1. A Methodological Introduction
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| People are observed to demand and to supply certain goods and services
through market institutions. They are observed to demand and to supply other goods and
services through political institutions. The first are called private goods; the second
are called public goods. |
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| Neoclassical economics provides a theory of the demand for and the supply
of private goods. But what does "theory" mean in this context? This question can
best be answered by examining the things that theory allows us to do. Explanation is the
primary function of theory, here as everywhere else. For the private-goods world, economic
theory enables us to take up the familiar questions: What goods and services shall be
produced? How shall resources be organized to produce them? How shall final goods and
services be distributed? Note, however, that theory here does not provide the basis for
specific forecasts. Instead, it allows us to develop an explanation of the structure of
the system, the inherent logical structure of the decision processes. With its help we
understand and explain how such decisions get made, not what particular pattern of outcome
is specifically chosen. |
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| This process of explanation involves several stages. There is first a set
of conjectural predictions, a set of basic behavioral hypotheses, or laws. These may be
wholly conjectural, requiring the mental feat of constructing the pound of ceteris
paribus. On occasion, hypotheses may be derived that involve empirically testable
implications, and when data can be assembled properly evidence may be adduced in
corroboration or refutation. This strictly positive content of economic theory has,
perhaps, been somewhat overemphasized in recent years to the partial neglect of theory's
more basic function. This is the development of the logical structure of an economy
through the making of what may be called inferential predictions. The trained economist
can predict the general shape or pattern which tends to emerge from the exchange or market
process. These predictions are not of the conditional "if A then B"
variety, at least not in any directly analogous sense. Instead, these generalized
predictions take the form, "A tends to equal B." The distinction
here between elementary conditional predictions and inferential predictions has not been
fully appreciated, perhaps because both are present in the central body of economic
theory. |
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| Conditional predictions take the form: If price falls, quantity demanded
increases; if price increases, quantity supplied increases. All such conditional
predictions, whether empirically verifiable or not, are combined to generate a logical
structure for the whole system of behavioral interactions that we call the economy. To the
extent that the conditional predictions in the set are valid, inferences may be drawn
concerning the general characteristics of the outcomes that will emerge. These inferences
are also predictions, and they are essentially descriptive in nature. They provide
information about the relationships among variables: Prices will equal costs; wage rates
for similar workers will be equalized; factors of production will earn their marginal
product. |
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| A vital link in the logical chain between conditional and inferential
prediction has been deliberately omitted in the above sketch. Assume that the conditional
hypotheses of the economist are valid. That is to say, the predicted behavioral responses
are correct. Individuals will buy more goods when prices fall; firms will supply more
goods when prices rise, etc. It is impossible to move from this knowledge directly to the
statement that "prices will tend to equal costs," until and unless we postulate
something about the institutional-organizational structure within which individuals are
allowed to make choices. Orthodox procedure in this respect has been that of explicitly or
implicitly postulating competitive organization. Once this missing step is added, the
inferences about results or outcomes follow logically from the set of conditional
hypotheses. The descriptive characteristics of the results can be indicated. |
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| In their most sophisticated form, these characteristics are presented as
the familiar statements for the necessary marginal conditions for efficiency or
optimality, the presumed domain of theoretical welfare economics. It is important to note
that these conditions are inferential predictions and that they are positive in content,
given that competition is postulated as the organizational structure. These conditions
become conceptually refutable predictions about the descriptive characteristics of the
results of the market interaction process. No normative elements need be introduced. |
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| The weak step in this methodological procedure is the assumption that
must be made about institutional-organizational structure. Only to the extent that this
assumption is relevant will inferences be corroborated. As an example, consider the
economist faced with predicting the effects of the 1965 excise tax reductions in a
particular industry. Assume he predicts that prices will fall to a certain degree; his
predictions are, we shall say, refuted by events. Does this refute the underlying
conditional hypothesis that firms in the industry are profit-maximizers, or does it,
instead, refute the hypothesis that the industry is competitively organized? Clearly, it
may do either, or neither if still other relevant variables have changed. The standard
procedure of assuming competitive order when this seems convenient is not acceptable.
Appropriately thorough analysis should include an examination of the institutional
structure itself in a predictive explanatory sense. The economist should not be content
with postulating models and then working within such models. His task includes the
derivation of the institutional order itself from the set of elementary behavioral
hypotheses with which he commences. In this manner, genuine institutional economics
becomes a significant and an important part of fundamental economic theory. |
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| If human interaction is limited to voluntary exchange conceived in its
broadest sense, a theory of institutional structure can be derived, yielding something
closely akin to the standard model of competitive order as the end or equilibrium product.
In other words, a somewhat loosely defined competitive economic organization can be
predicted to emerge from the play of human interaction so long as this interaction is
limited to voluntary exchange. Using nothing more than his standard tools, the economist
can predict, first, the emergence of this structure, and, secondly, the characteristics of
the outcomes that such a structure will tend to produce. |
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| Only after this stage is reached can the economist begin to talk about
the relationship between competition as an organizational structure, and efficiency. No
criteria can be externally introduced. Efficiency becomes a descriptive term that is used
to specify the existence of certain relationships among variables and among institutions
which are produced through the process of voluntary exchange. The satisfaction of the
necessary marginal conditions for efficiency, viewed in this light, becomes a prediction
of results that will tend to emerge from the exchange process, not a criterion for telling
us what should be present in order to further some externally derived value norm. The
derivation of these necessary conditions, and of the institutional structures that will
cause them to be satisfied from the choice processes of individuals engaging mutually in
trade, is the central task of economic theory. When observed results appear to counter
those predicted, either in terms of specific characteristics of outcomes or in terms of
institutional structure, explanation of divergence becomes a supplementary and proper
task. And analysis, here as elsewhere, must proceed simultaneously at several levels. |
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| The extended methodological digression on the function of orthodox
economic theory in application to the private economy is designed to provide some
assistance in discussing the analogous role of theory as extended to the public economy,
to the demand for and the supply of public as opposed to private goods. At base, the
economist must begin from the same set of conditional hypotheses. He deals with the same
individuals as decision-making units in both public and private choice, and, initially at
least, he should proceed on the assumption that their fundamental laws of behavior are the
same under the two sets of institutions. If he predicts that the average or representative
person will purchase a greater quantity of private good A when the relative price
of A is reduced, he should also predict that the same person will
"purchase" a greater quantity of public good B when the relative
"price" of B is lowered. This step in itself represents a significant
departure from orthodoxy in public finance. Individual behavior patterns in demanding
public goods, in participating in political decision processes, in voting, have not been
examined in detail by economists (or by anyone else). A body of theory devoted to
individual participation in voting processes is only now emerging. And even here, the
individual's behavior in demanding public goods, as some functional relationship between
quantity demanded and the "tax-price" that he pays, has not been studied either
analytically or empirically. Even more dramatic departures from public-finance orthodoxy
are required, however, when inferences as to results are drawn. There is nothing analogous
here to the competitive model, the use of which so greatly facilitates our elementary
textbook predictions concerning the outcomes produced under voluntary exchange processes
in the private-goods sector. |
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| As suggested above, many economists have more or less jumped over the
step of institutional theorizing in their analysis of markets, perhaps without fully
realizing that they have done so. They are able to do this because the competitive-model
assumptions yield predictions about outcomes that are not dramatically at variance with
observation, tending thereby to corroborate both the assumptions and the conditional
hypotheses. Despite all of the discussion about the unrealism of these assumptions, they
remain paradigmatic for economists. Decisions on the demand-supply of public goods are
made through political, not market, institutions, and there is no analogue to competitive
order that eases the analytical task. |
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| There are two possible ways along which the analyst might proceed. First,
a specific political decision structure can be postulated and inferences made concerning
the pattern of results that will emerge. Alternative models can be tried, and various
differences in predictions noted. This approach has much to recommend it. However, nothing
can be said about efficiency in this framework. |
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| The second approach is that of making an attempt to derive the
institutional structure from the broadly conceived exchange process. The economist can try
to predict, as best he can, what sort of political decision structure will tend to emerge
from the voluntary "political exchanges" that may be entered into by rational
persons. Once this decision structure is derived, he may be able to characterize outcomes
of actual processes in a manner that is analogous to his treatment of the private-goods
sector. To a limited extent, the term "efficiency" may be introduced to describe
certain outcomes, with this term having essentially the same meaning as that which applies
in the private-goods world. |
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| There must remain, however, an important difference in the degree of
relevance that theory has in the two sectors. As Wicksell so perceptively noted, outcomes
or results of individuals' choices for public goods in discrete instances can only be
classified unequivocally as efficient or optimal by some external observer if group
decisions are made under some effectively operating rule of unanimity. For discrete
allocations, political-choice institutions embodying decision by unanimity become the
analogue to market-choice institutions that are described as perfectly competitive. In
both cases, we are dealing with idealizations. For the latter, however, observed
interactions seem to produce proximate realization, and the ideal commonly becomes, in one
sense, the accepted norm for policy changes. That is to say, the institutions of the
competitive market economy have been widely accepted to be desirable, over and above their
place in the analysis which suggests that these describe the structure that would tend to
emerge, ideally, from the free workings of voluntary exchange processes. Presumably the
costs of achieving some approximation to the ideal here are not considered sufficiently
high to warrant significant modifications in the norm, although some of the discussions of
workable competition may be so interpreted. It is for this reason that efficiency
conditions applicable to the private-goods economy have been widely understood as carrying
important normative implications. And the very use of the emotive words
"efficiency" and "optimality" tends, of course, to reinforce this
interpretation. |
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| I have suggested above that the familiar conditions need not embody such
normative implications. Basically, they represent nothing more than inferences drawn from
the set of hypotheses that make up economic theory, inferences that describe certain
results that will tend to emerge from the interaction of many separate persons in
voluntary exchange processes, including the institutions themselves as variables subject
to choice. The drawing of such inferences, which are themselves predictions, remains
within the scope of positive economic theory, and hence within the professional competence
of the economist. He can, and should, say nothing whatever concerning the desirability of
such outcomes or such institutions as might generate these outcomes. |
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| The barrier between positive theory and normative advice must always be
vigilantly maintained. It is difficult to accomplish this separation even in the strict
private-goods world, as the discussion here suggests. Theoretical welfare economics, as a
subdiscipline, is considered by many economists, perhaps by most, to involve necessarily
normative elements. As I have tried to indicate, however, the fundamental content of this
subdiscipline can be incorporated into positive theory with no normative overtones. |
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| The same barrier between positive and normative theory is much more
difficult to maintain when the demand-supply of public goods is introduced. Here the role
of theory seems much more limited, and the analysis much less relevant to the observed
world. The theoretical idealization analogous to the competitive order, that represented
by Wicksell's unanimity rule for making group choices, is sufficiently removed from
real-world experience so that it rarely serves even as a norm for policy action.
Presumably, by contrast with the private-goods sector, the costs of attempting to
approximate the ideal here are considered to be so great that wholly different norms must
be introduced. |
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| Properly conceived, however, theory can do precisely what it can do in
the private-goods world. It can describe, and at several levels, the outcomes that will
tend to emerge from the process of voluntary exchanges among individuals. It can do no
more than this, and the economist has no role in pushing further. By the nature of the
different universe that he confronts, the limits of theoretical relevance for the
economist seem to be reached much earlier here. In a genuine sense, all discussions of
political-decision rules can be interpreted as treating of "workable unanimity,"
but the distance between the ideal and the alternatives that seem plausibly possible is so
great as to cause the ideal itself to lose apparent relevance. |
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| The reason is not difficult to find. A community of individuals decides
to demand goods and services publicly through governmental-political processes, rather
than privately, precisely because the bilateral exchanges facilitated by market
arrangements are insufficiently inclusive. External effects are exerted on parties other
than those directly entering into the market exchange, and these effects are considered to
be relevant and important. "Exchanges," trades, agreements among all members of
the community are deemed more efficient by these members. Multilateral agreements are,
however, far more costly to negotiate than bilateral ones. In addition, the incentive for
initiating negotiation leading toward agreement in such cases may be absent. These facts
are evident to such an extent that it often appears as folly to make any attempt to
examine the outcomes that genuinely voluntary exchange processes would produce in the
theoretical idealization described by the unanimity rule. The limits of the voluntary
exchange theory of the demand for and the supply of public goods are indeed narrow,
especially when compared with its analogue, the theory of perfectly competitive markets. |
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| The exercise is nonetheless useful, and it does provide the only
available "pure theory" of public finance, upon which all derivative theoretical
constructions rest. By first ignoring the costs of negotiating n-person agreements,
by ignoring the absence of individual incentive to organize agreements in the n-person
case, the theorist can proceed with his description of the results of idealized political
process. These descriptions are wholly analogous to those made about results of market
processes that are characterized by perfectly competitive conditions. The statements of
the necessary conditions for efficiency are closely similar in the two cases, and in
neither is normative content necessary. The satisfaction of the necessary marginal
conditions may or may not represent desirable social objectives, and it is not the role of
the economist to make such a determination. |
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| One of the primary purposes of this book is that of stating these
conditions and examining their implications. The theory is intended to be positive, and
its extremely limited relevance is recognized and acknowledged. It is the "pure
voluntary exchange theory of public finance" and is presented for the simple reason
that this theory must first be developed rigorously before we can begin to examine more
relevant models. Again the theory is on all fours with that of perfectly competitive
markets; only after the latter was fully worked out could more refined analysis begin. In
specific terms, the theory presented in the early part of this book describes the results
that the political process would produce if a general rule of unanimity should be
operative. The treatment here is in the strict Wicksellian tradition, and is, in fact,
Wicksell revisited or modernized. |
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| Initially, the costs of negotiating n-person agreements are
largely ignored. In a broader framework, and at a later stage, these costs must be
introduced since they are essential to an understanding of the public economy. Analysis at
this second stage must incorporate the costs of reaching agreements, or making collective
decisions, and an economic theory of political constitutions developed. The individual's
own recognition that, in the public-goods world, he is likely to be caught in an n-person
analogue to the prisoners' dilemma will prompt him to agree to "workable
unanimity" rules. He will trade off some efficiency (as measured by the standard
criteria) in exchange for more efficient decision-making. The whole theory of political
order becomes directly relevant to the demand and the supply of public goods, inclusively
considered. |
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| The analysis is developed progressively from the simplest models to
complex ones. Chapter 2 examines the demand-supply of a single pure public good in the
highly restricted two-good, two-person, world-of-equals model. Only the world-of-equals
assumption is dropped in Chapter 3. The purity of the public good is abandoned in Chapter
4, and the analysis is extended to a many-person group in Chapter 5. The novel world where
all goods are public is treated in Chapter 6. The problems presented by the publicness of
any political decision are introduced in Chapter 7, and the specific institutions of
fiscal choice are considered in Chapter 8. The interesting and important question that has
been assumed to be central in much of the modern theory, Which goods should be public? is
examined in Chapter 9. Suggestions for a positive theory of public finance are advanced in
the concluding chapter. |
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| For those students and scholars who do not fully share the methodological
approach that I have suggested, and whose interests lie primarily in the derivation of the
necessary conditions for Pareto efficiency or optimality in the public-goods sector, most
of the analysis is applicable and relatively straightforward. To an extent, my treatment
can be interpreted within this framework as an alternative version of the normative theory
of the public sector in the Samuelson-Musgrave tradition. |
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| One additional and final point should be made in this introductory
chapter. The demand for and the supply of public goods are discussed throughout the book
under the assumption that the community contains a specific number of persons. I shall
neglect in this book the important set of issues that is introduced when attempts are made
to determine efficient or optimal sizes of membership in sharing groups. I hope to develop
some of the analysis of these issues in a later work. |
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