a loaf of bread, I alone get the nutritional benefit of eating that bread. Now imagine a world where each time I eat a loaf of bread, all my neighbors are nourished as well. This is absurd regarding bread, but consider what happens in other facets of economic life where my benefits “spill over” to my neighbors.

I live in the heart of America’s Tornado Alley. Halteman uses the example of storm-warning devices. If I install a storm-warning device to protect my family, my family will certainly benefit from such a device. But so will all my neighbors who invested nothing. So, is it economically prudent for me to install my own storm-warning system? Maybe I should wait for one of my neighbors to install one and benefit from their expenditures. Of course, all my neighbors are doing the same. In these instances, it is better to levy a tax to provide these services so that no one has to bear the costs of services that benefit the whole community unfairly.

In reality, a great many of the goods and services we buy probably have some spillover effect. The question is the matter of degree. For instance, if I get an education, there will almost certainly be financial benefits that accrue to me alone. However, as Halteman points out, our complex post-industrial society requires people to read, do basic math, understand our civic structures, manage personal finances, and have a variety of other life skills. Each time you send an email or publish an advertisement, you benefit from my reading ability. Therefore, we provide public education and require people to achieve a certain level of competency. People can choose to use the public option or not, but the goal is to be sure everyone has a minimal standard of education.

There are several other examples where goods or services a publicly provided due to positive externalities: military service, police and fire protection, garbage collection, and communications. Of course, the big issue today is health care. Certainly, there are positive spillovers for me from you being healthy. But unlike basic education, for example, the cost of achieving health can vary wildly from person to person. Basic preventative care and treatment for common ailments may have similar characteristics to public education but services beyond this can present profound challenges.

By their very nature, some things likely require a government approach to providing just and efficient services. Others appear to have a hybrid nature where a combination of government and market approaches may be required. We will have more to say in a future post about the challenges of using non-market approaches to address problems effectively, but for now, it is enough to see that positive spillovers do occur and that, in some instances, we have decided to intervene in the markets to facilitate and expansion of those spillovers.

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Allocation of Limited Resources. Part 4 - (Negative Externalities)

At the core, market exchange is about well-informed buyers and sellers freely exchanging to their mutual advantage. But what happens when the transaction price doesn’t capture all the cost or benefits of the transaction … that is, someone external to the transaction bears part of the cost and/or reaps part of the benefit? When this external impact occurs, economists refer to it as an externality. There are both negative and positive externalities. Today we look at negative externalities.

Negative Externalities

The most typical externality example is pollution. If I build a factory that puts smelly odors into the air, my neighbors will have to live with that odor. That odor decreases my neighbors’ quality of life and reduces their property values. Yet my neighbors get none of the income from the factory. Therefore, both my customers and I engage in exchange, which places a cost on my neighbors.

There are a number of ways to address these problems. First, government creates zoning laws that segregate pollution-emitting enterprises from residential and retail areas. That way, my pollution will only affect those who have bought property in an area with the full knowledge that pollution will likely be present. They calculate the cost of this pollution into the price they pay for their land. This clearly is a limit on the market. I can’t buy any piece of land and just do with it what I please. But zoning helps minimize the likelihood that neighbors will engage in activities that exact costs on their neighbors.

Another way to address an externality is through taxation. Many believe that carbon dioxide is having a damaging effect on the environment. In that sense, it is a society-wide externality. The cost to ourselves and future generations isn’t captured in the costs of the fuel sources we use. By adding a significant tax to activities relative to the amount of CO2 they produce, the costs of these activities are more fully factored into market exchanges.

Another way pollution is addressed is through cap and trade. Here the total allowable amount of a specific particulate over the course of a year is set. Then permits to emit a set amount of the particulate are sold at auction. These licenses will be highly valued for businesses that find it very costly to reduce emissions, thus driving the auction price up. For businesses that find it easier to reduce emissions, converting to other technologies will be less expensive, thus reducing overall pollution. But over time, as the cost of licenses becomes more constraining, more businesses will find it in their financial interest to make significant investments in pollution reduction. The last holdouts will eventually find themselves paying prohibitive fees to stay in operation.

With both taxation and cap and trade, businesses and markets develop their own solutions. Another approach is to outright ban certain activities or mandate technologies to be used in particular activities. A softer approach is to give subsidies to people who will employ specific technologies. In this way, government is not only ensuring externalities are captured in the price of transactions but dictating what transactions will be permissible.

So externalities are often created and must be addressed. But notice that there are perils with each of the suggested solutions above. An overarching one is the unequal application of these laws. Some powerful industries or companies make a case for why they should receive special treatment. If politicians bow to this approach, competitors of these now favored entities must enter the lobbying arena to get similar deals or block their competitors’ deals. This suddenly makes politicians very important recipients of campaign dollars and other support from these competing interests.

Many fail to appreciate that many large corporations welcome regulation of their industry. Regulation creates a barrier for firms wanting to enter the market and compete. The burden of regulation is usually disproportionately cumbersome for smaller firms. The net result can be a melding of powerful political and business interests, all in the name of protecting the public and capturing externalities.

Both taxation and cap and trade have inherent information problems. Using taxes to counter externalities lets businesses know how much things will cost, but how do you know which tax amount will get you the right result? Cap and trade make the pollution level known, but how do you know how much impact a cap will have on costs and the ability of businesses to plan?

Another factor is that regulation sometimes has the reverse effect of what is intended. Several years ago, I read about a guy in North Carolina with hundreds of acres of tall timber forest land. He would cut 1% to 2% of the trees each year and then replant. Then a species of owl was placed on the endangered species list. An environmental regulation was proposed that no tree harvesting could occur within a given distance from wherever a habitat for one of these owls was discovered. Doing the calculations showed that it would take only a few owls before his entire property would not be available for harvest. He, and many other landowners, were preparing to harvest their entire acreage before owls would arrive or be found, thus wiping out habitats for the owls. What eventually happened was that the regulation was abandoned, and a volunteer owl preservation program was initiated that became very successful.

There is no question that externalities are a problem, but solutions also have problems. There are usually trade-offs between options, and there are differences of opinion about which trade-off should be valued over another. The idea that no interference in the markets on these matters is always the most just approach is highly doubtful. But which policy to apply on which occasions is rarely self-evident.

As I noted at the start, there are also positive externalities … instances where people external to a transaction receive benefit from the transaction. They are sometimes called spillovers. We will turn to these next.

(Paul Krugman has a piece about externalities and climate change in the New York Times today. I don’t necessarily agree with Krugman’s assessment at every point, but it gives you an idea of how economists process the issues.) 

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Allocation of Limitied Resources. Part 3 - (A Driving Metaphor)

In the first post, I made the case that auction (market exchange) is the most efficient and just mode for allocating limited goods in society. In the previous post, I made the case that face-to-face communities are very different from commercial society. Face-to-face community provides us with intimate knowledge of others and a level of solidarity that cannot be achieved among more than a few people. For these reasons, face-to-face communities can use allocation modes other than auction quite effectively. But it is also for these reasons that we cannot view society as a family writ large.

When discussing a market economy, we discuss coordinating production, consumption, and exchange between millions of people who do not know each other. Thinking about markets metaphorically as an urban transportation system may be helpful. We can imagine two extremes. One extreme would be complete anarchy, with people driving where and how they wish without restraint. The other extreme would be akin to an air traffic control system where no one moves without express permission, and everyone follows precisely the path they have been given.

Economist-theologian Paul Heyne develops this metaphor in an essay "Income and Ethics in the Market System." (Chapter 3 in "Are Economists Basically Immoral?" and Other Essays on Economics, Ethics, and Religion) Below is a lengthy excerpt from that essay.

Radical Individualism

It's [the traffic system] a radically individualist system, to begin with. Drivers sit in their own vehicles, cut off from any communication with the other drivers who surround them, pass them, meet them, and cross their path. There are citizens-band radios, of course, but it's my impression that drivers use them to communicate with people who aren't close by and whom they don't expect to encounter. I've seen no evidence that drivers use citizens-band radios to work out problems of potential conflict on the freeways during the rush hour, or generally while driving in urban areas.

On the contrary, drivers formulate their plans quite independently, with no knowledge of the plans that have been or will be made by others whom they're going to encounter. Each of us decides what time to leave for work and what route to take, and we do so without even consulting anyone else. The choice of both ends and means is made by individual drivers who characteristically don't have the slightest inkling of what others are going to do. There is currently no grand plan, no overarching design constructed by the Department of Commuting to make sure that you and I aren't planning to occupy the identical road space at the same time. (The urban traffic system, in short, is not like the air traffic control system.)

Individualism, Selfishness and Concentration

Now one could correctly say of this system, as Adam Smith said about investors in his day: Each person intends only his own gain. But is that selfish? Is it selfish of me, while driving, to focus exclusively on getting to my chosen destination as quickly as is consistent with my person well-being? Is it selfish of me to ignore completely, not even to think about, the welfare of other drivers? If in fact I start to wonder where other drivers are going and whether their missions might be more urgent than mine, I'm beginning to daydream, and I become to that extent a greater menace not only to my own welfare but also to the welfare of other drivers in my immediate environment. An important insight emerges from this: Responsible, ethical behavior will often require an exclusive preoccupation with the technical task at hand. Driving in traffic is an example that we will all concede. So is the act of performing surgical operations; surgeons don't operate on close friends or relatives, because the personal relationship could easily introduce considerations irrelevant to the task at hand and inimical to success.

Might this also be true of most activity in the market? We'll return to that question.

Morality or Muddle?

Meanwhile, let's note in the traffic situation what harm is likely to be done by people who decide to insert "morality" into their decisions. What will a driver accomplish if he refrains from advancing when the light turns green, perhaps because he's running early and suspects that some in the cross-traffic are running late? He will almost certainly not persuade the cross-traffic to go on red; he will delay people behind him, who could well be on much more urgent missions than his own; and he will increase the likelihood of an accident by introducing substantial new uncertainties into the calculations of drivers who are observing and trying to anticipate his erratic behavior. And, of course, if everyone decided to be "unselfish" in this manner, traffic would come to a halt, as drivers regularly got out of their vehicles to discuss the relative urgency of their current goals and to insist that the welfare of others be advanced before their own.

Is this also generally true of ordinary market activity, that it would come to a halt, at enormous cost to all participants, if they were all to act consistently on the principle of advancing the welfare of the most needy or the most worthy – rather than focusing on the accomplishment of their own personal goals? To that question, too, we'll want to return.

The Rules of the Game

I have not mentioned a very important aspect of traffic systems: They are not systems of complete anarchy. There are definite rules of the game that must be obeyed by participants if the system is to work. Drive to the right, stop for red lights, stay close to the legal speed limit, and, above all, do not touch the cars around you. We even have rules for suspending the rules. Everyone stops and yields to vehicles with sirens and flashing lights, and uniformed police officers may trump all the rules.

Heyne goes on to point out that some rules are somewhat arbitrary (driving on the right) but necessary for clarity and stability … so people can react and cooperate with the actions of others. Then he writes:

Parallel Definitions

Let me now try to summarize in one sentence the social system for moving traffic with which we are all familiar. It is a system in which individuals pursue their own interests on the basis of the situation they perceive, obeying a few clear and stable rules of the game.

And let me follow that up with an equally brief definition of capitalism, or a free-market economy. It is also a social system in which individuals pursue their own interests on the basis of the situation they perceive, obeying a few clear and stable rules of the game. 

Looking at Consequences

What emerges from the traffic system? Some fatal accidents. More damaged fenders. A certain amount of anxiety. Occasional incidents of personal nastiness. But if those were the principal consequences of the system's operation, none of us would participate. The fact that we do play the game, and we do so voluntarily, because we expect to be better off by playing than not playing. We venture into traffic every day, and we regularly get back home in satisfactory condition. The system works. Judged by its consequences, it's a success. I don't doubt that improvements will be made in the system in the future as they're discovered and we learn how to implement them. But the system works astonishingly well as it is right now, with all its warts; and no one really knows how to design a better system for enabling people who live in dense population clusters to move about quickly, freely, safely, comfortably, and inexpensively.

Social Cooperation as Mutual Accommodation

One of the elements that make it work is the mechanism of mutual accommodation that it embodies. This mechanism becomes especially important and visible in large cities during the rush hours. Have you wondered – we too seldom ask such absurdly instructive questions – why it never happens that everyone using the freeway chooses to drive in the same lane? Just too unlikely, you might think. But isn't it also most unlikely that each of the four alternative lanes on the freeway will be chosen by precisely twenty-five percent of drivers? And yet that's roughly what happens every day, morning and evening. A coincidence too improbable to be believed – until we notice how and why it happens.

A lane carrying fewer than one-fourth of the traffic will move more quickly; that advantage will be noticed by a few drivers traveling in adjacent lanes; they will respond by changing lanes. As they do so, they slow down the lane which they enter and accelerate the land which they left. Through the continuous process of marginal adjustments, initiated by individual drives responding to the perceived advantages to themselves of changing lanes, the traffic is continuously adjusted to keep each lane moving at approximately the same speed. And thereby the sum of the time traveled by all of the commuters together is minimized. ...

... In a market economy, the changing net advantages that participants perceive are communicated not by different land speeds but primarily by changing relative prices. When suppliers and demanders aren't accommodating each other very well, relative prices start to move. The prices that rise relative to other prices induce suppliers to offer more and demanders to ask for less. The prices that decline encourage demanders and discourage suppliers. These responses begin to close the gaps that had opened up between what producers were offering and what users were requesting, which in turn checks the relative price movements that had induced the mutually accommodating responses. Changing money prices serve both as information and as incentive in the remarkable system of social cooperation that we call a market economy. (32-36)

No metaphor is perfect. We could probably develop a similar metaphor from biology as Eric Beinhocker does in his 2006 book Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics, focusing on evolution. But the basic point is this: A market economy is neither anarchy nor a centrally directed system. It functions within a set of rules. Therefore, the first and foremost thing markets need are rules. Optimally people will internalize the rules and live by them, but human nature being what it is, we know there must also be "referees" who enforce rules.

While most agree that neither anarchy nor total control are effective ways to run transportation systems or economies, there is frequently disagreement about what constitutes "fairness" within the rules and how well (both in terms of justice and efficiency) the economy can be adjusted to meet social ends. Libertarians tend to be skeptical of political decision-makers' ability to have sufficient knowledge for adjusting the economy and politicians' ability to do what is just and efficient versus that which is politically expedient. They tend to believe that solutions will emerge outside of political intervention. Liberals tend to believe sufficient information can be gathered for well-informed adjustments, and the risk of non-interference in the market is greater than the unintended consequences that may emerge from market intervention.

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Allocation of Limited Resources. Part 2 (Two Communities)

I wrote in the previous post that markets are the most just and efficient way of allocating resources in mass society. But as I noted at the end, markets are far from perfect. Neither are they appropriate for all forms of human interaction. I want to spend the rest of this series of posts discussing the limits of markets and exploring in what ways markets need to be supplemented.

We first need to acknowledge that markets are not appropriate for all forms of human relationships. We have a growing tendency to think about only two realities: Individuals and mass society. When I hear the word "we" among libertarians, I get a sense that "we" means the collective behavior of atomized individuals. When I hear "we" among liberals … as in I think "we" are obligated to care for the poor … "we" is frequently synonymous with "government." But "we" don't just exist as individuals or as mass society. We also exist as families, neighborhoods, worshiping communities, members of voluntary associations, and so on. These societal institutions are intermediate (bigger than the individual and smaller than society) and intermediary (they help connect and facilitate aspects of human existence.)

Going at least as far back as Adam Smith, there has been an awareness that we exist as members of both face-to-face community (FFC) and mass society (which, in economic terms, I'll refer to as commercial society (CS).) Early sociologist Ferdinand Tonnies wrote Gemeinschaft und Gesellschaft  (roughly "Community and Society") in 1887, attempting to work through the distinctions between the two. There have been many theorists sense who have characterized the two in various ways. In my estimation, much of it comes down to information.

The family is probably the most elemental FFC. Imagine a multigenerational family living under the same roof. There is a married couple with three children, ages 15, 12, and 6. The wife's widowed father and the wife's mentally impaired sister live in the home. The household's internal functioning will not be based on market transactions. Most of the members of this household are incapable of taking full financial responsibility for themselves. Most likely, the father and mother will be breadwinners for the household. The grandfather probably has retirement income and social security. There may be some government assistance for the sister.

Most living spaces will likely be shared communally, with each person assigned a private space according to their needs. Meals will like be prepared and shared communally. There will be a "needs" based allocation.

Parents will likely have chores for the kids, and completing those chores may be tied to an allowance. Certainly, a minimal standard of good behavior will be expected to receive an allowance. In other words, there will be "cronyism"… you have to get in the good graces of the one with the resources to get what you want.

Other models of allocation may also come into play. Unless prior arrangements have been made, the one who gets to the TV first may be the one who chooses what program to watch … "first come, first serve." Other resources may be divided by equal shares. There are many different allocation models like those we saw in the previous post that could apply in a family FFC for very legitimate reasons.

Now we could expand this model to three families living communally. But we can only expand this model so far. When a community begins to have more than a few dozen people, the FFC begins to break down. Essential to strong FFCs is the ability to have reasonably good knowledge about the other community members. Solidarity and accountability come through ongoing interaction. When more than a few dozen people are involved, having this level of intimacy is humanly impossible. Free riders begin to emerge who take advantage of the work of others. Knowing enough about others to justly allocate resources based on individualized needs is no longer possible. Some people become neglected.

Society can't function as a family writ large. So there are two options. One is for FCCs to become completely self-sufficient communities. While this may seem plausible initially, consider the creation of a simple pencil. If we are going to be self-sufficient communities making our own pencils, then we will need to find the graphite and process it into tiny graphite rods, collect wood and process it down to a pencil cylinder, find tin and process it into an eraser holder, collect and chemically process materials to form an eraser head, and then find the materials and dye to paint the pencil. Think of the number of hours expended by our small community to create the pencils.

Now multiply this by countless products vastly more complex than a pencil. The computer you are using now has components made from raw materials from as many as forty different countries. How will you make computers from local materials? And assuming you lived in one spot on earth where are all these materials are available, how likely is it that our tiny community would have the productive capacity to produce a computer … not to mention cars, medical devices, building products, power plants, and an endless variety of things we take for granted?

The only other option is for FCCs to trade with those outside the community. It is the only way to achieve this standard of living. How will that trade be coordinated? It means producing goods (or hiring your labor to produce) that can be sold to generate income to purchase goods from others. We each put goods up for sale in the auction, and then the supply and demand price mechanism provides a real-time feedback loop of how much of which things people want. Those that do the best at meeting demands get rewarded.

As noted, the auction method is the only allocation method that links production and allocation. If there were no market prices, and producers were not looking to make the best sell, how would we know how much of which things to make all across society? There is no practical alternative that works with any kind of efficiency and justice.

But to say that the auction, or the market, is the most efficient and just system does not mean it will avert all inefficiency or injustice. Far from it. So, what are the challenges, and how do we create greater efficiency and justice within markets? Stay tuned.

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Allocation of Limited Resources. Part 1

Recently I finished reading James Halteman’s The Clashing Worlds of Economics and Faith published in 1995. It is a revised and expanded edition of his book Market Capitalism and Christianity, which I read in grad school back in 1988. It is written from an Anabaptist perspective, and while I disagree with him at various points in the book, overall, it is helpful.

One passage I liked was Halteman’s discussion of the importance of markets versus other economic allocation processes. He writes:

“Picture yourself as owner of a gas station in a town bracing for a hurricane. You have only one hundred gallons left in your supply tank, and ten cars are lined up, each needing fifteen gallons.” (24)

What will you do? Haltemnan suggests six possible options:

First, you might use a first-come, first-served method. You could simply keep pumping until the seventh car exhausts the supply of gas. The remaining three cars get nothing. Whether the tenth car is an ambulance, or a police car, or driven by someone on their way to the hospital for emergency care, it will not be serviced. The first come first served method places the highest value on being early. People with a low cost of time can afford to line up early for the fuel.

A second system might be to allocate resources based on need. In this case you would ask all drivers how they intended to use the gas and then decide, either by yourself or through democratic process of voting or polling, how the gas should be divided. This system assumes that people have a generally accepted view of what need is and are prepared to live with the consequences of the allocation. Under this system, everyone has an incentive to appear most needy. If need is related to low income, there is incentive to be poor or at least to appear poor.

A third method of allocation is simply to give everyone in the line ten gallons of gasoline, irrespective of their place in line or their need. This system puts a high value on equal treatment of everyone, so there is no reason to be early in line or to project a position of need. But the system also faces the difficulty in maintaining equality when, after serving one customer or more, someone new joins the line.

A fourth way of solving the problem is cronyism. In this system, the supplier identifies his regular customers or friends and gives them fuel. This gives people incentive to seek friendships with people of power and wealth. Political patronage and conformity to the wishes of those with resources characterize a system based on cronyism.

Another allocative process is open conflict. If the people waiting for gasoline became irate and feared losing their source of transportation, fights could erupt and the victor could have the fuel. This chaotic approach usually erupts when a society’s institutional structures are so weak or unfair that people take matters into their own hands.

One other approach to resource allocation is the auction method, in which those who bid highest get the most gasoline. In this system, it is important to have enough money to bid to the level required to get the desired quantities of gasoline. Except for cases of inherited wealth or unmerited windfall income, one bids with money that comes from wages in the labor auction. Thus one’s work effort is directly related to the amount of gas one can buy. This link between allocation and production is unique among all the methods discussed.

In any large economy, virtually every method described above is used formally or informally. However, in an overall economy, one method or another dominates economic exchange. In the United States, the auction method prevails. The fact that bidders and sellers exchange freely makes this method appealing to a democratic tradition. In other parts of the world, where populations lack the sophistication and social support structures of low-cost communication, information, transportation, and political stability, the auction allocation mechanism works far less effectively. In societies with a tradition of centralized governmental power or a dominant leader, a method that relies on the leader’s choices – what we described as cronyism – is common.

No matter what system a society uses, it must deal with the forces of supply and demand. If an auction isn’t used, the people who wait in line pay in money plus time rather than just money. The king who allocates to his cronies pays in reduced political support from the masses, who pay in reduced political and personal choice. In short, a price is paid whenever scarce resources are allocated, though the effects differ depending on the method used. We generally prefer a system that minimizes this cost. (24-26)

A helpful feature of this thought experiment is that it shrinks the issues to a problem we can easily get our heads around. Most would agree that the “first come, first serve,” “equal treatment,” “cronyism,” and “open conflict” options do not lead to an efficient or just distribution. But repeatedly, people are drawn to attempts to substitute the “need” option for the market “auction.” Here, shrinking things to ten people can radically understate the challenge of the “need” option. It is conceivable that we could get ten people together and work out who needs how much. But multiply those times millions of people. How could anyone possibly assess the ever-fluctuating need for gasoline and allocate it justly? Now multiply these millions of people by millions of different products. No “Great Mind” or supercomputer can know needs, much less adjudicate between them.

The most efficient and just allocation system allows people to take responsibility for themselves, earn an income, and bid for what they need in an auction system. That brings what they need to their door. The changes in bid prices also inform the suppliers on what to produce. No other system can match the coordinating information system the auction creates.

Yet the market auction is not perfect. There are reasons why market intervention is needed. Stay tuned.

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