Tuesday, October 16, 2012

Failures in Romney's Economic Proposals - Postitive Externalities

I am a fan of free markets. However, I am no fan of the Republican Party when it ignores what is understood about how markets work. This poisonous brew they are selling and that they want us to drink over the next four years is a poor imitation of a free market system that will leave many of us worse off than we would otherwise have been.

The first of its problems that I will discuss is the fact that many positive externalities are ignored. This leaves people worse off than they would have been if these positive externalities could be harvested.

Here is an experiment that you can repeat with any group of strangers that demonstrates the fact that things that produce positive externalities are underfunded when left to voluntary contributions.

Let us assume that you have collected 10 strangers in a room. In the middle of the room you place a "magic money machine". The way this machine works is that when somebody puts $20 into the machine, $5 will appear in the pockets of everybody in the room (or something worth $5 will appear in the lives of everybody in the room).

There really is no magic money machine. In this experiment, what you will do is tell people that if anybody gives you $20, you will give everybody in the room $5. You can use monopoly money if you wish - as long as you announce that, at the end of the game, the person with the most money wins.

Then, see what happens.

What the machine represents is not magic either. It represents goods that produce a positive externalities - benefits for people other than the people who pay for them.

If one person sprays a stagnate pool for mosquitoes, everybody benefits from fewer mosquitoes (and less malaria or West Nile). If one person gets a flu shot, everybody benefits from having one less path for the flu virus to travel through to get to Great Aunt Nellie or little baby George. If one person finds and confines a rapist, everybody benefits from greater safety for themselves and those they care about. If one person pays a company upwind from town to produce less pollution, everybody gets to breathe cleaner air.

These things exist in the real world. The "magic money machine" simply captures the economically essential properties in an easy to grasp example. One person spends the money. His benefit is less than the cost. However, the overall public benefit is greater than the cost.

This is an experiment you can run anywhere at any time so you can see how it works.

Now, you have your magic money machine in the middle of the room. You tell people that if any of them gives you $20, you will take it and give everybody $5. You might want to limit this to one $20 contribution per person.

If everybody gives you $20, everybody walks away with $50. However, if one person keeps his $20, then everybody else leaves with $45, but he leaves with $65 - a smart move. Remember, the person with the most money at the end of the game wins. However, if everybody does this "smart move", everybody leaves with just $20, when they could have left with $50 if they were just less smart.

The question is: How do you fund goods that produce positive externalities.

My objection to Romney's economic plan is that he provides no way for funding goods that produce positive externalities. He would have everybody keep their own $20 in their own pockets, and only spend money where they, themselves, get more back from the investment than they put into it. He claims that this will make everybody better off. However, in the real world - a world in which some goods produce positive externalities (produce more social good than good for the person who spends the money), it leaves people poorer and worse off than they would otherwise be.

Let us collect 10 more strangers and put them in another room. We make them the same offer. Chances are, we will get the same results. Nobody invest $20 to give everybody $5 except the sickeningly irrational and unselfish "bleeding heart liberal" who actually likes the fact that he has produced a social benefit. Yet, for his efforts, he ends up poorer - and the person who would never dream of parting with even one dime ends up wealthier and more powerful.

However, in this room we will introduce a new policy option. If enough people agree to it, you will impose a $5 tax on each person and feed that money into the magic money machine (into goods that produce positive externalities such as those presented above). With this $5 tax, everybody ends up with $50.

While, at the same time, in the room next door where people are waiting for voluntary contributions from people who are told that it is simply wrong to do anything that leaves you, personally, worse off - everybody has $20.

Please note how this follows the "conservative" plan with respect to global warming. The official Republican position is to wait around for people to voluntarily contribute to reducing greenhouse gas emissions in an environment where one is punished for doing anything that benefits people generally but leaves the investor worse off. We do see some sickingly irrational and unselfish "bleeding heart liberal" types making these contributions. But they end up poorer, while those who would never dream of parting with even one dime end up wealthier and more powerful.

At this point, the conservative charge - at it is a valid point - is that the government method of collecting taxes and feeding them into the magic money machine (economic goods producing positive externalities) is inefficient and prone to corruption. The government does a poor job of deciding what produces positive externalities and funding them at the appropriate levels. Instead, the money gets diverted to cronies and campaign contributors, lost to corruption and bureaucratic red tape.

These are serious problems.

However, the people in the room that taxes people to fund goods that produces positive externalities can argue that, even with $20 of inefficiency, the $30 it leaves in everybody's pocket still leaves them better than the people with $20 where nobody funds these goods.

This is not to say that corruption, red-tape, and pork can be ignored. Here, too, if $5 invested in reducing these inefficiencies produces $10 worth of efficiency, it is worthwhile to make the investment - but that is a side-issue.

Furthermore, these problems exist for all goods that produce positive externalities, not just those that Romney and company decide to ignore.

There are two sources of positive externalities that conservatives do not ignore - national defense and criminal law. America has more people (per capita) in prison than any other country. We spend huge amounts of money keeping people behind bars. Plus, we have a massive military - much larger than that of any other country.

How do conservatives justify spending money on these things?

The argument is that these are "public goods". They are goods that produce positive externalities and, because of this, they tend to be under-funded if we leave their funding up to voluntary contributions. What happens is, just as is shown in the example of the magic money machine, people are prone to hang on to their money and to wait for others to make voluntary contributions that leaves them poorer but those who do not spend a dime on such things wealthier and more powerful.

The conservative answer to this problem is to use the government to tax people in order to make sure that the military and police/prison systems are properly funded. Proper funding, in this case, is funding that approximately equals the value of the benefits people obtain living in a society where they are well defended from external and internal threats.

At this point a charge can be made that the government method of collecting taxes to fund the military and police system is inefficient and prone to corruption. The government does a poor job of deciding what to invest in - wasting money on such things as a war on drugs and other victimless crimes. A lot of the money gets diverted to cronies and campaign contributors, or gets lost to corruption and bureaucratic red tape.

Against this, the conservatives can answer that we are still better off taxing people in order to fund these services that produce these positive externalities. We are still better off with the corruption and inefficiencies of government than we would be if we did not tax people to invest in goods that produced these positive externalities.

As these examples illustrate, free market economics is quite confortable with the fact that there are some goods that produce positive externalities, that these goods will be under-funded if we stand around waiting for people to make voluntary contributions (particularly contributions that leave them poorer and weaker while those who do not contribute become wealthier and more powerful). In these cases, it is a legitimate purpose of government to collect money from people proportional to the benefit they receive in order to fund these public goods.

Romeny's plan will work great in an imaginary world where military and police are the only goods that produce positive externalities. However, they will fail in the real world where this is simply not true. They will leave us standing around with money in our pocket that could be invested in goods producing positive externalities. However, these investments will not be made because - on his system - wealth and power are accumulated in the hands of those who refuse to fund such things.

1 comment:

tshilson said...

An Ayn Rand style of hands off capitalism was tried before. It got us into the Great Depression and then it couldn't get us out of it. "What is good for GM is good for America" was the slogan.