V. Welfare Economics: A Reconstruction

Demonstrated Preference and the Free Market

It is the contention of this paper that the wake for all welfare economics is premature, and that welfare economics can be reconstructed with the aid of the concept of demonstrated preference. This reconstruction, however, will have no resemblance to either of the “old” or “new” edifices that preceded it. In fact, if Reder’s thesis is correct, our proposed resurrection of the patient may be considered by many as more unfortunate than his demise.56

Demonstrated preference, as we remember, eliminates hypothetical imaginings about individual value scales. Welfare economics has until now always considered values as hypothetical valuations of hypothetical “social states.” But demonstrated preference only treats values as revealed through chosen action.

Let us now consider exchanges on the free market. Such an exchange is voluntarily undertaken by both parties. Therefore, the very fact that an exchange takes place demonstrates that both parties benefit (or more strictly, expect to benefit) from the exchange. The fact that both parties chose the exchange demonstrates that they both benefit. The free market is the name for the array of all the voluntary exchanges that take place in the world. Since every exchange demonstrates a unanimity of benefit for both parties concerned, we must conclude that the free market benefits all its participants. In other words, welfare economics can make the statement that the free market increases social utility, while still keeping to the framework of the Unanimity Rule.57

But what about Reder’s bogey: the envious man who hates the benefits of others? To the extent that he himself has participated in the market, to that extent he reveals that he likes and benefits from the market. And we are not interested in his opinions about the exchanges made by others, since his preferences are not demonstrated through action and are therefore irrelevant. How do we know that this hypothetical envious one loses in utility because of the exchanges of others? Consulting his verbal opinions does not suffice, for his proclaimed envy might be a joke or a literary game or a deliberate lie.

We are led inexorably, then, to the conclusion that the processes of the free market always lead to a gain in social utility. And we can say this with absolute validity as economists, without engaging in ethical judgments.

The Free Market and the “Problem of Distribution”

Economics, in general, and welfare economics, in particular, have been plagued with the “problem of distribution.” It has been maintained, for example, that assertions of increased social utility on the free market are all very well, but only within the confines of assuming a given distribution of income.58 Since changes in the distribution of income seemingly injure one person and benefit another, no statements, it is alleged, can be made about social utility with respect to changes in distribution. And income distribution is always changing.

On the free market, however, there is no such thing as a separate “distribution.” A man’s monetary assets have been acquired precisely because his or his ancestors’ services have been purchased by others on the free market. There is no distributional process apart from the production and exchange processes of the market; hence the very concept of “distribution” becomes meaningless on the free market. Since “distribution” is simply the result of the free exchange process, and since this process benefits all participants in the market and increases social utility, it follows directly that the “distributional” results of the free market also increase social utility.

The strictures of the critics do apply, however, to cases of State action. When the State takes from Peter and gives to Paul it is effecting a separate distribution process. Here, there does exist a process separate from production and exchange, and hence the concept becomes meaningful. Moreover, such State action obviously and demonstrably benefits one group and injures another, thus violating the Unanimity Rule.

The Role of the State

Until quite recently, welfare economics has never analyzed the role of the State. Indeed, economics in general has never devoted much attention to this fundamental problem. Specific problems, such as public finance, or price controls, have been investigated, but the State itself has been a shadowy figure in the economic literature. Usually, it has vaguely been considered as representing “society” or “the public” in some way. “Society,” however, is not a real entity; it is only a convenient short-hand term for an array of all existing individuals.59 The largely unexplored area of the State and State actions, however, can be analyzed with the powerful tools of demonstrated preference and the Unanimity Rule.

The State is distinguished from all other institutions in society in two ways: (1) it and it alone can interfere by the use of violence with actual or potential market exchanges of other people; and (2) it and it alone obtains its revenues by a compulsory levy, backed by violence. No other individual or group can legally act in these ways.60 Now what happens when the State, or a criminal, uses violence to interfere with exchanges on the market? Suppose that the government prohibits A and B from making an exchange they are willing to make. It is clear that the utilities of both A and B have been lowered, for they are prevented by threat of violence from making an exchange that they otherwise would have made. On the other hand, there has been a gain in utility (or at least an anticipated gain) for the government officials imposing this restriction, otherwise they would not have done so. As economists, we can therefore say nothing about social utility in this case, since some individuals have demonstrably gained and some demonstrably lost in utility from the governmental action.

The same conclusion follows in those cases where the government forces C and D to make an exchange which they otherwise would not have made. Once again, the utilities of the government officials gain. And at least one of the two participants (C or D) lose in utility, because at least one would not have wanted to make the exchange in the absence of governmental coercion. Again, economics can say nothing about social utility in this case.61

We conclude therefore that no government interference with exchanges can ever increase social utility. But we can say more than that. It is the essence of government that it alone obtains its revenue by the compulsory levy of taxation. All of its subsequent acts and expenditures, whatever their nature, rest on this taxing power. We have just seen that whenever government forces anyone to make an exchange which he would not have made, this person loses in utility as a result of the coercion. But taxation is just such a coerced exchange. If everyone would have paid just as much to the government under a system of voluntary payment, then there would be no need for the compulsion of taxes. Given the fact that coercion is used for taxes, therefore, and since all government actions rest on its taxing power, we deduce that: no act of government whatever can increase social utility.

Economics, therefore, without engaging in any ethical judgment whatever, and following the scientific principles of the Unanimity Rule and demonstrated preference, concludes: (1) that the free market always increases social utility; and (2) that no act of government can ever increase social utility. These two propositions are the pillars of the reconstructed welfare economics.

Exchanges between persons can take place either voluntarily or under the coercion of violence. There is no third way. If, therefore, free market exchanges always increase social utility, while no coerced exchange or interference can increase social utility, we may conclude that the maintenance of a free and voluntary market “maximizes” social utility (provided we do not interpret “maximize” in a cardinal sense). Generally, even the most rigorously Wertfrei economists have been willing to allow themselves one ethical judgment: they feel free to recommend any change or process that increases social utility under the Unanimity Rule. Any economist who pursues this method would have to (a) uphold the free market as always beneficial, and (b) refrain from advocating any governmental action. In other words, he would have to become an advocate of “ultra” laissez-faire.

Laissez-faire Reconsidered

It has been quite common to scoff at the French “optimist” laissez-faire school of the nineteenth century. Usually, their “welfare economic” analysis has been dismissed as naive prejudice. Actually, however, their writings reveal that their laissez-faire conclusions were post-judices — were judgments based on their analysis, rather than preconceptions of their analysis.62 It was the discovery of the general social benefit from free exchange that led to the rhapsodies over the free exchange process in the works of such men as Frédéric Bastiat, Edmond About, Gustave de Molinari, and the American, Arthur Latham Perry. Their analyses of State action were far more rudimentary (except in the case of Molinari), but their analyses generally needed only the ethical presumption in favor of social utility to lead them to a pure laissez-faire position.63 Their treatment of exchange may be seen in this passage from the completely neglected Edmond About:

Now what is admirable in exchange is that it benefits the two contracting parties…. Each of the two, by giving what he has for that which he has not, makes a good bargain…. This occurs at every free and straightforward exchange…. In fact, whether you sell, whether you buy, you perform an act of preference. No one constrains you to give over any of your things for the things of another.64

The analysis of free exchange underlying the laissez-faire position has suffered general neglect in economics. When it is considered, it is usually dismissed as “simple.” Thus, Hutchison calls the idea of exchange as mutual benefit “simple”; Samuelson calls it “unsophisticated.” Simple is perhaps it, but simplicity per se is hardly a liability in science. The important consideration is whether the doctrine is correct; if it is correct, then Occam’s Razor tells us that the simpler it is, the better.65

The rejection of the simple seems to have its root in the positivist methodology. In physics (the model of positivism), the task of science is to go beyond common-sense observation, building a complex structure of explanation of the common-sense facts. Praxeology, however, begins with the common-sense truths as its axioms. The laws of physics need complicated empirical testing; the axioms of praxeology are known as obvious to all upon reflection. As a result, positivists are uncomfortable in the presence of universal truth. Instead of rejoicing in the ability to ground knowledge on universally accepted truth, the positivist rejects it as simple, vague, or “naive.”66

Samuelson’s only attempt to refute the laissez-fare position was to refer briefly to the allegedly classic refutation by Wicksell.67 Wicksell, however, also dismissed the approach of the French “harmony economists” without argument, and went on to criticize at length the far weaker formulation of Léon Walras. Walras tried to prove “maximum utility” from free trade in the sense of an interpersonally cardinal utility and thus left himself wide open to refutation.

Furthermore, it should be stressed that the theorem of maximum social utility applies not to any type of “perfect” or “pure” competition, or even to “competition” as against “monopoly.” It applies simply to any voluntary exchange. It might be objected that a voluntary cartel’s action in raising prices makes many consumers worse off, and therefore that assertion of the benefits of voluntary exchange would have to exclude cartels. It is not possible, however, for an observer scientifically to compare the social utilities of results on the free market from one period of time to the next. As we have seen above, we cannot determine a man’s value-scales over a period of time. How much more impossible for all individuals! Since we cannot discover people’s utilities over time, we must conclude that whatever the institutional conditions of exchange, however large or small the number of participants on the market, the free market at any time will maximize social utility. For all the exchanges are exchanges effected voluntarily by all parties. Then, suppose some producers voluntarily form a cartel in an industry. This cartel makes its exchanges in Period 2. Social utility is again maximized, for again no one’s exchanges are being altered by coercion. If, in Period 2, the government should intervene to prohibit the cartel, it could not increase social utility since the prohibition demonstrably injures the producers.68

The State as a Voluntary Institution: A Critique

In the development of economic thought, far more attention has been paid to analysis of free exchange than to State action. Generally, as we have indicated, the State has simply been assumed to be a voluntary institution. The most common assumption is that the State is voluntary because all government must rest on majority consent. If we adhere to the Unanimity Rule, however, it is obvious that a majority is not unanimity, and that therefore economics cannot consider the State as voluntary on this ground. The same comment applies to the majority voting procedures of democracy. The man who votes for the losing candidate, and even more the man who abstains from voting, can hardly be said voluntarily to approve of the action of the government.69

In the last few years, a few economists have begun to realize that the nature of the State needs careful analysis. In particular, they have realized that welfare economics must prove the State to be in some sense voluntary before it can advocate any State action whatever. The most ambitious attempt to designate the State as a “voluntary” institution is the work of Professor Baumol.70 Baumol’s “external economy” thesis may be put succinctly as follows: certain wants are by their nature “collective” rather than “individual.” In these cases, every individual will rank the following alternatives on his value scale: In (A) he would most prefer that everyone but himself be coerced to pay for the satisfaction of the group want (for example, military protection, public parks, dams, and so on). But since this is not practicable, he must choose between alternatives B and C. In (B) no one is forced to pay for the service, in which case the service will probably not be provided since each man will tend to shirk his share; in (C) everyone, including the particular individual himself, is forced to pay for the service. Baumol concludes that people will pick C; hence the State’s activities in providing these services are “really voluntary.” Everyone cheerfully chooses that he be coerced.

This subtle argument can be considered on many levels. In the first place, it is absurd to hold that “voluntary coercion” can be a demonstrated preference. If the decision were truly voluntary, no tax coercion would be necessary — people would voluntarily and publicly agree to pay their share of contributions to the common project. Since they are all supposed to prefer getting the project to not paying for it and not getting it, they are then really willing to pay the tax-price to obtain the project. Therefore, the tax coercion apparatus is not necessary, and all people would bravely, if a bit reluctantly, pay what they are “supposed to” without any coercive tax system.

Second, Baumol’s thesis undoubtedly is true for the majority, since the majority, passively or eagerly, must support a government if it is to survive any length of time. But even if the majority are willing to coerce themselves in order to coerce others (and perhaps tip the balance of coercion against the others), this proves nothing for welfare economics, which must rest its conclusions on unanimity, not majority, rule. Will Baumol contend that everyone has this value ordering? Isn’t there one person in the society who prefers freedom for all to coercion over all? If one such person exists, Baumol can no longer call the State a voluntary institution. On what grounds, a priori or empirical, can anyone contend that no such individual exists?71

But Baumol’s thesis deserves more detailed consideration. For even though he cannot establish the existence of voluntary coercion, if it is really true that certain services simply cannot be obtained on the free market, then this would reveal a serious weakness in the free-market “mechanism.” Do cases exist where only coercion can yield desired services? At first glance, Baumol’s “external economy” grounds for an affirmative answer seem plausible. Such services as military protection, dams, highways, and so on, are important. People desire that they be supplied. Yet wouldn’t each person tend to slacken his payment, hoping that the others would pay? But to employ this as a rationale for State provision of such services is a question-begging example of circular reasoning. For this peculiar condition holds only and precisely because the State, not the market, provides these services! The fact that the State provides a service means that, unlike the market, its provision of the service is completely separated from its collection of payment. Since the service is generally provided free and more or less indiscriminately to the citizens, it naturally follows that every individual — assured of the service — will try to shirk his taxes. For, unlike the market, his individual tax payment brings him nothing directly. And this condition cannot be a justification for State action; for it is only the consequence of the existence of the State action itself.

But perhaps the State must satisfy some wants because these wants are “collective” rather than “individual”? This is Baumol’s second line of attack. In the first place, Molinari has shown that the existence of collective wants does not necessarily imply State action. But, furthermore, the very concept of “collective” wants is a dubious one. For this concept must imply the existence of some existent collective entity who does the wanting! Baumol struggles against conceding this, but he struggles in vain. The necessity for assuming such an entity is made clear in Haavelmo’s discussion of “collective action,” cited favorably by Baumol. Thus, Haavelmo grants that deciding on collective action “requires a way of thinking and a power to act which are outside the functional sphere of any individual group as such.”72

Baumol attempts to deny the necessity for assuming a collective entity by stating that some services can be financed only “jointly,” and will serve many people jointly. Therefore, he argues that individuals on the market cannot provide these services. This is a curious position indeed. For all large-scale businesses are “jointly” financed with huge aggregations of capital, and they also serve many consumers, often jointly. No one maintains that private enterprise cannot supply steel or automobiles or insurance because they are “jointly” financed. As for joint consumption, in one sense no consumption can be joint, for only individuals exist and can satisfy their wants, and therefore everyone must consume separately. In another sense, almost all consumption is “joint.” Baumol, for example, asserts that parks are an example of “collective wants” jointly consumed, since many individuals must consume them. Therefore, the government must supply this service. But going to a theater is even more joint, for all must go at the same time. Must all theaters therefore be nationalized and run by the government? Furthermore, in a broad view, all modern consumption depends on mass production methods for a wide market. There are no grounds by which Baumol can separate certain services and dub them “examples of interdependence” or “external economies.” What individuals could buy steel or automobiles or frozen foods, or almost anything else, if enough other individuals did not exist to demand them and make their mass-production methods worthwhile? Baumollian interdependencies are all around us, and there is no rational way to isolate a few services and call them “collective.”

A common argument related to, though more plausible than, Baumol’s thesis is that certain services are so vital to the very existence of the market that they must be supplied collectively outside the market. These services (protection, transportation, and so on) are so basic, it is alleged, that they permeate market affairs and are a prior necessary condition for its existence. But this argument proves far too much. It was the fallacy of the classical economists that they considered goods in terms of large classes, rather than in terms of marginal units. All actions on the market are marginal, and this is precisely the reason that valuation and imputation of value-productivity to factors can be effected. If we start dealing with whole classes rather than marginal units, we can discover all sorts of activities which are necessary prerequisites of, and vital to, all market activity; land, room, food, clothing, shelter, power, and so on — and even paper! Must all of these be supplied by the State and the State only?

Stripped of its many fallacies, the whole “collective wants” thesis boils down to this: certain people on the market will receive benefits from the action of others without paying for them.73 This is the long and short of the criticism of the market, and this is the only relevant “external economy” problem.74 A and B decide to pay for the building of a dam for their uses; C benefits though he did not pay. A and B educate themselves at their expense and C benefits by being able to deal with educated people, and so on. This is the problem of the Free Rider. Yet it is difficult to understand what the hullabaloo is all about. Am I to be specially taxed because I enjoy the sight of my neighbor’s garden without paying for it? A’s and B’s purchase of a good reveals that they are willing to pay for it; if it indirectly benefits C as well, no one is the loser. If C feels that he would be deprived of the benefit if only A and B paid, then he is free to contribute too. In any case, all the individuals consult their own preferences in the matter.

In fact, we are all free riders on the investment, and the technological development, of our ancestors. Must we wear sackcloth and ashes, or submit ourselves to State dictation, because of this happy fact?

Baumol and others who agree with him are highly inconsistent. On the one hand, action cannot be left up to voluntary individual choice because the wicked free rider might shirk and obtain benefits without payment. On the other hand, individuals are often denounced because people will not do enough to benefit free riders. Thus, Baumol criticizes investors for not violating their own time-preferences and investing more generously. Surely, the sensible course is neither to penalize the free rider nor to grant him special privilege. This would also be the only solution consistent with the Unanimity Rule and demonstrated preference.75

Insofar as the “collective want” thesis is not the problem of the free rider, it is simply an ethical attack on individual valuations, and a desire by the economist (stepping into the role of an ethicist) to substitute his valuations for those of other individuals in deciding the latter’s actions. This becomes clear in the assertion by Suranyi-Unger: “he (an individual) may be led by a niggardly or thoughtless or frivolous evaluation of utility and disutility and by a corresponding low degree or complete absence of group responsibility.”76

Tibor Scitovsky, while engaging in an analysis similar to Baumol’s, also advances another objection to the free market based on what he calls “pecuniary external economies.”77 Briefly, this conception suffers from the common error confusing the general (and unattainable!) equilibrium of the evenly rotating economy with an ethical “ideal” and therefore belaboring such ever-present phenomena as the existence of profits as departures from such an ideal.

Finally, we must mention the very recent attempts of Professor Buchanan to designate the State as a voluntary institution.78 Buchanan’s thesis is based on the curious dialectic that majority rule in a democracy is really unanimity because majorities can and do always shift! The resulting pulling and hauling of the political process, because obviously not irreversible, are therefore supposed to yield a social unanimity. The doctrine that endless political conflict and stalemate really amount to a mysterious social unanimity must be set down as a lapse into a type of Hegelian mysticism.79

• 56 To a considerable extent, welfare (and related) theorizing of the 1930s and 1940s was an attempt to show the variety and importance of the circumstances under which laissez-faire was inappropriate.” Ibid.
• 57 Havelmo criticizes the thesis that the free market maximizes social utility on the grounds that this “assumes” that the individuals “somehow get together” to make an optimal decision. But the free market is precisely the method by which the “get together” takes place! See Trygve Haavelmo, “The Notion of Involuntary Economic Decision,” Econometrica (January 1950): 8.
• 58 It would be more correct to say given distribution of money assets.
• 59 On this fallacy of methodological collectivism, and the broader fallacy of conceptual realism, see the excellent discussion in Hayek, Counter Revolution of Science, pp. 53ff.
• 60Criminals also act in these ways, but they cannot do so legally. For the purpose of praxeological rather than legal analysis, the same conclusions apply to both groups.
• 61 We cannot discuss here the praxeological analysis of general economics which shows that, in the long run, for many acts of coercive interference, the coercer himself loses in utility.
• 62 Lionel Robbin’s The Theory of Economic Policy in English Classical Political Economy (London: MacMillan, 1952) is devoted to the thesis that the English classical economists were really “scientific” because they did not uphold laissez-faire, while the French optimists were dogmatic and “metaphysical” because they did. To uphold this, Robbins abandons his praxeological approach of twenty years before, and adopts positivism: “The final test whether a statement is metaphysical (sic) or scientific is … whether it argues dogmatically a priori or by way of appeal to experience.” Naturally, Robbins cites examples from the physical sciences to bolster this fallacious dichotomy. Ibid., pp. 23–24.
• 63 Bastiat’s writings are well known, but his “welfare” analysis was generally inferior to that of About or Molinari. For a brilliant analysis of State action, see Gustave de Molinari, The Society of Tomorrow (New York: G.P. Putnam and Sons, 1904), pp. 65–96.
• 64 Edmond About, Handbook of Social Economy (London: Straham, 1872), p. 104. Also, ibid., pp. 101–12; and Arthur Latham Perry, Political Economy, 21st ed. (New York: Charles Scribners’ Sons, 1892), p. 180.
• 65 Terence W. Hutchison, A Review of Economic Doctrines, 1870–1929, p. 282; Samuelson, Foundations of Economic Analysis, p. 204.
• 66 For an example of this attitude, see the critique of Hayek’s Counter Revolution of Science by May Brodbeck, in “On the Philosophy of the Social Sciences,” Philosophy of Science (April 1954). Brodbeck complains that the praxeological axioms are not “surprising”; if she pursued the analysis, however, she might find the conclusions surprising enough.
• 67 Knut Wicksell, Lectures on Political Economy (London: Routledge and Kegan Paul, 1934), 1, pp. 72ff.
• 68 It is also possible to argue, on general economic, rather than welfare-economic, grounds, that a voluntary cartel action, if profitable, will benefit consumers. In that case, consumers as well as producers would be injured by governmental outlawry of the cartel. As we have indicated above, welfare economics demonstrates that no governmental action can increase social utility. General economics demonstrates that, in many instances of government actions, even those who immediately benefit lose in the long run.
• 69 Schumpeter is properly scornful when he says: “The theory which construes taxes on the analogy of club dues or of purchase of services of, say, a doctor only proves how far removed this part of the social sciences is from scientific habits of mind.” Joseph A. Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper and Brothers, 1942), p. 198. For a realistic analysis see Molinari, The Society of Tomorrow, pp. 87–95.
• 70 See William J. Baumol, “Economic Theory and the Political Scientist,” World Politics (January 1954): 275–77; and Baumol, Welfare Economics and the Theory of the State.
• 71 Galbraith, in effect, does make such an assumption, but obviously without adequate basis. See John K. Galbraith, Economics and the Art of Controversy (New Brunswick, N.J.: Rutgers University Press, 1955), pp. 77–78.
• 72 Haavelmo, “The Notion of Involuntary Economic Decision.” Yves Simon, cited favorably by Rothenberg, is even more explicit, postulating a “public reason” and a “public will” as contrasted to individual reasonings and wills. See Yves Simon, Philosophy of Democratic Government (Chicago: University of Chicago, 1951); Rothenberg, “Conditions,” pp. 402–3.
• 73 See the critique of a similar position of Spencer’s by “S.R.,” “Spencer As His Own Critic,” Liberty (June 1904).
• 74 The famous “external diseconomy” problems (noise, smoke nuisance, fishing, and so on) are really in an entirely different category, as Mises has shown. These “problems” are due to insufficient defense of private property against invasion. Rather than a defect of the free market, therefore, they are the results of invasions, of property, invasions which are ruled out of the free market by definition. See Mises, Human Action, pp. 650–56.
• 75 In a good, though limited, criticism of Baumol, Reder points out that Baumol completely neglects voluntary social organizations formed by individuals, for he assumes the State to be the only social organization. This error may stem partly from Baumol’s peculiar definition of “individualistic” as meaning a situation where no one considers the effects of his actions on anyone else. See Melvin W. Reder, “Review of Baumol’s Welfare Economics and the Theory of the State,” Journal of Political Economy (December 1953): 539.
• 76 Theo Suranyi-Unger, “Individual and Collective Wants,” Journal of Political Economy (February 1948): 1–22. Suranyi-Unger also employs such meaningless concepts as the “aggregate utility” of the “collectivized want satisfaction.”
• 77 Tibor Scitovsky, “Two Concepts of External Economies,” Journal of Political Economy (April 1954): 144–51.
• 78 See James M. Buchanan, “Social Choice, Democracy, and Free Markets,” Journal of Political Economy (April 1954): 114–23; and Buchanan, “Individual Choice in Voting and the Market,” Journal of Political Economy (August 1954): 334–43. In many other respects, Buchanan’s articles are quite good.
• 79 How flimsy this “unanimity” is, even for Buchanan, is illustrated by the following very sensible passage: “a dollar vote is never overruled; the individual is never placed in the position of being a member of dissenting minority” — as he is in the voting process (Buchanan, “Individual Choice in Voting and the Market,” p. 339). Buchanan’s approach leads him so far as to make a positive virtue out of inconsistency and indecision in political choices.