Political economy in the neoclassical approach

How is the relation between economics and politics conceived in the neo­classical framework? Economics is the process by which we seek to maximize the satisfaction of our wants given the means available (and usually their distribution among us).

In the first instance, the market consists of a system of voluntary trans­actions between independent property owners pursuing their self-interest. To the neoclassical thinker, these transactions take place when they are deemed welfare-improving for both parties. When contracts are in fact vol­untary, when no impediments exist to welfare-improving transactions, and when the consequences of those transactions affect only the contracting par­ties, market interaction should allow individuals to exploit fully opportunities to increase their level of satisfaction.

This observation regarding the neoclassical way of setting up the problem leads naturally to two sets of political agendas. The first involves securing the system of property rights so that transactions are in fact voluntary. This means establishing and enforcing a set of property rights designed to support the stated objectives of the neoclassical ideal of individual well-being. The second involves circumstances in which parties other than those contracting are affected by transactions or in which potentially welfare-improving trans­actions cannot be undertaken for reasons other than limitations on property rights.

Neoclassical political economy applies the basic economic logic of con­strained choice to circumstances in which private transactions fail to maximize welfare.

This idea of political economy is, for reasons suggested above, synonymous with that of market failure. It points us toward circumstances in which the market falls short of enabling individuals to achieve the highest level of want satisfaction available given their endowments. In the remaining sections of this chapter we focus first on the idea of property rights as the framework for private want satisfaction, a framework for the market but not created by it. Politics can play an important role as the process for setting up the frame­work of property rights and contract. We then go on to explore three important classes for market failure: externalities, public goods, and monopolies.

Property rights

A system of self-interested exchange requires some prior understanding of rights of ownership and use of property. Yet neoclassical economics has tended to omit discussion of rights from its analysis. The position generally taken is that rules specifying rights may be important but that they are outside the structure of economic models. They are not only exogenous in the sense that the distribution of endowments is exogenous, they are also outside the model in the sense that they are assumed not to vary in the short run, hence they do not affect allocative behavior in the short run. As Field points out, neoclassical economists have made “a categorical distinction... between the modeling of short-term self-interested behavior within rules and the rules themselves” (Field, 1979:53).

In recent years neoclassical economists have started to address property rights. They have treated these rights not only as part of the framework of economic activity, but also as part of a system of rules that itself results from economic processes, that is, rational maximizing behavior. This section offers a definition of property rights and provides some examples of the different forms taken by these rights and their significance for political economy. Property rights are rights of ownership, use, sale, and access to wealth. Property includes physical property (consumer objects, land, capital equip­ment) and intangible property (such as ideas, poems, chemical formulas, and investment algorithms for the stock market). Perhaps the most important forms of property for economic theory are labor and the means of production. A well-defined system of property rights would limit permissible uses of owned capital, that is, the ways in which it could be invested, joined to labor and other productive factors, and who has what claims to the output. It could also limit the range of external effects. During certain periods of history there have been prohibitions on lending capital beyond certain rates of interest, hiring labor below a certain wage, reaping profits beyond a certain level and so on. However, a private property rights system gives broad scope over disposal of property by its owner. With respect to financial capital, one can invest it, hide it, use it for consumption, transform it into physical assets, use it to hire wage labor, or purchase unproductive holdings such as art, antiques, jewelry, and so on.

Similarly, one could specify alternative property rights for labor. Under capitalism, everyone’s labor is self-owned. It cannot legally be coerced or pressed into service. One may feel the compulsion to work, but this comes from the need to have an income to purchase the essential consumption goods. Thus, under capitalism, one sells his or her labor in return for a wage.

The specification of rights and limits to property is crucial for the pro­ductive inputs - land, labor, and capital. Some of these rights are so ele­mentary that violation of them is immediately recognized as criminal. Theft - acquiring the property of others through coercion or stealth - comes readily to mind. Other examples are more subtle; they include selling “insider in­formation” on the stock market or establishing a consulting firm on the basis of knowledge acquired by serving in a governing administration for a brief period. But the principle is the same, the extent of rights to property (in­tellectual property in the case of the stock market and consulting examples). Finally, even governmental policies, though of shorter time horizon than more elementary rights, have important property rights implications. Tax policy defines how much of output goes to the state; minimum wage legislation sets a floor to the price at which labor may be hired, and unemployment insurance establishes rights to income (usually temporary) when people are out of work.

How do issues surrounding property rights bear on political economy? The political process institutes property rights and, in so doing, sets their limits. Over time, these limits change and develop as society’s conception of rights and property themselves change and develop. In some ways this process of development occurs outside of politics. But eventually it expresses itself within the political arena in the form of contention over rights. In this sense, the issue of property rights has an important political dimension.

The presence of such a dimension may or may not justify us in charac­terizing rights as inherently political, however.

For the positivist school, it would seem appropriate to consider rights political in that they are the output of a political process. They may be contested in the same way all outcomes are contested. But the winners can make no special claim for their position beyond that of its (perhaps temporary) political dominance. The existence of such rights is a political fact (which is not to deny, as suggested previously, that the political struggle has links to broader social conflicts). For the natural rights school, it would not be ap­propriate to treat rights as essentially political. The claims rights have over us stem not from their success in a political debate, but from their significance to our sense of what is demanded of a society organized to respect and protect the dignity of its members. Such rights may be politically instituted, but they are not in essence political.

Second, property rights are not static. They do not refer only to an original condition that must exist for exchange relations to emerge and deepen. The nature and extent of property rights are open to change. Legislation can create or eliminate property rights by establishing which classes of goods can or cannot be privately appropriated (for example, handguns, gold, or slaves), or it can alter the degree and limits of rights over classes of goods.

Externalities

The voluntary transaction is the sine qua non of the neoclassical conception of human interaction. It is the archetype of all forms of human relatedness. This is so for reasons suggested earlier in this chapter. Indeed, the elevation of the exchange contract to this special status follows from the idea that human life is ultimately about maximizing private satisfaction in the context of resource constraints. The voluntary character of exchange, together with the assumption that each person knows best what he or she wants, leads naturally to the theorem stating the optimality of free markets.

But free markets are not always optimal by neoclassical standards. The first reason for this is that the theorem that links free markets to welfare maximization assumes that no one is affected by a transaction who is not party to it. That is, no one has his level of want satisfaction affected by a contract he does not voluntarily enter into. The term “externalities” refers us to a set of effects of transactions on persons not party to those transactions. If transactions have such effects, they are not necessarily welfare-improving. If they are not, the market has failed to achieve its purpose, and other than market methods must be introduced to fulfill the end of maximization of private want satisfaction. These nonmarket methods include those instituted by political processes and political institutions.

What exactly are externalities? Externalities refer to “effects on third par­ties that are not transmitted through the price system and that arise as an incidental by-product of another person’s or firm’s activity” (Rhoads, 1985:113). In ideally functioning markets, all transactions are either private, or, to the extent that third parties are involved, they are compensated or charged. Under such conditions, the cost to producers equals society’s costs and benefits to society equal producer benefits. If these conditions obtain, the market sends the correct signals to the producers and neither “too much” nor “too little” of the good in question will be produced. But in certain cases this equation of private and social costs and benefits does not hold. In practice, there are often uncompensated external effects of production (and con­sumption).

Let us emphasize a point that is important for understanding the theoretical linkages between externalities and the state. It is best illustrated by starting with several questions: Why is it undesirable for externalities to exist?

What special problems do they create in neoclassical theory? One could argue from the standpoint of social justice that, with externalities, people are required to pay for or benefit from certain states of affairs they had no part in bringing about. They are rewarded or punished on grounds irrelevant to their own performance. While this argument has some appeal, the neoclassical economist reasons on a different basis: that of efficient operation of the economy. Mansfield argues that the pattern of resource allocation is distorted when externalities exist.

If a man takes an action that contributes to society’s welfare but which results in no payment to him, he is certainly likely to take this action less frequently than would be socially optimal. The same holds true for firms. Thus, if the production of a certain good, say beryllium, is responsible for external economies, less than the socially optimal amount of beryllium is likely to be produced under perfect competition, since the producers are unlikely to increase output simply because it reduces the costs of other companies. By the same token if a man takes an action that results in costs he is not forced to pay, he is likely to take this action more frequently than is socially desirable. The same holds true for firms. (1982:453-4)

Consider a negative externality produced by a firm, such as pollution that imposes a cost on agents outside of the firm in the form of ill health and medical expenses. The cost is imposed on agents independently of their will. In a sense these agents are victims of an imposed exchange (in which they receive ill health in exchange for no payment) and as such is not to the agent’s benefit. By the Pareto criterion, the outcome cannot be optimal. We can also see this by considering the firm’s calculation of the profit-maximizing level of production.

Assuming that the firm aims to maximize profit, neoclassical theory tells us that it will increase its level of production until the cost of additional output, the marginal cost, equals the price at which it sells that output. If the marginal cost exceeds the price, the sale of the additional output costs more than the revenue generated, which implies a loss to the producer. If the marginal cost falls short of the price, additional profit can be made by producing more. So long as the price (therefore the revenue) exceeds the additional cost, the firm should continue increasing its level of production. Only when the additional cost is just offset by the additional revenue (that is, marginal revenue equals price) will no incentive exist for the firm to change its level of production.

If we take the price to be given and assume diminishing returns, we can easily see how externalities will lead to inefficient levels of production. Di­minishing returns means that higher levels of production impose higher unit costs (marginal cost rises as output rises). The profit-maximizing output, given price, depends on the level at which marginal cost equals price. The higher the level at which marginal cost equals price, the more output pro­duced. But the higher the level of marginal cost at each level of output, the lower the level of output at which it equals the price. As the firm increases its level of production, its marginal cost rises, so it continues to increase that level until the marginal cost rises to the price.

Now, consider two situations. In one, part of the cost of production (that part borne by those suffering the negative externality) is not calculated into the firm’s marginal cost; in the other, it is (for example, by a tax on the producer). When the cost to the agent suffering the externality is not cal­culated into the firm’s costs, the profit-maximizing level of production must be higher than it would be were that cost included. This is for the following reason. When we force the firm to include in its own calculation of its cost this additional cost imposed on others, its marginal cost is higher at each level of output so that given the price, the profit-maximizing level of output is lower. Thus, the market, left to its own devices, since it is incapable of imposing the cost of the externality on the producer, induces that producer to produce too much (that is, more than the efficient amount) of the good involving a negative externality. By a similar logic it is easy to show that a positive externality leads to lower than optimal levels of output.

For the neoclassical thinker, the idea of a set of activities in which economic agents engage others involuntarily opens the door to politics, in the sense of state action (see Baumol, [1952] 1965; Whynes and Bowles, 1981; Mansfield, 1982). First, the political process can be used to correct market deficiencies by bringing private costs and revenues into line with social costs and benefits. There are different policy instruments that could be used to equate private and social cost. One of them is fines; another is subsidies. Fines are imposed on the producer of the externality. If a firm is polluting, government can impose a fine. How large a fine should be imposed? The fine should be just large enough to cover the gap between private and social cost. By imposing a fine of this magnitude the government forces the firm to take account of (to internalize) the full costs of production. And by facing squarely the true social costs of their actions, firms will produce (and pollute) the optimal amount. Subsidies work differently. Here the government pays the firm a subsidy for pollution abatement. The reduction of pollution becomes part of the process (and cost) of production. The objective of both of these policies is the same: reduction of externalities. However, the approach is different and the costs of these reductions are distributed differently.

The second major approach to controlling externalities is government reg­ulation. In contrast to fines and subsidies, which attempt to limit externalities through the price system, regulation seeks control through establishing rule­like standards that can be legally enforced. In other words, regulations involve authoritative prohibitions and demands. Regulations may concern permis­sible pricing behavior for monopolies, bidding standards for the weapons industry, safety standards for airlines, legal limits of pollution for polluting firms, and rules for the disposal of toxic waste.

The third governmental response to externalities is provided by the judicial system. Instead of a governmental regulation, fine, or subsidy, injured parties might file a suit and take the accused party to court. While this approach has some advantages, its drawbacks are notable. As Stiglitz (1988:233) points out, for this approach to work, property rights must be well defined. Judicial action would not work if the resources being used were held in common. In addition, transaction costs for those mobilizing to bring legal action (the injured parties) could be extremely high and subject to the same collective action problems as exist for public goods. Just the information costs associated with determining who was injured, and how much, might be prohibitive. And the costs of legal action for one person may be prohibitively high in relation to the benefit, while for a group the costs may be far outweighed by the benefits.

Public goods

The third entry point for political economy within the neoclassical paradigm has to do with public goods, or collective consumption goods as they are sometimes called. Neoclassical economists have written about education, roads, and research and development, as well as property rights as public goods, while political scientists, influenced by this way of thinking, have contributed to the literature on leadership, regimes, and the institutional framework for economic action. The importance of public goods spans many levels of government activity: sanitation and traffic rules at the local level, defense policies at the international level.

As with externalities, neoclassical theorists treat public goods as examples of market failure. With an externality, an activity has a consequence that confers a (nonpriced) cost or benefit on a nonparticipant. Where public goods are concerned, the problem is that these goods often will not be produced by the market. The reason for this underproduction of public goods is that the market will produce only those goods for which the producers who bear the costs can also capture the benefits. Such goods are in some sense “own­able,” fungible, and transferable.

Many goods do not fit these criteria. These goods, by virtue of their indivisibility and diffuseness, are difficult to own. Once produced, they enter the public realm. Indeed, one definition of a public good is a good that, once produced for any member of a group, automatically is available for any other member of that group. This definition highlights the importance of nonex­cludability for public goods. The beneficial effect of a technical improvement on economic growth, the existence of a well-tended public park, the public educational system, national disease control, and an effective deterrence sys­tem are all examples of the nondiscriminating quality of public goods.

The general properties of public goods are their nonexcludability and non- rivalness. Goods exhibit nonexcludability when there is no practical way to channel their benefits exclusively to those who have paid for them - or, to put it the other way, those who have not purchased the good cannot be excluded from consuming it. They become “free riders,” enjoying all the benefits without any of the costs. The property of nonrivalness means that as one person consumes the good, no less will be available to someone else. These two properties are practical categories rather than logical absolutes. They depend on the goods in question or, more importantly, on the speci­fication of property rights. Additional cars on our highways can create ri-

valness due to congestion. Defense can be selectively used to protect certain parts of a population, and deterrence, which is often treated as the closest thing to a “pure public good,” can even be invoked selectively. European critics of the United States’ policy of graduated deterrence certainly believed this.

How do public goods bear on the concerns of political economy? Within the neoclassical world, public goods are of interest because they suggest limits to the self-seeking, perfectly functioning market model. If we go back to our self-seeking individual and join our knowledge of him to the knowledge that markets underproduce public goods, we immediately see the problem. Our maximizer would not be able to achieve all he would like within a market setting. Public goods like clean air, disease control, an educated citizenry, safe roads, and defense - all in his utility schedule - would be largely un­satisfied by the market.

Let us turn to some of the reasons why goods such as those mentioned in the preceding paragraph are not produced by the market; and after that, we will show how this defect of the market encourages recourse to politics. The major problem of public goods production at the microeconomic level is that there is little incentive to invest energy and resources into their production because those who invest such energies cannot capture all the benefits. Of course the producer will enjoy the benefits of the good in the same way that everyone else in a particular jurisdiction does, but no more so. He enjoys the same fraction of the benefits as everyone else. At a macroeconomic level the difficulty is that private costs and benefits cannot be linked to social costs and benefits. As with externalities, this distorts resource allocation and leads to an undersupply of public goods.

The often cited case of the lighthouse illustrates the basic principle well. A single operator of a ship, or owner of a fleet of ships, may find it advan­tageous to build a lighthouse and may do so if the costs are less than the benefits received. However, it is more likely that the costs for any one ship­owner will be larger than the benefits received. Yet the costs for a lighthouse are constant, whereas the benefits can expand depending on the number of ships that can use it. However, since these ships cannot be excluded from the benefits once the lighthouse is in existence, they have no incentive to pay. They have an incentive to free ride, in the language of public goods theory.

It follows that even where total benefits exceed total costs, lighthouses may not be built. As Stiglitz points out, this underproduction of public goods involves an inefficiency and provides a rationale for government intervention (Stiglitz, 1988:75). Of course, the fact that markets cannot produce goods of a public nature does not mean that the government can. Neoclassical economists like to point out that governments fail too. However, some classes of public goods seem so important that they are provided, with varying degrees of success, by nearly all countries. We can think of education, de­fense, a legal system, police, sanitation, and health (particularly control of contagious diseases) as goods typically provided by government. Of course, a particular good is often not exclusively provided by the market or the state. We have private education, personal bodyguards, private lawyers, and a health-care system that relies on private doctors and health-care providers as well as their public counterparts. In addition, in some countries there is an increasing tendency to introduce market principles into government policymaking.

Since the market works through voluntary exchange, many persons who are not public-spirited would not pay their share of the cost of public goods provision but would still enjoy the benefits. In addition, public goods involve teamwork. There are collective action problems involved. The state can more easily overcome these problems. It has coercive powers to force individuals to do what is in their interest (that is, to pay for the benefits enjoyed). And the fact that government is inherently more centralized than the market helps it overcome the coordination problems associated with decentralized decision making.

Monopoly and oligopoly

A central theme of neoclassical economics is that there is a link between perfectly competitive markets and efficiency, defined in terms of the max­imization of private want satisfaction. Yet three previous sections (property rights, externalities, public goods) suggest that even with perfectly compet­itive conditions, there are market failures. In this section we briefly consider the case of what happens when markets cease to be perfectly competitive. To make the contrast strong, we compare perfectly competitive markets to oligopoly and monopoly.

In a perfectly competitive market, there are a large number of buyers and sellers. Each producer and consumer is so small in relation to the rest of the market that he or she cannot affect aggregate market properties, especially prices. In fact, under perfectly competitive conditions, individual firms have very little power at all. Their choices are limited to which products to produce and how much. For firms to be restricted in this fashion is simply to say that markets are functioning as they should.

Some scholars (e.g., Lindblom, 1977) have objected that modern industrial economies do not fit the description of perfectly competitive markets. While departures from perfectly competitive markets include numerous analytic distinctions, we frame our discussion in terms of the most extreme deviations, monopolies and oligopolies.

Oligopolies occur when several firms control a large share of the market (or assets) in a particular sector. In these circumstances, firms may affect key market parameters such as prices. Indeed, firms might set prices well above the level allowed in a perfectly competitive market. The difference between the price and the costs of production may be reaped as an excess profit, called a rent. Along with raising prices, firms may limit output, sat­isfying themselves with selling fewer units at a higher price.

From the standpoint of efficiency, the above scenario is troubling. Firms produce “too little” and charge “too much” in comparison with the baseline of pure competition. Individuals and firms who could have purchased goods at lower prices are excluded. Utility satisfaction is lowered. Under these circumstances prices will not reflect real costs and scarcities and, as a result, will not be efficiently allocated.

In the case of externalities and public goods, markets fail even under ideal circumstances - that is, even if they are perfectly competitive. With oligopoly, there are also inefficiencies, but they result from the erosion of the competitive nature of markets themselves. Nevertheless, the rationale for government intervention remains the same. The economy is impaired in its function of efficiently allocating resources. The government can intervene to break up large firms, to prevent collusion (cooperation among firms and price fixing), and to discourage or prevent mergers that would restrict competition.^[18]