Moral Foundations of Capitalism: Chapter 10
Chapter 10: Welfare Economics as Social Ethics:
Economic Support and Critiques of Market
Outcomes
The man who chooses to work longer to gain an income
more than sufficient for his basic needs prefers some extra
goods or services to the leisure and activities he could
perform during the possible nonworking hours; whereas the
man who chooses not to work the extra time prefers the
leisure activities to the extra goods or services he could
acquire by working more.
Given this, if it would be illegitimate for a tax system to
seize some of a man’s leisure (forced labor) for the
purpose of serving the needy , how can it be legitimate
for a tax system to seize some of a man’s goods for that
purpose? Why should we treat the man whose happiness
requires certain material goods or services differently from
the man whose preferences and desires make such goods
unnecessary for his happiness? [Nozick, Robert (1974 /
2013-11-12). Anarchy, State, and Utopia (p. 170). Basic Books.
Kindle Edition.]
I.
Introduction: Welfare Economics as Social Philosophy
During the late nineteenth century the marginal revolution took
place in economics with a series of new analytical devices introduced that
allowed geometric and mathematical representations of markets to be
undertaken. Those devices include utility functions, indifference curves,
demand and supply curves, profit maximizing models of a firm’s output
decisions, and new price-driven theories of general equilibrium. All these
innovations where generalized and deepened during the twentieth century,
a the standard neoclassical “tool bag” was assembled and sharpened.
The same might be said of the tools of welfare economics which
represented new more abstract mathematical representations of utilitarian
principles. Sedgewick and Pigou were a pioneers in efforts to join the
utilitarian system to the new neoclassical economic analytical devices. After
WWII, Ronald Coase and James Buchanan showed how the same tools
could be used to think about bargaining and therefore could be used for
contractarian as well as utilitarian analysis.104
Chapter 7 used these tools to illustrate the impact that private codes
of conduct tend to have on market equilibrium. This chapter illustrates
how the neoclassical approach can be (and has been) used by utilitarians
and contractarians to assess the merits of particular market outcomes.
Contemporary welfare economics, for the most part, relies upon
utilitarian and contractarian theories as the foundation of their assessments
of market performance, although they do not often refer to references on
utilitarianism, beyond those of economists such Pigou or Samuelson. That
is not to say that economists interested in welfare economics routinely
estimate social utility or suggest social contracts, but it is to say that the
techniques used have their foundations in those broad social ethical
theories.
There remains an overlap between the work of economists and
philosophers, but it occurs in the most philosophical work by economists,
104
The precision of the new geometric and mathematical analyses exaggerates their ability to shed light on economic and social activities, but may important insights
were developed using the neoclassical approach. Indeed, the precision associated with the new analysis caused the older more philosophical and historical approaches of
nineteenth century economics to gradually disappeared from mainstream economics.
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Moral Foundations of Capitalism: Chapter 10
as with Harsanyi, Hayek, and Buchanan and among the subset of
philosophers interested in institutional choice, as with Rawls, Nozick, and
Skyrms.
II.
The Neoclassical Debt to Utilitarian Analysis and
Contributions to Utilitarianism
Many of the leading utilitarians of the nineteenth century are also
highly regarded for their contributions to economics. Bentham, Mill, and
Sidgwick, for example, all made significant contributions to economics and
wrote principles of political economy books. Mill’s textbook was among the
most used in the English speaking world during the mid nineteenth century.
Thus, most economists trained in the nineteenth century could be regarded
as students of Mill.
The utility concept became an important part of the analytical tool
back of economics as the diminishing marginal utility concept was used to
explain the diamond-water paradox. The utility concept was also used to
illustrate the existence of gains to trade and as a basis for explaining the
thought process of consumer demand.
Pigou, the founder of welfare economics was clearly influenced by
utilitarian thought and used it extensively in his normative analysis of the
distribution of income, as noted in the previous chapter. His discussion of
economic welfare and the national dividend both had utilitarian
foundations, that is to say the reflected an interest in maximizing aggregate
satisfaction or utility. Mathematical representations of utility as with utility
functions allowed aggregate utility to be clearly represented and subsequent
development of social welfare functions were simple generalizations of the
Bentham aggregate utility principle. They allowed functional forms of
aggregate utility (aggregate social welfare) to be used as well as Bentham’s.
The contractarian approach is less obviously associated with
neoclassical economics, in part because it had fades so much during the
nineteenth century. Nonetheless, insofar as exchange is supported because
of its voluntariness, the existence of gains to trade and institutions for
105
realizing them can be supported by voluntariness based arguments, which
bear more than a passing resemblance to contractarian theories. It is not
necessary to add up mental states or compare them to conclude that that
society of two is improved by institutions that promote voluntary
exchange.
The various Pareto principles formalize this non-utilitarian intuition.
One state of the world (A) is better than or Pareto superior to another (B),
if at least one person prefers A to B and no one prefers B to A. Such is
normally the consequence of any enterprise adopted through contract or
unanimous agreement. Exchange demonstrates that each participant
prefers the result after the exchange to that before the exchange. Assuming
that no one is harmed by the transaction, the result can be regarded as an
improvement.
Shortly after WWII, James Buchanan seems to have more or less
rediscovered the contractarian approach as he wrestled with his many
methodological concerns with mainstream welfare economics.105 Rawls also
seems to have gravitated toward the contractarian approach in the same
period as a solution to problems of utilitarianism.
III.
Neoclassical Analysis of Market Exchange and Institutions
from Utilitarian and Contractarian Perspectives
Insofar as neoclassical economics and utilitarianism emerged
simultaneously during the nineteenth century and was substantially the
product of the same minds, it is not surprising that utilitarian assessments
of economic activities lend themselves to illustration with neoclassical
geometry. Contractarian analysis of markets and institutions arose later, but
also benefited from the same general collection of analytical devices. Both
Rawls and Buchanan routinely use neoclassical concepts and geometry to
assess the relative merits of alternative legal and political institutions.
A. Mutual Gains to Trade
Economists tend to take a materialistic view of utility rather than a
philosophical one. The consumption of real goods and services generates
For the course of Buchanan’s contractarian intellectual development, see Congleton 2014.
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utility, rather than ethical conduct. Given this pragmatic assessment of the
interests of most consumers and the assumptions that tastes are complete
and transitive, it is possible to characterize utility as a function of
combinations of goods consumed at a moment in time or over a lifetime,
U= u(X, Y, Z, ...) . Such functions can be graphed in the same way that any
other can, if one makes assumptions about the manner in which utility is
generated by goods. For example, it is normally assumed that goods exhibit
diminishing marginal utility, that each successive unit of a good generates
less and less additional utility. This implies that marginal utility curves are
downward sloping. If the consumption of one good does not affect the
marginal utility of any others, this assumption is sufficient to prove that
demand curves slope downward and that the utility function itself is strictly
concave.106
Figure 10.1: Trading Goods X and Y
ZF
2
3
potential gains to trade
1
Vilfredo
106
Zv
Francis
For many purposes a two dimensional choice setting is sufficient to
illustrate the main implications of decision making by utility maximizing
persons--what economists usually mean by rational persons. A function
U=u(X,Z) can be represented in a two dimensional diagram by graphing all
the combinations of X and Z that generate a particular utility level. Each
such line or curve is called an indifference curve. The “higher” an
indifference curve a person can reach, the higher is their utility and
therefore their welfare or happiness. In 1881, an economists named Francis
Edgeworth realized that one could represent gains to trade from such
curves, and in 1906 Vilfredo Pareto realized that one could form a box by
representing two persons in a setting in which given amounts of two goods
are divided between two persons. The result was called an Edgeworth box.
It can be used to illustrate the idea of mutual gains to trade from
both utilitarian and contractarian perspectives. Suppose that the two goods
are divided up as at position 1, where both Francis and Vilfredo have
positive quantities of the goods.
Note that Francis become better off (reaches higher indifference
curves and there for utility levels) as divisions of the good move to the
south west and Vilfredo become better off as divisions of the two goods
move to the northeast. Although this would seem to place them in conflict
with each other, it turns out that at many points in the box both parties can
simultaneously be made better off, by shifting one resource (Z) from
Francis to Vilfredo while shifting some of the other resource (X) from
Vilfredo to Francis. Note that any point in the lens shaped area labeled
gains to trade will simultaneously place both Vilfredo and Francis on a
higher indifference curve.
The Edgeworth box demonstrates that there unrealized mutual gains
to trade that exist at a wide variety of initial allocations, as with ones similar
to division 1 and also for polar ones similar to division 2. Both persons
would benefit from terms of trade that would move them from 1 to 3. Self
If the consumption level of one good increases the marginal utility of other goods, demand curves will also always slope downward. If it reduces the marginal
utility of other goods ,there are cases in which a demand curve may be upward sloping for some part of its range. Strict concavity is a useful mathematical property in
maximization exercises. It implies that a function can have at most one maximum. In geometric representations of utility functions with indifference curves, strict
concavity implies that the indifference curves are “c-shaped” as drawn in most intermediate microeconomic text books.
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Moral Foundations of Capitalism: Chapter 10
interest is sufficient to induce trade in such cases, if one assumes that the
original division is protected in some way by norms or civil law, so that
theft does not pay.
Note that the fact that higher indifference curves can be reached also
implies that aggregate utility is not maximized at all possible divisions of
resources. Utilitarians can thus could propose a wide variety of alternative
divisions of the resources that increase aggregate utility. And, as argued by
Bentham, any voluntary exchange that takes place will increase social utility.
The Edgeworth box also demonstrates an important difference
between the contractarian and utilitarian norms. Gains to trade are
exhausted when divisions reach points along the wavy line running from
Francis’ corner to Vilfredo’s corner. At those points, no further voluntary
transactions will take place. Individual utility levels vary along that line (the
contract line) and thus it is likely that total utility does as well.
Utilitarians would thus be prepared to force moves along the contract
curve to a point where aggregate utility is maximized. Such calculations, of
course, require knowing utility levels for each person for each of the
divisions that are feasible. If, however, Vilfredo and Francis can be assumed
to have identical utility functions (a convenient, but unrealistic assumption),
then the division at the exact center of the box will both be on the contract
curve and maximize aggregate utility. Except in that one case, precise
measures of utility are necessary to determine the best utilitarian allocation.
For a contractarian, the issue is not between allocations per se, but
between allocating systems, voluntary exchange, some other system ,or
some combination of the two. Alternatives might include random divisions
of the resources, equal divisions, or combinations of one of these systems.
For example, the X and Z may be initially be divided equally and trade
allowed after that initial division. It is clear that a composite system that
includes exchange would be preferred to a simple allocative rule from
behind a veil, because it can make all parties better off and cannot make
anyone worse off--ignoring cases of envy or malice, as usually done in such
illustrating exercises.
This composite system satisfies Rawls’ maximin criteria (difference
principle) in the circumstances of an Edgeworth box, and is also consistent
with Buchanan’s veil of uncertainty when initial allocations are not
characterized by the status quo ante.107 Given a choice between systems in
which most ownership rights are alienable or not, there would be
unanimous agreement to accept alienable ownership rights, because this
allows potential gains from trades to be realized by all parties. In contrast,
if the initial allocations are known beforehand, redistribution will tend to
be vetoed by those with initially larger endowments.
The pure exchange model can be and has been generalized in a
number of ways. For example, generalized exchange models have been
used to prove the first fundamental theorem of welfare economics, that in
a market in which firms and consumers are both price takers and there are
no externalities, as normally assumed for competitive markets, market
equilibria are Pareto efficient. However, the Edgeworth box illustration
demonstrates that Pareto optimality alone is not a sufficient condition for
maximizing social utility nor is ex post Pareto efficiency sufficient to assure
Contractarian support for the institutions that produce specific outcomes.
Surprisingly, the Pareto criteria are not directly relevant to either
utilitarian or contractarian assessments of the relative merits of markets in
fixed resources environments. Issues in distributive justice are explored in
greater depth later in this chapter. Other feasibility issues are examined
below and in the next chapter.
IV.
Monetized Indicators of Welfare: The Geometry and Logic of
Net Benefit Analysis
Figure 10.2 illustrates why economists from Pigou forward have
been comfortable shifting from utility based analysis to dollar based
107
A similar rule might be adopted by utilitarians if the specific utility functions of the two individuals are known only probabilistically and cannot be assumed to be
identical. Harsanyi (195x, 1976). He also suggest that some persons may be dropped from a social welfare function, namely those with antisocial or illegitimate preferences.
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Moral Foundations of Capitalism: Chapter 10
analysis. In many cases, money values for ouputs--as with GDP--and
money representations of net benefits--as with cost benefit analysis--allow
sharper conclusions to be reached using measurable monetary indicators of
welfare than can be deduced from abstract utilitarian analysis. Besides being
linked to tangible phenomena, analysis using net-benefits can be easily
undertaken with the graphic tools of introductory economics. This section
illustrates three of the core results and discusses their relevance for
utilitarian and contractarian analysis of markets.
A. Social Net Benefits and the Efficiency of Competitive Markets
On widely monetary representation for aggregate utility is concept of
the social net benefits. It is simply the total benefits in dollars less the total
cost associated with some outcome, often an output level or public policy.
Social benefits are simply the highest amount that a person is willing to
have quantity Q rather than 0 of the good or service of interest. Total cost
is simply the production cost of the good or service, which is an indicator
of the opportunity cost of production, although that is not important for
the calculation of social net benefits. In cases, in which all persons are
identical there will be a one to one correspondence between social net
benefits and aggregate Benthamite utility for given utility functions. In
other cases, as in that above, other assumptions are necessary to assure an
exact correspondence, although these are normally ignored for reasons
suggested by Pigou.
one thing is desired by a person more keenly than another,
it is said to possess a greater utility to that person. [Pigou,
A.C. (1920 / 2013-11-15). The Economics of Welfare
(Kindle Locations 483-486).
It is a matter of great convenience for elementary welfare economics
that the social marginal benefits of consumption can be represented with
market demand curves and the marginal social cost of production with
market supply curves, under conditions that are not much stronger than
those required to derive them in the first place. This implies that areas
between those curves correspond to social net benefits, as long as all the
benefits from this product accrue to consumers in this market and
production costs are fully accounted for by each firm’s own cost functions
for this market. In that case, it can be easily shown that competitive
markets tend to produce output levels that maximize social net benefits,
and thus maximize each product’s separate contribution to aggregate utility,
which in turn tends to maximize aggregate utility, other things being equal.
Figure 10.2 illustrates ordinary demand and supply curves, which can
be interpreted as curves representing industry marginal cost and consumer
marginal benefits with more or less usual neoclassical assumptions.108
Market prices adjust to equate the quantity demanded with the quantity
supplied in both the short run and long run.
[T]he money which a person is prepared to offer for a thing
measures directly, not the satisfaction he will get from the
thing, but the intensity of his desire for it. This distinction,
obvious when stated, has been somewhat obscured for
English speaking students by the employment of the term
utility —which naturally carries an association with
satisfaction— to represent intensity of desire. Thus, when
108
The supply curve is assumed to represent a Ricaradian market in which suppliers have different cost functions and so most producers earn profits--e.g. net
benefits from their production choices. In the long run MC=MR = P (in equilibrium) at the output produced by each firm and MR>MC over the range below that output.
Demand curves that represent marginal benefits of consumers can be derived either in the Hicksian manner from utility functions, or perhaps better and more general for
the purposes of this exercise from individual marginal benefit curves directly. In this case MB = MC = P (in equilibrium) and MB>MC over most of the range of
consumption and so consumer surplus is realized.
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Moral Foundations of Capitalism: Chapter 10
From a contractarian perspective, the above diagram can be used in a
Interpreted as a long run equilibrium, consumers realize consumer
surplus equal to area 1 and firms earn long term profits equal to area 2. The
total cost of production is area 3. In a market without externalities, all the
relevant costs and benefits for a single market are characterized by the
demand and supply curves and in that case the demand and supply curves
can be interpreted as social marginal benefit and social marginal cost curves.
Maximizing social net benefits in the usual case where there is a
unique interior maximum requires an output level, Q**, where SMB(Q**)
equals SMC(Q**). Insofar as prices adjust to clear the market, this is the
output normally produced by competitive markets. Subject to various
caveats, Figure 10.3 thus demonstrates that markets tend to maximize
aggregate utility. This contrasts with the more general Edgeworth box
representation of exchange, where voluntary exchange does not necessarily
maximize the sum of the utilities for the traders involved.109 However, in
this case, markets simultaneously solve the production and the distributive
problems in a manner approximately maximizes aggregate utility, other
things being equal.
The market outcome also divides up the net social benefits between
firms and consumers based on price and the slopes the relevant demand
and supply curves. In these widely used diagrams, it is essentially assumed
that net benefits are the same for each person or firm, and being
denominated in dollars, they can be simply added up. A dollar of net
benefits is a dollar of net benefits, and social net benefits are simply profits
plus consumer surplus. Such cost-benefit calculations clearly are in the spirit
of utilitarian analysis, and they make it possible to measure and add up net
benefits across individuals because dollars, prices, and outputs are
observable cardinal numbers, whereas “utils” are not.
109
Figure 10.2 Market Equilibrium
$/Q
S=MCi=SMC
1
P*
2
3
D=MBc=SMB
Q*=Q**
Q
variety of ways. At the institutional level, the fact that no further gains from
trade exist at the competitive equilibrium implies that no other institution
can generate additional net benefits for consumers and producers beyond
those generated by competitive markets. Distributional issues, however, are
more difficult to analyze. Whether these are important or not depends on
the contractarian perspective adopted. From behind the veil of ignorance
or veil of uncertainty, risk neutral citizens would accept any system that
maximizes aggregate social net benefits are maximized. Such persons are
indifferent about distributional matters. Institutions that produce
competitive markets would thus be supported. However, if citizens are risk
averse or maximin optimizers as in Rawls’ analysis, distributional
considerations are important. In such cases, the contractarian case for
markets is less clear, as is evident in Rawls’ discussion.110
It bears noting that the informational assumptions of the partial
equilibrium mode of analysis are far less demanding than those required for
the pure utilitarian approach and for some versions of the pure
contractarian approach, which require a general equilibrium perspective.
The Pareto efficiency of competitive market outcomes is easier to demonstrate and requires far fewer assumptions. See Varian (xxxx) for a illustrating proof.
Figure 10.3 can also be used to demonstrate the fundamental theorem of welfare economics. Net gains to trade exist for all units produced having a marginal benefit
greater than its marginal cost. Such potential gains exist for all units up to Q*, and for none afterwards. At the market equilibrium, all potential gains to trade are realized
and no changes in output or price are possible that would make one person better off without making another worse off.
110
Rawls (xxxx) suggests that competitive markets are compatible with the principle of equal liberty, but not usually with the difference principle.
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Moral Foundations of Capitalism: Chapter 10
No mind reading is required; nor is it necessary to have a complete model
of the economic and social universe in order to understand the
ramifications of this market’s relationship to all others or all other
possibilities. However, the partial equilibrium approach it cannot fully
address distributional issues, nor do the strong results of this lean
representation of market processes apply directly to markets that are not
fully competitive or which have spillover costs.
B. Monopoly
The other extreme in the neoclassical spectrum of market types is a
pure monopoly. This is a firm that has market power in that it can set prices
and faces its own distinct demand curve. In the real world, these conditions
are met by a wide range of local retail stores, although with internet
shopping and efficient shipping, there are arguably fewer such retail stores
than there used to be. There are two forms of monopoly of interest, first
the standard text variety that sells all of its output at a single price and
second a price discriminating monopoly that sells its output at different
prices. Both can be analyzed with figure 10.3 below.
Figure 10.3 Monopoly Equilibrium
$/Q
P*
MCi=SMC
1
2
3
4
MR
Q* Q**
D=MBc=SMB
Q
In the case in which a monopolist a monopolist sells all of its output
at a single price, it will take account of the effect that price has on revenues
and costs and select the output where marginal revenue (MR) equals its
marginal cost (MCi). That point is labeled Q* in the diagram. The area
between the demand curve and the monopoly’s marginal cost curve again
represents social net benefits. However, in this case, they are not
maximized at the market equilibrium. That, as before, requires social
marginal costs to equal social marginal benefits which occurs at Q**.
Although consumers and firms again benefit from exchange and so
aggregate social utility rises and social net benefits are realized as units of
this good or service are sold, total output is less than ideal. There are
unproduced units that would have added still more to aggregate utility or
social net benefits, namely those between Q** and Q*. Social net benefits
equal to area 4 are possible, but not realized. This area is normally called
the deadweight cost of monopoly in textbooks.
A perfectly price discriminating monopolist sells every successive
unit of its output for the highest price that consumers are willing to pay for
them. In this case, the firm’s marginal revenue curve is the same as the
demand curve and output Q** will be produced. This case is difficult to
motivate for consumers, since they realize no net benefits from their
purchases; nonetheless, it represents the limit of what price discrimination
can achieve for monopolists. In that limiting case, the social net benefit
maximizing output is produced by the monopolist and all the net benefits
of trade are realized by monopolists.
Utilitarians would oppose monopolies that fail to realize all social net
benefits insofar as aggregate utility rises with social net benefits. In addition
to the output effects there is a distributional affect that would concern
utilitarians. Social net benefits are shifted from consumers to firm owners,
who are on average wealthier than consumers. This also tends to reduce
aggregate utility. Note that this effect is larger in the case of a perfectly
price discriminating monopolist, although the output level is the optimal
one. As a consequence, utilitarians favor replacing monopoly markets with
competitive ones, whenever this is possible. Utilitarians thus have
historically opposed the creation of monopoly privileges by governments
and favored antitrust policies.
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Moral Foundations of Capitalism: Chapter 10
Contractarian analysis is similar in this case, although institutional
issues tend to arise. The contractarian case against the creation of
monopoly privileges is clear. Total net gains from trade (social net benefits)
decrease and the distribution of net benefits is more concentrated relative
to competitive markets. Thus, the case against the creation of monopoly
privileges is clear. The case in favor of antitrust is less clear, because it may
require restrictions on core civil institutions or interfere with the equal
liberty principle in the case of Rawls’ analysis. However, some limits on the
use of property or contracts are evidently permissible (as with selling
oneself into slavery), and so rules against cartel agreements and the like are
compatible with contractarian analysis, although more problematic because
grounding institutions and laws rather than regulation is normally the focus
of contractarian analysis.
It bears noting that many other normative theories have also opposed
monopoly while supporting competition as with La Courts (1662)
comments on monopolies as relatively inefficient organizations or Smith’s
(1776) many comments on monopoly and conspiracies to control trade in
his Wealth of Nation.
[N]o members of those guilds, under what pretext
soever, can be countenanced or indulged in their
monopoly, or charter, but by the excluding of all other
inhabitants, and consequently to the hindrance of their
country’s prosperity. For how much soever those
members sell their pains or commodities dearer than if
that trade or occupation was open or free, all the other
better inhabitants that gain their subsistance
immediately, or by consequence by a foreign
consumption, must bear that loss. [Pieter de la Court
(1662) The True Interest and Political Maxims of the Republic of
Holland. Liberty Fund (p.78).]
People of the same trade seldom meet together, even
for merriment and diversion, but the conversation ends
in a conspiracy against the public, or in some
contrivance to raise prices. It is impossible indeed to
prevent such meetings, by any law which either could be
executed, or would be consistent with liberty and justice.
But though the law cannot hinder people of the same trade
from sometimes assembling together, it ought to do
nothing to facilitate such assemblies; much less to
render them necessary. [Smith, Adam (1776 / 2010-03-23).
Wealth of Nations: Full and Fine Text of 1776 Edition (p.
90). . Kindle Edition.]
Normative support for free trade and markets does not usually
include support for monopoly.
C. Externality Problems
Another critical assumption of the neoclassical case in favor of
markets is that all relevant costs are included in producer accounts. This is
often not the case, because some inputs are not paid for or only partly
paid for. Examples include the cost of air, water, and transport, whether
used as inputs or to disperse unwanted (unmarketable) outputs. In some
settings, these additional factors of production are not scarce resources, in
which case their absence on company spreadsheets does not change the
results of the previous analyses. Roads may have substantial excess capacity
or the air and water circulation systems sufficient capacity to be used
without affecting others. However, in many cases, these resources are used
in their “congestion zones,” where additional use imposes costs on others,
as with highway congestion, unpleasant odors, and health risks imposed on
others. Such “external” costs have to be accounted for when calculating
social marginal cost. Such usage became more common with the advent of
capitalism in the nineteenth century because both urbanization and the
scale of production increased enormously.
Figure 10.4 illustrates the problem associated with external costs. In
this case the market supply curve no longer includes all production costs
and the external ones (MCx) have to be added to industry marginal costs
(MCi) to determine social marginal costs (SMC). The market equilibrium is
at the output level that equates the quantity supplied with the quantity
demanded, Q*. But the social net benefit outcome is somewhat less when
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Figure 10.4 Market Equilibrium and Externalities
Moral Foundations of Capitalism: Chapter 10
SMC= MCi+MCx
$/Q
all costs are taken account of, Q**. The social net benefits of this product
are smaller than markets would lead one to believe..
Again, insofar as social net benefits correspond to aggregate utility,
utilitarians would intervene to improve the result generated by the market.
For example, they might support the possibility of law suits in civil law
(torts) to recover damages from such external costs. Or, in cases in which
court assignments of damages are unlikely to produce optimal results, they
might, as Pigou did, favor excise taxes on this product equal to marginal
spillover damages at Q**. Such steps can induce firms and consumers to
“internalize” the external costs generated by the demand and supply of this
product.111
Contractarian analysis tends to focus on grounding institutions rather
than regulation, which is a “post constitutional” matter, to be decided
through political and legal processes. At the level of grounding law, in
recognition of such damages they would also support a civil law code that
allows damages to be recovered by those damaged. Such a code might allow
for class action suits or punitive damage awards to account for the difficulty
of bring small cases to court. Other matters would be left to the
post-constitutional political system, which is analyzed in the next chapter.
V.
Critiques of the Market-Based Distribution of Income
Within a perfectly competitive market framework, wages reflect
marginal revenue products of the persons employed, and inequality in
wages reflects inequality in marginal products. Some persons are stronger,
smarter, better educated, and entrepreneurial than others. Differences in the
distribution of wealth reflects inheritance (initial endowments), differences
in marginal product, differences in savings rates, and luck. Additional
inequalities tend to be induced by monopoly power. Inequality associated
with differences in marginal product or working conditions tend to increase
aggregate output. Those associated with inherited wealth and monopoly
power do not necessarily have a similar role, although relatively wealth
persons tend to save more which promotes capital formation.
111
S=MCi
P*
MCx
D=MBc=SMB
Q** Q*
Q
As demonstrated below, both utilitarians and contractarians will
favor some inequality in settings in which resources are produced.
Incentive effects matter. In a world of equals, institutions that maximize
per capita GNP tend to maximize average utility. Insofar as commercial
societies have higher per capita GNPs than all societies, this provides
macro-ethical support for market systems as a whole. In a setting of equally
productive persons, the distribution of income simply reflects choices in
the pursuit of goals other than income.
Nonetheless, in settings in which productivity varies among persons
in the society of interest, both utilitarian and contractarian logic can be
used to support large scale interventions in the distribution of income
produced by markets.
A. Utilitarian: Efficiency and Distributional Tradeoffs
Support for a welfare state in combination with relatively open
markets is one possible contemporary utilitarian response the inequality
generated by markets. This line of argument stretches back through Pigou,
Sidgwick, to Mill, although the extent of the redistribution justified has
increased substantially through time. To illustrate the utilarian case for
redistribution, imagine a society with N high productivity persons and M
low productivity persons. Under a market based allocation, each persons is
paid according to their natural marginal product and so members of the
high marginal product group is paid more than the low marginal product
group, consumes more and so realized higher utility levels.
Spillover benefits, in contrast, have no routine remedy in civil law. In those cases, Pigou would recommend appropriate subsidies.
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Now assume that a utilitarian redistribution is to be undertaken. A
proportional consumption tax imposed on the high productivity persons
and used to provide a proportional consumption subsidy for the low
productivity persons. As the tax increases, the high marginal product
person engage in more leisure, and their material consumption diminishes
because of the effects of reduced effort and higher taxes. On the other side
of the utilitarian balance sheet, utility accrues to low marginal product
persons, who may also work less but receive sufficient additional
consumption from the subsidy that their utility increases. Note that GNP
falls, because both groups tend to work less hard, but aggregate utility
increases.
Represented as an equation, aggregate utility is just W = NUh(t) +
MU (s(t)). Differentiating with respect to t and setting the result equal to
zero yields NUt = MUsst. The tax and transfer system should take place
until the marginal losses from the high productivity persons equals the
marginal gains in utility of the low productivity persons. Figure 10.5
l
Figure 10.5 A Utilitarian Tax
and Transfer Scheme
u/%
SMC=N MUt
1
2
SMB=M MUs
t**
112
tax
illustrates the essential logic of the utilitarian case for such a redistributive
program.112
The net increase in aggregate utility is 1, which comes at a cost of
area 2 borne by the high marginal productivity group. Aggregate utility
increases because of diminishing marginal utility. The lost utility from
consumption by the high marginal product group is smaller than that
gained by the low marginal product group. .
The optimal tax varies with the group sizes and with the difference in
marginal utilities at the market equilibrium (without tax or subsidies). Note
also, that as in the case developed below for figure 10.6, that simply
dividing up the joint output between each group would have a much
different result than this tax and transfer program. The group choices are
analogous to those of choices 2 and 4 in figure 10.2, and the result after
the after tax and transfer result is analogous to that of outcome 3. A simple
share the output rule would generate a result similar to that of 1.
Insofar as market systems are regarded to maximize total
consumption, this tax and transfer system is fundamentally grounded in
markets, and may be regarded to support the commercial society, although
the government intervenes to redistribute income, given the properties of
the labor markets. The goal of most welfare-state utilitarians is not to
replace markets, but to modify them at the margin so that social utility is
increased. For many utilitarians, such tax-transfer systems are analogous to
Pigovian taxes.
B. Contractarian: From Maximin to Maximal
Contractarians differ in their concern for redistribution because of
differences in the presumed “initial position” and in the risk aversion of
those negotiating over fundamental institutions. Contemporary
contractarians use a methodology similar to that of the utilitarians, in that it
This result is based on the following simple model .The high productivity person makes a labor leisure decision that maximizes U = u(T-L, (1-t)ch(L)), where T is
the time available to distribute between labor and leisure, t is the tax rate, and ch is the high productivity persons production function. The low productivity persons
maximizes U=u(T-L, (1+s)cl(L)). The utilities at their solutions are U*=uh(T-L*, (1-t)c(L*)) and U*=ul(T-L*, (1-s)cL*)) for the high and low productivity persons
respectively, which can be written as U(t)) and U(s(t)) as above in the text, for a given T. The balanced budget constraint requires revenues to equal subsidies, t N ch(Lh*)
= s M cl(Ll*).
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global and assumes rational individuals, but their goal is to establish
grounding rules for society rather than particular outcomes. To that end,
they have attempted to develop analytical devices that can identify points of
agreement among individuals.
In Buchanan’s case, the point of departure is a well understood status
quo from which a constitutional solution to some problem or set of
problems is to be devised. It could be the Hobbesian jungle or it could be
today’s American society. In either case the problem is the same, to develop
rules that advance common interests. If such rules can be agreed to the
result is an improvement. One can only be sure that society is better off,
through agreement. If the point of departure is a market with a standard
neoclassical equilibrium, with wages equal to marginal value product, and
not externalities, there is no prospect for a Pareto improvement (recall the
first theorem of welfare economics) and so no redistributive agreement
would occur--unless the persons in a community were altruists.
A community of altruists might conceivably agree to redistribute
income from the most productive to the least, because their , who would
themselves be benefited by shifting income from the most productive to
the least productive. A community of pure altruists might, for example,
agree to the tax and transfer scheme developed above for utilitarians. Their
interest in redistribution, however, is not moral, but simply Smithian
fellow-feeling. They have internalized the benefits that the poor would
receive from their alms. In cases in which individuals were only self
interested and property secure, the Buchanan approach would not generate
an agreement to alter the distribution of income.
Rawls’ approach differs from that of Buchanan in that he s more
concerned with creating a just society from scratch than in improving an
existing one. His reliance on a veil of ignorance, in which one does not
know his or her place in the society that follows, but has complete
knowledge of how social systems operate, is likely to generate agreements
favoring shifts away from a competitive equilibrium. For example, suppose
that do know whether you will be a high productivity or low productivity
113
person in our illustrative two-type society. One might know the odds of
being a high productivity persons (N/[N+M]), in which case one would
want to maximize one’s expected utility in the society that will follow the
adoption of a competitive market system augmented with a tax and transfer
system. This calculation looks very similar to the utilitarian one above,
which implies universal agreement on something like the utilitarian
program.113
The minimax principle, suggests that rather than maximize the
average result one should focus all of one’s attention on the worst one and
attempt to make that as good as possible. Rawls uses this principle to block
possibilities of slavery and of assassinations for body parts, both of which
are conceptually consistent with utilitarianism. In many settings it will also
imply greater transfers or a higher safety net than the utilitarian calculus
does.
It bears noting that Rawls’ maximin principle is not a consequence of
the veil of interest but rather of the assumed inner sense of justice that
people bring to the veil. It is this which produces both the equil liberty
principle and the maximin principle. Rawls’ spends a good deal of the
revised version of A Theory of Justice defending it from various attacks in the
two decades after he introduced it, including the one that it represents an
extreme assumption about risk aversion. Harsanyi (1976), for example,
regards the minimax principle as a “highly irrational decision rule,” and
provides a defense of the maximize average utility idea.
C. Distributive Justice as a Consequence of Process rather than
Outcomes
Although the two main social normative theories used by economists
can be used to defend and challenge the moral properties of markets, other
less used theories can as well. Private ethical theories may not be able
to--or interested in--assessing the merits of social systems but they can be
used to evaluate market outcomes. The following quote from Nozick
provides much of the logic of the private ethics approach to judging
market and other outcomes.
Harsanyi (1976) for this reason refers to this sort of calculation as a utilitarian, although much of his reasoning is otherwise similar to Rawls. He advocates a form
of utilitarian calculation that he refers to as rule utilitiarianism, in which strategies are chosen for all, rather than single acts.
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The complete principle of distributive justice would say
simply that a distribution is just if everyone is entitled
to the holdings they possess under the distribution. A
distribution is just if it arises from another just distribution
by legitimate means. The legitimate means of moving
from one distribution to another are specified by the
principle of justice in transfer. [Nozick, Robert (1974 /
2013-11-12). Anarchy, State, and Utopia (p. 151). Basic
Books. Kindle Edition.]
In other words, if you have come by your income honestly and
without coercion, the result is surely just. What matters from this
perspective is not the global properties of a social system, but how it
emerged and evolves through time. Are the individual acts that generate the
system moral? If so then the system may be defended on moral grounds.
The difficulty of this approach is that it assumes that the various
social and market dilemmas analyzed in the past three chapters are ethically
irrelevant. The extent to which their relevance may be acknowledge is only
insofar as recognizing a dilemma may lead to a just solution: for example
one voluntarily adopted by those trapped in the dilemma. If not, it may be
argued that the dilemma does not really exist or that solutions are infeasible.
With respect to distributive justice, many private normative theories
would accept Nozicks characterization of it as a property of the process
that generates the distribution of income (through moral acts or at least
ones that are not immoral), rather than the final outcome.
D. Distributional Mechanisms, Production, and Welfare
As one shifts from the Edgeworth environment in which goods and
services are exogenously determined to ones in which some or all of the
goods and services of interest are produced with scarce resources including
labor, consequence-based normative theories have to take account of the
incentive effects of alternative allocation mechanisms. The egalitarian
solution to the Edgeworth allocation problem was consistent with
utilitarian analysis for the case in which the extent of the resources available
114
are not affected by the manner in which they are distributed. If, however,
the size of the Edgeworth box is determined by the manner in which
resources are allocated, these effects also have to be taken into account.
For example, suppose preferences are identical for leisure (L) and a
single produced output (C) that can be produced either alone or by teams.
Assume further that a subset of the necessary jobs on teams is unpleasant
and that every job on the team is less pleasant than that of solo production,
which in turn is less enjoyable than leisure over the full range of choice. In
the absence of an internalized work ethic or the like, no one in such
circumstances will work for the joy of working.
Several allocative mechanisms can be analyzed in this relatively
simple production environment. Consider the following four possible rules
for distributing the output of a community or firm output among its
members. Two are egalitarian rules and the two others are non-egalatiarian
rules First, consider the case in which output is always equally shared
among all N persons in the community, a solution that satisfied utilitarian
norms in the Edgeworth case. In this setting, however, when each potential
laborer can independently choose whether to work or not, they will all free
ride (shirk rather than work) if the value of 1/N of a unit of the output is
worth less than the value of the leisure that has to be sacrificed to produce
it.114 The rewards to labor are minimal. In effect the sharing rule operates
as a (N-1)/N tax rate on one’s labor output.
(2) A second possibility is paying everyone the same hourly wage
regardless of where they work. In this case, a single flat hourly wage rate
would be paid for all work undertaken, whether on teams or alone. The
shirking problem is avoided in this case, because if one does not work, one
does not get paid. Work is rewarded, but not the difficulty of it. Given that
the displeasure of team production is greater than that of working alone (by
assumption), everyone would work alone. Output would be higher than
under the equal share of output rule and would vary with the wage rate,
insofar as different wage rates elicit different amounts of work and
therefore produce more or less goods. There is, of course, a feasibility
constraint on possibe wage rates. If NL* hours are worked in total and
Other equilibria are possible, although all involve relatively low levels of output in the absence of counterveiling private norms such as personal work ethics..
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NQ* units of output are produced, wages cannot exceed Q*/L*, the
average rate at which output is produced per hour by a typical laborer.
The work choice is voluntary and preferences are identical, so work
takes place only if it makes each person better off. Aggregate utility
consequently tends to be higher under such a universal flat wage system
than under an equally shared output system, although output in this case
could be said to be shared equally in this case as well, given our assumption
about identical individuals. This illustration demonstrates that allocative
rules have incentive effects that are relevant for utilitarians and
contractarian analysis.
(3) A third possibility is to allow wage rates to differ among firms,
although wages must be uniform at each firm. Suppose that a person is
either paid a wage that is equal to the marginal product of the last hour
worked alone or equal to the marginal product of the last hour worked at
the factory. Because of the assumed productivity differences, wage rates will
be higher at the factories than for solo production. All labor will be
attracted to the factories if the productivity advantage of team production is
sufficient to more than compensate persons for their less pleasant working
conditions. Factory employment dominates if the average productivity of
labor in the factory is relatively large or the working conditions are only
marginally less attractive than working at home alone. Output again
increases, and insofar as the employment choices are all voluntary ones,
aggregate utility rises as well.
(4) Now suppose that compensating differentials are paid within the
factory for more or less pleasant work there. In this case, a somewhat better
(more productive) allocation of persons to specialties within the factory
takes place and output rises again. It is clear that the result is preferred by
each worker to solo production option, because the place of work is freely
chosen. If there is no diminution of wage rates caused by this compensation
scheme relative to (3), the result again higher aggregate utility, because of
115
higher total output If some wages decrease but output increases, average
utility is still likely to rise, although this will depend on the extent to which
utility diminishes with income and the wage differences within the factory.
Insofar as total output increases and wage differentials are small or
diminishing marginal utility small, aggregate and average utility is likely to
increase.115 In such cases, the losses of persons bearing pay reductions (in
the more pleasant jobs) are more than offset by the persons gaining higher
wages (in the less pleasant jobs).
Figure 10.6 illustrates the average person’s choices and welfare under
these four regimes. Each allocation rule has associated with it a different
(average) production possibility frontier (PPF) reflecting how the
distributional rules affect the mode of production used. An average PPF is
created by dividing every point on the community’s PPFs by N, the
number of residents in the community. Along any single PPF, increases in
the consumption good require reduced increases in the hours worked. The
average PPFs allow the average person’s indifference curves to be used to
demonstrate the direction, although not the magnitude, of changes in
aggregate utility.116
Figure 10.6 Incentive Effects of
Allocative Rules
L
1
4
2
3
PPF2
PPF3
PPF4
C
Because of team production problems, it is not necessarily the case that output is now maximized (Congleton 1991), only that output is higher than in the previous
case because of a more productive allocation of labor across tasks.
116
These comparisons could not be done with a social welfare function indifference curves because of changes in the distribution of income associated with the shift
to possibility 4. When defined over aggregate output, each social indifference curve series is based on a particular distribution of goods and services.
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Moral Foundations of Capitalism: Chapter 10
Insofar as markets tend to produce allocations similar to that of 4 in
these circumstances, utilitarians would be indifferent between market
determination of wage rates and that by the identical choice of an imaginary
utilitarian social planner. Both would maximize aggregate utility given the 4
output sharing rules illustrated in the present circumstances. In effect, the
social planner would function as the Walrasian auctioneer in such cases. For
utilitarians, markets would simply be a method of inducing outcome 4, the
pattern of life that yields the highest feasible social utility for the rules
examined in this setting.
person could be identified and hired to manage this simple economy,
because the planner’ wages would reduce the incomes of all persons
relative to that available in the market. (The planner and his apparatus
would need to be funded through taxes or voluntary contributions, but
would not increase output over that produced by markets).
It is important to note that the egalitarian utilitarian solution to the
Edgeworth box allocation problem is only a special case. Whenever
incentive matters, utilitarian analysis takes them into account. The
distribution of income is equal among the first three cases, but unequal in
the fourth, because of differentials paid to compensate for the
unpleasantness of the various jointly productive factory jobs. Moreover,
because of incentive effects, egalitarian divisions of aggregate output are no
longer the best or “optimal” ones. Wages should vary among and within
firms. Note also, that the illustration represents a case in which the
magnitude of the observed commercial output (C) is positively correlated
with aggregate utility in this setting. Average utility rose in each case as the
PPF expanded and the output chosen increased.
VI.
The contractarian assessment of market wages in this case is similar
to the utilitarian one, but for contractarians, the focus of analysis is not the
outcome, per se, but on the institutions that induce particular outcomes to
emerge. The assumption that the individuals have identical tastes and
capacities makes it easy to anticipate the outcomes associated with each rule
(which in this case are unique) and so to rank alternative rules or
institutions for allocating aggregate output.
Insofar as markets realize allocations like 4, the persons in those
communities would unanimously prefer the institutions generating that
outcome to the others. In this case at least, institutions that assure
competitive wages are preferred to equal sharing rules, uniform wage rates,
or uniform wage rates by firm or industry. Contractarians would in
principle reject the hiring of a utilitarian central planner even if such a
Insofar as market supporting ethics--such as the work ethic--generate
similar shifts in the various production possibility frontiers, such private
virtues would also be supported by utilitarian and contractarian analyses.
The Limits of Welfare Economics
Social, as opposed to civil and private ethics, attempt to make global
claims about society as a whole. Contemporary welfare economics attempts
the same types of calculations for economic aspects of society. However, it
also includes more modest efforts to evaluate and address specific
problems such as air pollution or highway congestion, which are more
analogous to the problems addressed by civil ethics. Global assessments are
clearly more challenging than the partial equilibrium based analysis of civic
or private ethics.
First, the informational requirements are enormous. Global
utility-based analysis requires knowledge of every single living persons’
utility function, and in some cases those of every person that might ever
live. To do so in as exact a manner as the mathematics suggests one might,
is clearly impossible unless people are identical and population can be
perfectly predicted. Beyond utility functions, one must know the various
production possibility frontiers that emerge under different social systems,
a matter that is much debated among economists and other social sciences.
The specific responses of individuals to the incentives and opportunities of
different social systems are empirical rather than matters that can be
determined via deduction.
There are methodological issues as well. It is one thing to suggest
that utility maximizing man and competitive markets are useful analytical
constructs that shed light on how well-developed markets operate, and
another to say that they represent exactly how such markets operate. Again
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Moral Foundations of Capitalism: Chapter 10
the mathematics associated with contemporary social normative theories
tends to exaggerate the precision with which conclusions can be teased out
of even rigorous normative theories. The consequences of alternative
grounding laws, collective choice methods, and policies can be
characterized in analytical models, but rarely conclusively compared.
Without precise information, social normative assessments of the
relative merits of alternative policies are at best approximations of the ideal.
This is not to say that approximations cannot be useful, but it is to say that
one should take most conclusions of utilitarian and contractarian analysis
with a grain of salt.
Applied welfare economics attempts to make the inferences of
analytical norms more useful by devising material measures that are
correlated with the aims of those theories. Global assessments of economic
systems as with per capita real gross national product and unemployment
rates provide measures that are likely to be correlated with aggregate utility.
Cost-benefit analysis similarly attempts to assess whether aggregate utility
rises or fall when a new policy is adopted. The latter cannot happen, of
course, unless markets fail to maximize aggregate utility along some its
margins. Various survey measures of contentment, optimism and the like
can also be employed as indicators of aggregate utility, which allow some of
the tools of welfare economics to be tested for their utilitarian validity. If
such measures typically improve during booms, when RGDP per capita is
increasing rapidly and unemployment is falling, the macro-economic norms
can be useful indicators of aggregate utility.
In this manner, welfare economics can provide guidance to voters
and policy makers that are grounded in sophisticated social normative
theories. However, because they are imperfect correlates rather than
perfection ones, they cannot be used to characterized a utilitarian utopia or
utopian path, nor the perfect social contract or procedures for just
redistribution of existing resources. However, they can provide some
useful indications of the direction a society should move if its aim is to
become such societies. RGNP per capita, for example, is often increased
by a well functioning legal system and liberal economic policies.117
However, it cannot really be assumed that all voters are utilitarians or
contractarians, nor that those occupying elective and appointed offices are
motivated by such theories. Moreover, even if they were so motivated,
there would be points of disagreement about the relevance of individual
actions (act or rule utilitarians), grounding laws (standing rules or adaptive
policies), and just procedures for reform.
As examined in the next chapter, social, civil, and private ethical
theories may influence the votes cast by voters and therefore the policies
adopted by democratic governments. In this manner ethics may be said to
provide one of the foundations for public policy in a manner analogous to
the ones through which partly determine market outcomes. However, as in
the case of market relevant norms, only a subset of normative theories are
likely to lend support to policies that reinforce rather than undermine the
viability of a commercial society.
Similarly, if approval of markets and public policies increases provide
evidence of consensus, which in turn provides evidence of the extent to
which policies may be regarded as consistent with contractarian norms.
High degrees of support imply that a society’s core policies may be
regarded to be products of a hypothetical social contract. Procedural forms
of distributive justice are similarly affirmed by indices of corruption and
crime rates. The higher are those indices, the fewer transactions satisfy
procedural norms.
117
See for example: Feld and Voigt ( 2003), Blume and Voigt (2007), and Gwartney, Lawson, and Holcombe (1999).
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Moral Foundations of Capitalism: Chapter 11
Chapter 11: Ethics and Markets Ethics and Democratic
Rule: Legislation and the Commercial Society
failure that emerged from the theoretical welfare economics
of the 1930s and 1940s. [James Buchanan (1984) “Politics
without Romance, in Buchanan, J. M. and R. D. Tollison
(Eds.) The Theory of Public Choice II. University of Michigan
Press.]
I.
As long as the reason of man continues fallible, and he is at
liberty to exercise it, different opinions will be formed. As
long as the connection subsists between his reason and his
self-love, his opinions and his passions will have a reciprocal
influence on each other; and the former will be objects to
which the latter will attach themselves.
The diversity in the faculties of men, from which the
rights of property originate, is not less an insuperable
obstacle to a uniformity of interests. The protection of
these faculties is the first object of government. From the
protection of different and unequal faculties of acquiring
property, the possession of different degrees and kinds of
property immediately results; and from the influence of
these on the sentiments and views of the respective
proprietors, ensues a division of the society into different
interests and parties. [Hamilton, Alexander; Jay, John;
Madison, James (1980 / 1787/2011-06-09). The Federalist
Papers (Annotated) (Kindle Locations 1014-1020). ]
Public choice theory has been the avenue through which a
romantic and illusory set of notions about the workings of
governments and the behavior of persons who govern has
been replaced by a set of notions that embody more
skepticism about what governments can do and governors
will do. ... [P]ublic choice offers a theory of governmental
failure that is fully comparable to the theory of market
On the Source of Framing and other Laws Affecting the
Extent of Commerce
Chapter 6 argues that the civil society is partly a consequence of
internalized ethics and partly of laws. Ethics can reduce problems of
violence, theft, and coordination, but insofar as they do not completely
solve these problems, they may have to be supplemented by external rules
and punishments to more fully resolve the many social dilemmas associated
with life in communities. As Hobbes argued, an organization may be
created for this specific task, as with a central government and a judicial
system. When the rules enforced simply reinforce the norms already
internalized by most members of a community, the laws themselves may
have a moral character and be said to be grounded in ethics, as argued by
Kant. However, Kant also notes that not all laws are moral laws and there
are ethical principles that are rarely codified.
A subset of the laws that have moral foundations may said to be said
to support commerce, as with the civil laws protecting the possession of
real assets and providing for voluntary exchange. Without transferable
property rights, trade would be illegal and that which took place would be
opposed rather than supported by the law. Without laws against theft and
formal punishment of thieves, there would be far more theft and far less
production. Farming itself would be nearly impossible as theft would be
more economical than plowing, planting, and harvest. Capital goods would
also be less likely to be built and refined, if the profits from doing so were
open to theft.
Just as some ethical systems support commerce, while others oppose
it, some laws may undermine the development of extensive markets. For
example, Aristotle suspicion of interest when incorporated into law
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Moral Foundations of Capitalism: Chapter 11
essentially eliminates the banking industry and replaces it with more
roundabout methods of saving and finance.118 rules against charging
interest on loans reduce prospects for inter-termporal exchange and risk
sharing.
The emergence of a formal system of laws and law enforcement does
not necessarily require a government in the sense of a rule making body
with a monopoly on force or law enforcement. A community may form
such an organization itself, as for example, meetings of the persons affected
by problems gradually become more formally organized (e.g. adopt rules
for its own administration and procedures) and enforcement might be
routinized, yet remain decentralized. Decisions about new rules or
interpretations of old laws may be reached via consensus or majority rule at
informal tribal council meetings or assemblies such as the ancient tings of
Scandinavia. Such decisionmaking procedures may be codified and
considered governments when they combine law choosing and law
enforcing authority. Coercive power is not necessarily a precondition for
the existence of government.119
The existence of an organization with the ability to intimidate all
others through threats of violence is another plausible source of external
rules and rule enforcement. Such groups may organize militarily and use its
military abilities to impose rules on others. They may in the limit control
everything and everyone outside their organizations. Rules in such systems
would emerge for the convenience of the ruler making group. The lives of
slaves and serfs are normally rule bound.
When slavery is not possible or less profitable than more open
systems, such despotic groups may impose laws that promote economic
development because this ultimately provides them with greater wealth and
power than alternatives systems that they know of. Such “stationary
bandits” have what Olson (xxxx) terms an encompassing interest in the
economic resources of their societies, insofar as wealth does not undermine
their authority. Laws that promote economic development increase long
term expected government revenues from taxation, rent extraction, and
extortion.
Nonetheless, one rarely observes well functioning markets in
dictatorships. This is evidently due to conflicts between a ruling groups
interest in retaining power and its interest in long term generalized
economic growth. In most cases, impoverishing one’s enemies and
enriching only one’s supporters is a useful strategy. Medieval law was shot
through with laws favoring persons, families, and towns that supported the
central government, and death penalties for those that did not.
Because the emergence of capitalism and democracy in nineteenth
century Europe were closely linked, it may be presumed that markets and
democracy are inherently reinforcing. However, this depends in part, as
shown in this chapter, on the extent to which the ethics of the electorate
tends to support commerce. Support for equality before the law, open
markets, and political systems are not associated with every system of
ethical beliefs or ideology. Neither the rule of law nor ethics, per se, are
sufficient to support extensive markets or the commercial society.
To demonstrate this point, some elementary public choice ideas need
to be introduced. It turns out that ethics, as with self restraint and rule
following propensities, are a prerequisite for a functional majoritarian
system of governance. Additional ethics are evidently required for mutually
supporting democratic-capitalistic system.
118
See Kuran (xxxx) for an overview of the financial methods of Moslem countries in which banking is illegal. See ... for a similar treatment of Europe during the medieval
period.
119
Nozick (1974, ch.5) discusses how a centralized enforcement authority might emerge from a society that initially used only informal procedures for self defense, rather
than through the imposition of laws by dominate military organization.
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Moral Foundations of Capitalism: Chapter 11
II. The Feasibility of Majority Rule
differences among citizens. After all, some persons can more readily
shoulder the burden than others ( 1, 4, 7).
Most modern analyses of democracy assume that democratic
governance is always feasible. However, a precondition for majority-rule
based governance is that it settle on particular rules or policies. The early
public choice literature showed that majority rule is not always to makes
such choices.120 Internalized ethical theories of various kinds can help avoid
that fundamental problem.121
A fourth proposal might account for the fact that the shepherds
could benefit from learning the craft of masonry, and, moreover, have
more free time available for undertaking the required work. The shepherds
have the most to gain, or the least to lose by undertaking most of the work.
Indeed, it could be claimed that the merchants were already carrying the
burden of expanding the town's cathedral ( 6, 5, 1).
To illustrate why widely shared norms may be a precondition for
democracy, imagine a village located in a territory where roving bandits
exist. The community decides that a defensive wall would solve problems
associated with such raiders. Suppose that the wall will cost 12 monets.
Now consider efforts to divide the cost of the wall among three groups,
shepherds, masons, and merchants. One proposal for financing the wall
would be to simply divide up the costs equally among the three groups.
Such an apportionment may be plausibly justified from the common
interests advanced by the wall. The distribution of the tax burden can be
written as (Tshepherd, Tmason, Tmerchant) which in this case is (4, 4, 4).
Since all four tax systems are sufficient to finance the public good of
interest here, any will serve. Note, that majority rule cannot do so. There is
a majoritarian cycle in this case. The first proposal loses to the second, the
second by a vote of two to one. The second similarly loses to the third, the
third to the fourth, and the fourth to the first. So no decision may actually
emerge from democratic deliberations. As a consequence, the town will
continued to be ravaged by the roving bandits or may be annexed by the
neighboring dictatorship.
A second proposal for funding the wall's construction might be based
on comparative advantage. Perhaps, the wall should be provided by those
best able to provide the needed services, which in this case would be those
already skilled at wall construction. Some might argue that "clearly" the
middle class masons should be public spirited and construct the wall for the
city, ( 2, 8, 2).
Another proposal might be developed based on differences in the
ability of the townspeople to pay for the wall. Proponents of that view
might reason that the community should take account of physical or wealth
If only one tax system is supported by a community’s dominant
normative theory, the others would be rejected because they yield burdens
that are “improper” or “unfair.” For the two groups that benefit from such
immoral or unfair proposals, the cost of violating their internalized norms
must be greater than their material benefits. Similarly, one could imagine a
customary method of finance existing, and deference to custom--the “right
way of doing things”--could also serve as a solutoin to the cycling problem.
In cases where community norms do not lead directly to particular
policy outcomes, norms may limit the domain of policy alternatives in a
manner that helps assure stability. For example, a consensus that taxes
should be based on ability to pay limits tax systems to a relatively small
subset of those which can fund the desired services, although it does not
120
See for example Black (1948) or Arrow (1953). See Mueller (2003) for a useful overview of efforts to explain the existence of stable majority choices. One such
expalnation is the existence of an ideological spectrum, which for the purposes of this book can be thought as a spectrum of ethical dispositions insofar as ideologies
include normative theories and conclusions.
121
The illustrating examples here and later on redistribution and the poverty trap are slightly modified versions of one from Congleton (2003).
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Moral Foundations of Capitalism: Chapter 11
imply a unique distribution of tax burdens.122 Cycles may also be curtailed
by procedural norms. For example, it may be widely regarded as improper,
unfair, or unsportsman-like to reintroduce tax schemes that have already
been rejected.
the cost sharing rule. Because each anticipated different marginal benefits
from the service, their ideal points differ. Such difference may reflect
differences in income or simply in the extent to which they expect to use
the service.
The same logic also implies that the existence of widely-shared norms
can also enhance prospects for constitutional building. In effect, shared
norms can serve as a super-constitutional foundation for decisive
majoritarian decision making at both the constitutional and day-to-day
levels of democratic politics.123
These three ideal points can be used to illustrate the process of
voting among rational persons. Net benefit maximizing voters with linear
marginal benefit and marginal cost curves act as spatial voters, that is to say
they will vote in favor of the alternative that is closest to their own ideal
point. As drawn, Anthony’s ideal point is the highest of the three (A*),
followed by Duncan’s (D*). Gordon prefers 0 over the other possibilities
under this cost-sharing arrangement.
That ethics and culture for democracy has long been recognized.
Tocqueville (1972/1835, p. 319) notes that "the maintenance of democratic
institutions in the United States is attributable to the circumstances, the
laws, and the customs of that country" while emphasizing that the latter
two causes are more important than the former. Ostrom (1998) provides a
very complete overview of the role of norms in making collective action
both feasible and productive. However, not ethical system supports
commerce.
Figure 11.1 Selection of a Public Service
Level via Majority Rule
$/Q
MC = SMC
MB-A
III. The Median Voter and Political Failure
Whenever majority rule is decisive, “middle of the road” voters tend
to vote with the majority. Under some institutional arrangements the choice
that emerge from a sequence of votes or negotiations is the one that most
pleases the voter exactly in the middle (the median voter). The former is
referred to as the weak form and the latter as the strong form of the median
voter theorem.
SMB
MB-D
MC/3
MB-G
G*
Q**D* A*
Q
Figure 11.1 illustrates the ideal service levels of three different
persons, Anthony, Duncan, and Gordon under an equal cost sharing rule.
Each favors the service level that maximizes their own net benefits given
122
Usher (1981) demonstrates that tax systems that preserve the pretax rank order of income tend to be more stable under majority rule than those which do not.
123
Buchanan (1994, ch. 3) argues that norms may emerge as rhetorical devices that get other persons to adopt the behavior that advances the interest of those using the
rhetoric.
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Moral Foundations of Capitalism: Chapter 11
Note that in pair-wise elections, D* can defeat any other alternative,
because Duncan is the median voter, the voter whose ideal point is the
median of the distribution of ideal points. Anthony and Duncan will vote
for D* over any service level below D* and Gordon and Duncan will voter
for D* over any service level greater than D*. Thus if D* is on the ballot, it
will be the outcome.. The same logic can be extended to any odd number
of spatial voters.
One can assess the median result using various normative theories.
For example, it can be assessed from the utilitarian perspective using tools
form welfare economics. If the public service of interest is a pure public
good, the the social marginal benefit curve is the vertical sum of the
individual marginal benefit curves. If the marginal production cost curve
(MC) includes all costs, then it is the social marginal cost curve. Together
these imply that social net benefits are maximized at Q**, which in this case
is a bit less than the median voter desires.124
The outcome that would have been chosen by a hypothetical
“utilitarian social planner” is not likely to emerge from majority rule. Thus,
for utilitarians, the choice in a liberal democracy is among allocation by an
imperfect market, by an imperfect government, or by some combination of
the two.
In cases in which outcomes are likely to be improved via majority
rule (that is, aggregate utility increased), utilitarians will prefer democratic
interventions in markets. For example, if public goods, externality, or
monopoly problems are large, it is likely that democratic interventions will
increase aggregate utility, even if they do not maximize it. In cases in which
the problems are small or democratic interventions are themselves
especially problematic, the competitive market outcome is likely to yield
greater aggregate utility.
With respect to redistribution rather than regulation and public
services, their recommendations will also depend on the expected
outcomes of majoritarian policies, which are also likely to be imperfect.
These are analyze in the next section.
Other ethical theories may not reach such sharp looking conclusions,
but they also can be used to judge the outcomes of majoritarian decision
making. From the point of view of private ethics, some might argue that
the effect of this policy on Gordon is unethical. He has been forced t
contribute to a service that he does not want given the cost sharing rule.
Contractarians. They might insist that if coercion is wrong among private
parties it is also wrong in government. Other private ethical theories might
note that the taking of revenues from Gordon for use in this project,
without his consent, resembles theft among private persons. They might
insist that only those that benefit from programs pay for them.125 They
might suggest that consensus decisionmaking, when possible, is superior to
majority rule.126
From a contractarian point of view, the issue is whether
unconstrained majority rule is itself a cause for concern. That is to say,
given a cultural and institutional setting in which stable majorities exist, are
124
Note that if public production generated negative externalities, that the social marginal cost curve would be higher than that curve, and so the optimal level of the public
service would be lower, as shown for private choices in chapter 10. The early tests of nuclear weapons, for example, left large tracts of radioactive land and generated
significant fallout. Military aggression imposes costs on persons living in the area under dispute. Highway, metro, and office construction generates noise and congestion.
We ignore such nontrivial externalities here to focus on majoritarian decision making.
125
Astute readers may note that under a Lindahl tax system there would be complete consensus for output level Q**. The point here, however, is simply to point out that
in the absense of such taxes, majority rule outcomes can be criticized from a variety of ethical perspectives. This criticism tends to reduce the sphere of government
activity.
126
James Buchanan often made this point, insisting on what he called “Wicksellian unanimity” as the proper way to choose public policy.
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Moral Foundations of Capitalism: Chapter 11
their other constraints or other decision rules that can make the process of
choosing policies more broadly acceptable, whether from a given set of
individuals or from behind a veil of ignorance or uncertainty. They might,
for example, advocate constraints on the taxing or regulatory authority of
government to reduce the worse case outcomes of majority rule. For
example, contractarians might insist that all government services be funded
through such taxes, to the extent that Lindalh benefit taxes feasible. (Note
that under a cost sharing rule that set marginal cost shares equal to
Anthony’s, Duncan’s and Gordon’s marginal benefits at Q**, there would
be unanimous agreement about the service level.) They may also favor
other constraints such as a bill of rights to block regulation that is likely to
harm minorities, as with censorship of news, and arbitrary creation and
enforcement of laws. This may be countered with free press, takings, and
due process constitutional laws.
With respect to the distribution of income, contractarian perspectives
vary with respect to the priority of private property. If a distribution of
private property pre exists constitutional negotiations, only altruistic
redistribution or social insurance programs would tend to be supported. If
not, as in Rawls’ framework, the extent of redistribution favored would
depend on the anticipated outcomes of majoritarian redistribution.
IV. The Median Voter and Redistribution
Both utilitarians and some contractarians favor some redistribution
of income by governments; however, in each case, the extent to which a
democratic government should be charged with authority to do so depends
on the expected results. Redistribution, per se, is not a good. It should
either increase aggregate income or increase support for the
post-constitutional society. There are several potential problems with
majoritarian redistribution. First, there is the cycling problem noted above.
An unconstrained redistributional authority tends to generate endless cycles
and no choices may actually emerge. Second, if one constrains
redistributional policies to particular tax and transfer instruments or
127
assumes that ethical considerations limit the domain of “acceptable”
redistribution so that the cycling problem is avoided, too much or too little
redistribution may occur.
Problems with redistributive choices can be illustrated with a few
equations and a diagram.127 Suppose that a majority imposed a uniform tax
on everyone’s income of t percent and used the proceeds to make an equal
lump sum payment to each person in society. Each voter would then have
after tax income of Xi = (1-t)Yi + G, where Yi is voter I’s pretax income, t
is the tax rate, and G is the demogrant. Since G is paid for through taxes,
NG =  tYi which after dividing both sides by N implies that G = tYA ,
where YA is average income. If individuals act as pragmatic income
maximizers, they will favor the tax that sets the marginal benefits from the
demogrant equal to their marginal tax cost. However, this equality, perhaps
surprisingly, may never occur.
Figure 11.2 illustrates the basic mathematical problem under two
scenarios. In the first case, taxes do not affect work effort or income in
which case the marginal benefit from the tax is simply tYA and its cost is
simply Yi. If the voter has below average income, Yi < YA, and the optimal
tax is 100%. Such a tax will increase the voter’s income to the average in
the community.
In the second case, the effect of a tax on work effort and income is
taken into account. In this case the marginal benefit of the tax falls as the
tax increases because those tax cut back on work effort which shrinks the
tax base and the revenues produced to fund the demogrant. It also tends to
reduce the marginal cost for voters insofar as he or she too cuts back on
work and so pays a smaller tax at the margin. In this case the marginal
benefits of taxes is again larger demogrants, but are now MB=YA+tYAt and
somewhat lower than before. The marginal cost is now, MC = -Yi
+(1+t)Yit. which is higher than before. (A somewhat more general analysis
of such a tax system is undertaken in the appendix.)
Note that in the first case, pragmatic voters with below average
income will prefer a tax rate of 100%. A completely egalitarian society
This redistributional program is a slightly simplified version of that used in Meltzer and Richards (1981).
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Moral Foundations of Capitalism: Chapter 11
results. This would be the case in a manna from heaven society or, perhaps,
in a society in which every persons has an extremely strong work ethic.
Figure 11.2 The Transfer Poverty Trap
MB=YA
MB=YA + tYAt
i
MC = Yi + (1-t) Y t
MC = Yi
T*
100
Tax Rates
In the second case, optimal taxes are likely to be less than a hundred
percent for middle income voters with below average income, because of
the effects of the tax on the magnitude of transfers at the margin. However,
the poorer is the median voter relative to average income, the higher taxes
tend to be. The poorer the median voter relative to average income, the
more nearly confiscatory taxes tend to be. In such cases, work effort will be
low and income also low. In the limit, everyone in the community works
just a bit more than sufficient to assure subsistence, and commerce declines
to a pittance. Market are unlikely to function well, if at all, in such societies,
unless supported by an extremely strong work ethic.
One possible solution to the poverty trap is a series of constitutional
constraints on taxation similar to those analyzed by Brennan and Buchanan
(xxxx). By restricting tax rates and the tax base, such constitutional
constraints could reduce the problem. However, there are few if any
historical examples of such constraints.
Instead what seems to be common within democracies that have an
extensive commercial economies is a collection of internalized tax and
fairness norms that advance similar purposes. If a majority of voters have a
sense of what a fair or appropriate tax rate is and/or norms about
appropriate redistribution, the marginal cost of inappropriately high taxes
or transfers increases. As one violates such internalized norms, there is a
virtue or guilt premium that must be borne. The results, may for example,
limit tax rates to less than 50 percent and/or transfers to only the deserving
poor, rather than to all persons with below average incomes. Similar tax
norms may also be generated through utilitarian or contractarian analysis.
Figure 11.3 illustrates the effects of such internalized norms. The
norms internalized by moderate voters increase their personal marginal
costs for tax and transfer programs by amount v(t), which represents the
guilt or reduced self esteem associated with inappropriate taxation or
transfers. The stronger and lower the norm, the lower the optimal tax is for
the median voter, now represented as t**. The redistributive programs
adopted may resemble insurance program more than pure tax and transfer
programs, because transfers amy be targeted at persons experiencing bad
luck (unemployment and ill health), rather than below average income, per
se.
It bears noting that such norms may only incidentally affect the size
and scope of markets through effects on incentives for work and
investment, rather than aim at this result for its own sake. By increasing the
marginal cost of tax and transfer programs, such norms reduce tax rates
and scope of such programs, which indirectly increase work effort, average
income, capital accumulation, and thereby the extent of commerce.128
128
Brennan and Lomaski (xxxx) argue that voters tend to vote expressively, which implies that their moral theories will tend to have greater weight in the voting booth than
in ordinary life. Although they are most interested in cases in which problems emerge from such voting behavior, insofar as market supporting ethical theories are applied,
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Moral Foundations of Capitalism: Chapter 11
domain of public policy. The latter may, in contrast, advance general
interests, although disagreements about norms do not assure this.
Figure 11.3 Escaping the Transfer Poverty Trap
A. Rent Seeking and Rent Seeking Losses
i
MC = Yi + (1-t) Y t + v(t)
MB=YA
A
MB=Y + tY
A
t
i
i
MC = Y + (1-t) Y t
MC = Yi
T**
V.
T*
100
Tax Rates
Privileges, Interest Groups, and Rent Seeking
Liberal democracies normally include rights of assembly, petition, and
political speech, which in turn allows individuals and groups of individual
outside government to conduct persuasive campaigns of various kinds. In
some cases, the aim is to promote interests that run counter to those of the
majority. In others, persuasive campaigns press for reforms based on
shared normative beliefs.
Both sorts of campaigns consumer resources. The former does so
without increasing social net benefits, thus utilitarians may wish to
discourage such activities, which may require further restrictions on the
The right to assemble and petition government allows groups to
form for all manner of political purposes. Such groups attempt to affect
policy indirectly through launching persuasive and ingratiating campaigns
The policies of interest are often narrow ones that confer benefits on its
members and costs on persons outside the group in the form of more
stringent regulations or higher taxes.
Commercial groups often lobby for entry barriers of various kinds to
shield their firms from competition. Examples include explicit grants of
monopoly privilege, tariffs, regulations with grandfather clauses (which
impose lower regulations on incumbent firms), licensing, and a variety of
subsidies. In many of these cases, there is competition between groups
seeking to be the beneficiary of such privileges. In other casess, groups
proposing and opposing a new program, tax, fee, license etc. expend
resources for opposite purposes.
These activities were first analyzed by Tullock in 1967 and were
subsequently named rent seeking by Anne Krueger in 1974. To an
economist, a rent is an unearned income, rather than the amount paid to
use a room or house for a serious of months. Tullock pointed out that
resources are consumed by the process of seeking policy reforms without
necessarily contributing to the national dividend or social net benefits.
Table 11.1 illustrates such a contest. The use of resource in
persuasive campaigns that make others worth off also tends to make the
participants themselves worse off because such contests tend to escalate. In
evenly matched contests of the sort represented, note that each participant
would benefit from limiting the extent to which resources can be invested
in this process.
the results will be policies that are more supportive of markets than self interest alone would have generated.
page 174
Moral Foundations of Capitalism: Chapter 11
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In the case of rent seeking per se, those outside the contest are
harmed by the results through higher taxes, prices, or less variety--all of
which tend to reduce the size and scope of commerce. Perhaps surprisingly,
“crony capitalism” tends to reduce the extent of the commercial society.129
B. Ideological
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Contests between ethically motivated groups that attempt to promote
their own vision of the good society have similar properties at the level of
political active groups. Resources tend to be consumed by the rival efforts
of such groups to persuade the public or government officials of the merits
of their particular vision of the good society. However, in this case there is
the prospect for improvements in the preexisting state. For example, if one
such campaign persuades everyone in society that a particular reform is
beneficial, it will be reflected in electoral outcomes with near unanimous
levels of support.
On the other hand, unsuccessful campaigns consume resources
without producing benefits and so they may be regarded as analogous to
the rent seeking contests, where resources are consumed but without
producing net benefits for anyone (assuming that lobbyists are paid
approximately their opportunity cost wage).
C. Ethics and Rent-Seeking Dilemmas
It bears noting that it is often difficult to determine whether a
particular group is a narrow or broad interest group, because it is normally
useful rhetorically to present oneself as a broad, public spirited, group,
rather than as a money grubbing group simply attempting to increase one’s
profits at the expense of everyone else. Thus, various ethical narratives are
normally part of the persuasive campaigns of most interest groups.
Nonetheless, as in the case of other social dilemmas analyzed in
chapters 6 and 7, ethical dispositions can reduce the extent to which
persons and firms participate in rent seeking contests. Recognition of the
costs or of the unethical nature of the transfers that might be gained, my
inhibit the efforts of at least a subset of groups and group organizers.
Firms, for example, may prefer to earn their money “honestly” rather than
as the consequence of a government privilege. In effect such persons
behave as if they have internalized the costs of that rent-seeking contests
impose on society at large.
Such norms would eliminate both rent seeking campaigns and public
spirited campaigns clearly doomed to failure, if their long run effects were
fully accounted for by participants. If such ethical inhibitions to rent
seeking are less than fully internalized, the effects of such norms may still
be important. They may reduce the extent to which crony capitalism,
protective tariffs and narrow interests groups undermine the commercial
society or democracy, thereby improving the overall performance of
markets and politics.
D. Rules to Restrict the Domain of Public Policy
129
For an accessible overview of the rent-seeking literature see Congleton and Hillman (2015). For a mathematical examination of differences between ideological and
pragmatic interest groups see Congleton (1991).
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Moral Foundations of Capitalism: Chapter 11
Constitutional and other solutions to rent seeking problems typically
limit the types of influence that can be exerted. For example, bribery of
government officials is normally illegal.
procedures and constraints are often supplemented by more abstract duties
to advance the general welfare, which are inherently determined by the
prevailing ethical beliefs of voters and government officials.
One can also attempt to restrict the domain of policy making
authority. However, because it is difficult, if not impossible, to distinguish
systematically between rent seeking and potentially beneficial idealistic
interest groups, rent seeking itself cannot simply be ruled out, given rights
to free speech and petition. Moreover, most rent-seekers pretend (or may
sincerely believes) that their policies will advance general interests, not
merely their share of the national dividend.
. In addition to such ethical provisions, most constitutions have
significant unwritten parts that are the products of internalized voter and
government official norms. The decline of royal power in most Western
European countries during the late nineteenth century was only partly the
result of forma reforms of their constitutions. For example, until just a few
years ago, all laws in Norway were officially proclamations of the king, but
the king had long internalized the norm that he would proclaim only what
the Norwegian legislature “recommended” to him.
Buchanan and Congleton (1998) suggest that generality rules can
both stabilize democratic politics and reduce the extent of losses generated
from rent seeking activities. Rather than limit rights of speech and petition,
governments might, for example, be prohibited from granting monopoly
privileges, using differentiated taxes and tariffs, or from adopting
regulations unless they have obvious and broad benefits or are adopted as
by super majorities.
VI. Ethics, Constitutions, and the Rule of Law
Just as the regimen of the healthy is not suited to the sick,
one must not try to govern a corrupt people by the same
Laws as those that suit a good people. Nothing proves
these maxims better than the long life of the Republic of
Venice, which still retains a simulacrum of existence, solely
because its laws are suited only to wicked men. [Rousseau
(1997/1755) The Social Contract. p. 135)]
Political constitutions describe the procedures used to select persons
for government office and the procedures that are to be used by those
officials in the course of their official duties, including the creation of new
laws and modifications of existing law. In addition, many constitutions
have restrictions on the domain of legislation as with rules against
censorship, the taking of private property without compensation, and
assurances that particular services will be provided. These specific
The extent to which written and unwritten laws are followed are
partly determined by formal enforcement mechanisms, as with the courts
and regular elections and partly with the ethical dispositions of officials and
voters. A written constitution can be ignored and elections canceled by
rulers who lack an internalized disposition to follow rules and/or in favor
of constitutional governance. This has, of course, happened numerous
times in the past century in Africa and South America.
At the sub-constitutional level of law, the court system has the
authority to arrest persons who appear to have violated the law, conduct a
trial to determine whether or not the accused has actually done so, and
impose punishments if that is the case. At each step in this chain, the law
enforcers have to be ethical or themselves fear punishment for their
crimes. For example, in the United States, a policeman, district attorney,
judge could all, in principle, be bribed or threatened, and the law left
unenforced.
That ethical dispositions can substitute for formal rules has been
mentioned several times in previous chapters. That ethical predispositions
are prerequisites to constitutional governance and the rule of law has not
been argued to this point. However as the Latin expression, Quis custodiet
ipsos custodes? implies, not all the guardians of the law or constitution can be
directly policed. The law is most likely to be faithfully enforced if those
enforcing it have ethical dispositions that induce them to do so--as a matter
of duty--rather than because not doing so may lead to punishment.
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Moral Foundations of Capitalism: Chapter 11
In general, the further up the chain of responsibility for faithfully
enforcing the law one goes, the more difficult it is to punish someone for
malfeasance. This is in part because the method of bribery or coercion
employed at higher levels tends to be more round about, the trading of
favors, the opening or closing of doors of opportunity, job offers and the
like. The more subtle the temptations, the more difficult it is to write laws
that block them and the harder it is to enforce the laws promulgated.
In the justice system, ethical predispositions are arguably more
important than in any other area of a political economy system because
malfeasance in the application of the law may undermine both political and
civil rights. In addition, corruption can be used to undermine the
commercial society by producing privileged exemptions from civil law for
those with the resources to corrupt government officials and/or threats of
over zealous enforcement by the officials themselves to obtain “protection”
money or kickbacks. Only a strong sense of duty to enforce the law is likely
to be able to resist such temptations and threats.
Both ethical theories and practical training emphasize the existence of
such duties among citizens and government officials, as with Rawls:
There is quite clearly no difficulty in explaining why we are
to comply with just laws enacted under a just constitution.
In this case the principles of natural duty and the principle
of fairness establish he requisite duties and obligations.
Citizens generally are bound by the duty of justice and those
who have assumed favored offices and positions ..are in
addition obligated to do their part by the principle of
fairness. [John Rawls (1999) A Theory of Justice. Harvard
University Press. Epub edition, page 306.]
Without dutiful citizens and government officials, few, if any laws
would advance their expressly stated goals, rather they would become
opportunities for corruption or extortion. In the absence of ethical
dispositions, the result would be a society with less trust and higher
130
transactions costs, as efforts to avoid, rather than seek, formal government
law enforcement when laws or contracts are violated.130
VII. Ethics, Democracy, and the Commercial Society
All the above suggests that ethics play a variety of roles in
democracies that are relevant for commerce. Some laws reduce the risk of
commercial transactions, while others increase them. Enforcing the former,
helps resolve problems of contract enforcement, while discouraging fraud
and theft. Enforcement of the latter, in contrast, may increase risks (as
from takings of extortion) or impede trade through tariffs and red tape.
Neither democracy nor the rule of law are sufficient conditions for a
commercial society to emerge. Rather the market supporting laws have to
be favored over market impeding laws by the citizenry , elected officials,
and the courts.
Thus, just a a subset of ethical beliefs tends to provide private
support for extensive commercial networks, so do a subset of ethics with
respect to government policies. If the same ethical beliefs that support
markets also commonplace in government, one anticipates that market
supporting rules and dutiful implication will occur.
If not, there may be tensions between government programs,
whether well implemented or not, and the legal foundations of capitalist
societies. Tax and transfer programs may be larger than compatible with
extensive markets. Corruption may promote privileged rather than open
markets. Constitutional protections for property, as with takings clauses,
may be strong or weak, diligently enforced or neglected.
Again, the point is not that societies without market supporting
ethical and legal systems are necessarily unethical, but simply that markets
without supporting ethical and legal systems will work less well, because
risks are higher and rates of return lower.
Such efforts may create a parallel system of government, as arguably occurred among the traders and cities of the Hanseatic League in the middle ages.
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Moral Foundations of Capitalism: Chapter 11
It is interesting to note that both von Mises and Rawls believed that
internal dispositions to resist temptations and promote justice are more
important in politics than in markets.
Liberalism does not have the least thing in common with
any of these parties. It stands at the very opposite pole from
all of them. It promises special favors to no one. It
demands from everyone sacrifices on behalf of the
preservation of society. These sacrifices—or, more
accurately, the renunciation of immediately attainable
advantages—are, to be sure, merely provisional; they quickly
pay for themselves in greater and more lasting gains.
Nevertheless, for the time being, they are sacrifices.
[Mises, Ludwig von (1927 / 2012-01-02). Liberalism (p.
179). Ingram Distribution.]
The leading political actors are guided therefore in part
by what they regard as morally permissible’ and since
no system of constitutional checks and balances succeeds in
setting up an invisible hand that can be relied upon to guide
the process to a just outcome, a public sense of justice is to
some degree necessary. [John Rawls (1999) A Theory of
Justice. Harvard University Press. Epub edition, page 430.]
VIII. Tradeoffs: Laissez Faire as a Second Best Policy?
From the perspective of welfare economics the possibilities of
political and market failures both need to be taken account of when
contemplating the optimal political economy system as a whole and when
undertaking the more modest task of analyzing policy alternatives for a
specific externality, public goods, or coordination problem. If one accepts
the social net benefit framework, many the problems are empirical in
nature. Which policies or which political economic systems produce the
greatest net benefits?
A. Welfare Economics and the Assessment of Political Economy
Systems
Insofar as most empirical results are approximations of richer
models that are themselves simplified versions of reality, it is clear that
definitive answers for systems as a whole are beyond the scope of present
day analysis and likely of the computer assisted human mind. With respect
to individual policies there is a greater likelihood of more or less definitive
results, but again the issues are not simply economic ones, but political
economy ones.
At the level of system choices, there is an irreducible element of
uncertainty in every analysis that depends on interactions between markets
and politics in settings where information is far less than perfect.
Nonetheless, it is possible to make some rough estimates of the relative
merits of alternative political economy systems. Based on our previous
analysis, a good deal of the performance differences among governments
and markets reflect cultural distributions of ethical dispositions.
Table 11.2 summarizes some possible conclusions about the best
political economy system--that is the best line between the public and
private sectors--from the perspective of welfare economics. Three rough
political economy system categories are used: laissez faire (relatively little
intervention in markets beyond enforcement of civil law), mixed (many
interventions, but mostly for large market failures), social democracy
(significant regulatory and tax interventions and redistribution).
Note that other combinations are possible. It use Laisez faire in the
sense used by late nineteenth century and early twentieth century liberals: as
a watchman state (the civil law state) augmented by modest social insurance
and support for equal opportunity, as with public education. Previous
generations of liberals, as with Spencer, and contemporary libertarians,
such as Rothbard, would agree to only a watchman state, the doctrinaire
liberal position of 1880. The liberal spectrum could be expanded further to
the left to include medium to large investments in public education, social
insurance, and infrastructure, but little regulation and only uniform taxes. A
position common among today’s European liberals. The three categories in
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Moral Foundations of Capitalism: Chapter 11
table 11.2 are simply to illustrate how market and political imperfections
affect conclusions about the proper line between private and government
authority.
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If democratic politics is thought to be flawless, but markets produce
mediocre or poor results from the perspective of welfare economics, the
traditional welfare economic cases for interventions on market structure,
externalities, and public goods problems are clear. In such cases, social net
benefits are very likely to be increased through interventions that address
externality, public goods, and monopoly problems. In such cases, the lower
social net benefits from market outcomes tend to be, the more intervention
should be undertaken. This is the implicit assumption of most textbook
treatments of welfare economics.
However, as democratic or interest group politics are considered to
be problematic, the case for intervention declines. With an error prone but
not corrupt government, policy choices may worsen as often as they
improve on market outcomes. In the case of dysfunctional governments
dominated by corrupt or rent-extracting officials and interest groups,
government interventions may be presumed to always reduce social net
benefits relative to those of well functioning markets. The upper right hand
corner, thus recommends minimal state intervention, whereas the lower
left hand corner suggests extensive intervention and high safety nets.
The mid range results down the diagonal are more difficult to assess
in the abstract. In the case in which both markets and democratic politics
perform flawlessly, one can support market outcomes, because of their
lower administrative costs, perhaps modified by a modest social safety net
for times of bad luck. In that case, there is little reason for state
intervention in markets from the perspective of welfare economics.
If one accepts Rawls’ argument that markets are more robust to poor
or weak ethical dispositions than political systems are, then one should also
support laissez faire in cases in which markets are less than perfect but
governments are just as bad or worse. In such cases, markets will produce
somewhat more social net benefits without the intervention of error prone
or corrupt political systems, even if markets themselves are not performing
as well as they would with stronger moral foundations or better
institutions. In such cases, more or less unregulated markets with a modest
safety net may be as well as one can do. In the three of the four lower
righthand cells, laissez faire may be regarded as a second best solution,
rather than the best case one.
The first best upper lefthand cell may be regarded as the first best
case for a liberal democracy. However, it will be infeasible if ethical
dispositions are insufficiently common or strong.
B. Private Ethics and the Line between the Pubic and Private
Sectors
Other normative theories can be used to evaluate individual policies
and politicians as well. Prudent officeholders will deliberate on the choices
before them and act in a manner consistent with moderation and
temperance. Contrariwise, imprudent leaders will act on impulse, take
needless risks, and be apt to adopt policies that are neither moderate nor
temperate. The results of policies chosen by good men thus tends to be
better--at least on average--than those chosen by bad men, other things
page 179
Moral Foundations of Capitalism: Chapter 11
being equal, where better here means more consistent with their voters’
normative assessment of policies and outcomes. A wise and good man can
be trusted to select good policies, that is to say, such leaders select policies
that are virtuous, e.g. consistent with private ethics.131
If on average, good men rise to positions of authority in democracies,
greater license will be granted government. If bad or ignorant men rise to
positions of authority, then less authority will be granted--at least to the
extent that voters can control or influence this. Such conclusions may seem
a bit naive to contemporary analysts, but it should be kept in mind that the
overwhelming mass of policy decisions are made in private, often secret,
deliberations and that most of those decisions will be little known to the
public, regardless of the extent of their interest in public affairs.
That a good deal of political advertising in contemporary
democracies concerns the character of the men and women running for
office rather than their policies, especially in polities that rely upon
first-past-the-post elections to select officer holders, suggests that many
voters use private ethics to select policymakers.
Private ethics can also be used to evaluate the process through which
policy makers are chosen and the manner in which policies are developed
and adopted. If the process itself seems likely to produce good men or
good policies, then greater authority to government will be consistent with
voter interests. Policies adopted in smoke filled rooms by corrupt officials
and their supplicants, may be regarded with suspicion as more likely to be
instances of rent extraction than policies adopted in public after televised
debate. The latter may also be used to assess the quality of the men and the
deliberations undertaken, which again may lead voters to prefer granting
more or less authority to government officials.
The policy positions of candidates can also be assessed a voter’s
ethical system. For example, if one follows the golden rule--do on to others
as you would have do onto you--then one can try to imagine the
consequences of a particular policy and determine whether it satisfies that
reciprocity condition. Is the result one that those initiating it would have
found desirable, had they been directly affected by the policy or not?
Other private norms might also be used to assess the relative merits of
policy, such as justice or fairness. Perhaps the most obvious of such
policies are “sin taxes” and other “temperance” related policies, although
many others exist as well.132
C. Ethical Foundations of Well-functioning Political-Economic
Systems
Overall, it seems clear that private, civil, and global ethical systems all
play a role in individual assessments of the merits of both market and
democratic outcomes and procedures. And, it also seems clear that only a
subset of ethical systems will support a domain of public policy that tends
to support rather than undermine competitive markets and the commercial
societies that they tend to produce. Moreover, it seems clear that the ethics
required to support open democratic politics are not always the same or
compatible with those that support capitalism.
The best functioning political-economic systems thus require the
support of a relatively narrow set of ethical dispositions and other policy
norms among voters, government officials, and in the society at large.
Both commercial societies and democratic politics have ethical
foundations. It was not simply fortunate, but necessary, that the
constellation of norms associated with liberalism in the nineteenth century
131
A model of moral voting behavior and evidence of morality-driven policy choices in the United States are developed in Congleton (2008). See Gene xxxx (xxxx) for
evidence on the effects of religion-based ethics in the United States with respect to state policies on abortion.
132
Note that such a process is consistent with what political scientists refer to as identity politics. Candidates whose internalized norms are similar to those of particular
voters will be supported by those voters. In this case, however, it is not simply because candidates are “like me,” but because their virtues are like mine. See (xxxx) for an
overview of identity politics.
page 180
Moral Foundations of Capitalism: Chapter 11
that gradually produced constitutional democracy and the commercial
societies were from that overlapping set of supportive ethical dispositions
IX. Mathematical Appendix: A Simple Model of Redistribution
with and without Ethical Constraints
Consider the following model of redistribution based on the Melzer
and Richard assumptions. Suppose that people have identical tastes but
vary by income and that a proportional tax is to be imposed and used to
fund a “demogrant,” an equal grant to all persons in society.
Universe of Dispositions
Universe of Moral Dispositions
Democracy
Supporting
Market
Supporting
Assume initially that tastes are simply a matter of leisure (L) and
material gratification (C), U = u(T-L,C) , and that people simply consume
what they earn after taxes and receive from the demogrant program. This
can be thought of as a lifetime pattern of consumption for simple egoists
with T hours to allocate between leisure and gainful employment in the
commercial society. Consumption is Ci = (1-t)wiLi+ G with G = tYA.
Substituting allows utility to be written as U = u( T-Li, (1-t)wiLi+ G). For a
given tax and demogrant, each voter will choose to work his or her utility
maximizing number of hours, which satisfies:
-UL + UC ( 1-t)wi = 0
The solution to which can be written as L* = l(w,t,G,T) with partial
derivatives:
L*w = [-ULC ((1-t)Li) + UC ( 1-t) + UCC( 1-t)2 wiLi] / -ULL
L*t = [ULC wiL - UCwi - UCC( 1-t) wi2Li] / -ULL
L*G = [-ULC + UCC( 1-t) wi] / -ULL < 0
L*T = [ULL + ULC( 1-t) wi] / -ULL > 0
Market supporting ethical dispositions
Democracy supporting ethical dispositions
Universe of ethical dispositions
Universe of all dispositions including ethical and pragmatic ones
The last two partial derivatives can be signed using the conventional
assumptions about utility functions (UL > 0, UC>0, UCL>0, ULL<0, and
UCC<0). The first two are ambiguous, with these assumptiosn alone and
depend upon the relative sizes of the first derivative and second derivative
effects. Demogrants tend to reduce work effort and time available tends to
increase it, but whether after tax wage rates increase or decrease labor
varies with the relative size of the first and second derivatives.
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Moral Foundations of Capitalism: Chapter 11
If the second derivatives are assumed to be small relative to the first
derivatives, the intuitive results can be obtained. In that case, labor
increases with wage rates (L*w > 0) and decreases with income taxes (L*t <
0). One convenient special case in which this holds is that in which the
utility function is separable with constant marginal utility. In that case,
however, the derivatives of labor supply with respect to size of the
demogrant and time to be allocated are both zero.
In either case, a voter’s optimization problem with respect to taxes
and demogrants can be written as maximize:
U = u( T-L*, (1-t)wiL*+ tYA*).
The median voter’s receives the median wage rate, wv. Her preferred
tax rate satisifies:
U = u( T-L*, (1-t)wiL*+ tYA*).
-UL(Lt + LG YAt) + UC [( 1-t)wi (Lt + LG YAt) + YA +t(YAt+YAG ] = 0
where subscripts denote partial derivatives. If we take the case in
which second derivatives are zero, this the derivatives with respect to G
disappear and we are left with:
-UL(Lt ) + UC [( 1-t)wi (Lt ) + YA + t(YAt)] = 0
These terms can be separated into marginal benefits and marginal
costs, with
an interior solution exists. The ideal tax could easily be one hundred
percent if the labor responses to taxation are small. It could be zero if they
are very large.
In a broad range of cases, taxes may be relatively high and economic
activity lower than optimal from a utilitarian perspective. In such cases,
internalized tax norms or distributive norms can produce better results
than self interest alone. For example, citizens may have internalized norms
that approve of wage based income differences or disapprove of transfer
payments except for those involving extreme need and bad luck.
The influence of such norms can be incorporated into sufficient
number of voters utility function that they are also part of the median
voter’s calculation. (Not all voters need have such internalized norms for
them to affect electoral outcomes.)
U = u( T-L*, (1-t)wiL*+ tYA*, [tN-t]).
The tax norm may be the result of a utilitarian calculation, a fairness
consideration, or other norms. The median voter is not necessarily the
voter with the median ethical disposition towards taxes, but remains the
voter with the median ideal tax rate.
In this case the optimal level of taxation satisfies:
-UL(Lt + LG YAt) + UC [( 1-t)wi (Lt + LG YAt) +
MB = -UL(Lt ) +UC Y
A
YA +t(YAt+YAG - YN] = 0
and
MC = UC [( 1-t)wi (Lt ) + t(YAt)]
The marginal benefits come from increased leisure and income from the
demogrant, whereas the marginal costs come from reductions in income
from working and through economy-wide effects on the tax base associated
with similar declines in work effort by everyone in the community of
interest. As noted in the geometric illustrations, there is no assurance that
These terms can again be separated into marginal benefits and
marginal costs, with
MB = -UL(Lt ) +UC YA
and
MC = UC [( 1-t)wi (Lt ) + t(YAt)] - YN
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Moral Foundations of Capitalism: Chapter 11
In this case, the tax norm raises the marginal cost of taxation which
tends to reduce taxation and under the assumptions adopted above
increase average income.
A completely idealistic voter would simply favor their personal tax
ideal, TN, without regard to self interest. A pragmatic voter would not have
personal tax norms, and would simply vote for the norm that maximized
his or her utility, which in this case is approximately the tax system that
maximizes their personal net of tax and transfer income.
Poverty traps are, of course, very likely in this last case insofar as
median income is below average income, a point neglected in the original
Meltzer and Richard (1981) analysis of the size of a transfer state.
page 183