Austrian Economics: The next generation 1787565785, 9781787565791

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AUSTRIAN ECONOMICS

ADVANCES IN AUSTRIAN ECONOMICS Series Editors: D  aniel J. D’Amico and Adam G. Martin Volume 6: Austrian Economics and Entrepreneurial Studies Edited by R. Koppl Volume 7: Evolutionary Psychology and Economic Theory Edited by R. Koppl Volume 8: The Dynamics of Intervention: Regulation and Redistribution in the Mixed Economy Edited by P. Kurrild-Klitgaard  Volume 9: The Cognitive Revolution in Economic Science   Edited by Elisabeth Krecké, Carine Krecké and Roger Koppl Volume 10: The Evolution of Consumption: Theories and Policy   Edited by Marina Bianchi Volume 11: Explorations in Austrian Economics  Edited by R. Koppl Volume 12: Unexplored Dimensions: Karl Menger on Economics and Philosophy  Edited by Giandomenica Becchio Volume 13: The Social Science of Hayek’s ‘The Sensory Order’  Edited by William N. Butos Volume 14: What is so Austrian about Austrian Economics?  Edited by R. Koppl Volume 15: Hayek in Mind: Hayek’s Philosophical Psychology  Edited by Leslie Marsh Volume 16: The Spatial Market Process  Edited by David Emanuel Andersson Volume 17: Experts and Epistemic Monopolies  Edited by Roger Koppl, Steven Horwitz and Laurent Dobuzinskis Volume 18: Entangled Political Economy  Edited by Roger Koppl and Steven Horwitz Volume 19: New Thinking in Austrian Political Economy Edited by Christopher J. Coyne and Virgil H. Storr Volume 20: Studies in Austrian Macroeconomics Edited by Steven Horowitz Volume 21: Revisiting Hayek’s Political Economy Edited by Peter J. Boettke and Virgil H. Storr Volume 22: The Austrian and Bloomington Schools of Political Economy  Edited by Paul Dragos Aligica, Paul Lewis and Virgil Storr

ADVANCES IN AUSTRIAN ECONOMICS  VOLUME 23

Austrian Economics: The Next Generation Edited by

Steven Horwitz Ball State University, USA

United Kingdom – North America – Japan India – Malaysia – China

Emerald Publishing Limited Howard House, Wagon Lane, Bingley BD16 1WA, UK First edition 2019 Copyright © 2019 Emerald Publishing Limited Reprints and permissions service Contact: [email protected] No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. Any opinions expressed in the chapters are those of the authors. Whilst Emerald makes every effort to ensure the quality and accuracy of its content, Emerald makes no representation implied or otherwise, as to the chapters’ suitability and application and disclaims any warranties, express or implied, to their use. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-1-78756-578-4 (Print) ISBN: 978-1-78756-577-7 (Online) ISBN: 978-1-78756-579-1 (Epub) ISSN: 1529-2134 (Series)

CONTENTS List of Contributors

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Editor’s Introduction: Austrian Economics: The Next Generation Steven Horwitz

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Chapter 1  Austrian Economics is Alive and Growing: Retrospect and Prospect Peter Lewin

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Chapter 2 Praxeology, History, and the Perils of Historicism Peter C. Mentzel

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Chapter 3  The Socialist Calculation Debate and its Normative Implications Rosolino A. Candela

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Chapter 4  Toward A Market Epistemology of the Platform Economy Lynne Kiesling

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Chapter 5  Austrian Economics as an Evolutionary Science Witold Kwasnicki

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Chapter 6  Robust Against Whom? Nick Cowen

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Chapter 7  The Role of Culture, Information, and Expectations in Police Self-Governance Jennifer Dirmeyer and Alexander Cartwright

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Chapter 8  The Spontaneous Order of Politics David J. Hebert

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Chapter 9  Principles of the Austrian Tradition in the Policy Cycle Rosamaria Bitetti

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Chapter 10  The Fall and Rise of Inequality: Disaggregating Narratives Vincent Geloso

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Chapter 11  The Challenges Facing Evidence-Based Policy Making in Canadian Agriculture Predrag Rajsic and Glenn Fox

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About the Editors

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Index199

LIST OF CONTRIBUTORS Rosamaria Bitetti

LUISS Guido Carli, Italy

Rosolino A. Candela

Brown University, USA

Alexander Cartwright

Ferris State University, USA

Nick Cowen

New York University School of Law, USA

Daniel J. D’Amico

Brown University, USA

Jennifer Dirmeyer

Ferris State University, USA

Glenn Fox

University of Guelph, Canada

Vincent Geloso

Bates College, USA

David J. Hebert

Aquinas College, USA

Steven Horwitz

Ball State University, USA

Lynne Kiesling

Purdue University, USA

Witold Kwasnicki

University of Wroclaw, Poland

Peter Lewin

University of Texas, USA

Adam Martin

Texas Tech University, USA

Peter C. Mentzel

Liberty Fund, Inc., USA

Predrag Rajsic

University of Waterloo, Canada

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EDITOR’S INTRODUCTION: AUSTRIAN ECONOMICS: THE NEXT GENERATION Steven Horwitz

ABSTRACT This chapter is the editor’s introduction to Austrian Economics: The Next Generation, which includes a brief description of the workshop that ­produced the papers and short summaries of each contribution organized by sub-topic. Keywords: Austrian economics; public choice economics; Bloomington school; evolutionary economics; entrepreneurship; economic history

This volume of Advances in Austrian Economics emerged out of the Sixth Biennial Wirth Workshop in Austrian Economics that was held March 23–26, 2017 on the campus of McGill University in Montreal, Quebec, Canada. The success of that workshop was due to the work of a number of people and institutions. As always, I start by thanking the Wirth Institute for Austrian and Central European Studies at the University of Alberta, and its director, Professor Joseph F. Patrouch, for their continued sponsorship of these workshops. Joe and his staff members at the Wirth Institute, Sylwia Adam-Ross and Rychele Wright, did exemplary work in organizing the logistics for the workshop. On behalf of all involved, I would to especially thank Alfred Wirth for his continued participation in, and support for, the workshop and its important role in forwarding the work of the Austrian school. I also thank Jacob T. Levy of McGill University’s Research Group on Constitutional Studies, Matt Bufton of the Institute for Liberal Studies, and

Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 1–5 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023002

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Jasmin Guénette of the Montreal Economic Institute for their help in the planning process and for co-sponsoring the Friday lunch. Peter Lewin gave us an inspiring keynote address that serves as the first paper in the volume. Daniel D’Amico and Adam Martin took over the editorial process for the volume a bit sooner than planned when I became ill, and I am grateful for their willingness to step up. Finally, I thank the participants for producing a very strong set of papers and for the constructive and convivial atmosphere in which we discussed them. The idea behind this workshop was to showcase the “next generation” of Austrian economics in two senses of the term. First, we brought together a group of mostly younger scholars, interspersed with a few more senior colleagues, for the purpose of giving the younger scholars an opportunity to share their work and have it engaged by those more senior participants. The other notion of “next generation” at play in this workshop was the range of ideas that could be explored under the broad umbrella of the Austrian school. As any school of thought grows and evolves, not only does its membership change, those new people bring with them new topics, new approaches, and new combinations of ideas that slowly transform what it means to work in that particular scholarly tradition. Like the more general claim that liberal societies are ones in which ideas are free to have sex, and thereby produce novelty (Ridley, 2010), schools of thought in the world of ideas similarly progress by cross-fertilization with other approaches and attempts to apply the school’s ideas to new subject areas. It was a conscious goal of this workshop to showcase the evolution of Austrian economics through the set of ideas and approaches that constitute its next generation. The papers can broadly be divided into four categories: method and philosophy, theory, political economy, and applications/history. These categories are not new to the Austrian school, but the particular ways in which each of these papers approaches their subject matter reflects some new understanding of what it means to work in the Austrian tradition. Peter Lewin’s keynote address opens the volume by providing both the historical context of the Austrian school’s rebirth in the 1970s and its development in the following decades up to the new research of the 2010s. He focuses on the complex relationship between the Austrians and the mainstream, emphasizing the ways Austrian ideas have pushed mainstream economics to ask some different questions. Having been a contributor throughout that evolution, Lewin offers a particularly important perspective on the next generation of Austrian economics. The chapters by Peter Mentzel and Rosolino Candela explore the ways in which the Austrian tradition continues to touch an important issues in philosophy, from the methodology of the social sciences to ethics. The epistemological questions raised by the relationship between theory and history have been central to Austrian economics since Menger. Mentzel’s chapter examines Mises’s discussion of the distinct roles of theory and history and argues that history is important because it informs us about human action in ways that make us “wise and judicious” rather than helping us succeed at a particular tasks. In doing so, Mentzel brings the historian’s eye to some of these important issues in economics and offers an implicit defense of the social value of studying history. Candela’s chapter discusses the relationship between the positive understanding of the

Editor’s Introduction

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market provided by economics and the normative judgments we make about market behavior. Focusing on the entrepreneur, Candela argues that the local and personal nature of human knowledge grounds not only our understanding of the market process, but also our ethical judgments within the market and about the market. Two of the chapters offer advances in economic theory in the context of the Austrian school. Lynne Kiesling explores issues of knowledge in her discussion of the “platform economy” (e.g., Uber, AirBnB, and other firms that connect people via software platforms). Her emphasis is on the way in which the platform economy enables market actors to align new technology with what she calls the epistemic benefits of technology-enabled decentralized market processes. She provides a helpful application of her model through a discussion of the market for electricity and how it might develop a business model that takes advantage of these features of both markets and new technology. The chapter by Witold Kwasnicki attempts to locate the Austrians in the broader context of evolutionary approaches to economics. He offers nine features of evolutionary processes and then analyzes the degree to which schools of thought frequently termed “evolutionary” actually meet those criteria. His conclusion is that the Austrian school is the most genuinely evolutionary of these schools. By taking the word “evolutionary” seriously and trying to provide criteria by which schools of thought might be compared, Kwasnicki’s chapter offers a new and meaningful contribution to understanding the Austrian approach. For social scientists influenced by the Austrian school, the line between “theory” and “political economy” is often a thin one. Austrians tend toward interdisciplinarity and the mix of the Austrian school, public choice economics, and Bloomington School political science has become more common and very fertile in the last decade or two. So it is perhaps somewhat arbitrary to separate the theory papers from the political economy papers, but the contributions of Cowen, Dirmeyer, Cartwright, Hebert, and Bitetti all do share important features of a true political economy perspective that incorporates the core insights of the Austrian school. Nick Cowen offers a critical take on the “robust political economy” literature that has emerged in the last several years. He focuses on whether the institutions of classical liberalism really are robust to behavior based on outright malice and delusion. Cowen argues that actors with truly anti-social desires can be more of a threat to classical liberal institutions than to alternative institutions. He also suggests that these problems may be related to the domain of liberal institutions, as the world of anonymous and impersonal interactions is not the only social context that matters. The chapter represents a serious challenge to the robustness of robust political economy defenses of classical liberalism. Jennifer Dirmeyer and Alexander Cartwright take insights from the Austrian, public choice, and Bloomington traditions to explore the causes of police misconduct and to suggest some ways to reduce that misconduct. They focus on interjurisdictional competition as an important way to achieve that goal, but also explore ways to make more knowledge available to more people and how best to foster better cultures within police departments. The latter is analyzed in game-theoretic terms based on the

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expectations of the various actors. In the end, the various features of police work suggest that self-governance will be central to any limits on misconduct, so solving the game-theoretic issues of any particular officer’s willingness to inform on peers is particularly important. This chapter offers an interesting application of the broad set of ideas that informs Austrian political economy. Dave Hebert offers some Austrian microfoundations of the long-standing observation in public choice theory that political outcomes are the unintended consequence of the interaction of multiple choosers. Extending the work of Richard Wagner, Hebert argues that political process must be seen as ways of coordinating the plans of individuals under conditions of uncertainty by the use of political institutions. Absent a price system, he argues, the emergent order of politics is less congruent and coordinated than would be the market, but reflects a kind of emergence nonetheless. He applies this argument to the particular case of tax codes. Rosamaria Bitetti’s chapter explores how Austrian ideas have influenced public policy analysis, in particular methodological individualism and the importance of assumptions about the benevolence and omniscience of policy makers. She offers evidence of the ways in which these ideas have already been brought into the world of public policy, though perhaps not as thoroughly as one would hope. She discusses the instrument of “impact assessment” as a specific way in which knowledge issues are having influence. Other parts of the chapter offer concrete examples of similar paths of influence. These two chapters show how Austrian political economy can fruitfully be applied to specific policy concerns. The final two chapters are extended applications of Austrian ideas in the areas of inequality and Canadian agriculture. Vincent Geloso’s chapter takes the Austrian tradition’s concerns about macroeconomic aggregates and applies them to measures of inequality. In particular, he argues that we have to, following Mises, decompose historical aggregates into the underlying microeconomic foundations that can help us determine which elements of the aggregate are the most relevant. In his discussion of inequality measures, Geloso focuses on geography, race, gender, and immigration in explaining pre-1970 movements in aggregate equality measures, and the same minus gender in the post-1970 environment. Doing so provides a more complex and careful understanding of inequality that challenges the dominant narrative of a dramatic increase. In their contribution, Pedrag Rajsic and Glenn Fox critically assess the “evidence-based policy making” perspective and apply their criticisms to its use in Canadian agricultural policy. They point out that this perspective starts from a comparative institutions approach by noting the existence of both market and government failure, but then biases the comparison by assuming some policy is necessary and that the role of evidence is to select the optimal one. By contrast, they draw upon insights from the Austrian contributions to the socialist calculation debate to suggest that claims of market failure are often overstated, as policy analysts define such failure in terms of a perfectly competitive ideal, the details of which cannot be known before actual market discovery processes unfold. The chapters in this collection very nicely reflect the ways in which the next generation of both Austrian-influenced scholars and Austrian ideas are producing

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new insights and applications, and mixing those ideas with related contributions from other traditions. They span an impressive range of topics and ways of integrating Austrian ideas, and they lay out several research paths for the future of the Austrian school. I am proud to have helped bring them to publication.

REFERENCES Ridley, M. (2010). The rational optimist: How prosperity evolves. New York, NY: Harper.

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CHAPTER 1 AUSTRIAN ECONOMICS IS ALIVE AND GROWING: RETROSPECT AND PROSPECT Peter Lewin

ABSTRACT A keynote address in which the author looks back at the rebirth of Austrian economics, characterizes its current state, and looks forward to its future development. The early years after the rebirth focused on methodology, but as the modern school has development its concerns have become much more varied and connected to specific current issues. The prospects for further development are good as more young scholars arrive. Keywords: Austrian economics; disequilibrium; entrepreneurship; institutions; methodology; expectations

In this keynote address I will assume I am permitted to begin with some remarks of a personal nature, to recount some aspects of my own experience with Austrian economics that I hope will be illustrative of the themes I want to highlight. When I first encountered Austrian economics, as an undergraduate economics major, from my teacher in South Africa, Ludwig Lachmann, in the years 1966– 1970, the Austrian School was less than a 100 years old. It reached that milestone in 1971, during my honors years in economics, when I attended Professor Lachmann’s bi-weekly honors seminar – which I realized later was inspired by the

Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 7–14 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023003

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Mises seminar in Vienna, though of course, it was but a pale reflection of that singular group of people. In 1972 I left South Africa to do my graduate work at the University of Chicago, where I remained until 1976. Meantime, Ludwig von Mises had died in 1973 and the famous meeting marking the rebirth of Austrian economics occurred in 1974, also the year that Hayek won the Nobel prize. I was immersed in my graduate studies and did not return to Austrian economics until about 1980, by which time I had moved to Dallas, and at which time I quickly got reconnected with Austrian economics. When the Society for the Development of Austrian Economics (SDAE) was founded I became the treasurer of the new organization, in which position I served for 17 years. I have thus witnessed the growth of the modern Austrian school from close quarters, first centered at New York University and then at George Mason University. It has been amazing to behold. There has been a lot going on at the same time, and being among the trees, it is hard to see the forest. How is one to make sense of all of it? Our theme at this symposium has been Austrian Economics: The Next Generation. So I asked myself which generation does this refer to? I thought I was part of the next generation – the generation of the revival of Austrian Economics in 1974. But, clearly, those many who have come after my generation outnumber us and have done important work. Are they the next generation or generations, plural? I decided it made sense to divide it up not according to the dates and ages of the participants, but, rather, according to the research agenda they have followed. In that sense, I hope I can claim to be a member of more than one of the next generations. Considered in this way a definite time pattern is revealed. In recent years some detailed retrospectives on the revival and development of Austrian economics have appeared. I do not plan to repeat them here. My account is deliberately much more sparse and impressionistic. I plan to highlight just a few ideas for your consideration.1

THE REBIRTH GENERATION – METHODOLOGY The rebirth generation focused almost exclusively on methodological questions, on an Austrian critique of the methods of mainstream neoclassical economics. I include in this both the market-oriented approach of the Chicago school and the more standard neoclassical-Keynesian synthesis, as it was called. For this generation of Austrian contributions, it was mainly an exercise in product differentiation. It was not the scientific product per se that was being differentiated, but, rather, the set of methods considered valid, the way in which economic inquiry was conducted and reported, that was distinguished. This is, or should be, well-known to anyone working within the broad Austrian tradition, but, I sense that it is not as familiar to those more distant from that first next generation. So perhaps I will spend a little time talking about these essential methodological matters and the issues they raised within the reborn Austrian school as well as distinguishing that school from the mainstream. For Austrians the subjectivism of value implies a process in which individuals with different subjective valuations interact in markets. The result is the formation

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of prices that guide individual production and consumption decisions. In neoclassical economics the subjectivism of value is dealt with, not by focusing on variation in individual valuations, but by focusing on the equilibrium that would arise if these interactions were allowed to play out indefinitely while the exogenous conditions remains fixed. The hypothetical equilibrium state, in which individual marginal valuations all coincide, is assumed to apply continuously. There is little or no discussion of disequilibrium behavior. It is actually a bit more complicated than this, and depends very much on what one considers to be the parameters within which this equilibrium is assumed. However, as a practical matter, the two approaches resulted in very different methods of analysis. Neoclassical economics moved steadily toward a paradigm of what came, somewhat confusingly, to be called “positive” economics, along the lines of Milton Friedman’s famous essay (1953). In crude terms it says that assumptions don’t matter, only predictions do. And some neoclassical practitioners take this very seriously and produce all kinds of technical nonsense. As Don Lavoie and others (Austrians and other heterodox types) pointed out, data have to be interpreted, and interpretation relies on notions of plausibility and comprehensibility – indeed, that the whole point of doing economics was to render the social world comprehensible. Clearly assumption do matter a lot. So, in the immediate rebirth period, much effort was devoted to trying to spell out a more satisfactory way of doing economics. This was a period of exploration resulting in certain pivotal contributions, starting with Israel Kirzner’s Competition and Entrepreneurship (1973) and Dolan’s volume on the Foundations of Austrian Economics (1976) and culminating in The Economics of Time and Ignorance by Rizzo and O’Driscoll and Don Lavoie’s masterful books National Economic Planning, What is Left and Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered all published in 1985, and numerous articles by these and others. During the period following this, into the 1990s a lot of what the reborn Austrians did was still motivated by the effort to carve out an intellectual space separate from the mainstream, but they focused more on applications. So for example, Esteban Thomsen’s great little book, Prices and Information published in 1992, as the first in the notable Routledge series, Foundations of the Market Economy, contains a series of answers to mainstream information economics, much of it based on a particular interpretation of Hayek’s (1945) AER article (“The Use of Knowledge in Society”). Thomsen’s agenda was, in effect, set by the then current mainstream contributions. And for most of this extended period, from the mid-1970s until the 2000s, the research agenda was dominated by reacting to mainstream concerns, and often in their terms. The mainstream set much of the agenda. Perhaps the most revealing example is Roger Garrison’s macroeconomics, a brilliant pedagogic framework (summarized in 2001), but one hitched onto the prevailing Keynesian theoretical structure. These contributions to a large extent were motivated by the desire to acquaint or reacquaint academic economists with the ideas and methods of the Austrian school; but in the process, of course, these ideas and methods were developed and tweaked. So if you go back to this period and look at the books and articles you will see a lot of methodology and history of thought. In fact,

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it was sometime during this period that I resolved henceforth to stay away from matters methodological. It had grown tiresome to me. As you might have guessed I have been singularly unsuccessful in fulfilling my resolution, in that I still frequently find myself embroiled in methodological discussions. I imagine this is the fate of an Austrian economist in today’s academic environment. We have to continue to have an understanding of the methods of our inquiry and how they differ and why they differ from the mainstream. The easiest way to see this is by looking at the role of the entrepreneur.

THE ENTREPRENEUR, SUBJECTIVISM, AND DISEQUILIBRIUM Cutting through all the complex and profound discussions about method, epistemology, ontology, etc., it seems to me that the most obvious difference in actually doing Austrian economics is the presence of the entrepreneur. Whatever one calls him, it is simply impossible to do Austrian economics without taking account of the autonomous individual who is sizing up his situation and acting to improve it. All human action entails the appraising of a current situation in terms of opportunities perceived for improvement. In this sense, as Kirzner has noted, Mises claims that all actors are entrepreneurial to some degree. And yet, one searches in vain in current neoclassical economic practice for the entrepreneur. There is no room for him in equilibrium, just like there is no room for profits. Within the neoclassical world the existence of profits is evidence of economic inefficiency. This means that neoclassical economics is essentially incapable of explaining fundamental aspects of the economy like innovation, business organization, or competitive processes that are driven by anything other than price competition. So anyone doing economics, who wants to make room for the entrepreneur, and for entrepreneurial profits and drivers of economic advancement, has to engage the question of action in disequilibrium. Doing this necessarily brings one faceto-face with the inescapable conclusion that actions are driven by subjective values and expectations. Once we allow the entrepreneur in we have an Austrian world that is different from a neoclassical world. As much as those endless methodological discussions that characterized the rebirth period, like the Kirzner– Lachmann debate (e.g., see the chapters by each in the Dolan book), might have been energizing and informative, going forward it is not clear that we need any kind of firm resolution to them in order to do good Austrian economics. All we need is the ubiquitous entrepreneur. Kirzner asked a simple question: if the existing price and quantity are not market-clearing, how does the market move toward equilibrium? Who makes this happen? And of course the answer is anyone who sees an advantage in doing so, anyone who sees that the market price is likely too high or too low, and acts accordingly, will move the market toward that market-clearing price. There is no guarantee that that market-clearing price is a fixed target. It may be changing. Yet as long as these entrepreneurial actions are successful in creating value for the actors, the price and quantity will move toward market clearing.

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Lachmann objected to Kirzner’s treatment of entrepreneurship as implying that such a tendency towards equilibrium was inherent in entrepreneurial action. He noted that since perceptions of opportunities are necessarily subjective, these perceptions may turn out to be wrong. Perceptions of opportunities, based as they are on expectations, are diverse. According to Lachmann, Austrians need to be aware that expectations are most unlikely to be single-valued. Different entrepreneurs are likely to have different expectations about the same future. In fact, without such differences there would be no competitive economic process. It follows then that if there are disparate expectations about the same future, then, at most, only one can be correct. To be sure, expectations are part of extensive human plans. And plans may be judged successful or not by the planners depending upon whether they fall within a particular range of outcomes. So, in that sense, more than one entrepreneur could carry out successful plans even if their expectations did not align completely. Yet, still, the occurrence of error is both inevitable and necessary. It is from market-made errors that social learning takes place. For Lachmann the emergence of order, in spite of the coexistence of both equilibrating and disequilibrating forces, is an empirical matter. Paris does get fed, reliably so. But not inevitably so. It seems that this is true for both Mises and Hayek, but in different ways. Hayek tackles it explicitly. It is more implicit in Mises. But what we Austrians in the post-revival period have realized and have come to increasingly concentrate on are the institutional conditions that militate in favor of the miraculous extended order that Hayek talked so much about – the order that results in Paris getting fed. In the post-revival period then this has come to be part of the normal science of Austrian economics. For social learning to take place, the institutions, in the broadest sense, have to be right.

INSTITUTIONS As a Lachmannian it has always seemed to me that Hayek’s conception of plan– equilibrium is not the kind of equilibrium toward which any tendency can be imagined. What does it mean to say that plans are rendered more or less compatible in a world of ceaseless competition and innovation? This is Lachmann’s issue with both Hayek and Kirzner. I don’t think it should be an issue. I have argued, most recently in the Review of Austrian Economics, that we don’t need an equilibrium of plans, or strict plan-coordination (2015). What we need is an institutional structure that can accommodate a huge diversity of incompatible plans based on alternative incompatible visions for commercially viable ventures. This means that most of these plans will fail, but the institutional structure is such that these failures are peacefully absorbed, like the defeats suffered by football teams in which only one team can be the ultimate victor. Institutions provide the rules of the game, and these are known and predictable and they do provide for the coordination of plans in the sense that our behavior is ordered and oriented to each other. It is because of this high level of predictability in the sphere of routines, norms, laws, etc., that we can live with and prosper from the lack of predictability

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in the innovative commercial sphere. This is a lesson, it seems to me, common to all of our respected Austrian forebears that should inform our practice as economists. Institutions are an integral and significant part of what we do. (The work of economists like Andrei Schleifer (2009), Daron Acemoglu and James Robinson (2012), and some others evidences a rare recognition of this in the mainstream).

PROSPECT So here we are in the second decade of the twenty-first century. Austrian economics is still a small part of the profession, but relatively speaking it is huge by comparison to where we were just two decades ago. And the growth seems to be accelerating. I think Austrians are influential in public debate to an extent that far exceeds their numbers. I don’t know if a budding Austrian economist can ever look forward to a teaching position in an Ivy-League or Chicago, but we do have some well-placed professors, and job prospects have greatly improved and will hopefully continue to do so. In any case, the world of Austrian economics is a different world, with different methods and criteria for success. We are much more concerned about policy issues and many are working for research institutes and centers around the country and the world. And the agenda is no longer set by the mainstream to the same degree, though, in some ways, it will always be. I am sure that in our more purely academic pursuits we will continue to discuss methodology and history of thought, but this will not be our main or our only focus. Instead we have now an impressive variety of work on many different subjects. For example, on the nature of business organizations the Austrian interest in entrepreneurship has made the work of Kirzner and more recently of Lachmann an item of great interest. It is somewhat ironic to note that Austrian economics is perhaps more familiar to management scholars than to economists. There are now many Austrian scholars working in this area making significant contributions. Of course, a major area in which Austrians continue to make significant contributions is in monetary theory and policy and, relatedly, in an area as obscure as Austrian capital theory, an indispensable ingredient of Austrian Business Cycle Theory. In that area Nicolas Cachanosky and I (2018) have discovered an important link to the theory and practice of finance and accounting. Other areas include the role of culture in shaping the institutional environment, for example, in the capacity of communities to cope with and recover from natural disasters; similarly the role of the institutional structure in coping with common-resource situations, and many other areas of great interest. An example is the advent of behavioral economics. Mario Rizzo, wrote just the other day: As I said in the late 1990s, I do not expect economics as an entire discipline or Austrian economics in particular to look the same in the next few decades as it did in the mid-20th century. Already we see a big difference between the Austrian work prior to the mid-80s and today. Much of this is thanks to Peter Boettke’s efforts and to those of his students. But we also see the enormous revolution that is taking place in our discipline due to the development of behavioral economics. A major, but as of yet incomplete, transformation in the economic conception of rationality is underway. This is highly relevant to Austrian economics and to any theory of the

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market process based on Hayek’s insight that the crux of the matter is learning and the social transmission of information. (Rizzo, 2017, p. 13)

In the interwar period Mises was under the impression that the lessons of the Austrian school had been absorbed into general economics. He was soon disabused of that impression. But surely it was an impression of a situation that was desirable. We are, in a sense, a school of thought working to achieve our own demise. To the extent that we believe in the soundness of our methods and principles, we would like Austrian economics to be the mainstream. For better or for worse this is not likely to happen any time soon even though significant gains have been made. In the meantime there is work to be done, interesting work and lots of it.

ACKNOWLEDGMENTS I would like to thank Steve Horwitz for organizing this conference and for inviting me, and to Alf Wirth and the Wirth institute, and the three supporting organizations for making it possible.

NOTE 1.  The number of contributions in the Austrian mode since the rebirth generation is too voluminous to even attempt to catalog here – the most notable early contributors included Karen Vaughn, Peter Boettke, and Steven Horwitz whose scholarly contributions and organizational efforts were pivotal.

REFERENCES Acemoglu, D. & Robinson, J. A. (2012). Why nations fail: The origins of power, prosperity and poverty. New York, NY: Crown Publishers. Dolan, E. G. (1976). The foundations of modern Austrian economics. Kansas City, KS: Sheed, Adrews & McMeel. Retrieved from http://www.econlib.org/library/NPDBooks/Dolan/dlnFMA.html Friedman, M. (1953). The methodology of positive economics. In M. Friedman (Ed.), Essays in positive economics (pp. 3–34). Chicago, IL: University of Chicago Press. Garrison, R. (2001). Time and money. The macroeconomics of capital structure. New York, NY: Routledge. Hayek, F. A. (1945). The use of knowledge in society. American Economic Review, 35(4), 519–530. Kirzner, I. (1973). Competition and entrepreneurship. Chicago, IL: University of Chicago Press. Lavoie, D. (1985a). National economic planning: What is left? Washington, DC: Cato Institute; republished, 2016 by the Mercatus Center, Washington, D.C. with a new forward by Christopher Coyne. Lavoie, D. (1985b). Rivalry and centeral. New York, NY: Cambridge University Press; republished 2015 by the Mercatus Center, Washinton, DC, with a new forward by Boettke, P. J., & Storr, V. H. Lewin, P. (2016). Plan coordination: Who needs it? Review of Austrian Economics, 29(3), 199–2013. Lewin, P., & Cachanosky, N. (2018). Value and capital: Austrian capital theory, retrospect and prospect. Review of Austrian Economics, 31(1), 1–26. O’Driscoll, G. P., & Rizzo, M. J. (1985). The economics of time and ignorance. New York, NY: Routledge; Second edition 2017.

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Rizzo, M. J. (2017). Israel M. Kirzner and the entrepreneurial market process. Retrieved from http:// lf-oll.s3.amazonaws.com/titles/2730/LibertyMatters27_Kirzner.pdf Schleifer, A. (2009). The age of Milton Friedman. Journal of Economic Literature, 47(1), 123–135. Thomsen, E. (1992). Prices and information. New York, NY: Routledge.

CHAPTER 2 PRAXEOLOGY, HISTORY, AND THE PERILS OF HISTORICISM1 Peter C. Mentzel

ABSTRACT This chapter investigates the, often neglected or confused, role that History plays within Austrian Economics, and suggests ways that the former can inform the latter. Relying mostly on the work of Ludwig von Mises, the chapter explores the apparent contradictions between an a posteriori discipline like History and an a priori field like economics, and argues that they are nevertheless necessary intellectual complements of each other. Keywords: Historicism; praxeology; thymology; Ludwig von Mises; Max Weber; Austrian economics

The study of history makes a man wise and judicious. But it does not by itself provide any knowledge and skill which could be utilized for handling concrete tasks. (Mises, 2007b, pp. 30–31)

What can this possibly mean? How can the study of history make us “wise” but at the same time not teach us anything of use for “handling concrete tasks”? Moreover, and perhaps more troubling to historians, what does this quote suggest about the role of the historian or indeed the discipline of history itself ? This question is further complicated by the a priorism that seems to lie at the heart of the Austrian project.2 How do we make room in such an intellectual landscape for a profoundly a posteriori field such as history?

Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 15–28 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023004

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This chapter will try to answer these questions. In order to do so, it will have to analyze Mises’ complex social-scientific architecture and briefly investigate its epistemological foundations. Having done so, the chapter will suggest that this statement becomes not only perfectly comprehensible, but also provides a succinct encapsulation of Mises’ views about History, and perhaps his overall view of the social sciences. In particular, the chapter will suggest that Mises held that, while History cannot provide material for the construction of theoretical systems, it can (and should) help us search for individuals’ purposes as acting, choosing, human beings. This is what, finally, helps to make us “wise and judicious.”

THE SCIENCES OF HUMAN ACTION The first major distinction in Mises’ system is between the Natural Sciences and the Social Sciences, or what he calls the “Sciences of Human Action.” The Natural Sciences (chemistry, physics, etc.), are based on experience and, especially ampliative induction. Through experiments, Natural Scientists develop scientific laws that describe the physical world. These laws are based on agreed upon facts. “There can be no dispute as to whether a definite piece of stuff is copper or iron or its weight is two pounds or five” (Mises, 2005, p. 202). Importantly, based on these facts, Natural Science can make predictions about the future. To return to copper, copper is something that reacts in the same way in which other specimens of the same class react. As the patterns of this reaction are known, the engineer knows what future reaction on the part of copper he has to expect. This foreknowledge … is considered apodictic. (Mises, 2005, p. 203)

The main distinguishing feature of the other main branch of science, the Sciences of Human Action, is the subject matter: individual human beings, distinguished from all other animals in their ability to act according to rational calculations.3 The category of the Sciences of Human Action is itself broken down into two fields, praxeology and history (Mises, 2006, p. 36, 2007b, p. 30). “Praxeology is a priori. All its theorems are products of deductive reasoning that starts from the category of action” (Mises, 2006, p. 39). A glossary entry for praxeology defines it this way: The science or general theory of (conscious or purposeful) human action … Praxeology is a manifestation of the human mind and deals with the actions open to men for the attainment of their chosen ends … Praxeology aims at knowledge valid for all instances in which the conditions exactly correspond to those implied in its assumptions and inferences. Its statements and propositions are not derived from experience, but are antecedent to any comprehension of historical facts. (Mises, 2007b, p. 984. Emphasis mine)4

Praxeology “does not require empirical data. It arises from a priori principles about human action and deduces consequences from them” (Crespo, 1997, p. 39). Furthermore, “praxeology is a theoretical and systematic, not historical, science. Its scope is human action as such, irrespective of all environmental and incidental

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circumstances and concrete acts” (Mises, 2016, p. 19). Lest praxeology seem too broad or unwieldy, it might be helpful to consider some of the aspects of human behavior outside of the scope of this science of human action. In particular, praxeology does not enter into a discussion of the motives determining choice. It does not ask why a customer prefers one pattern of a necktie to another … It deals with the choosing as such, with the categorical elements of choice and action … Neither does praxeology concern itself about the ultimate goals of human action. (Mises, 2016, p. 22)

As an example, The motives and springs of action are without concern for the praxeological investigation. It is immaterial for the formation of the price of silk whether people ask for silk because they want to be protected against cold weather or because they find it beautiful or because they want to get more sexual attractiveness. What matters is that there is a demand of a given intensity for silk. (Mises, 2016, p. 23)

History, on the other hand, is by definition a posteriori. It represents “the totality of human experience” (Mises, 2006, p. 40). To put it another way, “history … refers to past facts, from which we cannot deduce laws for the future…” (Crespo, 1997, p. 39) and similarly, “the subject matter of all historical sciences is the past; they cannot teach us anything which would be valid for all human actions, that means for the future too” (Mises, 2016, p. 19). Importantly, however, Mises clearly saw history as a crucial part of the sciences of human action, since “it is the scope of history and not praxeology to investigate what ends people aim at and what means they apply for the realization of their plans” (Mises, 2016, p. 26). And as he puts it in another work, “the characteristic feature of history is concern with the individual, the irrational life, and the domain of freedom” (Mises, 2013, p. 109). Despite these differences, it is helpful to keep in mind that Mises puts both praxeology and history under the category of the Sciences of Human Action. So what is it exactly that seems to justify this? The key factor linking the two branches is human action itself. While praxeology reasons aprioristically, starting with the category of action, history reasons a posteriorially, using the “record of human action” (Mises, 2005, p. 150). In other words, the crucial point of Mises’ entire (humane) scientific architecture is human action. But, unlike the actions of other animals, human action involves choice. As Mises said, “[man] is the acting animal; he chooses between conflicting ends. It is precisely this that is the theme both of praxeology and of history” (Mises, 2006, p. 41). This statement hints at the essential feature distinguishing the Sciences of Human Action (including both praxeology and history) from Natural Sciences, namely, that unlike, say, in Mises’ copper-example, “there is no such foreknowledge of the individuals’ value judgements” and of the many things that follow from this lack of foreknowledge. Mises acknowledges that we know something about these things, but our knowledge of them and about them is categorically different from the kind of knowledge the experimental natural sciences provide about natural events. (Mises, 2005, p. 203. Emphasis in original)

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Much of the foregoing is tied to a long-standing dispute over what Mises actually meant by his insistence on an a priori reality and an apodictic certainty to his praxeological “action axioms.” Much of this controversy stems from Murray Rothbard’s famous “Defense of Extreme a Priorism,” itself largely an attack on Fritz Machlup’s work on Misensian epistemology (Rothbard, 1957). Later work has challenged Rothbard’s position and instead urged a closer reading of Machlup’s approach to Mises. At the very least, recent work on this question clearly suggests that “Mises’s was more complex than just opposing to the use of empirical [including, presumably, historical] facts to aid economic theory” (Zanotti & Cachanosky, 2015, p. 22) And lest one presume that Mises believed in the absolute supremacy of theory over empirical evidence, note his admonition that in science one cannot be too cautious. If the facts do not confirm the theory, the cause perhaps may lie in the imperfection of the theory. The disagreement between the theory and the facts of experience consequently forces us to think through the problems of the theory again. But so long as a re-examination of the theory uncovers no errors in our thinking, we are not entitled to doubt its truth. (Mises, 2013, p. 27)

CATALLACTICS AND THYMOLOGY According to Mises, praxeology and history are each dominated by a particular branch or “sphere.” For praxeology, this is the field of Economics or, to be more precise, “catallactics” (Mises, 2006, p. 98). This term, coined by the English economist and theologian Richard Whately in 1831, is drawn from the Greek καταλλάσσω meaning “to exchange.” By using this term Mises (and later, Hayek) wanted to emphasize the centrality of exchange, a purposeful action undertaken by human beings. Note here that with economics/catallactics one is still dealing with a priori knowledge. That is, to understand what happens during an exchange, and why an exchange takes place, one must resort to a priori, universal laws of economics such as supply and demand. An exchange of goods or services, the basic component of any economic system, is governed by the same laws (e.g., supply and demand) regardless of the particulars of the case. Regardless, that is, of where or when the exchange is transpiring. We try to understand what is happening using the a priori knowledge we have of such economic laws as supply and demand. For example, using our knowledge of economic laws, we can tell a plausible story about the price of apples in the market place. We can draw not only upon our a priori knowledge about supply and demand, but also on our knowledge about the effects of government manipulation of the money supply, for example. Moreover, it is worth emphasizing that these economic laws are as valid for a discussion of the price of apples in Montreal in 2017 as they are for an investigation of the prices of apples in Montenegro in 1720. As a priori truths, they are not contingent upon time or place. It should also be noted that Mises held that economic laws were a priori true. That is, they did not need to be deduced by observable phenomena. Rather, they were capable of being demonstrated logically, just as were the basic laws of mathematics.

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While this kind of praxeological reasoning can thus explain a great deal about a particular market transaction, what they cannot do is explain why, for instance, John buys apples instead of oranges. Or, to put it another way, why does John value apples more than oranges? Note that this is an entirely different sort of question than what apples cost. As articulated by one scholar, Why does indirect exchange take a particular form? What determines its extent and organization: Why does it occur when it does? These are questions of aim, scope and trajectory. Economic theory will tell you broadly why indirect exchange is useful. It will tell you the sort of reasons individuals have to engage in the uses of money. It will not tell you why they made those specific choices at the particular moments they did, nor will it tell you why the carried it on to the degree that they did. (Eicholz, 2016, p. 11. Emphasis in Original)

In fact, it (like Mises’ observations about choosing neckties and silk) is the kind of question that cannot be answered using any a priori laws or knowledge. It is, in other words, an historical question. In order to answer a question such as this we need to have some idea of what might have occurred to John in the past to lead to his preference for apples over oranges. To describe the branch of history that seeks to understand the value judgments people make, Mises employed the term thymology, first used, it seems, by the German historian Wilhelm Dilthey (1833–1911) and later by R. G. Collingwood (1889–1943). This word is based on the Greek Θυμός, which ancient authors used as the term for the “seat of the emotions and as the mental faculty of the living body by means of which thinking, willing and feeling are conducted” (Mises, 2005, p. 177, n. 1)5 Thymology, can be defined as the “knowledge of human valuations and volitions,” or “that branch of knowledge which deals with human judgements of values and ideas” (Mises, 2005, p. 177). To put it yet another way, “thymological experience is what we know about human value judgements, the actions determined by them, and the responses these actions arouse in other people … Thymology is a historical discipline. (Mises, 2005, p. 207)

It “deals with the mental activities of men that determine their actions” (Mises, 2006, p. 43). What thymology achieves is the elaboration of a catalogue of human traits. It can moreover establish the fact that certain traits appeared in the past as a rule in connection with other traits. But it can never predict the way the natural sciences can. It can never know in advance with what weight the various factors will be operative in a definitive future event. (Mises, 2005, p. 182. Emphasis mine)

That is, it examines how and why John comes to value apples over oranges at the market. And it is important, by the way, that the object of this hypothetical historical investigation is “John” and not “people of John’s socioeconomic class” or “people of John’s ethnicity” or any of the myriad other sociological or anthropological categories to which John could be assigned. This is because a choice, for example the choice to buy apples instead of oranges, is an example of purposeful action which we know can only be carried out by an individual human being. “The ultimate goal of human action is always satisfaction of an individual’s desire” (Mises, 2016, p. 24). As Ludwig Lachmann put it,

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PETER C. MENTZEL Men are viewed [in the Austrian School] as highly unequal. Each one has different needs and abilities. The quantities and prices of goods sold in the market depend on these individual needs and abilities. This fact is exactly what the subjective value stresses. Each economic agent through his action imprints his individuality on economic events. Man as a consumer cannot be squeezed into any homogeneous class. The same may be said of man as a producer. (Lachmann, 1977, pp. 51–52. Emphasis in original)

VERSTEHEN AND THE CHALLENGE OF HISTORICISM Now we have finally made our way back to something that most of us will recognize as history. We are telling stories about people doing things. By why did it take us so long to get here? And how does this make us “judicious and wise” while at the same time failing to provide any knowledge for making decisions? To answer these questions we have to dig just a bit deeper into Mises’ formulation of the sciences of human action. In the process we will come face to face with the real villain of the entire piece: historicism. We get to historicism, however, via an interesting route. Recall that so far we have two related but different scientific process at work describing a particular action: catallactics and thymology. Economics/catallactics provides the a priori, but logically demonstrable, basic structure for a given action, while history/­ thymology is supposed to supply the a posteriori description of the motivations of the individual actor within the framework of those catallactic laws. What is missing, of course, is the mechanism that makes thymology work. That is, how does the historian know what particular “mental activities” (in particular a sense of worth) determine John’s choice of apples instead of oranges? As it happens, Mises was fortunate enough to have at his disposal just such a mechanism. This was a methodology, pioneered by the historian Johann Gustav Droysen (1808–1884) called in German Verstehen.6 The basic translation into English is simply “to understand.” But in this context it is used to describe a process by which the historian attempts to penetrate the mind of the subject in order to understand his motivations. Importantly, Droysen introduced and championed the method of Verstehen in conscious reaction against the ideas of Positivism, which intended to model historical inquiry on the natural sciences. The method was subsequently appropriated and elaborated upon by Dilthey (Beiser, 2011, p. 291). As Patrick Gardiner described Dilthey’s use of the “verstehen method”: under certain circumstances … we can imaginatively recreate in our own minds the events or emotions in question in the order in which they occurred: this is not … a question of literally having other people’s experiences, but rather of rearranging the structure of our own experience … according to the model presented by the literary or historical work in question. (Gardiner, 1959, p. 212)

While the basic ideas of what came to be called by some the “Verstehen School” were elucidated by Dilthey, the methodology of Verstehen was most thoroughly worked out by the towering intellectual figure of Max Weber (1864–1920).

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Weber’s Verstehen might best be viewed as a methodological tool designed to discover the nature of the situation-including the concept, “nature of the situation,” the coercive forces … in which human social action takes place. (Tucker, 1965, p. 164. Emphasis in original)

Mises eagerly appropriated the method of Verstehen for his own work on the development of the Sciences of Human Action. As he said, [Verstehen] is the method which all historians and all other people always apply in commenting upon social events of the past and in forecasting future events. The discovery and the delimitation of the Verstehen was one of the most important contributions of epistemology. (Mises, 2016, p. 28)7

In Mises’ formulation, “[Verstehen] refers to value judgments and the choice of ends and of means on the part of our fellow men” (Mises, 2006, p. 45). Mises was also very clear what Verstehen was not and on its limitations. For one thing, and in direct opposition to Madame de Stael’s famous dictum “tout comprendre c’est tout pardoner,” Mises was very clear that “to understand an individual case does not mean to explain it, still less to excuse it” (Mises, 2016, p. 28). Equally important, at least as far as Mises was concerned, was distinguishing between the methods of Verstehen and Einfühlung (empathy). Finally, Verstehen does not give a license to speculate wildly about people’s motivations. The historian must still ground his understanding of a particular event in the documentary evidence, as well as in the realities of natural and praxeological laws (Mises, 2016, p. 32). To put it another way, Verstehen can only work in the context of actual laws of praxeology. Otherwise it is merely a kind of impressionism. The discussions regarding Verstehen, and indeed the proper way to approach history, emerged out of the herculean efforts of such early historians as Leopold von Ranke (d.1886) and other German historians of the period (especially Droysen and Dilthey) to turn history into a genuine field of scientific inquiry, instead of a kind of subset of literature or folklore, while at the same time detaching it from both Positivism and Hegelian teleology.8 In so doing, they stressed the primacy of individual human agency. As far as they were concerned, the tools of Verstehen were meant to be applied to individual historical actors. This, in turn, was one of the earliest understandings of the term historicism. For these early historicists, this term meant that a historical subject could be grasped by using Verstehen to come to grips with the motivations and goals of particular individuals. As Dilthey put it, The secret of the individual draws us, for its own sake, into ever new and more profound attempts to understand [verstehen] it, and it is in such understanding that the individual and mankind in general and its creations are revealed to us. (Quoted in Gardiner, 1959, p. 219)

A corollary to this approach was that these motivations and goals were themselves influenced by the historical realities of the time in which the subject lived. As one scholar of the subject put it: historicism and the German Historical School were essentially interested in explaining variations in culture and national identity. Ideas and institutions mattered in this regard as variables, not as givens. Institutions were seen to reflect the visible intentions of their creators. Variations in either stemmed from the ultimate freedom of the human being to conceptualize the world in whatever way one wanted. (Eicholz, 2017, p. 79. Emphasis mine)9

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By the early twentieth century the earlier conception of historicism had undergone a profound change. Gustav von Schmoller (d.1917), associated with what came to be called the “Younger German Historical School of Economics,” developed the idea that not only is some knowledge of historical context important in the successful application of Verstehen, but that historical phenomena and individual historical action are actually contingent upon the cultural and historical context in which they occur.10 Or, as Mises described it, The fundamental thesis of historicism is the proposition that, apart from the natural sciences, mathematics and logic, there is no knowledge but that provided by history … Consequently, the attempts to develop a science of economics and to discover economic laws are in vain. (Mises, 2005, pp. 133–134)

This understanding of Historicism led Schmoller, and later Werner Sombart (d.1941), into a conflict with the emerging Austrian School of Economics, a battle later called the Methodenstreit. In a 1929 critique of the Austrian School, Sombart wrote, “They [the Austrians] take no account of the historical forces which affect the working out of economic principles” (Sombart, 1929, p. 8). As a matter of fact, Sombart’s statement was largely accurate. As Mises developed his science of praxeology, he came to the conclusion that the historicist doctrines of the Historical School were deeply flawed. He criticized especially its conceit that human actions, and economic actions in particular, are contingent on the historical context in which they take place. As one scholar of Austrian Economics put it: Against the German Historical School … Mises held that there were laws of economics that transcended time and place, and that could be derived by deduction from the so-called action axiom along with certain subsidiary postulates …. Because these laws were absolutely true, moreover, they were not subject to revision or rejection on the basis of historical data… (Woods, 2008, p. 200)

Mises found the implications of the Historical School profoundly troubling, for they suggested that there were no basic economic laws. If this were the case, then policy makers in each age were free to develop their own, historically contingent, set of economic laws which, Mises rightly feared, would inevitably call for statist intervention in the workings of the Market. Mises went so far as to argue that the historicists were in fact in league with the political foes of the Free Market and wanted to “propagandize for their interventionist and socialist programs” (Mises, 2005, p. 134). The end result, Mises feared, would be the bureaucratization of society, the establishment of the human society as a “World Post Office” as he put it (Mises, 2007a, p. 101). The only hope of escape from such a nightmarish fate, Mises believed, was the recognition of certain basic praxeological laws, especially those of economics, that held true for all people in all times and places. It is certainly worth noting that Schmoller was indeed a strong advocate of the bureaucratization of German state and society (as well as German overseas imperialism).11 But the dangerous work of Schmoller did not end with his rethinking of the historicism. There had been, since the beginning of the Historicist project,

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an impulse to broaden the unit of historical analysis from an individual human being to some larger social aggregate. As Otto Hintze explained, The individual, taken in isolation, does not constitute an historical object … The basic units in history are individual totalities in which psychic processes and certain natural features combine to form living wholes. (Gilbert, 1975, p. 382)

Schmoller and his students developed this line of thought and came to believe that the “individual” as historical subject could be not only an actual, human individual but also an “individual” in the sense of a particular class or nation. In time, the main subjects of historical inquiry ceased to be real individual human beings who were relegated to short cameo appearances in the broader narratives involving the lives of individual nations. Under the tutelage of Schmoller and Sombart, historicism came to take on a meaning almost exactly the opposite of what the early Historicists had originally intended. That is, it advocated a view of the world in which the key actors are groups of people (especially nations), which are in turn more-or-less at the mercy of an ever-changing historical context. Mises’ evaluation of the Historical School is interesting: Historicism was right in stressing the fact that in order to know something in the field of human affairs one has to familiarize oneself with the way in which it developed. The historicists’ fateful error consisted in the belief that this analysis of the past in itself conveys information about the course future action has to take. What the historical account provides is the description of the situation; the reaction depends on the meaning the actor gives to it, on the ends he wants to attain, and on the means he chooses for their attainment. (Mises, 2005, p. 191. Emphasis mine)

Hence, Mises’ main problem with the Historicists was their contention that history has predictive power, whereas in fact, its main use was explanatory, or in Mises’ own words, “historical analysis gives a diagnosis” (Mises, 2005, p. 191). This might get us closer to answering our original question in this chapter. Insofar as “information about the course future action has to take” might be in the same category as “knowledge and skill which could be utilized for handling concrete tasks” we might have hit upon a way of interpreting the quote with which this chapter began.

WEBER, MISES AND THE “IDEAL TYPE” One attempt to pull back from this kind of collectivistic understanding of historicism was provided by Max Weber, himself sometimes considered a representative of what has been called the “Youngest Historical School.” Weber’s contribution was to try to strike a balance, between the bearers of agency as individual human beings and as collectivities of some sort, by inventing the idea of the “Ideal Type.” The Ideal Type itself grew out of Weber’s development of the earlier concept of Verstehen. In Weber’s hands, the idea of Verstehen, of understanding, as it developed out of the whole hermeneutical tradition of Dilthey forward, was decisively shifted from its more emphatic and

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The Ideal Type was theoretically a single individual (e.g., a peasant, a king, a merchant, a bureaucrat) but at the same time Weber was very clear that these Types were not meant to be actually, really existing people, but were rather intellectual constructs who demonstrated all of the characteristics of the particular type of person under investigation (Weber, 1978, pp. 20–21). As one scholar put it: For Weber, the Ideal Type is to be derived inductively from the real world of social history. Pure or Ideal Types are derived from historical reality and are one-sided exaggerations of the essence of what occurs in the world. (Younkins, 2004, p. 1)

Furthermore, as Richard Ebeling discusses at length in an unpublished working paper, Ideal Types play an important role in “everyday, practical human action.” Speaking of the Ideal Types of “Butcher” and “Baker,” he points out that we assume not only the particular type of knowledge that either one of them may be able to provide us with … we also expect them to act and interact with us in particular or “typical” ways, regardless of which actual, real human being may be behind the counter.12

While Mises had earlier appropriated the concept of Verstehen as the workhorse of thymology, and in general seemed to hold Weber in great respect, he finally concluded that Weber’s idea of the Ideal Type was too dangerous. Weber’s ideal types intentionally blur individual distinctions, both in the phenomena they purport to represent and in the actions of actors themselves. They also commit their greatest error by explaining history according to how collective phenomena dictate individual action, leaving the individual no more than a “refractory rebel” if he fails to follow suit. (Anderson, 2004, p. 9)

Or, in Mises’ own words, Ideal types are expedients to simplify the treatment of the puzzling multiplicity and variety of human affairs. In employing them one must always be aware of the deficiencies of any kind of simplification. The exuberance and variety of human life and action cannot be fully seized by concepts and definitions. (Mises, 2005, p. 212)

Mises might have been a bit too critical of Weber, however, since the latter clearly understood the dangers of misusing the Ideal Type methodology. In particular, he warned against the dangers of “the Ideal Type and reality being pushed together.”13 Mises instead insisted that the tools of Verstehen should be brought to bear against real, individual human subjects without reference to any preconceived notions about what their particular desires or motivations might be. Mises believed that this was possible, despite the infinite variations in human motivations, because of the “logical structures of the human mind” (Mises, 2006, p. 14). It is precisely this that allows the historian to encounter the shared humanity of his subject and try to understand the thymological explanations for his actions.

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CONCLUSIONS So where does all this lead us? Can we form some working hypotheses about the relationship between praxeology and history, these two branches of Misensian human science? And are we any closer to deciphering the quotation with which this chapter began? The key here, it seems to me, is to recognize the limits of what Mises believed history was capable of. “History is the record of human action” (Mises, 2005, p. 150). But more than that, it is a record which is supposed to be able to explain why people behaved in the ways that they did, within the context of the laws of economics. It asks the question: “How did actors perceive their options and constraints and what sorts of consequences emerged from their choices?” (Horwitz, 2012). This also brings us back to our exploration of the relationship in Mises’ scientific architecture between the a priori theory and empirical (e.g., historical) evidence. Going from applied theory to economic history, including contemporary analyses, we need to dig into the actual empirical record of what people did and thought, as well as the relevant economic data. (Horwitz, 2012)

It is important to note that this explanation was absolutely not supposed to constitute a “proof ” of those laws which are a priori true and known through deductive logical reasoning. Equally important was Mises’ contention that history’s predictive powers were extremely limited.14 History, one might say, is diagnostic but not predictive. This is because it deals with individual human beings and their subjective wants and motivations which are unique and therefore, impossible to duplicate. The choices people make are sometimes, perhaps usually, informed by “the intention of making the greatest possible material or monetary profit” (Mises, 2007b, p. 62). But praxeology is based on the premise that people’s wants and desires are individual, even idiosyncratic, and completely subjective. [Consider]the desire to live in affluence. The very fact of asceticism evidences that the striving after more amenities is not inextricable but rather the result of choice. Of course, the immense majority prefer life to death and wealth to poverty. (Mises, 2016, p. 26)

This was an important insight, for it distinguished the Homo sapiens of human history from the Homo economicus, that strange, wealth-maximizing species of humanoid automaton that populates the world of classical economics. As already noted in this chapter’s introduction, it is in this sense that History “by itself does not provide any concrete knowledge and skill which could be utilized for the handling of concrete tasks.” All this is not to say that Mises found history irrelevant or useless, however. Quite the contrary. Mises contended that he wanted to “demonstrate the service that history renders to acting man in making him understand the situation in which he has to act.” But history is even more important than this. [History] not only provides knowledge indispensable to preparing political decisions. It opens the mind toward an understanding of human nature and destiny. It increases wisdom. It is the very essence of…a liberal education. It is the foremost approach to humanism, the lore of

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Finally, it is easy, but misleading, to ignore the important words “by itself ” in the quoted passage. While history “by itself ” may be severely limited, Mises clearly believed that, when grounded in praxeological theory, history can help to explain why certain historical events happened in the way that they did. “The substance of an action is disclosed by the a posteriori insights of [Verstehen] and the form of action is revealed via the a priori logic of … praxeology” (Younkins, p. 2). Praxeological history – understanding human action as purposeful – thus makes possible an approach to history as a search for individual purposes. Mises himself provided examples of what this methodological partnership between praxeology and history might look like. One of these was the German inflation of 1914–1923. Mises points out that while we have plenty of figures concerning this period, and that economic theory (i.e., the a priori laws of economics) “provide all the knowledge needed for a perfect grasp of the causes of the price changes” this still does not give a complete account of this inflationary period. That is because “the rise of German prices in the years of the First World War was not only due to the increase in the quantity of bank notes” but to a long list of other factors (e.g., Kriegsozialismus, the “Hunger Blockade,” etc.) as well. “It is impossible to establish by methods other than by Verstehen how much each of these factors contributed to the rise of prices” (Mises, 2016, pp. 30–31). Thus understanding of the past can indeed help make a man “judicious and wise.” Understanding that the world functions in the way it does because billions of individual human beings make countless daily decisions based on their subjective desires and motivations, which we can never hope fully to understand, is not only intellectually humbling but should be a powerful antidote to the hubris underlying social engineering and economic planning, the great social scientific sins which Mises argued were to be found at the end of the road called “Historicism.”

ACKNOWLEDGMENTS I received valuable comments on this project from my fellow participants at the Sixth Bienniel Wirth Institute Workshop on Austrian Economics, but would also like to thank Dr Hans Eicholz of Liberty Fund, Inc., and two anonymous reviewers of this chapter for their important suggestions, observations, and comments.

NOTES 1.  Earlier versions of this paper were presented at the annual conference of the Libertarian Alliance, London 2010, and at the Sixth Bienniel Wirth Institute Workshop on Austrian Economics, Montreal, March 23–26, 2017. 2.  It should be noted that the emphasis on a priorism was characteristic of Mises (and later Rothbard) but was not an important feature in the work of other Austrians such as Hayek, Lachmann, and Kirzner. I thank an anonymous reviewer for this important caveat. 3. Mises uses “rational” in a sense different from much of modern usage, particularly in the field of Behavioral Economics. Mises means purposeful action, that is, action

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understandable to anyone connecting means to ends. I thank an anonymous reviewer for this clarification. 4.  The term “praxeology” seems to have been coined by the French philosopher and sociologist Alfred Espinas (1844–1922). 5. A standard dictionary definition/translation of Θυμός is: “soul, life, will, desire, appetite, resolution, thought, mind, spirit, passion.” 6.  The French philosopher Henri Bergson seems to describe a similar method in his La Pensée et le Mouvant (1934): “la sympathie par laquelle on se transporte a l’intérior d’un objet pour coincider avec ce qu’il a d’unique, et par conséquent d’inexprimable” quoted in Mises (2016, p. 28, n. 8). 7.  This passage is one of the few I have encountered wherein Mises makes some very tentative allowance for the possibility of a predictive aspect to history. The degree to which Verstehen can be used “in forecasting future events” is highly problematic, especially considering Mises’ emphatic denial of the predictive powers of history. He might possibly have been drawing on Dilthey’s careful comments on the subject of the limits of Verstehen: Any deductions about the future behavior of the individual, once its total character has been understood through this inductive process [i.e., Verstehen], is valid only as an expectation or probability. (quoted in Gardiner, 1959, p. 218. Emphasis mine)

Similarly, In a world of uncertainty, all action is based on the anticipation of probable outcomes and not on knowledge of the future. In order to act, human beings have to form assessments of possible future outcomes of their actions, but the assessments that pertain to human action are not probability estimates in the conventional sense of instances of a class of events, but what Mises calls “case probability.” (Vaughn, 1994, p. 75)

My thanks to Hans Eicholz for this citation. 8.  “By contributing a methodological rigor and conceptual clarity woefully lacking in Ranke’s diffuse hermeneutical reflections, Droysen fortified and advanced the hermeneutical tradition in historical study, and thereby set the stage for Dilthey’s own subsequent efforts at theoretical clarification” (Maclean, 1982, p. 348). 9.  See also, Szacki (1972, p. 286). 10.  “Gustav Schmoller was the founder of the ‘Younger’ German Historical School. Its program combined a historical approach to economic phenomena with the pursuit of economic and social politics grounded in ‘moral principles’ ” (Mises, 2016, p. 41, n. 3). 11. “Schmoller’s exceedingly positive image of the bureaucracy does not stem from sociological analysis, but rather from his historical studies … This view of an officialdom above class and the legitimacy of its rule corresponds with the rejection of the parliamentary system of government” (Schön, 1987, pp. 65–66). I am grateful to Hans Eicholz for this reference. 12.  Richard M. Ebeling, “Austrian Market Process Theory and Expectations: Still an Underdeveloped Aspect of Subjectivist Economics.” 13. “der Gefahr, dass Idealtypus und Wirklichkeit ineinander geschoben werden” (Zöller, 2007, p. 216). Ludwig Lachmann, for one, recognized the crucial importance of Weber’s work to Mises. In his 1951 review of Human Action, Lachmann noted, “In reading this book we must never forget that it is the work of Max Weber that is being carried out here” (Lachmann, 1977, p. 95). Thanks to an anonymous reviewer for pointing me toward this important quotation. 14.  As noted earlier, Mises’ understanding of the predictive nature of the Sciences of Human Action was extremely nuanced. Consider the following: We can predict … other things being equal – a fall in the demand for ‘a’ will result in a drop in the price of ‘a.’ But we cannot predict the extent of this drop. This question can only be answered by understanding [Verstehen]. (Mises, 2007b, p. 118)

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This approach is similar to Hayek’s “pattern prediction” (Paqué, 1990, pp. 281–294). Thanks to an anonymous reviewer for this insight. 15.  Again, the study of history is important because it “makes a man wise.”

REFERENCES Anderson, W. P. (2004). Mises versus Weber on bureaucracy and sociological method. Journal of Libertarian Studies, 18(1), 1–29. Beiser, F. C. (2011). The German historicist tradition. Oxford: Oxford University Press. Crespo, R. F. (1997). Max Weber and Ludwig von Mises, and the methodology of the social sciences. In P. Koslowski (Ed.), Methodology of the social sciences, ethics, and economics in the newer historical school (pp. 32–51). Berlin: Springer. Eicholz, H. (2016). Time, purpose, and history: A qualified defense of the German Historical School. Paper presented at the annual meeting of the Association for Private Enterprise Education, Cancun, Mexico. Eicholz, H. (2017). Who raised the boats? or, Why Deirdre McCloskey has to be right. The Journal of Private Enterprise, 32(4), 71–82. Gardiner, P. (1959). Theories of history. New York, NY: The Free Press. Gilbert, F. (1975). The Historical Essays of Otto Hintze. New York, NY: Oxford University Press. Horwitz, S. (2012). “Theory and practice in the Austrian School.” Cato unbound. Retrieved from https://www.cato-unbound.org/2012/09/05/steven-horwitz/empirics-austrian-economics Lachman, L. (1977). Capital, expectations, and the market process. Kansas City, MO: Sheed, Andrews, and McMeel. Maclean, M. J. (1982). Johann Gustav Droysen and the development of historical hermeneutics. History and Theory, 21(3), 347–365. Mises, L. v. (2005). Theory and history: An interpretation of social and economic evolution. Indianapolis, IN: Liberty Fund. Mises, L. v. (2006). The ultimate foundation of economic science: An essay on method. Indianapolis, IN: Liberty Fund. Mises, L. v. (2007a). Bureaucracy. Indianapolis, IN: Liberty Fund. Mises, L. v. (2007b). Human action: A treatise on economics. Indianapolis, IN: Liberty Fund. Mises, L. v. (2013). Epistemological problems of economics. Indianapolis, IN: Liberty Fund. Mises, L. v. (2016). Money, method, and the market process. Indianapolis, IN: Liberty Fund. Paqué, K.-H. (1990). Pattern predictions in economics: Hayek’s methodology of the social sciences revisited. History of Political Economy, 22(2), 281–294. Rothbard, M. (1957). In defense of ‘extreme apriorism.’ Southern Economic Journal, 23(3), 314–320. Schön, M. (1987). Gustav Schmoller and Max Weber. In W. J. Mommsen & J. Osterhammel (Eds.), Max Weber and his contemporaries (pp. 59–70). London: Allen and Unwin. Sombart, W. (1929). Economic theory and economic history. Economic History Review, 2(1), 1–19. Szacki, J. (1972). On the so-called historicism in the social sciences. Quality and Quantity, 5(2), 281–295. Tucker, W. T. (1965). Max Weber’s Verstehen. The Sociological Quarterly, 6(2), 157–165. Vaughn, K. (1994). Austrian economics in America. Cambridge: Cambridge University Press. Weber, M. (1978). Economy and society. Berkeley, CA: University of California Press. Woods, T. E., Jr. (2008). What Austrian economics can teach historians. Quarterly Journal of Austrian Economics, 11, 219–229. Younkins, E. W. (2004, June 15). Ludwig von Mises: From historicist to praxeologist. Le Quebecois Libre, No.143. Zanotti, G., & Cachanosky, N. (2015). The epistemological implications of Machlup’s interpretation of Mises’ epistemology. Journal of the History of Economic Thought, 37(1), 111–138. Zöller, M. (2007). Max Weber (1864–1920). In H. Maier & H. Denzer (Eds.), Klassiker des politischen Denkens (pp. 207–221). München: Verlag C.H.Beck.

CHAPTER 3 THE SOCIALIST CALCULATION DEBATE AND ITS NORMATIVE IMPLICATIONS Rosolino A. Candela

ABSTRACT During the socialist calculation debate, Ludwig von Mises and F. A. Hayek made a positive argument regarding the impossibility of economic calculation under socialism. In this study, I argue that the arguments made by Mises and Hayek have normative implications for capitalism. I do so by drawing an analogy between an Austrian account of the market process and a neo-Aristotelian account of human flourishing. Neither economic calculation follows passively from implementing a set of profit-maximizing rules nor does human flourishing follow passively from following a set of universal moral norms (be they of utilitarian, deontological, or natural law inspiration). Both economic calculation and human flourishing are inherently based on individual acts of knowledge creation, actualized only by self-directed individuals. In both cases, the creation of such knowledge is both contextual and specific to the unique circumstances of each individual of a particular time and place. Therefore, to assume that such knowledge exists ex ante, and is objective and transpersonal across time, place, and institutional context renders both economic calculation and human flourishing into a technological problem of given means and given ends, in essence defining both activities out of existence. The possibility of economic calculation and human flourishing are therefore dependent upon a political/legal order that protects the possibility of self-directed knowledge

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creation in both the economic and moral realms, that is, to say an institutional framework of private property rights. Keywords: Austrian economics; economic calculation; entrepreneurship; eudaimonia; Ludwig von Mises; F.A. Hayek; Israel Kirzner JEL classification: B53; H11; P16

Political economists stress the technical economic principles that one must understand in order to assess alternative arrangements for promoting peaceful cooperation and productive specialization among free men. Yet political economists go further and frankly try to bring out into the open the philosophical issues that necessarily underlie all discussions of the appropriate functions of government and all proposed economic policy measures. They examine philosophical values for consistency among themselves and with the ideal of human freedom.  James M. Buchanan (emphasis added, 1958, p. 5)

1. INTRODUCTION What are the normative implications of the socialist calculation debate? As a byproduct of their positive assessment of the impossibility of economic calculation under socialism, both Ludwig von Mises and F.A. Hayek learned to articulate and refine a unique understanding of the market as a process of entrepreneurial discovery rather than an end-state of equilibrium. The Austrian position that was crystallized during this debate was an exercise of positive economics. However, as Israel Kirzner has argued, a comprehensive understanding of the Mises–Hayek account of the market process cannot “avoid recognizing the possible implications these lessons hold for an ethical assessment of capitalism” (emphasis added, Kirzner, 1988b, p. 166). Taking Kirzner’s claim as a starting point of analysis, the purpose of this study is to move this normative assessment one step further. Austrian economists are in a unique position to contribute to a deeper normative justification of the market process. This is best illustrated by drawing two analogies between an Austrian account of the market process and a neo-Aristotelian1 account of eudaimonia, or human flourishing (Den Uyl & Rasmussen, 2016; Rasmussen & Den Uyl, 1991, 2005). First, just as a framework of private property rights is necessary for economic calculation, it is also essential for the moral calculation of one’s unique eudaimonia, or human flourishing. Absent the institutional prerequisite of private property rights, the individual is precluded not only from the economic knowledge required to “know how” to generate the gains from trade and innovation but also precludes the individual from the moral knowledge to “know how” to flourish as unique individuals in society. Second, entrepreneurial insight is not only the source of economic conduct but also the source of moral conduct, from which generalized norms emerge to guide social cooperation under the division of labor, not vice versa. In other

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words, “[g]eneralized norms are the consequence, not the cause or source of moral action” (Den Uyl & Rasmussen, 2016, p. 318). The absence of private property, therefore, is morally abhorrent not only because it makes economic calculation impossible, but also because it makes the moral calculation of one’s human flourishing impossible as well. In drawing these analogies, I argue that if one takes the positive implications of economic calculation seriously, there exist distinct, though not separate, types of normative theorizing regarding the moral superiority of capitalism over socialism. There exists an incentive-based framework to normative theorizing, which is based on rules that are transpersonal, general, and universal across time and place. Both utilitarianism and deontology fall under this framework. But there also exists a knowledge-based framework to normative theorizing, within which the Aristotelian account of human flourishing resides.2 The argument here is not that incentives do not matter in defining our relations between individuals. Rather, the point here is to argue that the positive and normative superiority of capitalism over socialism is only proximately based on constructing a set of incentives, whether they are derived from following a Kantian categorical imperative,3 as Mises argued, or following set of profit-maximizing rules, as Hayek argued. To argue that this is all there is to economic calculation would purge capitalism of its moral content. If economic calculation were simply a matter of implementing objective knowledge that is already “out there” via a set of rules, then this would render economic calculation into a technological problem of efficiently applying given means to given ends. This in turn would also render human flourishing by self-directed individuals into a passive response to incentives by homogenous automatons. Fundamentally, the moral superiority of capitalism within an institutional framework of private property rights is that it protects the possibility for heterogeneous individuals to actualize the contextual and particularized knowledge that is integral not only to economic calculation but human flourishing as well.

2. ECONOMIC CALCULATION: AN OVERVIEW Economic calculation, according to Boettke (1998), “refers to the decision-making ability to allocate scarce capital resources among competing uses” (p. 134). Economic calculation is a process by which entrepreneurs discover, as a by-product of rivalrous competition, the most economically efficient mode of production from those modes of production that are technologically feasible (Horwitz, 2008, p. 85; Mises, 1966, p. 207). In order to understand how the normative implications of the Austrian account of the market process parallels the normative insights found in a neo-Aristotelian account of human flourishing, we must first develop, from a standpoint of positive economics, why economic calculation is fundamentally a knowledge-based process of discovery, and only proximately an incentive-based process of resource allocation. Among economists today, there still exists a misunderstanding of the argument made by Mises and Hayek directed against the

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Marxists and market socialists, respectively. For example, Harold Demsetz has argued the following: Mises and Hayek note that the price system is much better at using knowledge and improving calculation than is central planning, but they emphasize the price system too much. It is not the price system per se that improves knowledge utilization. If it were, a socialist society could implement a price system, and some economists have urged just that (Abba Lerner, The Economics of Control, 1947). A socialist price system would yield prices that differ from those that would arise if ownership were private. The problem is not knowledge acquisition per se but motives to marshal and use particular kinds of information. (Emphasis added, 2002, p. S664, fn. 18)

More recently, in an important work by Nobel Laureate Edmund Phelps, Mass Flourishing (2006), he draws a similar parallel between the importance of discovery in both the Austrian account of the entrepreneurial market process and human flourishing. As he argues, “the journey of life is not simply advances, one after the other, in self-realization. Rather it is a journey of self-discovery” (emphasis original, Phelps, 2006, p. 281). However, the parallel he draws is attributed only to Hayek, not Mises (2006): “The arguments of Hayek are knowledge-based, while those of Mises were incentive-based” (p. 125). Much of this confusion can be based on a failure to understand the intellectual context within which Mises and Hayek were arguing. It was during the socialist calculation debate of the 1920s–1940s that economic theory evolved from what was previously a shared understanding4 of the market among early neoclassical economists into two distinct paradigms of the market, perceived in terms of: (1) a static model of general competitive equilibrium; and (2) a dynamic process of entrepreneurial discovery (Kirzner, 1988a, p. 3; see also Boettke & Candela, 2017). Mises’ 1920 article, “Economic Calculation in the Socialist Commonwealth,” was the first salvo that was shot against the Marxian notion that socialism could deliver greater material prosperity than capitalism by (1) eliminating the wastes of competition inherent to production for exchange and (2) subsuming all production for direct use under a single, deliberate, unified plan (Lavoie, 1985, pp. 39–47). This required the abolition of private property rights in the means of production. Mises, however, responded that rational economic calculation under socialism was impossible precisely because it eliminated the institutional precondition required for the communication of contextual economic knowledge via money prices, which can only emerge through exchange. As Mises (1966) states, money prices “are the only vehicle of economic calculation” (emphasis added, p. 201). Outside the context of private property, the economic knowledge that is embodied in profit and loss signals are completely absent, without which economic planners would not be able to learn whether or not they have allocated capital goods to their most valued productive uses. Mises stated his argument as follows: 1. Without private property in the means of production, there will be no market for the means of production. 2. Without a market for a means of production, there will be no monetary prices established for the means of production.

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3. Without monetary prices, reflecting the relative scarcity of capital goods, economic decision makers will be unable to rationally calculate the alternative use of capital goods (Boettke, 1998, p. 134; see also Mises, 1920/1975, p. 111). Mises (1920/1975) also criticized socialists for having believed that “they can construct a socialist commonwealth on the basis of the Categorical Imperative alone” (p. 119). That is, even based on the best intentions and motivations bestowed to central planners, without bearing the costs of their decision making, they will never be able to learn and respond to the contingent and particular knowledge communicated through money prices, which only emerge through exchange between individuals. As he argued: But even if we for the moment grant that these Utopian expectations can actually be realized, that each individual in a socialist society will exert himself with the same zeal as he does to-day in a society where he is subjected to the pressure of free competition, there still remains the problem of measuring the result of economic activity in a socialist commonwealth which does not permit of any economic calculation. We cannot act economically if we are not in a position to understand economizing. (1920/1975, p. 120)

It was Mises, and later Hayek, in arguing that economic calculation under socialism is impossible, that an explicit, Austrian knowledge-based framework of positive theorizing became articulated and explicit. Competition is regarded as a dynamic process of discovery, and relative prices emerge from entrepreneurial action to guide production in a future that is imaginable but uncertain. “What Mises and Hayek were doing, in making these contributions was, in their view, not at all revolutionary. They were simply carefully explaining the basis for their earlier universally shared positions of the early twentieth century neoclassicals of all schools” but in doing so, “Mises and Hayek were in fact deepening their own Austrian tradition in a way which, retrospectively, we can only describe as a quantum leap, a dramatic advance, in the history of the Austrian School” (emphasis added, Kirzner, 2017, p. 867). There are two particular reasons why Mises and later Hayek responded to the claims of socialists as they did. The first reason can be regarded as one of the great ironies in the history of economic thought during the twentieth century. The tools of neoclassical economic theory, which had been used to analyze the allocative efficiency of capitalism, became utilized to demonstrate the superiority of socialism. A group of economists, known as market socialists, most notably Oskar Lange and Abba Lerner, adopted neoclassical marginal analysis to argue that rational economic calculation under socialism was possible and more efficient than under capitalism. What was most ironic about the response leveled against Mises by the market socialists, was the claim that Mises’ argument had been based upon a rejection of neoclassical economic theory. As Lange argued: It has been maintained, indeed, by Marx and by the historical school (in so far as the latter recognised any economic laws at all), that all economic laws have only historico-relative validity. But it is most surprising to find this institutionalist view supported by a prominent member of the Austrian school, which did so much to emphasize the universal validity of the fundamental principles of economic theory. Thus Professor Mises’ denial of the possibility of economic calculation in a socialist system must be rejected. (Lange, 1936, p. 55)

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The analysis of institutions, particularly private property rights, which had been a part of the shared understanding of economic science among early neoclassicals, became regarded as a rejection of the universal validity of rational choice across time and place. The second reason can be explained by the fact that Mises and Hayek were precluded from discussing the role of incentives in a market economy. According to the market socialists, discussions of incentives were regarded as outside the scope of neoclassical theory because economists’ discussions of incentives were analogous to an analysis of motivations, which was regarded as the realm of psychology and sociology, not that of economics. For example, Abba Lerner criticized a fellow market socialist, Evan F. M. Durbin, for having addressed the possibility of incentive incompatibilities under capitalism. As Lerner wrote: In this comparison we must take the theoretical system in both cases i.e., leaving apart such sociological questions as incentive, etc. In general Mr. Durbin refuses to discuss these matters in the article considered and he is well justified in refusing to accept in the context of the problem of economic accounting such criticisms of socialism as depend upon these considerations. He is, however, guilty of a similar sin in the opposite direction when he declares it to be a disadvantage of capitalistic production that the managers of joint-stock companies will reinvest their quasi-rents in their own enterprise, even if the yield is greater elsewhere, because by so doing they safeguard their own jobs … This is not an accounting but a personal or sociological problem which may well be even more serious in some forms of socialist economy. (emphasis added, Lerner, 1937, p. 267, fn. 1)

By the 1940s, both the utilization and rejection of mainstream neoclassical economic theory by its defenders5 and critics, respectively, became based upon an analysis of the formal similarities of socialism and capitalism under conditions of static equilibrium. On this basis, Abba Lerner and Oskar Lange, in response to Mises, devised an economic theory of market socialism. Briefly stated, the model of market socialism postulates that a Central Planning Board would instruct the managers of state-owned enterprises to follow a set of profit-maximizing rules, namely to price according to marginal cost and produce at a level of output that minimizes average costs. By doing so, such managers would grope toward the conditions of perfectly competitive equilibrium through “trial and error,” or what Leon Walras referred to as a series of tâtonnements (Lange, 1936, p. 59), a process which they regarded as analogous to that which takes place under capitalism. During this tâtonnement process, the Central Planning Board would mimic the function of a “Walrasian auctioneer” in its role of sorting goods and services to their most valued uses to eliminate shortages and surpluses in the market. The implementation of market socialism, according to Lange and Lerner, would outperform capitalism by eliminating inefficiencies associated with monopoly power and business cycles. Hayek’s primary response to the Lange–Lerner approach to market socialism was not one about the complexity of “solving” a computation problem, in which the information regarding the availability of means and ends of resource allocation is already given. To do so is to render economic calculation into a technological problem, one in which the “market” already is in general equilibrium, a static outcome in which, by definition, costs cease to be reciprocals of choice,

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and therefore cease to be guides to future action. Instead, cost curves become parameters to which individuals passively and mechanically respond as automatons. In essence, the market socialists were assuming away the very problem for which they claimed to be providing a “solution.” Moreover, the market socialist model rules out ex ante the discovery procedure actualized by entrepreneurs in the market process and the price formation process that follows as by-product of that discovery procedure. For Hayek, the main issue for economic calculation was one about discovering the contextual knowledge that is contingent and particularized to different individuals of a particular time and place. Outside the context of a framework of exchangeable private property rights, such knowledge would not even exist, and therefore would be inaccessible to central planners. As Hayek argued: In the discussion of this sort of problem, as in the discussion of so much of economic theory at the present time, the question is frequently treated as if the cost curves were objectively given facts. What is forgotten is that the method which under given conditions is the cheapest is a thing which has to be discovered, and to be discovered anew, sometimes almost from day to day, by the entrepreneur, and that, in spite of the strong inducement, it is by no means regularly the established entrepreneur, the man in charge of the existing plant, who will discover what is the best method. The force which in a competitive society brings about the reduction of price to the lowest cost at which the quantity salable at that cost can be produced is the opportunity for anybody who knows a cheaper method to come in at his own risk and to attract customers by underbidding the other producers. But, if prices are fixed by the authority, this method is excluded. (emphasis added, Hayek, 1948, p. 196)

To conclude, the socialist calculation debate reveals that it is one thing to define a set of general norms that structure the form of economizing action. Rules structure the set of incentives that are transpersonal and universally applicable across time and place, and such general norms are important in any society to set the guidelines for social interaction. Such incentive-based general norms may take the form of a categorical imperative or a profit-maximizing rule, as was the case with the socialists. However, it is quite another thing to understand how such economizing action is substantiated through the market process. The substantiation of such general rules are a consequence, or a by-product, of knowledge-based norms of conduct, which are never generated independently of entrepreneurial human choice as it manifests itself under particular circumstances of time, place, and context. “Choice exercised by an individual,” as Buchanan puts it, “involves self-creation along with the creation of constraints imposed on the choices of others. This reciprocal interaction takes place over a whole temporal sequence” (Buchanan, 1991, p. 226). What this implies, as I argue further below in the greater detail, is that normative theorizing that informs the structure of rules is distinct, though not separate, from normative theorizing that informs human conduct within a set of rules.

3. ECONOMIC CALCULATION, HUMAN FLOURISHING, AND DISCOVERY According to Den Uyl and Rasmussen (2016), “successful actors in ethics and markets are those who consider all the available alternatives and find ways either to either eliminate or lessen conflict among existing forces or principles”

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(p. 302). Building on this parallel insight, we shall develop the nature of entrepreneurial discovery as it pertains to economic calculation in the market process and to human flourishing in the Aristotelian tradition of ethics. Both the Austrian school and the Aristotelian ethical tradition emphasize that knowledge is both particular and contingent, and that social cooperation manifests itself within a framework in which individuals are free to act on such knowledge, both for moral self-direction and wealth creation. “The entrepreneurial market process,” according to Kirzner (2017), “consists of systematic market steps through which such sheer ignorance, irrational suboptimality, may tend spontaneously to dissipate” (emphasis original, p. 857). The basis of the entrepreneurial market process is the pervasiveness of disequilibrium, within which the entrepreneur creates a systematic, equilibrating tendency. The central concept in Kirzner’s notion of entrepreneurship is the “alertness” to opportunities that were previously unknown. The entrepreneur creates economic knowledge of unexploited opportunities through trade and innovation, namely by being alert to price discrepancies between existing commodities. Kirzner (1973) notes that the discovery of a profit opportunity means the discovery of something obtainable for nothing at all. No investment at all is required; the free ten-dollar bill is discovered to be already within one’s grasp. (p. 48)

This equilibrating tendency in the market process is facilitated by entrepreneurs identifying existing miscoordinations of resources, the discovery of which presents previously unnoticed pure profit opportunities for entrepreneurs by facilitating greater plan coordination between individuals, namely through arbitrage. The entrepreneur is one that creates gains from trade and innovation by acquiring assets at a low price and securing from their subsequent sale a portion of the revenue that exceeds the costs of acquiring such assets, this difference being pure entrepreneurial profit. Therefore, the entrepreneur plays a dual role of correcting previous entrepreneurial mistakes, a by-product of which is to further expand the scope of imaginable, but not yet known, profit opportunities in the future. “In short, yesterday’s inefficiencies are today’s profit opportunities and, in exploiting those opportunities, entrepreneurs serve as the catalyst of economic change” (Coyne, Isaacs, Schwartz, & Carilli, 2007, p. 239). Entrepreneurship is not manifested as an endowment in a particular group of individuals, but as an innate potentiality embodied in all individuals. As Mises put it, “in any real and living economy every actor is always an entrepreneur” (Mises, 1966, p. 252). It is the entrepreneurial element in each individual “that is responsible for our understanding of human action as active, creative, and human rather than as passive, automatic, and mechanical” (Kirzner, 1973, p. 35). The entrepreneur does not mechanically respond to profit opportunities as a calculative, maximizing homo economicus. The counterpart to the Kirznerian conception of entrepreneurship is the neo-Aristotelian conception of human flourishing. Eudaimonia, the ancient Greek term for “happiness” or “human flourishing,” is the ultimate good or value and that virtue ought to characterize how individuals conduct their lives (Rasmussen & Den Uyl, 2005, p. 111). Human flourishing is not merely a state

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of well-being. Rather, it is an activity, an actuality, and an end in itself, realized through self-direction or choice, which is aimed at the fulfillment of an individual’s telos, or end (Rasmussen & Den Uyl, 2005, p. 129). Human flourishing is an open-ended, contextual act of discovery that requires virtue6 in action; it is an act of entrepreneurial discovery of one’s potential self, to render explicit what is implicitly unique to each individual (Norton, 1976, p. 7). In addition, the notion of alertness in the Kirznerian entrepreneur corresponds to practical wisdom in the neo-Aristotelian tradition. As was the case with economic calculation, the object of human flourishing is not to “optimize” with respect to already given means and given ends, but rather to integrate or synthesize a set of competing ends in one’s life. This process is realized through practical wisdom, or the appropriate use of practical reason. Rasmussen and Den Uyl (2005) best define practical wisdom as the intelligent management of one’s life so that all the necessary goods and virtues are coherently achieved, maintained, and enjoyed in a manner that is appropriate for the individual human being. (emphasis original, p. 147)

Practical wisdom constitutes the “the ability of the individual at the time of action to discern in particular and contingent circumstances what is morally required” (Rasmussen & Den Uyl, 2005, p. 146), and this requires that the individual also demonstrate excellent dispositions to act, or moral virtue, in such circumstances. Practical wisdom is not only pursued for its own sake, but is also a self-directed process required for “achieving, maintaining, and integrating the goods needed for eudaimonia” (Den Uyl, 1991, p.  208). Just as entrepreneurs engage in error correction through his alertness in the ­market process, namely by integrating resources toward ends that were previously unnoticed, practical wisdom synthesizes the various goals and purposes integral to one’s life. Human flourishing, however, does not occur in isolation. Human flourishing is a radically social yet radically individualized activity, in that trade contributes to one’s own self-actualization, and as a by-product, contributing to that of others. “Trading is an objective good” not only because inherent nature to truck, barter, and exchange, but also because “it serves our biocentric need for physical survival that is fundamentally human” (Kline, 2008, p. 152). Not only does human cooperation under the division of labor expand the possibility of human flourishing; it is ultimately an expression of human flourishing as well (Kline, 2008, p. 152). Human flourishing is not reduced to a single end, but is also inclusive and constitutive of a series of intermediate ends spread over one’s lifetime (Rasmussen & Den Uyl, 2005, pp. 129–132). From an economic perspective, trade is simply an alternative form of production, an intermediate step in a larger structure of production. Taken from a bird’s eye view, what is regarded as a means to an end – exchange activity – at a snapshot in time is simply an intermediate end integral to the exercise of one’s practical wisdom during their lifetime. Moreover, the fundamental importance of economic growth that is promulgated by human cooperation under the division and labor is not merely an increased level of material prosperity. As Phelps (2013) adds,

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Therefore, trade also allows individuals the possibility to pursue enterprises that otherwise might not have been afforded to them. Essentially, trade is essential to a notion of markets as “a social and moral space” (Storr, 2008, 2009). Trading in the marketplace is inherently a moral activity, given that before individuals choose what to exchange, they must first choose to respect the private property rights of individuals and acknowledge the potential opportunity that trade can contribute to one’s human flourishing. The beneficial consequences that flow from trade, including generalized norms of peace, trustful relations, and toleration among diverse groups, are a by-product, or consequence from the initial act of choosing to trade. Trade has a universal moral attribute conducive to one’s flourishing, namely the respect of one’s private property, but more importantly, it also makes possible the expression and revelation of one’s individual valuations through exchange, which is fundamentally the basis for economic calculation. Without monetary calculation through the use of money prices, the inability to translate the individual valuations of anonymous others into mutually beneficial knowledge would limit our ability to exercise practical wisdom contingent to time and ­circumstance (see Horwitz, 2008). To summarize, both economic calculation and human flourishing are inherently based on individual acts of knowledge creation, actualized only by selfdirected individuals. They each require the creation of such knowledge that is both contextual and specific to the unique circumstances of each individual of a particular time and place. The possibility of economic calculation and human flourishing are, therefore, dependent upon a political/legal order that protects the possibility of self-directed knowledge creation in both the economic and moral realms, that is to say, an institutional framework of private property rights

4. THE NORMATIVE IMPLICATIONS OF ECONOMIC CALCULATION FOR CAPITALISM Having described the parallel insights between economic calculation and human flourishing in the market process, the question still remains: why can’t the justification for a political/legal order based on the protection private property rights be fundamentally based on incentive-based norms, such as following a categorical imperative or a consequentialist rule? Why can’t individual rights be justified on the basis of rules that are general, transpersonal, and universally applicable? What do the parallel insights between the Austrian tradition and Aristotelian tradition reveal to us about the normative implications of the socialist calculation debate? The answer, which we develop below in more detail, is that the socialist calculation debate demonstrates the need to develop a deeper normative justification for capitalism that is distinct, though not separate, from incentive-based norms that are deontological or consequentialist in nature.

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One way of seeing the difference between the two norms is to recall our discussion in Section II regarding the Lange–Lerner approach to market socialism. The model Lange and Lerner wished to implement would mimic the outcome of the market process as if the information required to mimic such an outcome where already given. What would be needed to achieve an efficient allocation of resources is simply to instruct managers of state-owned firms to follow a set of profit-maximizing rules, namely pricing according to marginal cost and producing at a level of output that minimizes average costs. Through a “trial and error” process, surpluses and shortages would be eliminated simply by adjusting decreasing or raising prices, respectively. But the achievement of such an outcome implies that the market already be in a state of equilibrium, assuming the epistemic problem of economic calculation away, and rendering it as a technological problem of given means and given ends. Under such a framework, the efficient allocation of resources is simply a matter of making sure that the correct incentives are in place for central planners to acquire the ­economic knowledge that is already objective and “out there” to achieve a p ­ erfectly c­ompetitive outcome. Central to the idea that economic calculation under socialism is possible is the notion that prices are equilibrium parameters, reflecting the full opportunity costs of producing a good, and that such costs are objective. However, prices and costs are never sufficient parameters for an allocative problem; rather, they are guides to future production that emerge from the entrepreneurial market process. The formation of prices is not simply a matter of legislating a set of universalizable, general, or transpersonal incentives, which are independent of human choice and to which individuals passively respond. Rather, the emergence and adjustment of prices as guides to production, in response to changing market conditions, are a function of applying knowledge-based norms, namely the application of one’s unique entrepreneurial insight to a particular context of time and place. A rule that instructs entrepreneurs to follow an impersonal categorical imperative or profit-maximizing command, such as “price according to marginal cost,” can never encompass the habits and dispositions that must learned and applied to the reality of a market situation at a particular time and place. As Henry Veatch (1962/2003) describes the point: The reason is that the particular concrete situations which are the actual points of application of any art or skill are always so complex and intricate that no set of general rules and principles ever suffices to cover them completely. We do not, for example, consider that a surgeon is not skilled merely because he cannot draw up a set of instructions so complete and detailed that all one need do is to follow them automatically and the success of a certain type of operation will thereby be guaranteed. On the contrary, each particular case being different from every other, no one will ever be a skilled surgeon merely by following rules, or by applying a technique automatically. Instead, true skill must involve the adaptation of a technique to the immediate and the particular circumstances at hand. (Emphasis added, p. 70)

Once we pay attention, however, to the fact that price formation, entrepreneurial alertness, and economic calculation are based on heterogeneous agents that embody unique potentialities, then normative theorizing must be regarded in terms of an open-ended discovery process, not merely following commands of interpersonal obligation. Self-actualization is a heterogeneous and multi-specific

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endeavor among individuals. The exercise of practical wisdom is different to each individual, given the time and circumstances in which they are acting, and yet multispecific because it embodies a nexus of ends, not the maximization of one final end. To incorporate economic calculation and human flourishing exclusively into a deontological or consequentialist framework would misleadingly imply that entrepreneurship and practical wisdom are merely a response to universal and transpersonal incentives. Rather, it is vice versa. Universalizable incentive-based norms, such as following a P=MC heuristic, are a by-product of human cognition and effort, which is only substantiated in a context where individuals are free to exchange and act in accordance with entrepreneurial alertness and practical wisdom. Economic calculation, therefore, implies that the exercise of practical wisdom is the basic foundation for ethical theorizing and economic calculation under capitalism. It renders foundational priority to the contingent and particular knowledge that is substantiated by the exercise of practical wisdom. Exercising practical wisdom in the marketplace is the source of the contextual knowledge required for economic calculation, which in turn guides the human flourishing of each individual. The coordination of each individual’s self-actualization in an ecology of plans requires the harnessing of the unique and particular knowledge expressed by individuals via money prices. Such knowledge can only be harnessed within an institutional context of private property. If this is the case, then deontological and consequentialist defenses of the liberal market order must be regarded as proximate defenses, derived from a deeper, more fundamental ethical foundation. Such a fundamental foundation must give ethical priority to practical wisdom, which requires consideration of moral obligations that are personal to the individual and independent of whether or not they contribute to social welfare or some total good (Rasmussen & Den Uyl, 2005, p. 114). Defining ethical theorizing merely in terms of rule specification of one’s duties and obligations or maximizing social welfare implies that ethical theorizing is merely a passive-computational problem. If incentive-based normative theorizing constitutes the entirety of normative theorizing, exhibiting a one-to-one relationship with knowledge-based norms, then economic calculation and entrepreneurial action have no moral content to contribute to a deeper ethical foundation of a liberal market order. The flaw in this conclusion is that it converts the derivation of rules from a set of guides to individual action to a set of computational parameters within which individuals maximize (Buchanan, 1964), something which classical liberals should avoid in their case for the economic and moral superiority of capitalism.

5. CONCLUSION The central contribution of Austrian economics to the discipline of political economy is economic calculation. In other words, all the unique contributions of the Austrian school of economics to substantive economics can be traced back to the central importance of economic calculation for human cooperation (emphasis original, Boettke, 1998, p. 133).

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As a by-product of the socialist calculation debate, both Ludwig von Mises and F.A. Hayek learned to articulate and refine a unique understanding of the importance of economic calculation for the coordination of economic plans in a market economy (Kirzner, 1988a). However, as Israel Kirzner has argued, “it is possible that yet another byproduct – one still to be carefully articulated – is the crystallization of a novel approach to capitalist morality” (Kirzner, 1988b, p. 182). Economic calculation has not only positive implications for understanding the productive superiority of capitalism over socialism but also for understanding its moral superiority. Building on Kirzner’s claim, I have attempted to go further and explicate the normative implications for capitalism from the socialist calculation debate. I have based this explication on parallel insights between the Austrian tradition of economics and Aristotelian tradition of ethics. In both traditions, the application of contingent, particular, and contextual knowledge is crucial not only for economic calculation but also for human flourishing, respectively. In drawing such an analogy, I’ve argued that there are two important lessons to be learned from the socialist calculation debate regarding normative theorizing. First, that there are two distinct, though not separate, ways of framing of normative theorizing. There exists an incentive-based framework to normative theorizing, which is based on rules that are transpersonal, general, and universal across time and place. Such rules may be utilitarian or deontological in nature. But there also exists a knowledge-based framework to normative theorizing, within which a particular Aristotelian account of human flourishing resides. Such normative theorizing renders foundational priority to the unique and individualized human flourishing of each individual. Second, and more importantly, to conflate universalizable, incentive-based norms of conduct, which create the conditions that make economic calculation and human flourishing possible, with economic calculation and human flourishing itself, presumes the existence of economic and moral knowledge independent of human choice. If economic calculation and human flourishing were simply a matter of following a categorical imperative or profit-maximizing rule, to do so would render one’s human flourishing completely interchangeable with another, turning it into a technological problem of given means and given ends. In such a case, there is no difference between the human flourishing of a particular individual with that of other individuals in society. The very basis for economic calculation and human flourishing is the expression of unique, particular, and contingent knowledge by individuals, which is manifested in their interaction with others. The tendency toward mutual coordination not only of economic plans but also moral plans, among individuals under a framework of exchangeable private property rights arises from individual discovery. Coordination is not the antecedent of human flourishing, for, if it were, knowledge of each individual’s flourishing would be independent of their own discovery, rendering human flourishing simply a “problem” of implementing general and transpersonal incentives. While rules that are general, transpersonal, and universally applicable across time and place are necessary for social order, this is only a proximate foundation

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of the morality of capitalism. A fundamental, or basic, normative justification of capitalism must be grounded in protecting the expression of particular and contingent knowledge unique to each individual that results from the exercise of practical wisdom. Such expression can only be made possible through the implementation of private property rights. If we can clarify the moral superiority of capitalism by contrasting with its antithesis, socialism, then socialism is morally abhorrent not only because it is precludes the institutional conditions, namely private property rights, for the protection of individual liberty, but fundamentally because the absence of individual liberty precludes the possibility for individuals from becoming or discovering who they are, namely creative actors in an open-ended world. To conclude with the words of James Buchanan, “Man wants liberty to become the man that he wants to become” (emphasis original, Buchanan, 1979/1999, p. 259).

ACKNOWLEDGMENTS This paper was prepared for the 6th biennial Wirth Institute Workshop on Austrian Economics, which was held March 23–26, 2017, in Montreal, Canada. I would like to thank Professor Steve Horwitz for the invitation to write and deliver this paper, as well as Professor Richard Ebeling and the conference participants for their valuable feedback and comments. I also thank Peter Leeson, Alexander Craig, Daniel D’Amico, Douglas Den Uyl, Julian Müller, and Ed Younkins for reading and commenting on an earlier draft of this paper. I owe a particular debt of gratitude to Peter Boettke and Douglas Rasmussen for their time and patience in reading different drafts of this paper and offering invaluable comments and feedback. I also acknowledge the financial support of the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center, the Institute for Humane Studies at George Mason University, the Intercollegiate Studies Institute, and the Political Theory Project at Brown University.

NOTES 1.  My discussion in this paper builds directly from the works of philosophers Douglas Rasmussen and Douglas Den Uyl, particularly Norms of Liberty (2005) and The Perfectionist Turn (2016). What should also be noted here that to use term “Aristotelian” in philosophical theorizing falls into three paradigms (Rasmussen & Den Uyl, 1991, p. xv; Miller, 1995, pp. 21–22). The first evaluates the political and ethical thought of Aristotle as expressed in his work, based in the terms and context within which Aristotle was writing. The second paradigm attempts to evaluate the work of Aristotle not only on his own terms, but also to clarify and defend his entire political-ethical framework by method of contrast with other political-legal traditions, such as liberalism. For example, as philosopher Alasdair MacIntyre argued in chapter 9 of After Virtue (1981/1984), entitled “Nietzche or Aristotle?” that applying Aristotelian ethical principles to the political tradition of liberalism is inconsistent, since human flourishing is a function of cultural traditions and values of a larger social whole, namely the polis. In other words, MacIntyre believes that human flourishing can only be actualized within a communitarian

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social doctrine. The third approach, referred to as “neo-Aristotelian,” adopts ideas and principles from the Aristotelian tradition as theoretical points of departure in providing an alternative ethical justification of the liberal political-legal framework. It is this third paradigm that I adopt in this paper. 2.  In the work of Rasmussen and Den Uyl (1991, 2005) and Den Uyl and Rasmussen (2016), they also argue that it is possible for transpersonal principles to be the result of such a knowledge based framework. 3.  The categorical imperative is philosophical maxim in the deontological normative theory of Immanuel Kant, which is an unconditional moral obligation that is binding in all circumstances and is not dependent on a person’s inclination or purpose. The categorical imperative can be best explained by the following statement: “Regardless of what ends you may seek, you must take the following steps” (emphasis added, Long, 2000, p. 61, fn. 65). 4. In Epistemological Problems of Economics, Mises remarked the following: “Within modern subjectivist economics it has become customary to distinguish several schools. We usually speak of the Austrian and the Anglo-American Schools and the School of Lausanne. . . . [The fact is] that these three schools of thought differ only in their mode of expressing the same fundamental idea and that they are divided more by their terminology and by peculiarities of presentation than by the substance of their teachings (1933, p. 214). Interestingly enough, Chicago economist Jacob Viner stated the same thing: Neoclassical economics is a sympathetic evolution of the English Classical School. Included under neoclassical economics is the English-American version in Taussig and Marshall and also the Austrian school, whose differences are not as important as the resemblances to the AngloAmerican type. Included also is the Continental Equilibrium School or the Mathematical School, such as Walras, Pareto, and their followers. They have much more in common with the neoclassicists than in dispute. (Viner, 2013, p. 19; see also Boettke & Candela, 2017)

5.  Surprisingly, Frank Knight and Joseph Schumpeter, both market-oriented economists of a Marshallian and Walrasian stripe, respectively, also agreed with Lange’s analytical assessment. Knight’s argument was that there was no economic problem of socialism because economic science is limited to applying marginalist principles to economic decision making in circumstances of perfect knowledge and perfect competition (Knight, 1936; see Boettke & Vaughn, 2002, p. 159). Schumpeter’s argument was that, assuming the conditions of general competitive equilibrium, the valuation of the factors of production can be logically imputed ‘ipso facto’ directly from the valuation of consumers’ goods (see Hayek, 1945, pp. 529–530). 6.  According to philosopher Henry Veatch (1962/2003), moral virtues are to be regarded simply as learned habits and dispositions that are directly solely at letting reason and intelligence come into play in the determination of our choices of what to do and what not to do. (p. 75)

REFERENCES Boettke, P. J. (1998). Economic calculation: The Austrian contribution to political economy. Advances in Austrian Economics, 5, 131–158. Boettke, P. J., & Candela, R. A. (2017). Price theory as prophylactic against popular fallacies. Journal of Institutional Economics, 13(3), 725–752. Boettke, P. J. , & Vaughn, K. (2002). Knight and the Austrians on capital and the problem ofsocialism. History of Political Economy, 34(1), 153–74. Buchanan, J. M. (1958). The Thomas Jefferson Center for studies in political economy. The University of Virginia News Letter, 35(2), 5–9. Buchanan, J. M. (1964). What should economists do? Southern Economic Journal, 30(3), 213–222.

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Buchanan, J. M. (1979/1999). Natural and artifactual man. In The collected words of James M.Buchanan, Vol 1.: The logical foundations of constitutional liberty (pp. 246–259). Indianapolis, IN: Liberty Fund. Buchanan, J.M. (1991). The economics and ethics of constitutional order. Ann Arbor, MI: The University of Michigan Press. Demsetz, H. (2002). Towards a theory of property rights II: The competition between private andcollective ownership. Journal of Legal Studies, 31(S2), S653–S672. Den Uyl, D. J., & Rasmussen, D. B. (2016). The perfectionist turn: From metanorms to metaphysics. Edinburgh: Edinburgh University Press. Hayek, F. A. (1945). The use of knowledge in society. American Economic Review, 35(4), 519–530. Hayek, F. A. (1948). Individualism and economic order. Chicago, IL: University of Chicago Press. Horwitz, S. (2008). Monetary calculation and the extension of social cooperation into anonymity. Journal of Private Enterprise, 23(2), 81–93. Kirzner, I. M. (1973). Competition and entrepreneurship. Chicago, IL: University of Chicago Press. Kirzner, I. M. (1988a). The economic calculation debate: Lessons for Austrians. The Review of Austrian Economics, 2(1), 1–18. Kirzner, I. M. (1988b). Some ethical implications for capitalism of the socialist calculation debate. Social Philosophy & Policy, 6(1), 165–182. Kirzner, I. M. (2017). The entrepreneurial market process: An exposition. Southern Economic Journal, 83(4), 855–868. Kline, W. (2008). Flourishing through trade. In A. J. Skoble (Ed.), Reading Rasmussen and Den Uyl: Critical essays on norms of liberty (pp. 149–164). Lanham, MD: Lexington. Knight, F. H. (1936). The place of marginal economics in a collectivist system. The American Economic Review, 26(1), 255–266. Lange, O. (1936). On the economic theory of socialism: Part one. The Review of Economic Studies, 4(1), 53–71. Lerner, A. P. (1937). Statics and dynamics in socialist economics. The Economic Journal, 47(186), 253– 270. Lavoie, D. (1985). Rivalry and central planning: The socialist calculation debate reconsidered. New York: Cambridge University Press. Long, R. (2000). Reason and value: Aristotle versus Rand. Poughkeepsie, NY: The Objectivist Center. MacIntyre, A. (1981/1984). After virtue: A study in moral theory 2nd ed.). Notre Dame, IN: University of Notre Dame Press. Miller, F. D., Jr. (1995). Nature, justice, and rights in Aristotle’s politics. New York, NY: Oxford University Press. Mises, L. v. (1920/1975). Economic calculation in the socialist commonwealth. In F. A. Hayek (Ed.), Collectivist economic planning (pp. 87–130). Clifton, NJ: August M. Kelley. Mises, L. v. (1933/1960). Epistemological problems of economics. Princeton, NJ: VanNostrand. Mises, L. v. (1966). Human action: A treatise on economics (3rd rev. ed.). Chicago, IL: Henry Regnery. Norton, D. L. (1976). Personal destinies: A philosophy of ethical individualism. Princeton, NJ: Princeton University Press. Phelps, E. (2013). Mass flourishing: how grassroots innovation created jobs, challenge, and change. Princeton, NJ: Princeton University Press. Rasmussen, D. B., & Den Uyl, D. J. (1991). Liberty and nature: An Aristotelian defense of liberal order. Chicago, IL: Open Court. Rasmussen, D. B., & Den Uyl, D. J. (2005). Norms of liberty: A perfectionist basis for non-perfectionist politics. University Park, PA: The Pennsylvania State University Press. Storr, V. H. (2008). The market as a social space: On the meaningful extraeconomic conversations that occur in markets. The Review of Austrian Economics, 21(2–3), 135–150. Storr, V. H. (2009). Why the market? Markets as social and moral spaces. Journal of Markets & Morality, 12(2), 277–296. Veatch, H. B. (1962/2003). Rational man: A modern interpretation of Aristotelian ethics. Indianapolis, IN: Liberty Fund. Viner, J. (2013). In D. A. Erwin & S.G. Medema (Eds.), Lectures in economics 301. New Brunswick, NJ: Transaction Publishers.

CHAPTER 4 TOWARD A MARKET EPISTEMOLOGY OF THE PLATFORM ECONOMY Lynne Kiesling

ABSTRACT The platform economy reflects the business model of some of the largest and fastest-growing firms in the economy. Platform business models emerge and thrive because of the potential profit in taking advantage of transactions cost reductions to connect people for mutual benefit, and this value creation is best understood by thinking about the epistemology of decentralized market processes. Three essential aspects of knowledge are relevant to platform business models: (1) knowledge can be private and diffuse; (2) knowledge can be contextual; and (3) knowledge may not exist outside of the economic process. After defining and analyzing the technology, economic, and institutional aspects of platforms the author defines and applies market epistemology to explore how platforms harness technological and organizational features to create value-enhancing market platforms by exploiting the epistemic benefits of technology-enabled decentralized market processes. The author concludes by using this epistemic framework to propose an electricity distribution platform business model – the retail electricity industry is undergoing a process of technological dynamism, and as a regulated infrastructure industry, evolving into a decentralized market industry is presenting challenges to which this epistemic framework can bring increased understanding. Keywords: Electricity distribution; knowledge problem; market epistemology; platform economy; transaction costs; industrial organization Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 45–70 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023006

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1. INTRODUCTION The platform economy – with companies such as Airbnb, Uber, Lyft, Amazon, Facebook, and Instagram – reflects the business model of some of the largest and fastest-growing firms in the economy. The 15 largest publicly traded platform firms globally already have $2.6 billion in market capitalization,1 and continued improvements in cloud computing, the Internet of Things, and mobile devices enable the extension of platforms into increasing numbers of markets and the creation of new markets. These business models have evolved for a variety of supply-side and demandside reasons. On the supply side, digital technology and its dramatic transactions cost reductions make it possible to have businesses that specialize in connecting agents for mutual benefit. New businesses and new industries emerge, and for existing vertically-integrated firms, there is less economic impetus for vertical integration, so unbundling happens and specialization occurs in connecting agents for mutual benefit. On the demand side, demand complementarities and network effects combine with new products and services tapping into latent demand because the transactions cost reduction has brought new and different supply to the market, making excess capacity transactible in new ways (Kiesling, Munger, & Theisen, 2018). Platform business models emerge and thrive because of the potential profit in taking advantage of transactions cost reductions to connect people for mutual benefit. They do so in a particular way, not by offering a specific product at a take it or leave it price, but rather by acting as a connector, a search cost reducer, enabling people to find each other and agree to terms (Uber does this algorithmically, and to an extent Airbnb does too). A market clearing platform operates as a separate layer on top of the digital technology platform. This analysis begins by defining platforms and using a taxonomy to analyze them according to their technology, market, and organizational-institutional aspects. Platform technologies, services, and business models are welfare-enhancing precisely because of the incremental benefits of aggregating diffuse private knowledge at lower cost. Thus, in this paper, I argue that a foundational reason why digital technologies and platform business models are value-creating is best understood by thinking about the epistemology of decentralized market processes. In applying market epistemology to digital platforms, I emphasize three essential aspects of knowledge that are relevant to exchange: (1) knowledge can be private and diffuse; (2) knowledge can be contextual; (3) knowledge may not exist outside of the economic process. After defining and analyzing the technology, economic, and institutional aspects of platforms in Section 2, in Section 3 I define and apply market epistemology to explore how platforms harness technological and organizational features to create value-enhancing market platforms by exploiting the epistemic benefits of technology-enabled decentralized market processes. The firms mentioned above that we associate with platforms are all “digital natives,” created in the digital era. Can the technological, economic, institutional,

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and epistemic features of platforms apply in an industry with decidedly analog origins? I conclude in Section 4 by using this epistemic framework to propose an electricity distribution platform business model. The electricity industry is one of the most important network infrastructure industries in the economy, and is experiencing dynamic technology pressures from digital innovations and distributed energy technologies. Smart grid technologies in electricity are applications of general-purpose digital communications technologies within and around the electric power network; a smart grid is a digital communications integration and overlay on the existing electro-mechanical physical wires network. Smart grid technologies embedded in the distribution network enable automated outage notification, fault detection and repair, and routing of current flows around faults to maintain service. They also enable the interconnection of increasingly heterogeneous types of devices, owned and operated by increasingly heterogeneous agents. Smaller-scale distributed generation and other distributed energy resources (DERs) are also increasingly economical, placing pressure on the historical regulated distribution utility model. These DERs are on-site energy sources from any number of resources, including solar photovoltaics (PV), small wind, biogas, and batteries. On-site is the crucial feature of these assets: when located on a home or business, DERs create new types of operators in power markets who both purchase electricity from the grid and generate power from their own sources. These drivers converge in pointing toward a desirable policy objective: an electricity distribution model for the future that will enable resilient, sustainable electricity and reduce barriers to innovation around the edge of the distribution network. This business model would exploit the epistemic benefits of decentralized market processes made possible by innovations in digital technologies.

2. PLATFORM ECONOMICS Digital technologies have created the potential for firms in a variety of industries to operate as platforms. Baldwin and Woodard (2009) define a platform as a set of stable components that supports variety and evolvability in a system by constraining the linkages among the other components (p. 19), a definition reflecting an engineering design perspective. More generally, Parker, Van Alstyne, and Choudary (2016) define a platform as ... a business based on enabling value-creating interactions between external producers and consumers. The platform provides an open, participative infrastructure for those interactions and sets governance conditions for them. The platform’s overarching purpose: to consummate matches among users and facilitate the exchange of goods, services, or social currency, thereby enabling value creation for all participants. (p. 5)

As a business model, a platform architecture creates value by facilitating exchange. A network context is an important precondition for development of a platform – one defining economic feature of a platform is network effects, where the benefits to one user are increasing in the total number of users on the platform.

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Following Parker et al. (2016) and Gawer (2014), this analysis employs three complementary definitions of aspects of a platform, or three different lenses of analysis:

• Technological lens: A technology platform is a common core of technolo• •

gies within a modular architecture, with variable technology elements around the periphery that interoperate with the core technologies and architectures. Economic lens: An economic platform is a means for facilitating and coordinating mutually-beneficial exchange through transactions in a two-sided or multi-sided market (Rochet & Tirole, 2003). Organizational lens: An organizational platform can provide institutions that enable the coordination of the actions and plans of agents (be they individuals or firms) within a technology platform for mutual economic benefit, and it can have different organizational form in different industries and contexts. The organizational lens encompasses the three dimensions of an institutional framework: firm structure, market structure, and regulatory structure.

Gawer’s addition of the organizational lens is particularly valuable because it emphasizes the importance of the institutional framework for analyzing and understanding why platforms emerge and how their effects depend on firm structure, market structure, and regulatory structure in context. 2.1. Technological Platforms A technology lens emphasizes a platform’s technology elements and the architecture shaping the system that these elements create. A technology platform has several connected elements, typically with a stable, common core and a variable, heterogeneous periphery (Gawer, 2014, p. 1242). Video game platforms – Playstation or Xbox, for example – are a canonical example: the core technology is a set of proprietary but common elements that work in conjunction with other, diverse elements to enable game playing. The core of a video game platform is the controller box and the software that determines how the games, peripherals, and users will interact on the platform. The “other” elements include games (software written to play on the platform using the common core software) and peripheral devices such as controllers or joysticks that complement the core system. The  technology architecture of a platform involves subsystems that are not necessarily visible at the periphery and that enable the delivery of products and services around the periphery through common interfaces with the heterogeneous elements around the periphery (Meyer & Lehnerd, 1997). The interaction of heterogeneous human agents with diverse periphery technologies around a common core creates a complex system. A system is complex if outcomes arise from multiple interacting agents and the specific outcome

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cannot be predicted. Outcomes in complex systems depend on the patterns of interaction; system components (technological and human) are interdependent and their interactions create feedback effects. Complex systems (for example, biological systems and neural networks) are characterized by self-organization – some form of order in the system emerges out of the interactions, interdependencies, and feedback effects. Technology platforms are complex systems, and again video games provide a useful example. Consider an online m ­ ulti-player game: the players and their devices are diverse, the game core is shared, their interactions generate the outcome interdependently, and their adaptations and reactions to what they experience generate a nonpredictable yet ordered ­outcome. Technology platforms as self-organizing complex systems have three dimensions: algorithms, modularity, and interoperability. Algorithms are an essential aspect of technology platforms, and are relevant to the epistemic dimensions of platforms. An algorithm is a process or set of rules to be followed in calculations or other problem-solving operations, particularly in computing. Algorithms establish rules for actions, and the rules are embedded in defined relationships. Algorithms also enable automation of processes based on these rules and relationships. Algorithms implement actions based on previous actions or interactions (“if this then that”), given rules established by a human choice at the programmer, firm, industry, or regulatory level. Powerful algorithms drive the transaction cost reductions in digital platforms and make it possible to achieve economies of scope across firms. Another central dimension of technological platforms is how the common core and variable periphery technology elements interrelate in an additive, or modular, fashion. Russell (2012) calls modularity an “ordering concept” for organizing and using information, and defines a modular system as “... smaller parts (modules) that fit together within a predefined system architecture” (p. 257). Modular technology design means that standardized elements fit together, and when combined they form a larger system. Modularity in technology design implements Herbert Simon’s (1962) argument that “decomposable” systems and standardization can attenuate some aspects of complexity by removing some dimensions of ­interdependency. Modularity accommodates heterogeneity and innovation in functionality as long as the relevant technical standards are met. Most importantly, modularity makes systems more resilient; if one component fails replacing it, and it alone, is cheaper and easier than replacing the entire system. Modularity contributes to resilience by making loosely coupled systems possible; loose coupling means that components are complementary but do not rely too strongly on each other, so replacing one component with another one that has the same interface and functionality does not undermine the system. Modularity reduces the dimensionality of interdependency. Modularity means that when thinking about the “ecosystem” that emerges around a platform, the sharing aspect and the nonrivalrous nature of the separate elements enable them to substitute for each other. Modularity also increases

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the ease of interconnection within the system. Modular systems have standardized physical sizes and rules for interconnection and interoperability, which makes each element less interdependent with the other elements in the system (in other words, a loosely coupled system rather than a tightly coupled system). In a game system, for example, one can remove or end one game and begin another seamlessly. In the case of ride sharing, the app provides a common core, built on the common core and technology standards embodied in the Internet. The diverse mobile devices of users are the variable technologies around the periphery. In any technology platform, elements within the platform and at the periphery are independent in the sense that, for example, replacing an element in the core does not necessitate replacing other core elements or the elements at the periphery. Modularity entails breaking up an otherwise complex system (in the technical sense of possessing complex interdependencies) into discrete components, and having the components interact in an additively separable fashion. The function that most users would associate with modularity is plug-and-play functionality: the user can unplug one printer or other peripheral and plug in another, with no other changes to the system, but the system immediately adapts to the new peripheral. That high level of integration and functionality in a modular technology platform cannot happen without agreed-upon standards for interoperability and interconnection. Interoperability is the ability of a system to connect components (technical interoperability), to share information across the interfaces between components (syntactic interoperability), and to understand the unambiguous meaning of the shared information and make meaningful use of it (semantic interoperability) (Kubicek, Cimander, & Scholl, 2011, Chapter 7). Technical interoperability standards include the TCP/IP protocol that connects all devices on the Internet, or the USB protocol that enables connection of different devices to each other. Syntactic interoperability involves using commonly agreed-upon protocols for the format of data being transferred, so that both sender and receiver agree that the data being shared has the expected format, or syntax; examples include the set of XML data format protocols. The semantic layer of interoperability is where the meaning of the data is defined, and where the data become information. Semantic interoperability ensures that both sides of the data transfer share an understanding of the meaning of the data transferred with the particular ­syntax across the particular interface between components. Interoperability standards are most useful when they are commonly known and agreed, or are open standards rather than proprietary. In technology platforms, the standards used typically result from industry working groups that meet to negotiate consensus standards. To a great extent interoperability standards are emergent orders – the goal of coordinating upon a standard is general, and the specific outcome emerges from interaction and negotiation. These standards become a foundational set of rules for the operation of the platform governing the interaction and interdependencies of the components of the systems and the people using them.

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Such modular, loosely coupled architecture with open interoperability standards makes platforms well-suited to facilitating innovation, because all a new application needs to do is modify or improve one discrete, separable function and adhere to interoperability standards. Modularity makes designs more easily and incrementally adaptable, and implements common rules for interfaces that can act as focal points around which designers can create new designs that simply plug directly into a large system while changing only one part of that system. This approach simultaneously helps manage complexity and facilitate beneficial complexity. The technology lens on platforms is agnostic about the economic activities taking place around the platform and the institutional framework in which the platform operates. A core of common components allows economies of scope in production to develop around the platform by reducing the average cost of producing different goods and services using the same capital assets. Because the platform shares certain features across all applications and peripherals, substantial portions of software can simply be copied, rather than having to be reproduced from scratch for each new use. These economies of scope – declining costs for producing several different products on the same platform – are some of the main drivers of innovation around technological platforms.2 Such cost efficiencies can be realized both within firms and across firms, depending on market structure and whether transaction costs create barriers to market contracts or to innovation that generates new products and services. The Coasian implications for the extent of vertical integration and the expansion of a single firm to make a variety of different products are thus quite complex and vary by industry. Technology-induced reductions in transaction costs enable economies of scope to emerge within supply chains across firms, uncoupling economies of scope from ownership.3 2.2. Economic Platforms Using the economic lens models platforms as transaction facilitators and intermediaries. By using technologies that reduce transaction costs, economic platforms create value by enabling parties to connect for mutual benefit, typically in the form of a transaction or exchange. Platform providers create markets, connecting producers and consumers (Armstrong, 2006; Parker & Van Alstyne, 2005; Rochet & Tirole, 2003; Rysman, 2009). Such a framework views human agents as having specific roles (buyer, seller, and platform provider) and exchanging a specific good or service. In the video game platform example, the platform provider creates value by providing a technology (the game console and its operating system) that acts as a focal point (Schelling, 1960) for a game seller and game buyer to transact; the exchange yields mutual benefit, and the  existence of the platform provides incentives to the seller to develop games for the platform and the buyer to purchase the games. Thus an economic analysis of platforms views the platform as a two-sided market or multi-sided market, where the platform provider coordinates agents through transactions

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and price signals. Platforms can create markets, both in practical terms and in the minds of participants, where no market previously existed. The items or services being transacted may not have previously been “commodified” because of high t­ ransactions costs, but now can be leased or rented in a new market for excess capacity (Kiesling et al., 2018). Economic platform models generally rely on several assumptions. First, they assume an exogenous, fixed technology platform and a given organizational framework (Gawer, 2014, p. 1241), a restrictive assumption that rules out analyzing dynamic evolution of the platform itself technological and organizationally. Economic models also assume that the cross-platform relationship is buyer–seller, which rules out analyzing differentiation and heterogeneity in both the roles of agents around the platform and technological aspects of the platform. For example, a strictly economic model has a hard time analyzing a situation in which a platform complement firm then becomes a competitor (e.g., Facebook starting to offer search that competes with Google), or a competitor becomes a complement by choosing to adopt interoperable standards and architecture for its own products and services. However, these strict assumptions do allow some analysis of product differentiation and innovation at the edge of the platform (such as new, different games or complementary devices). But that analysis takes place within a transactional framework that abstracts from the process of innovation itself, and cannot provide an analysis of how a platform can facilitate innovation. That process must include experimentation, trial and error learning, and social learning through engaging in the market process. 2.3. Platforms as Institutional-Organizational Elements Platforms arise and evolve in different institutional contexts, so an organizational lens is a worthwhile complement to the technological and economic platform analyses. Gawer’s (2014) integrated theoretical framework for analyzing platforms starts from the observation that in order to create value, platforms rely crucially on economies of scope in supply and innovation (for the engineering design view), and economies of scope in demand (for the economics view) (p. 1244). Agents who constitute the platform ecosystem may take on multiple roles; they may be individuals, households, firms, or some other organizational form that is endogenous to the system. Agents can be individuals or firms, and can play a variety of roles. Those roles can change over time, as environment changes, as interactions in a complex system yield new patterns and outcomes. Both the technological analysis and the economic analysis abstract from how the roles of platform owners and platform complementors can evolve between complementarity and competition. They also abstract from the ability of an agent to have different roles in the ecosystem at different times, but this heterogeneity is a novel feature that digital technology enables, and that can have significant institutional and organizational implications.

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The technology literature models agents as having fixed roles as collaborative innovators around the platform, while the economics literature models agents as having fixed roles as producers and consumers in multi-sided markets. Empirically, agents can and often do play different roles, and those roles can change as transaction costs and opportunity costs change (Gawer, 2014, p.  1243). Modeling the platform as an institutional-organizational element draws on l­iteratures in Austrian capital theory, entrepreneurship, and the organizational economics literature on transactions costs and vertical integration. Modeling a platform as institutional-organizational elements raises the subject of governance. In a standard neoclassical competitive model, with full information, no incentive alignment problems, and zero transaction costs, the existence of firms is entirely an artifact of the cost functions in the industry, of such associated issues as economies of scale and scope, and of the size of the relevant (well-defined) market. This approach undergirds the natural monopoly theory and the definition of subadditivity of costs that is the hallmark of ­electricity regulation. Institutional analysis drawing on Austrian economics models’ firms as organizational frameworks to acquire, organize, and economize on useful knowledge (Langlois, 1992; Langlois & Robertson, 1992). If a firm does so successfully, it creates new knowledge in the process of producing goods and services. To be successful in a dynamic, changing environment, though, a firm’s organization must be flexible enough to adapt to unknown and changing conditions. This insight connects the technical features of modularity to the organizational aspects of platforms. Modularity captures both flexibility and coherence and enhances adaptability.4 Austrian capital theory provides other important insights connecting modularity and institutions. The common core/heterogeneous periphery nature of platforms and the decomposable nature of modular systems both allow heterogeneous capital elements to work together as complements in production (Lewin, 2002, p. 156). Lewin couches this insight in a broader analysis connecting Austrian capital theory to transaction cost economics; a transaction cost theory of organizational structure complements the Austrian theory of capital structure as specific combinations of diverse capital elements with a time dimension (Lewin, 2002, p.  134). Lewin even claims the institutions of organizational structure as one ­element of a firm’s capital. Work in transaction cost economics and organization theory demonstrates that this standard approach overlooks the incentive and governance reasons for having some transactions occur within firms and some occur in markets. As Coase (1937) and others have shown, the desire and ability to decrease transaction costs shapes vertical integration and contracting in a variety of industries (e.g., Bajari & Tadelis, 2001; Baker, Gibbons, & Murphy, 2002; Bresnahan & Levin, 2012; Joskow, 1988; Klein, Crawford, & Alchian, 1978; Masten, 1986). Rather than model the firm as a set of cost functions, Williamson (1985) argues that organizational structure is a consequence of the act of economizing on transaction costs.

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Digital technologies are dramatic transaction cost reducers, and falling transaction costs imply a welfare-enhancing shift in the transactional boundary of firms – transactions that used to be too costly to consummate using market processes and were thus bundled and integrated into firms can now take place through contract in markets. Falling transaction costs thus imply, ceteris paribus, firms moving away from vertical integration. Video game companies are an example of this organizational phenomenon; different firms own the systems/consoles and manufacture and sell the games. In technology platforms, interoperability and modularity are ways of reducing transaction costs and also institutional design choices that make platform organizational structures feasible ways to take advantage of falling transaction costs for mutual benefit. For these reasons, a synthesized technology-economic-institutional framework captures much, but not all, of what drives the emergence of platforms.

3. MARKET EPISTEMOLOGY OF PLATFORMS This analysis adds a fourth lens of epistemology to Gawer’s conceptual platform taxonomy (technological-economic-organizational). Platforms are epistemic frameworks for decentralized coordination. Digital technology, multi-sided markets, and governance combine to take the technology-induced transaction cost reductions and create value by accessing diffuse private knowledge that was inaccessible pre-platform and creating new forms of exchange that lead to new knowledge generation in the discovery procedure. Platforms change the context of market activity in ways that bring new forms of knowledge into existence. Economic activity is always embedded within an institutional context (firm structure, market structure, and regulatory structure), and this institutional context can be analyzed epistemically and has epistemic implications and consequences. Different institutions yield different knowledge aggregation and creation potential and processes. This analysis focuses on the institutional context of platforms and its connection to discovering, using, and communicating the knowledge of the individuals in the platform system. Thus, this is an empirical analysis of processes and consequences of social learning. Knowledge is embedded within social systems, and knowledge guides actions, even when it is incomplete or false. Knowledge is generated by the interaction of agents in systems. Markets, and thus market platforms, are epistemic systems (Koppl, 2005). 3.1. The Epistemic-Institutional Dimensions of Platforms In platforms, how do agents discover, use, and communicate diffuse private knowledge, some of which is tacit and contextual? Platforms have three epistemic dimensions: access to and aggregation of diffuse private knowledge, actionable contextual knowledge where it was not actionable before, and creating knowledge within the platform interaction itself.

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3.1.1. Diffuse Private Knowledge We typically associate market epistemology with Hayek’s (1945) knowledge problem concept and the rich literature arising from it (Kiesling, 2015). Hayek argued that the fundamental economic problem societies face is not the allocation of a given set of resources based on a given set of preferences and technical capabilities. Instead, the coordination of decisions and actions among interacting individual agents with diffuse private knowledge and plans forms the basis of economic activity.5 Subjective meaning and fragmentary perception combine to create private local knowledge. This cognitive reality has institutional implications. Accessing and aggregating dispersed private knowledge is impossible in the absence of some institutional framework – in Hayek’s formulation, in the absence of prices and market processes. The diffuse and private nature of knowledge hampers plan coordination, but out of human interaction, institutions emerge that enable decentralized coordination. Prices and market processes compose an institution for coordination in the face of the knowledge problem. Moreover, knowledge transcends “scientific” information, there is no given and uniform set or distribution of data, and such information fails to capture all knowledge relevant to both static and dynamic decision making and coordination (Hayek, 1937). Information is relevant to human action, but it is not sufficient for central planning, and if it is the only epistemic pathway that the institutions permit, then you miss and forego the benefits that could be discovered and created through harnessing both knowledge and information in the innovation and creation processes. Examples of information in contrast to knowledge in platforms include the location of cars for ride sharing or the physical characteristics of apartments for housing rental. Technology platforms that undergird market platforms, and the institutionalorganizational framework in which they emerge and are embedded, enable such knowledge aggregation where it was not before possible. Platforms arising out of the lower transaction costs of digital technology expand the volume and scope of activity over which using market processes for decentralized coordination creates mutual benefit. By so doing they enhance plan coordination across more and more people, generating wealth and well-being in the process. 3.1.2. Actionable Contextual Knowledge While the argument for diffuse private knowledge captures much of the substance of the knowledge problem as both a coordination problem and an epistemic issue, Hayek and other scholars developed the concept more deeply, including the idea that knowledge may be contextual, and may not even exist outside of the economic process. Private knowledge includes knowledge of “time and place,” which is difficult to articulate, communicate, and aggregate. Its highly contextual nature can make private knowledge fleeting and ephemeral. Contextual knowledge includes tacit knowledge (knowledge relevant in specific contexts that we do not know consciously that we know or how we acquired the knowledge), inarticulate knowledge (unexpressed or unspoken knowledge

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underlying an action or decision), and emergent knowledge that only exists in the specific context of a purposeful action or interaction. Some of the knowledge relevant to decision making and economic calculation does not exist independent of the market context. Knowledge is, therefore, in part a function of individual perception (Boettke, 1998, p. 145). Such knowledge is itself emergent and is endogenously created within the market process; this endogeneity is the primary sense in which the market is a discovery procedure. Platforms increase opportunities for individuals to engage in exchange and thus to act on their contextual knowledge in ways that were not available to them before. Actionable contextual knowledge increases potential mutual benefit by increasing the choice sets of actors and providing technologies that makes exchange easier and more convenient.6 3.1.3. Platform as Discovery Process: New Knowledge Creation By enabling deeper and broader decentralized coordination through exchange, platforms create discovery processes. Some knowledge relevant to such coordination does not exist outside of the market context; such knowledge is either created in the process of market interaction, tacit knowledge that is not consciously known (Polanyi [1966] 2009), or inarticulate knowledge that is difficult to express or aggregate (Thomsen 1992, pp. 16–17; Kiesling 2015, pp. 53–55). Boettke (1998) summarizes the argument that some knowledge needed for economic calculation exists only within the actual market context: [T]he benefits of competitive markets are tied to the existence of markets and cannot be obtained independent of that context. ... The knowledge argument is a contextual argument. Hayek’s argument is not limited to the complexity issue of how various scattered bits and pieces of information held privately can be summarized in a form which is objectively useful for others so that economic actors can coordinate their plans. ... In addition to the complexity argument that most scholars read in Hayek, there is an argument — as we have seen — that the knowledge required for economic calculation is available only within the market process itself. Outside of that context this knowledge does not exist. And, it is precisely this contextual knowledge of the market which enables economic actors to select out from among the numerous array of technologically feasible production projects those which are economically viable—in other words to engage in rational economic calculation. (145; emphasis in original)

Thus, such knowledge is itself emergent and is endogenously created within the market process; this is the primary sense in which the market is a discovery procedure. 3.2. Construction of Shared Meaning in Platforms Shared meaning is the channel connecting the epistemic dimensions of platforms to the consequences and outcomes they generate. Platforms construct shared meaning in ways that parallel Gawer’s technology-markets-governance taxonomy,, and they all involve the representation of knowledge as symbols, or symbolization: language, money, and interoperability. Platforms harness transactions cost reductions to create what the philosopher John Searle (1998) calls “an epistemically objective social reality that is partly

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constituted by an ontologically subjective set of attitudes” (p. 113). Language plays a key role in this process. Searle argues that the symbolization function that language performs can bridge the subjective realities of individuals and create a shared social reality. Such symbols help us understand and convey meaning. Language also varies by context and local conditions, another way that language can convey meaning among agents with subjective experiences. Through such symbolization and contextualization, language undergirds all human thought and makes a shared reality possible (Searle, 1998, p. 153; see also Boettke & Subrick, 2002). Horwitz (2007) argues that money and monetary calculation perform the same functions for markets as language does more generally. Monetary calculation and prices fulfill a symbolization function, enabling “us to communicate that which cannot be put into words but is nonetheless central to economic coordination” (p. 83). Symbolizing and making diffuse private knowledge more concrete makes that knowledge more accessible for others to use, especially when the contextuality of knowledge makes it particularly inaccessible to others. Monetary calculation is the language of markets, and monetary exchange is an institution of social coordination in much the same way that language is. Platforms add to this language-money contextual symbolization by harnessing both language and money and incorporating algorithms. Algorithms embody the rules that determine prices and other attributes of the platform market process – they determine what products and services are presented based on the search activity of the individual, and they take advantage of digital technology to create a richer and deeper institutional reality in which individuals coordinate and exchange. Interoperability plays an important role in creating shared meaning in technology platforms, and consequently in market platforms and the institutionalorganizational context. The converse is also true, though – institutions provide the processes through which interoperability is achieved. In technology platforms, interoperability is usually achieved through a consensus-building process that can be mediated through industry working groups or through a standard-setting organization (SSO). Interoperability emerges out of this process, which is a deliberate choice. This choice to coordinate on a standard embeds shared meaning in modular technologies and systems, and then can layer on markets and organizations on that technological foundation. 3.3. Epistemic-Institutional Consequences of Platforms Digital technology platforms have important epistemic implications. The architecture of a common core technology with a variable periphery of devices and interoperability standards creates an environment in which diverse, heterogeneous agents around the edge of the platform can choose devices that best meet their subjective preferences and still engage in production, consumption, and/ or social exchange using the platform. This architecture makes diffuse private and contextual knowledge accessible and actionable, enabling coordination and mutual benefit. Moreover, the modular nature of devices and of the overall

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architecture of digital platforms means that systems are more loosely coupled and that specific individuals in the system are less dependent and interdependent on each other specifically. That loose interdependence contributes to a more flexible and resilient system that can both exploit diffuse knowledge and better enable the creation of new knowledge through exchange. The loose coupling means that emergent order can be more resilient to changes in specific technologies around the periphery or changes in specific individuals. Platforms do this by reducing the costs of and enabling three types of consequences: decentralized coordination for mutual benefit, innovation, and error correction. These consequences all result from applications of social learning and taking actions/making choices. These actions and choices are individual and decentralized and are adaptations and adjustments on multiple margins by ­individuals using relative prices as signals. 3.3.1. Decentralized Coordination for Mutual Benefit How do individuals learn the plans of others? How do they learn when they are wrong and take action accordingly? Prices and market processes provide feedback channels. Feedback loops, learning, adaptation to a changing environment and changing actions and plans of others, interdependence of agents and their actions in a complex system, and how prices and markets serve as feedback loops making a complex system adaptive are all important implications. As epistemic-institutional constructs, platforms aggregate diffuse private knowledge through a decentralized market process, with prices as knowledge surrogates and prices and profits as the signals triggering error correction. Market processes are mechanisms for allocation, reallocation, and error correction through production, consumption, and entrepreneurship (both Schumpeterian & Kirznerian). This decentralized coordination means that as a whole the economic system is better able to satisfy heterogeneous and subjective preferences and opportunity costs, achieving better matching of buyers and sellers. Agents learning knowledge relevant to their situations enables coordination of plans and actions, creates gains from trade, and creates gains from innovation. Digital platform technologies enable these market processes to exist at a more decentralized and granular level through the reduced transactions costs of connecting agents for mutual benefit. Contrast taxis and ride sharing, for example. Transactive technologies allow for more granular decentralized exchange across time and space, so to the extent that “knowledge of time and place” is important for value-generating exchange, digital platforms that facilitate more granular exchange create value. The deeper sense in which the market epistemology of platforms matters is that without a platform and the transactions it enables, the knowledge does not exist. Because knowledge is itself emergent and is contextual, it often does not exist outside of a market process. Competition as a discovery procedure means that knowledge is created in the process of exchange. Since digital technologies reduce transactions costs, they make those processes more feasible and more available, and platforms are a manifestation of that. Technological change begets

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institutional change, more knowledge is created and aggregated through increasingly decentralized exchange, all of which is welfare enhancing. 3.3.2. Innovation and Experimentation Platforms enable experimentation and social learning, leading to innovation around the platform in two different channels: producers and consumers. Experimentation is among the most substantial drivers of value creation in an entrepreneurial theory of competition that emphasized competitive market processes – the ability of producers to bring new ideas to market, of producers to combine and bundle existing and new products and services in novel ways, and of consumers to discover these new value propositions and learn how much to value them. Rogers (1962) identifies experimentation as one of the primary factors influencing the diffusion of innovation. Greenstein (2008, 2012, 2015) argues that economic experiments played a significant role in creating value in the markets for Internet access; his analyses suggest that although economic experimentation is a driver of value creation, pre-1990s federal spectrum policy erected a regulatory barrier to such experimentation, and the regulated monopoly status of AT&T pre-1984 heightened that barrier in other dimensions of communications. An environment that allows experimentation fosters social learning through trial and error. Such learning is the best (not perfect, but best) feasible social process for improving human well-being in the face of uncertainty and unavoidable cognitive limitations. An environment for experimentation is valuable because it enables the experimentation and learning that can mitigate the knowledge problem. In dynamic markets with diffuse private knowledge, neither entrepreneurs nor policymakers can know a priori which goods and services will succeed with consumers and at what prices. Similarly, consumers’ preferences are not fixed and known either to others or even to themselves. Consumers learn their preferences through the process of evaluating available choices in a marketplace, and analyze the relative value of those tradeoffs over time. The set of available consumer choices itself changes due to entrepreneurial activity. Even the most benign, well-intentioned group of government administrators with the most powerful computer possible cannot access that knowledge because it is dispersed in the minds of individuals, and they do not even create that knowledge until they are in a context where they have to consider making a choice. Experimentation makes learning possible and creates knowledge that would not otherwise exist, including the knowledge embedded in new products, services, and value propositions. Humans are also limited in our ability to anticipate future events, contexts, and outcomes, all the more so because of the rich dynamism of change that emerges in a complex system like the modern global economy. Knowing what future we are creating from today’s actions is almost impossible, particularly knowing specific outcomes that will happen. An environment that fosters trial-and-error learning is more likely than others to better enable more people to adapt to these unknown and changing conditions, and to find ways to improve well-being and

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living standards. No one can anticipate future uses of technology, and the only way to find them is to allow people to experiment, not to rely on selection and approval by a regulated monopoly or by a regulatory authority (as has been the case in electricity distribution). Schumpeter’s (1934, 1942) pioneering work examines how disruptive innovation creates economic growth via individuals who create “new combinations” of materials and forces, leading to change away from economic equilibrium (p. 65). Individuals come to discover these “combinations” by experimentation. Existing producers differ from these experimenters in their tendency to initiate dynamic, growth-generating change by participating in existing markets, producing existing goods and services, using existing techniques at lower prices. Schumpeter (1934) defines five methods for creating dynamic change in markets: introducing a new good or service, or adding new features to an existing one, introducing new production technology or methods, opening new markets, and capturing new sources of raw materials or new methods of industrial organization (p. 75). Competition in dynamic, free-enterprise societies is a process of change and creative destruction, with new combinations making previous ones obsolete (Schumpeter, 1942, p. 84). Dynamic competition often takes the form of product differentiation and bundling to compete for the market. Rivalry occurs among differentiated products; innovators and entrepreneurs change market definitions and boundaries by creating new products and services as well as new bundles of products and services. That dynamic discovery of new value propositions necessarily takes place in an experimentation process in which different producers interact, as do old and new combinations, to meet the market test of consumer value creation. Schumpeter’s disruptive innovator finds its complement in the activity of Kirzner’s (2009) alert, aware, entrepreneur. The “entrepreneur-as-equilibrator” (p. 147) uses differential alertness to profit, at least speculatively, from an existing opportunity to create net value. Differential alertness means awareness of and openness to a business opportunity that has not yet been widely noticed. This entrepreneur is not a Schumpeterian disruptive creator but engages in trial-and-error experimentation, playing a coordinating role by adapting to underlying changing conditions. Commercializing new products and service – as well as new bundles of products and services – is an example of “equilibrating entrepreneurship.” 3.3.3. Error Correction How do individuals learn the plans of others? How do they learn when they are wrong and take action accordingly? Prices and market processes provide feedback channels. Feedback loops, learning, adaptation to a changing environment and changing actions and plans of others, interdependence of agents and their actions in a complex system, and how prices and markets serve as feedback loops making a complex system adaptive are all important implications. The technology, market institutions, and organizational institutions of platforms combine to facilitate error correction in a dynamic and changing environment. Good market and organizational institutions provide feedback through

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information and incentives to correct errors better than other institutional frameworks. The role of markets as processes for error correction is frequently overlooked, but this ability to adapt to change is the foundation of dynamic value creation. The error correction features of markets translate into a platform environment. Platforms enhance error correction by harnessing transaction cost reductions, providing more timely information, and enabling individuals to respond more quickly (and even autonomously) to updated information. The same trialand-error process of experimentation and social learning enables individuals to observe outcomes and change their behavior to improve those (expected) outcomes. Platform technology, exchange, and governance that enable prices and profits to aggregate and communicate diffuse, private, contextual knowledge creates more, and more decentralized, opportunities for error correction. Economic calculation is a decentralized process of identifying and eliminating waste; compare that to more centralized processes (e.g., socialist calculation debate and central planning, use of regulation to “stand in” for competition), and you see the epistemic tradeoff. Regulation may yield some benefit in some dimension, for example, in instances of concentration and market power, but that benefit comes at an epistemic cost of losing this process of experimentation and error correction. Thus in addition to being technological, economic, and institutional, platforms are epistemic frameworks. Platforms harness digital technology to create market processes within specific institutional contexts to aggregate diffuse private and contextual knowledge and enable new knowledge creation within exchanges through the platform. As a result, the potential is larger for decentralized coordination, experimentation and innovation, and error correction.

4. APPLICATION: ELECTRICITY DISTRIBUTION PLATFORM FOR DISTRIBUTED ENERGY Here I apply the institutional-epistemic platform framework to articulate an electricity distribution platform business model and the economic logic underlying its possible effects. Using the four lenses of technology, economics, governance, and epistemology, I describe an electricity distribution platform design and how its features relate to those different aspects of platforms.7 The near-term implications of our analysis for electricity distribution are to consider the regulated wires utility as a distribution and market platform rather than a traditional vertically-integrated utility. Here the platform economy transaction involves individual, residential ownership of distributed resources (DERs), such as an electric vehicle or rooftop solar panels. When a person is generating more energy than s/he is using, a market platform would enable a transaction with another agent who may want to purchase energy, creating gains from trade by using digital technology and platform governance institutions to exploit the epistemic benefits of market platforms.

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4.1. Historical Background Since the beginning of commercial electric power in the 1880s, vertically integrated firms have sold electricity as a bundled good to consumers at a regulated, fixed volumetric price that compensates them both for the fixed costs of wires and capital equipment and the variable costs of generation. The distribution system was designed and built for the one-way flow of current from large-scale centralized generators to end users. In this system, agents are homogeneous; generators are only producers, end-use customers are only consumers. By early 1900s, the mechanical technologies of generation and transmission created economies of scale and the distribution system had subadditive costs, which created an early impetus for states to regulate prices. The resulting rate-of-return regulation is based on creating a legal entry barrier and a government-granted vertically integrated monopoly whose profit is based on recovering its costs and earning a rate of return on its physical assets. Separate real-time monitoring of electric current was technologically feasible by the 1950s, but bundling and vertical integration remained the status quo for the electric utility business and regulatory environment, until technological change in generation precipitated the regulatory and organizational changes that brought about competitive wholesale markets in the early 1990s. Heretofore, monopoly utilities only traded with one another to meet emergency needs, which meant that few high-voltage interconnections existed among service territories. In the United States, meaningful institutional change at the federal level occurred with the Energy Policy Act of 1992, creating the potential for wholesale electricity markets by reducing legal entry barriers to exchange, and allowing third-party generation and sales of electricity to distribution companies. A wave of unbundling of generation assets into separate companies ensued. The case of liberalizing wholesale power markets illustrates how technological change can reduce transactions costs and lead to organizational change. Innovation changed the transactional boundary of the firm, reduced the benefits of vertical integration, and made generation unbundling possible. In a regulated industry, though, organizational structure is a function both of technology and of the regulatory institutions/framework. New technologies also made possible both centralized and decentralized generation, diversifying the means of energy generation and in turn providing further support for the regulatory unbundling of energy from wires. Yet the regulation of energy and wires as a bundled good persists in many regions to this day. Digital and DER technological change has created a second wave of innovation in electricity, this time at the distribution and retail level. As digital and DER technologies around the distribution edge have become more feasible and heterogeneous in nature and scale, they enable organizational unbundling of the vertically integrated distribution utility, self-generation at smaller scales for smaller customers, and organization of self-contained microgrid systems around the distribution edge. Furthermore, in retail markets when consumers can selfgenerate with electric vehicles or other forms of distributed energy, the existence of a retail market platform would enable such a consumer to be a consumer in

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some conditions and a producer in other conditions, a phenomenon captured in our model. 4.2. An Electricity Distribution Platform Model In the context of historically regulated vertically integrated industry such as electricity distribution, governance means not just organizational and managerial questions, but also regulatory institutions. An electricity distribution platform ecosystem will involve heterogeneous agents in many scopes and roles – an electric vehicle owner can be both a consumer and producer where she was previously just a consumer; a private microgrid operator can aggregate demand and supply transactively within the microgrid and contract with the distribution wires company to provide ancillary grid services (e.g., voltage support, frequency support, and black start service). As traditionally constituted, the utility would see these agents as substitutes, while in a platform ecosystem, they are possible complements if the wires company operates a market platform and earns a service fee for facilitating a multisided market. Regulators play a role in this ecosystem to the extent that the distribution wires network continues to exhibit the economies of scale and scope associated with a natural monopoly cost structure, in which case the wires will continue to be a regulated network with competitive markets on either side of the supply chain (wholesale and retail). Today, utilities operate based on regulatory cost recovery, and any move toward a platform business model would have to meet the approval of the regulatory commission (or as in the case of New York, be initiated through a regulatory proceeding). Since the origins of the electricity industry in the 1880s, firms have been vertically integrated. Innovation in generation technology in the 1980s led to the unbundling of generation from vertically integrated utilities in states that restructured their regulation to allow competitive wholesale markets. Today, digital consumer device and smart grid technologies reduce transaction costs so dramatically at the distribution edge that another wave of unbundling may occur, this time of retail from distribution. Using Gawer’s (2014) framework and the epistemological framework outlined in Section 3, I model electricity distribution platforms as evolving organizations or meta-organizations that (1) federate and coordinate constitutive agents who can innovate and compete; (2) create value by generating and harnessing economies of scope in supply and/or demand; and (3) entail a modular technological architecture composed of a core and a periphery. (p. 1240)

Applying that model to electricity distribution suggests some clear roles and scope for an electricity distribution and retail market platform while still leaving some questions open for analysis and debate. Tabors, Parker, Centolella, and Caramanis (2016) provide a detailed example of such a platform design in the specific context of the New York Reforming the Energy Vision (REV) regulatory proceeding; in this section, I sketch briefly a more general model in the context of the theoretical frameworks presented above. In a regulated industry like electricity distribution, neither regulators nor other market participants have access to the knowledge influencing individual decisions made about production or

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consumption, reflecting the importance of the epistemological analysis. This platform model then suggests the regulatory institutions conducive to dynamism and innovation – unbundling retail from wires, quarantine the monopoly to reduce incumbent vertical market power, and open retail markets to rival providers. The distribution wires network has always had economic value, but the nature of that value is changing as technology changes, and the distribution utility’s business model can, and should, change to continue creating value from this central backbone. In the early decades of the industry, the distribution network helped local electric companies increase their generation capacity utilization and reduce their average cost by supplying electricity for lighting to residences in the evening and for transportation and industrial motors during the day. The distribution network made large-scale remote generation possible, enabling electric companies to create and exploit economies of scale and scope to reduce average cost even further. For most of the twentieth century, the benefits of centralized generation and the relatively low cost of maintaining the distribution grid meant that it continued to have value. A core function of a distribution platform will continue to be providing this distribution wires network. Given existing technology, and given initial conditions of existing physical distribution wires network, a “central backbone” distribution network is likely to continue to have economic value into the foreseeable future. To the extent that economies of scale and scope still exist in electricity distribution, a grid that is a central backbone will have value. The distribution platform firm has the operational and regulatory requirement to deliver electricity services to end users. Accompanying that role are a reliability requirement, with some administrative definition of what constitutes reliability, and the physical real-time network balancing function. The distribution platform is the orchestrator of grid needs, that is, reliability, voltage regulation, and capacity. The distribution platform earns a normal rate of return and the revenue to maintain and modernize infrastructure through a wires charge to retail customers. The defining feature of a platform firm is that it acts as an intermediary connecting two or more agents for mutual benefit, and the most common economic role of a platform firm is intermediation in transactions by providing a market platform that brings together potential buyers and sellers and makes it easier for them to find each other. Consider the analogy to financial market exchanges, such as stock exchanges or futures exchanges, which provide trading platforms. By being attentive to the interests of both buyers and sellers, they define standard products and rules by which exchanges will occur, and provide timely information and a way for buyers to bid and sellers to offer, opening or closing new markets as the interests of buyers and sellers wax and wane. The physical distribution platform firm would also be a market platform. This market platform function also reflects the primary epistemic benefit of market processes – coordination for mutual benefit, experimentation, and error correction. As the end users become more heterogeneous and can possess more diverse generation, storage, and automation technologies, the distribution company would create additional value by facilitating the interconnection of those agents

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and their technologies to the distribution network and the connection of agents, most likely in transactions. In that sense a distribution platform would layer market platforms on top of the physical distribution network. The existence of these retail market platforms would generate incentives and opportunities for entrepreneurs to develop devices that can operate on that platform (e.g., vehicles, home energy management) and applications that connect the owners of those devices to other agents via the platform. For this market facilitation, the distribution platform would earn a service fee (details about per transaction or per kWh remain an open question). But even in such a decentralized, meshed network rather than the traditional linear network, the distribution network as a central platform still has the potential to provide value to individuals to being interconnected. The two main value categories are insurance and exchange. A distributed energy installation that disconnects completely from the distribution network is independent and likely to be reliable and/or resilient, but in the case of system maintenance or an unexpected system failure, that system’s owner/user(s) bear all of the cost incurred in the outage. A reasonable range of risk aversion is consistent with wanting some insurance, some backup for the times when such an outage will occur. An insurance contract for such backup would be valuable, depending on the relative risk aversion of the distributed resource owner. Backup entails some form of external distribution of energy to that system, and thus entails use of the distribution network. The distribution platform company would have to factor that probability and capacity into its investment plans for maintenance and expansion. One form this transaction could take in a platform model would be for the distributed system owner to contract with a retailer for energy backup, a transaction that would require wires backup, so the insurance charge would be an energy price and a wires charge. There are lots of different ways to price this contract – an annual fixed fee split between energy and wires (with the wires charge being part of an open-access tariff, along with the other standard distribution wires charges), and a prenegotiated per-kilowatt-hour (kWh) energy price and wires price that would be incurred in the case of having to use the backup. Given how contentious the fights have been over the past two decades over standby charges and fixed fees charged to distributed system owners,, the details of this insurance transaction are likely to be fraught and difficult to work out, but this form of insurance is one of the main benefits of a distribution network as a central backbone in a decentralized system. The other, related, benefit is exchange. A distributed resource owner can benefit only from self-generation if not interconnected to other agents via a distribution network, and only the owner of that asset can benefit from it. Having some means of interconnection enables voluntary, mutually beneficial exchange. In the electricity context, this means of interconnection is multilayered – exchange requires a data connection for the exchange of information and a physical connection for current flow. If an agent is considering whether or not to purchase a distributed energy system, or what size of system to install, the possibility of exchange influences that decision greatly. The subjective and contextual nature of preferences also means that the existence of a market platform enables new

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opportunities to benefit from knowledge aggregation and knowledge creation through market processes. Deciding to buy a rooftop solar system or an electric vehicle provide examples. The potential to sell excess energy from a solar system, or to sell stored energy from a car battery, increases the probability that a consumer would be willing to buy the asset, knowing that s/he can monetize some of the value of the asset. Similarly, in making that decision the consumer may decide to purchase a larger-capacity solar system. Note how these opportunities, to purchase distributed energy assets and to exchange the energy derived from those assets, creates the opportunity for the homeowner to be both consumer and producer. The DER purchase calculus for each individual then becomes one of evaluating his/her subjective discounted present value of the revenue stream that is likely from the asset, in addition to the consumption value that the owner will derive from consuming the energy and/or transportation services of the asset. Importantly, this value proposition is precisely the same as that seen in other platform companies. Ride-sharing platforms, for example, give vehicle owners an opportunity to monetize an underutilized asset they own – seat space in their cars – while giving others an opportunity to get rides. Ride-sharing platforms change the vehicle purchase calculus, at the margin affecting the decision of when to buy a new car, how nice a new car to buy, and how many hours to spend on the platform and available to give rides. Note that the availability of these potential decentralized transactions may also serve the insurance role, because an interconnected DER owner could transact with another DER owner in the case of an individual system problem. In that case, exchange enables DER owners to insure each other mutually, and the beneficial role of the distribution platform is facilitating the data and current connection, for which the distribution company earns a (per kWh) wires charge. The potential benefits arising from exchange are the biggest reason for the distribution business model to be a platform, which lends itself naturally to providing the data and physical interconnection required for exchange. The mission of the firm evolves from providing reliable commodity electric service to all end users in geographical territory to facilitating their mutually-beneficial connections. Those connections are not necessarily only transactions, but most likely to be transactions. Thus a distribution platform company would provide market platforms for energy products, would provide standard terms and definitions (e.g., time-delimited, green-gray, ancillary services). Everything else is done by agents operating around the edges of the platform. That includes wholesale markets that are upstream from the platform, but most importantly includes independent retailers who are energy service providers. The technologies enable them to offer energy services that are as customized or as generic as individual consumers prefer, as automated or manual as they prefer, bundled with other services or not as they prefer. The burgeoning residential solar market is an example of the kind of market that can grow at the edge of such a platform (Kiesling & Silberg, 2015). The residential solar market has grown substantially over the past decade, through a combination of technology, market, and policy drivers. Three-quarters of

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US utility, commercial, and residential-scale PV systems went online between 2011 and the first half of 2013 (GTM Research, 2013). Installed cost of distributed photovoltaics fell 44% between 2009 and 2014, with distributed solar installations comprising 31% of all electric power installations completed in 2013; in that same year, overall residential solar PV capacity increased 68% across the nation. California led this growth with a 161% increase in 2013 (Sherwood, 2014). The residential solar market is showing how it can be competitive without vertical integration, and its growth would be facilitated by its technological and economic location at the edge of a distribution network with transparent, autonomous interconnection and competitive retail electricity markets. Unlike a traditional wires-only business model, a platform model emphasizes the role of the firm as an intermediary facilitating the interactions of agents in the network. A platform model does imply some technological differences in the distribution network compared to the traditional distribution grid architecture. The architecture of the distribution grid is designed for one-way current flow, from generator to end user. In a technological context with few large-scale generators and many users, one-way flow was a cost-effective architecture choice. But smart grid and distributed resource technologies have the potential to enable smallerscale generation and distribution throughout the network, and to enable smallscale transactions between distributed agents, which would require a network capable of two-way current flow. Digital sensors and other distribution automation technologies allow for more transparent monitoring and balancing of twoway flows in a distribution network, but the distribution grid as currently built, configured, and operated cannot provide the central backbone for a platform utility; thus moving to a platform model would take advantage of the widespread transaction cost reductions, enable experimentation and innovation around the distribution edge, and create a business model for investing in innovation within the network.

5. CONCLUSION This analysis provides a first step toward modeling platforms as epistemic frameworks for decentralized coordination. Digital platforms reduce transactions costs, including the cost of economic calculation. Digital platform business models solve the three transactions cost problems of triangulation, transfer, and trust (Kiesling et al., 2018). Platforms harness digital technologies that reduce transaction costs to create dramatically decentralized markets, with implications for the organizational structure of firms and the institutional framework in which platforms operate. Technologies, markets, and institutions combine to enable important epistemic consequences from platforms. The knowledge of time and place of the man on the street is relevant to decision making and outcomes, but is either not accessible or not yet generated without some institution and, in platforms, technologies that make such diffuse private and contextual knowledge accessible and actionable. Prices and markets make more coordination possible than would happen in

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their absence, and platforms make more and different types of markets possible, deepening and broadening the scope of human activity over which we can achieve decentralized coordination and inducing experimentation and innovation. As technology, markets, and institutions evolve, digital nonnative industries like electricity will adopt some of these changes. An epistemic analysis of electricity platform design can inform these changes in firm, market, and regulatory structures.

ACKNOWLEDGMENTS This paper has benefited from comments from an anonymous referee and from conversations on these topics with Jean-Michel Glachant, Dominique Lazanski, Stephen Littlechild, and Samantha Zyontz. I am grateful to participants at the 2015 Public Choice Society meetings, a 2016 PERC brown bag workshop, and participants in the 2016 Platform Strategy Research Symposium at Boston University, for comments on an earlier version of this paper. Some of the work in this research project occurred while I was a visiting senior lecturer in the Department of Political Economy at King’s College London, and I am grateful to them for their collegiality and hospitality.

NOTES 1. Accenture Trend 3 Report 2016, available at https://www.accenture.com/us-en/ insight-digital-platform-economy. 2.  The relevant economies of scope literature includes seminal contributions from Panzar & Willig (1981) and Teece (1980, 1982). 3.  Gawer (2014, p. 1242) provides extensive references documenting this phenomenon in the supply chain management literature. 4.  I am grateful to an anonymous reviewer for making this point clear to me. 5.  For a multidimensional definition of knowledge from the social epistemology literature, see Goldman (1999 pp. 4–10). 6.  Algorithms are another epistemic aspect of digital platforms, and in particular algorithms play an important role in making contextual knowledge actionable by automating market decisions. For example, an app that lets you control the trigger price below which your electric vehicle will charge can take advantage of inexpensive power in the middle of the night, and if you automate your price response you can sleep through the night while saving money. This process changes the discovery procedure, though – rather than discover your opportunity cost in the moment you are discovering it at a more contractual-algorithmic level, removed in time from the consumption context but enabling you to realize other benefits that you value (like saving money while having a good night’s sleep). 7. This discussion provides a general economic platform market design; the specific details, including the necessary engineering analysis of a decentralized, transactive distribution grid, are beyond the scope of this analysis.

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CHAPTER 5 AUSTRIAN ECONOMICS AS AN EVOLUTIONARY SCIENCE Witold Kwasnicki

ABSTRACT The author presents a comparative study of the three evolutionary economic schools, namely the Austrians, neo-Schumpeterians, and institutionalists. The comparison is based on an analysis of nine basic features of the evolutionary process and evolutionary approach, including a dynamical view of economic phenomena (seen from a historical perspective), a focus on ­far-from-equilibrium analysis, a proper and realistic perception of time, and a population perspective (to what extent emergent properties are results of interaction among economic agents). The relevant features of the evolutionary process are the heterogeneity and behavior of economic agents, the search for novelty based on a concept of economic agents’ hereditary information, a selection process (based on the concept of rivalry), spontaneity of development, and the presence of decision-making procedures (how economic agents make decisions, and to what extent their subjective values play a role). The goal of the comparative analysis is to estimate the level of “evolutionary content” of the three schools. My subjective evaluation suggests that only the Austrian school can be called entirely evolutionary. Slightly less evolutionary are the neo-Schumpeterians, and the least ­evolutionary are the institutionalists. Keywords: Evolutionary economics; spontaneous order; Austrian School of Economics; neo-Schumpeterian economics; institutionalism; social Darwinism; natural selection; competition as rivalry process JEL classification: B15; B25; B41; D50; E14 Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 71–90 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023007

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The evolutionary approach to economic analysis is not a new one, but its significance and popularity substantially increased in recent decades. Besides proposing a new approach to economic analysis, evolutionary economics stipulates a new, humbler attitude of economists to controlling and predicting the course of the economic process. Friedrich A. Hayek (1960) wrote in The Constitution of Liberty (p. 4): I want to make it quite clear here that the economist cannot claim special knowledge which qualifies him to co-ordinate the efforts of all the other specialists. What he may claim is that his professional occupation with the prevailing conflicts of aims has made him more aware than others of the fact that no human mind can comprehend all the knowledge which guides the actions of society and of the consequent need for an impersonal mechanism, not dependent on individual human judgments, which will co-ordinate the individual efforts.

Historical evidence, starting at least from the French Revolution (1789–1799), through the Bolshevik Revolution of 1917, to Pol Pot, and Khmer Rouge rule of Cambodia (1975–1979), clearly indicates the negative results of all attempts to design social order and to achieve predetermined social aims. Naturally, the social engineers devising all these attempts aim at improving human conditions and are full of goodwill. Facing all of civilization’s problems and keeping in mind all the social experiences of the last two to three centuries, we see how little we know about social and economic reality. The words of Hayek (1988, p. 76) seem to convey that essential truth: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” An orthodox economist, especially a neoclassical one, intends to discover laws of economic life and, using these laws, tries to manipulate human actions to achieve predetermined goals. Evolutionary researchers see themselves in the opposite role. In their opinion, it is more important to learn human motivations, human decision-making processes, and mechanisms governing the economic process to better understand economic agents’ behavior (Hayek, 1988, p. 98; Mises, 1966, p. 878). We can identify the three main modern evolutionary economic schools, namely the Austrians, neo-Schumpeterians, and institutionalists (see Fig. 1). The main aim of this article is to give evidence that only the Austrians fulfill the criteria to be called a truly evolutionary school. The arrows in Fig. 1 indicate the main influences of different authors and researchers. Contemporary evolutionary economics has its roots in biology (Charles Darwin, A. R. Wallace, and Jean-Baptiste Lamarck) as well as in the classical school of Adam Smith, David Hume, and Adam Ferguson. I stress the influences of the social sciences on the emergence of the Darwin/Wallace theory of biological evolution (these influences are indicated by the arrows from the great Scots [Smith, Hume, and Ferguson] and Thomas Malthus, Charles Babbage, and William Jones). The expression “evolutionary economics” is used in many, in some cases very different, approaches to economic analysis. In the most general understanding, it is used to emphasize the role of changes in economic processes, which indicates its opposition to economic analysis focused on static and equilibrium properties. In a narrow sense, it relates to economic analysis based on analogies and metaphors borrowed from the Darwin/

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Fig. 1.  Evolutionary Economics and Mutual Influences of Economics, Social Sciences, and Biology.

Wallace and Lamarck theories. As I said above, the label has frequently been used in recent decades by a few distinguished economic schools:

• Economists calling themselves neo-Schumpeterians. The school originated

• •

with Joseph Alois Schumpeter’s work. By the term “evolutionary,” they indicate the importance of long-term economic development, innovation, and the role of the entrepreneur. According to this school, the evolutionary process is a dynamical, historical one with macroeconomic characteristics resulting from microeconomic activity. A fundamental feature of the evolutionary economic process is the heterogeneity of behaviors. Selection and search for innovation are two primary mechanisms of development. Institutionalist theory, initiated by the work of Thorstein Veblen (which Veblen sometimes called post-Darwinian). Followers of Veblen and John Commons use the terms “evolutionary” and “institutional” interchangeably. The Austrian school. The work of the founders of this school, especially Carl Menger’s theory of the formation of money and other social institutions, is truly evolutionary. Friedrich Hayek frequently used the adjective to describe his approach (particularly his approach to spontaneous order). Other Austrian economists (e.g., Friedrich von Wieser and Ludwig von Mises) have directly referred to the concept of evolution.

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• Many

mathematical approaches used to describe economic phenomena, including chaos theory, computer simulations based on selection and replicator dynamics, genetic algorithms and genetic programming, and game theory.

Reviewing the literature, I frequently get the impression that the term “evolutionary economics” is used by many authors to describe essentially different approaches to the study of economic phenomena, with little correspondence to essential properties of evolutionary processes. Many authors use this term without explaining its meaning, assuming it is not necessary because everybody understands the term. This practice is not peculiar to economics but seems to be present even in biology. Jacques Monod, a well-known biologist of the twentieth century, said: “Another curious aspect of the theory of evolution is that everybody thinks that he understands it!” (quoted in Dawkins, 1976, p. 19). A very general definition of what constitutes modern evolutionary economics can be found in the 2008 New Palgrave Dictionary of Economics (vol. II, pp. 67–68): Evolutionary economics focuses on the processes that transform the economy from within… These processes emerge from the activities of agents with bounded rationality who learn from their own experience and that of others and who are capable of innovating.… The question in evolutionary economics is therefore not how, under varying conditions, economic resources are optimally allocated in equilibrium…. The questions are instead why and how knowledge, preferences, technology, and institutions change in the historical process, and what impact these changes have on the state of the economy at any point in time. (Witt, 2008)

That definition seems too general, allowing some approaches (mainly those focused chiefly on dynamical properties of the economy) to be unjustifiably called evolutionary. Some essential features of the evolutionary process are missing. Therefore, I would like to make the definition more operational. Hopefully, it will allow us to evaluate to what extent each approach to economic analysis is indeed evolutionary. The first important feature of the evolutionary approach in economics is the dynamical view of economic phenomena, seen from a historical perspective. The dynamical view is closely related to the second feature, namely to focus on farfrom-equilibrium analysis. The dynamical perspective and far-from-equilibrium analysis ought to be coupled with a proper and realistic perception of time. The other feature that seems crucial for a school to be called evolutionary is a population perspective (to what extent emergent properties are results of interactions among economic agents). The population perspective is connected with the heterogeneity of economic agents and their behavior, the search for novelty based on agents’ hereditary information, and a selection process that leads to a diversified set of products. Last, but not least, is the extent to which considerations are based on the concept of spontaneity of development. Evolutionary economic models incorporate decision-making procedures (i.e., how economic agents make decisions, and the importance of agents’ subjective values ). These decision-making procedures are closely related to the problem of price setting (e.g., to what extent diversity of prices results from the abovementioned evolutionary factors). Naturally, all the features are equally important, but it is worth commenting on spontaneity of development. In a most general understanding, spontaneity of

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development relates to the emergence of some properties, phenomena, and order due to interactions of economic agents, not the actions of any central institutions or groups of people. This idea has a long history, which can be called the Mandeville–Hume–Galiani–Smith–Ferguson–Menger–Leoni–Polanyi–Hayek tradition. The tradition starts with Bernard Mandeville’s Private Vices and Public Benefits, followed by Ferdinando Galiani’s idea of the supreme hand (Della moneta, 1751) and Smith’s invisible hand. Hume describes the idea well: “The rules of morality … are not conclusions of our reason.” Ferguson writes: “Nations stumble upon establishments, which are indeed the result of human action, but not the execution of any human design.” Two lesser-known scientists involved in the research on spontaneous order were Bruno Leoni and Michael Polanyi. Leoni (1961), contemplating the limitations of the planned social order, indicated that central decision-making bodies did not have the necessary knowledge to manage social systems. As a lawyer, he focused his attention on the formation of legal norms. He discussed law as an example of central control of an institution whose complexity goes beyond humans’ cognitive ability. He pointed out that rather than constructing the law, it should be discovered within a polycentric system. Polanyi (1948, 1951, 1958, 1966) developed the idea of itself-organizing structures. He made a distinction between corporate order and dynamic order. The corporate order is exogenous, which means relations among its elements are determined by external factors. In endogenous dynamic orders, the behavior of a given element depends on the behavior of other elements. Consequently, the regularity of a given order is the result of a process in which the elements of the system mutually adapt their behavior. Such an order is deprived of an overriding authority imposing its decisions on the system.1 Ulrich Witt (1994, p. 179) is entirely right in his opinion that spontaneous order in the interactions of the members of society is something to which everyone contributes, from which everyone benefits, which everyone normally takes for granted, but which individuals rarely understand.

I have made a purely subjective evaluation of evolutionary features present in the three outlined schools. I have evaluated each of the nine discussed features using a scale from zero (no presence) to five (full presence). The maximal possible evaluation is thus 45 points. The overall evaluations are presented in Table 1. The sums of collected points are in parentheses beside the names of the schools (the first column). The most advanced school is the Austrians (43 points), with the neo-Schumpeterians collecting slightly fewer points (38). The institutionalists received around half of the maximum, namely 25 points.

NEO-SCHUMPETERIANS Joseph A. Schumpeter (1883–1950) was one of the first economists (besides Carl Menger) who formulated and presented relatively mature propositions of principles and goals of economic analysis in the evolutionary spirit. He did it in his Theory of Economic Development in 1912 and in later publications

Austrian School (43) NeoSchumpeterians (38) Institutionalists (25)

 

5

4

3

5

4

Far-fromEquilibrium Analysis

4

Dynamical Vision

2

4

5

Perception of Time

3

5

5

Population Perspective

4

4

5

Diversity

3

5

4

Search for Novelties Hereditary Information

3

5

5

Selection Process

Table 1.  Overall Evaluation of the Three Evolutionary Schools in Economics (Each Feature Worth 0 to 5).

1

2

5

Spontaneity of Development

2

4

5

Decision Making Procedures

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(e.g., Schumpeter, 1928, 1935, 1939, 1942, 1947). Conventional marginalist theory, dominating at the beginning of the twentieth century, searched for the causes of development in factors exogenous to the economic process. One of the founders of that marginalist school, J. B. Clark (The Distribution of Wealth, 1894), treated population growth, changes in consumers’ attitudes, and changes in production methods (emerging out of current, normal economic activity) as such exogenous factors. This view was challenged by Schumpeter, who correctly pointed out that the causes ought to be sought in the economic process itself. In his opinion, capitalism never can be in an equilibrium state and never can be treated as stationary. The essential element of Schumpeter’s theory is the concept of recurring structural changes, what he called gales of creative destruction, followed by waves of expansion and rapid growth: “Evolution is lopsided, discontinuous, disharmonious by nature … evolution is a disturbance of existing structures and more like a series of explosions than a gentle, though incessant, transformation” (Schumpeter, 1939, vol. 1, p. 102). Persons responsible for those gales of creative destructions are pioneering entrepreneurs introducing radical innovations. Entrepreneurs search for new products and combinations of factors (innovations, in Schumpeter’s understanding) to gain higher profit. Entrepreneurs’ profit flows from what Schumpeter called temporary monopoly position. Profit emerges during economic growth – in other words, in a dynamic economy. In Schumpeter’s opinion, profit is not always the primary motivation for entrepreneurs. Frequently, such motivation comes from entrepreneurs’ drive for artistic creation, as an outlet for their temperament, or from a wish to show what is possible by acting in novel ways. Schumpeter was so convinced of the evolutionary character of the capitalistic economy that in 1942 he wrote: The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process. It may seem strange that anyone can fail to see so obvious a fact which moreover was long ago emphasized by Karl Marx. (p. 82)

Nevertheless, Schumpeter’s understanding of the word “evolutionary” is slightly different from that of Darwin or Lamarck. Economic development, like all evolutionary processes, is a historical one in which future development is determined by past changes as well as by current changes: Every concrete process of development finally rests upon preceding development. … Every process of development creates the prerequisites for the following. Thereby the form of the latter is altered, and things will turn out differently from what they would have been if every concrete phase of development had been compelled first to create its own conditions. (Schumpeter, 1934, p. 64)

Innovations in the economic process, like mutations in biological evolution, are an essential element of development. In 1939, he wrote that economic evolution is equivalent to “changes in the economic process brought about by innovation, together with all their effects, and the responses to them by economic system” (Schumpeter, 1939, vol. 1, p. 86). In Schumpeter’s (1942) opinion, those changes illustrate the same process of industrial mutation – if I may use that biological term – that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, creating a new one. This process of Creative Destruction is the essential fact about capitalism. (p. 84)2

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The notion that economic changes come “from within,” not exogenously to the economic process, seems to be one of the most important contributions of Schumpeter’s theory. This notion shaped the future development of the evolutionary approach to economic analysis. Schumpeter’s vision leads to a diminished role for analysis of the economic process in a state of equilibrium and instead treats analysis of states far from equilibrium and of transitions as much more important. Schumpeter’s approach to economic analysis stresses qualitative changes as much more critical than quantitative ones, although it is tough to encompass them in mathematical models or any other formal approach. Qualitative differences and generation of economic diversity are central from a long-term perspective on economic change. Therefore, for Schumpeter ([1912] 1934), the most interesting kind of change is one which so displaces its equilibrium point that the new one cannot be reached from the old one by infinitesimal steps. Add successively as many mail coaches as you please, you will never get a railway thereby. (p. 64)

Schumpeter pointed out an essential feature of the capitalistic economy, a feature common to all evolutionary processes: progress strongly depends on diversity, which is the primary source of innovation and can be called an evolutionary engine. Diversity leads systems to diminish in current performance. Therefore, from a short-term perspective, it is disadvantageous. But it is beneficial from a long-term perspective. As Schumpeter wrote (1942, p. 83): A system … that at every point in time fully utilizes its possibilities to its best advantage may yet in the long run be inferior to a system that does so at no given point in time, because the latter’s failure to do so may be a condition for a level or speed of long-run performance.

Schumpeter is considered one of the founders of the evolutionary approach to economic analysis, and his works have been read in such a way in recent decades. Nevertheless, and paradoxically, Schumpeter, commenting on the possibility of using biological analogies to analyze economic phenomena, wrote that “no appeal to biology would be of the slightest use” (Schumpeter, 1954, p. 789). One feature of capitalist systems is their relatively high product diversity. Chamberlain ([1933] 1962; see also Robinson, 1933) proposed a model of monopolistic competition. Although Chamberlain’s model was rooted in the neoclassical paradigm, it included an evolutionary element, namely it focused on the importance of product diversity. Despite its dynamical features, Chamberlain’s model is not based on evolutionary foundations. Armen A. Alchian, almost two decades later, was the first to formulate such a model. Alchian searched for a way to replace the neoclassical maximization principle with the biological concept of natural selection. The possibility of using natural selection to describe firms’ behavior was discussed by Alchian in 1950 and by Penrose two years later (Alchian, 1950; Penrose, 1952). As Alchian argued, competition is not described by the motive of profit maximization but by “adaptive, imitative, and trial-anderror behaviour in search for profit,” and therefore “those who realize positive profit are the survivors; those who suffer losses disappear.” Alchian’s vision is concordant with the Darwinian proposition (Alchian, 1950, pp. 211–13). His work was the first significant step toward building mathematical models of economic development based on evolutionary metaphors. In one place, he stated that “the

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economic counterparts of genetic heredity, mutations, and natural selection are imitation, innovation, and positive profits” (Alchian, 1950, p. 220). The proposition of Alchian and Penrose was developed, and rooted in the evolutionary paradigm, by Richard Nelson and Sidney Winter in their numerous articles and books (e.g., Nelson, 1968; Nelson & Winter, 1973, 1977, 1980, 1982; Winter 1964, 1971). Nelson and Winter’s primary interest was competing firms searching for innovation. During its development, each firm bases its behavior in its distinct environment on “routines,” where a routine is “a pattern of behavior that is followed repeatedly, but is subject to change if conditions change” (Winter, 1964, p. 264). Routines encompass technical routines for producing things … procedures of hiring and firing, ordering new inventory, stepping up production of items in high demand, policies regarding investment, research and development, advertising, business strategies about product diversification and overseas investment. (Nelson & Winter, 1982, p. 14)

Searching for innovations and ways of proceeding with research is, to some extent, also governed by routines. In fact, “routines govern choices as well as describe methods, and reflect the facts of management practice and organizational sociology as well as those of technology” (Winter, 1964). Each firm searches for new routines and a new combination of routines to improve its status compared to its competitors. In contrast to the neoclassical approach, firms in Nelson and Winter’s model do not optimize their behavior. Nelson and Winter’s work was continued and extended by numerous researchers working to apply the Darwinian notions of selection and mutation to economic processes (Dosi, 1983; Freeman, 1990; Haag, Weidlich, & Mensch, 1987; Kleinknecht, 1987; Silverberg, 1987; Verspagen, 1993) or searching for evolutionary mechanisms acting at the industry and firm levels. Researchers also sought to understand the influence of technological and organizational innovations on aggregate characteristics of economic activity; the behavior of industries and firms under the pressure of technological and price competition; and the diversity of economic agents, routines, and institutions (Gowdy, 1985; Iwai, 1984a, 1984b; Kwasnicki, 1994/1996; Kwasnicka & Kwasnicki, 1992). To make the above outline more adequate, it is necessary to mention some other streams of modern economic analysis related in some sense to the evolutionary paradigm, namely the behaviorists (among them Herbert Simon, Richard M. Cyert, and James G. March) and managerialists (e.g., W. J. Baumol and Oliver E. Williamson). Nicholas Kaldor’s research showed that a market is never balanced in Walras’s sense (e.g., his Economics without Equilibrium [1985]). Businesspeople know and take into account this qualitative fact in their activity, introducing innovations and fulfilling orders. Despite theoretical postulates, in practice we do not observe any tendency to price uniformity (movement toward the equilibrium price) – quite the contrary. Through introducing innovations, and in responding to ongoing changes in the market, economic agents contribute to the emergence of a high diversity of prices. Industrial development is a historical process in which cumulative causation plays a significant role. In the theory of the firm by Coase (1937), Penrose (1959), Cyert and March (1963), and Simon (1955, 1988), the basic notion is that firms’ knowledge is far

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from complete and everlasting. Firms cannot be called maximizers. They aim to satisfy some general behavioral criteria, and therefore it is better to call them satisficers (as Herbert Simon proposed). Humans are not fully rational; reality is too complicated to take into account all the influences, constraints, and prerequisites that make optimization possible. Human action and firms’ behavior are governed by rules worked out during lengthy processes of human development and firm growth. Therefore, Herbert Simon worked out the concept of bounded rationality. A similar opinion was expressed by Cyert and March (1963), who also argued that firms might not have clear and precise criteria to act appropriately. In most cases, those criteria exist in verbal form only, not as any set of well-defined equations.

INSTITUTIONALISTS Thorstein Veblen (1857–1929) was an economist at the end of the nineteenth century who also declared the necessity of an evolutionary approach to economic analysis. In his famous article of 1898, he asked the titular question, “Why is economics not an evolutionary science?” It is a vital and fundamental question, but he did not give a full answer. Like Alfred Marshall (1925), Veblen did not propose a cohesive research program based on the evolutionary paradigm. In the Veblenian tradition, the adjective “evolutionary” was used in the next decades by institutionalists to describe a particular kind of development based on the selection principle, but without the detailed precision of evolutionary biologists after Darwin. Veblen, like Marshall, saw in biology a source of fertile metaphors for better understanding economic and social processes, especially those of technological change in a capitalist economy. His position differs from Marshall’s in paying more attention to dynamics and less to static analysis and analysis of economic equilibrium (the neoclassical concepts of equilibrium and static analysis were borrowed from physics, especially from classical mechanics). Veblen said, “The question is not how things stabilize themselves in a ‘static state’, but how they endlessly grow and change” (Veblen, 1934, p. 8). What he considered important was to better understand economic development and technological change. He wrote in 1898, An evolutionary economics must be a theory of a process of cultural growth as determined by the economic interest, a theory of a cumulative sequence of economic institutions stated in terms of the process itself. (Veblen, 1919, p. 77)

Veblen studied deeply biology, psychology, philosophy, and the social sciences. In many articles, he demonstrated his knowledge of Darwinism, Mendelian genetics, and Hugo de Vries’s theory of mutation. Using his biological knowledge and the philosophical ideas of Charles Sanders Peirce and William James, Veblen attempted to build an evolutionary theory of socioeconomic development. He assumed customs of thought-dominate human behavior. Veblen tried to find causes of the origin and development of those customs. Under the influence of the theory of instincts presented by Spencer in Principles of Psychology (1855) and the ideas of McDougall presented in Introduction to Social Psychology (1908), Veblen postulated that the roots of these customs lie in human instincts. The emergence of mental customs results from people’s evolutionary adaptation

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to the continuously changing environment in which they live. Cultural changes, everyday experiences, and technological changes shape these mental customs. Still, Veblen’s approach neglected to explain how these mental customs become the hereditary element of human nature. From his notion of instinct, he was only a step away from working out his concept of an institution. In the opinion of Veblen (1919, p. 241), Institutions are an outgrowth of habit. The growth of culture is a cumulative sequence of habituation, and the ways and means of it are the habitual response of human nature to exigencies that vary incontinently, cumulatively, but with something of a consistent sequence in the cumulative variations that so go forward.

Veblen saw analogies between institutions and genes. He interpreted socioeconomic development with the concepts of Darwinian selection (Veblen, 1899, p. 188) Thorstein Veblen did not go further than a verbal description of socioeconomic development. There are a few reasons for the limited further development of biological economics in the first decades of the twentieth century. Biological evolution was still a young science, still defining itself. Although Darwin’s ideas influenced the work of social researchers significantly, all those influences were visible at the level of concepts, not at the level of formal, methodologically consistent, and valid models of socioeconomic phenomena. The research was focused on classification problems and qualitative description. One of the favored themes of that period was competition as the basic force controlling economic processes. The competition was treated as a force analogous to Newtonian gravitation, allowing the economy to reach equilibrium, not as a selective force in the Darwinian sense. All these economic considerations missed almost wholly the problems of technological change. Diversity of products and processes, a diversity observed in everyday economic life, is caused by technological change. Up to the 1950s, all considerations of the economic process from the evolutionary perspective were confined to verbal description. Veblen’s work was continued by the next generations of institutionalists, among them those associated with new institutional economics (e.g., Williamson, 1975) and those broadly associated with the viewpoints of Ronald Coase, Douglass North, Mancur Olson, and Richard Posner. A revival of the “old institutionalists” in the style of Thorstein Veblen, Wesley Mitchell, John Commons, and Clarence Ayres came at the end of the 1970s and beginning of the 1980s (e.g., John Kenneth Galbraith; Marc Tool, 1979). The great work of putting institutionalism back into the context of evolutionary economics was done by Geoffrey Hodgson (1993; Hodgson, Warren, Samules, & Tool, 1994, 1995, 1998).

THE AUSTRIANS At the end of the nineteenth century, some economists declared unequivocally and explicitly the need for an evolutionary approach to economic analysis. Paradoxically, they did so during the same period when Stanley Jevons and Leon Walras founded neoclassical economics, the basic principles of which were rooted in the mechanistic paradigm.3 Carl Menger (1840–1921) was one of a few evolutionary economists

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of this period. Similarly to what the great Scots had done a hundred years earlier, he used such phenomena as language, customs, morality, and common law as examples to show that regularities in the development of human societies are the outcome of individual decisions and actions of all members of society. Menger ([1871] 2004) understood money as a pragmatic, “organic” social institution, similar to language or common law. In his understanding, “organic” means being the spontaneous product of human activity, not the result of any rational project or design. We find Menger’s (2004) suggestion of an evolutionary process leading to the emergence of money in his Principles of Economics of 1871: The origin of money … is entirely natural.… Money is not an invention of the state. It is not the product of legislative act. Even the sanction of political authority is not necessary for its existence. Certain commodities came to be money quite naturally, as the result of economic relationships that were independent of the power of the state. (pp. 261–62)

Money is the unintended outcome of individual cooperation and personal choices (Menger, 1950, p. 260). In 1883, he published Investigations into the Method of the Social Sciences with Special Reference to Economics (Untersuchungen über die Methode der Socialwissenschaften und der politischen Oekonomie insbesondere). He suggested that goods selected to be money were those “the most easily transported, the most durable, the most easily divisible” ([1883] 1985, p. 154). Money originates as the result of selection. Because it is selection at the level of customs, agreements, and conventions, it can be debated to what extent it is natural selection. It is interesting that Menger ([1883] 1985) uses the term “genetically” in his considerations, arguing that each economic theory has primarily the task of teaching us to understand the concrete phenomena of the real world as exemplifications of a certain regularity in the succession of phenomena, i.e., genetically.… This genetic element is inseparable from the idea of theoretical science. (p. 94)

In Menger’s understanding, genetic means causal. As Menger ([1883] 1985, p. 130) observes, spontaneous development is present in the evolution of a broad spectrum of human institutions: Natural organisms almost without exception exhibit, when closely observed, a really admirable functionality of all parts with respect to the whole, a functionality which is not, however, the result of human calculation, but of a natural process.… But with closer consideration they still do not prove to be the result of an intention aimed at this purpose, i.e., the result of an agreement of members of society or of positive legislation. They, too, present themselves to us rather as “natural” products (in a certain sense), as unintended results of historical development.

Friedrich von Wieser (1851–1926) followed Menger’s idea of individualistic and spontaneous emergence of social institutions. However, Wieser pointed out that old institutions act as a restraint and that people make decisions in an institutional context. As Wieser (1927) wrote, Indeed, the mass never acts with a clear consciousness of aim. It is not teleological. Rather it follows the path of success opened by the leaders without measuring its operation.… Men always act with diverse emotions.… The much-quoted phrase ‘the good is the enemy of the better’ holds especially for social institutions and their historical power. The individual is helpless against the historical force of old institutions. He must take them as he finds them. (pp. 165–66)

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Wieser proposed a genuinely evolutionary concept of competition as a rivalrous process, contrasting it with a static perception of competition (Wieser, 1927, pp. 210–211). In his understanding, competition is a condition in which a number of persons in rivalry with one another pursue identical aims of supply and demand. By deflection of its meaning, the term may also be made to stand for this rivalry in trade itself. (Wieser, 1927, p. 174)

Rivalrous competition is fundamental to a proper understanding of the market economy. In Social Economics as well as in his previous work Natural Value, Wieser discussed the relationship between natural value and the objective theory of value. For him, natural value “arises from the social relation between amount of goods and utility” (Wieser [1889] 1893, p. 60). Natural value is one element in the formation of exchange value. It does not, however, enter simply and thoroughly into exchange value. On the one side, it is disturbed by human imperfection, by error, fraud, force, chance; and on the other, by the present order of society, by the existence of ­private property, and by the differences between rich and poor. (pp. 61–62)

In his last work, The Law of Power (1926), Wieser combined economic analysis and sociology in his interpretation of the role of institutions. It seems that at least partly he put aside his liberal ideas and stood much closer to Schumpeter’s ideas than to Menger’s. He develops his original concept of the institution, in which power and social stratification play a leading role in the formation and evolution of institutions. Ludwig von Mises in Human Action commented under the heading “Current Misinterpretations of Modern Natural Science, Especially of Darwinism” (Mises [1949] 1966, p. 174) that “the notion of the struggle for existence as Darwin borrowed it from Malthus and applied it in his theory, is to be understood in a metaphorical sense” (p. 176). In the vein of Carl Menger, Mises ([1949] 1966) wrote that the evolution of reason, language, and cooperation is the outcome of the same process; they were inseparably and necessarily linked together. But this process took place in individuals. It consisted in changes in the behavior of individuals. There is no other substance in which it occurred than the individuals. (p. 43)

Mises paid special attention to the emergence of cooperation and the division of labor (Mises [1949] 1966, p. 145). Frequently in Human Action Mises pointed out that human institutions are products of evolutionary mechanisms: “Conscious and purposeful cooperation is the outcome of a long evolutionary process” (p. 194). The market economy is a man-made mode of acting under the division of labor.… The market economy is the product of a long evolutionary process. It is the outcome of man’s endeavors to adjust his action in the best possible way to the given conditions of his environment that he cannot alter. It is the strategy, as it were, by the application of which man has triumphantly progressed from s­ avagery to civilization. (p. 265)

“Property rights as they are circumscribed by laws and protected by courts and the police, are the outgrowth of an age-long evolution” (p. 654).

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Mises referred to evolution, spontaneous order, and Darwinism in Theory and History (1957). In his opinion, “the keystone of Western civilization is the sphere of spontaneous action it secures to the individual” (Mises [1957] 1985, p. 374). Mises saw evolution in the broader context of biological and cultural development. He wrote that “the evolution of society and that of civilization were not two distinct processes but one and the same process” (Mises [1957] 1985, p. 252). However, Mises ([1957] 1985) saw essential differences between biological and social evolution: The biological evolution that resulted in the emergence of the structure–function systems of plant and animal bodies was a purely physiological process in which no trace of a conscious activity on the part of the cells can be discovered. On the other hand, human society is an intellectual and spiritual phenomenon. In cooperating with their fellows, individuals do not divest themselves of their individuality.… Men have ideas and seek chosen ends, while the cells and organs of the body lack such autonomy. (p. 253)

Friedrich A. Hayek (1899–1992) was one of the followers of Menger’s and Wieser’s ideas. Hayek frequently used the expression “evolutionary approach,” especially concerning “the evolution of systems of rules of conduct.”4 He wrote: “The evolutionary selection of different rules of individual conduct operates through the viability of the order it will produce,” and the transmission of rules of conduct takes place from individual to individual, the natural selection of rules will operate on the basis of greater or lesser efficiency of resulting order of the group. (Hayek, 1967, pp. 67–68)

We find direct references to evolutionary biology in his essay on Bernard Mandeville (Hayek, 1978, p. 265). He similarly incorporates evolutionary concepts in his analysis of socioeconomic process in his three-volume work Law, Legislation and Liberty (Hayek, 1982, vol. 1, pp. 9, 23–24, 152–53, vol. 3, pp. 154–59, 199–202). However, the fullest expression of his evolutionary view is seen in his latest works – for example, The Fatal Conceit (1988, pp. 8–9, 11–28, 147). Hayek postulated the existence of a second basic mechanism of social evolution, which is complementary to selection, namely a mechanism for generating new solutions. Institutions and practices that had “been adopted for other reasons, or even purely accidentally, were preserved because they enable the group in which they had arisen to prevail over others” (Hayek, 1982, vol. 1. p. 9). In 1952, Hayek published the not-so-well-known book The Sensory Order, which he thought to be of considerable importance. He seems to have been right, because the ideas presented in that book shaped all of his economic ideas, among them ideas related to the evolutionary approach to economic analysis. Steven Horwitz (2000) is entirely right in seeing that work as a way (to borrow from his title) “from the sensory order to the liberal order.” Horwitz (2000) writes at the end of his paper that Hayek’s thought will have come to fruition when the social sciences abandon rationalist and constructivist explanations of social phenomena in favor of ones that recognize the roles of tacit and contextual knowledge, institutional evolution, and spontaneous order. Such an approach would dramatically improve our understanding and appreciation of the liberal order, and must begin with a better understanding of the human mind. Hayek’s The Sensory Order ­provides just such a beginning.5

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FINAL REMARKS Modern evolutionary economics can be characterized as an approach focused on analyzing economic development from short- and long-term perspectives, on searching for causes and mechanisms of industries’ emergence and persistence, on researching the motivations of economic agents, and on understanding their actions. This short review of evolutionary approaches taken by three schools, namely the Austrians, neo-Schumpeterians, and institutionalists, suggests that from the methodological point of view the Austrian school is the most advanced school. Less methodologically advanced, although much more prolific (e.g., regarding the number of publications), is the neo-Schumpeterian school. The institutionalists’ methodology of economic analysis seems rather feeble. All three schools focus their analysis on dynamics of economic phenomena and keep in mind that far-from-equilibrium analysis is much more important than static, equilibrium analysis. The Austrians and neo-Schumpeterians are more consistent and rigorous in that matter than the institutionalists. All three schools treat with almost equal importance some other features of evolutionary approach mentioned at the beginning of the paper, namely the population perspective, diversity of economic agents and their behavior, search for innovation, hereditary information of economic agents, and selection process. However, the Austrian school seems to be much more advanced in the realistic perception of time and treating spontaneity of development as a prerequisite for the proper understanding of the economic process. Institutionalists, and to some extent neo-Schumpeterians, still treat elements of central planning, government intervention, and constructivism as essential for economic development. Despite the solid methodological foundations for evolutionary analysis provided by Menger, Wieser, Hayek, and Mises, the general perception is that the achievements of the Austrian economists are smaller than those of the neoSchumpeterians and institutionalists. What are the reasons for that? I do not know, but it seems that it ought to be treated as a challenge for the next generation of Austrian economists. Evolutionary economics is far from having reached a mature formulation. However, given the development of evolutionary economics in recent decades, we may conclude that the description of the economic process and behavior of economic agents at the micro level provided by researchers working within the evolutionary paradigm is far more complete and closer to reality than the description provided by orthodox economists. Further development of evolutionary economics requires efficient and very specific tools of informal and formal analysis. As Kenneth Boulding (1991) writes: One of the great opportunities … for the next few decades is the development of a mathematics which is suitable to social systems, which the sort of 18th-century mathematics which we mostly use is not. The world is topological rather than numerical. We need non-Cartesian algebra as we need non-Euclidean geometry, where minus minus is not always plus, and where the bottom line is often an illusion. So there is a great deal to be done. Let’s get after it!

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The simulation approach, mostly used in nonlinear, evolutionary models in economic analysis, seems to be very useful but does not completely fulfill the requirements to be considered the right and entirely appropriate tool of formal analysis. One of the important criteria used by researchers to apply one or another approach is the potential for further development. It seems the neoclassical paradigm has approached the limits of its development, but the evolutionary paradigm, although it is as old as the neoclassical one and has been developing much slower in the last 150 years, still has ample possibilities for further development.

NOTES 1.  For discussion of the relationship between Polanyi’s and Hayek’s ideas on spontaneous order, see, for example, Bladel (2005), Jacobs (1997, 1999), and Leszek (2014). 2.  A few decades earlier, Schumpeter ([1912] 1934) expressed it as follows: “By ‘development’ … we shall understand only changes in economic life as are not forced upon it from without but arise by its own initiative, from within” (p. 63). And: Development in our sense is a distinct phenomenon, entirely foreign to what may be observed in the circular flow or in the tendency toward equilibrium. It is spontaneous and discontinuous change in the channels of flow, disturbance of equilibrium, which forever alters and displaces the equilibrium state previously existing. (p. 64)

3.  Stanley Jevons, 1871, The Theory of Political Economy; Leon Walras, 1874, Élements d’économie politique pure. 4.  Hayek (1960, pp. 57–61); see also a number of essays written in 1960 – for example, Hayek (1967, pp. 31–34, 66–81, 103–4, 111, 119). 5.  Discussing evolutionary ideas of the Austrian school, I started from Carl Menger and continued to his followers: Wieser, Hayek, and Mises. I have not mentioned other famous Austrian economists, such as Eugen von Böhm-Bawerk, Ludwig Lachmann, Murray Rothbard, or Israel Kirzner. Not all members of the Austrian school have referred directly to the evolutionary approach or evolutionary metaphors. In their research, these other economists were focused on different aspects of economic analysis, although we can identify some specific elements of the evolutionary approach. This situation is not peculiar to the Austrians but can be identified within the other discussed evolutionary schools, the institutionalists, and neo-Schumpeterians.

REFERENCES Alchian, A.A. (1950). Uncertainty, evolution, and economic theory. Journal of Political Economy, 58, 211–21. Babbage, C. ([1832] 1846). On the economy of machinery and manufactures (4th ed.). London: John Murray. Baumol, W. J. (1959). Business behavior, value and growth. New York, NY: Macmillan. Bladel, J. P. (2005). Against Polanyi-centrism: Hayek and there-emergence of “Spontaneous Order.” The Quarterly Journal of Austrian Economics, 8 (4, Winter 2005), 15–30. Boulding, K. E. (1991). What is evolutionary economics? Journal of Evolutionary Economics, 1(1), 9–17. Chamberlain, E. (1962). The theory of monopolistic competition. Cambridge, MA: Harward University Press (the first edition in 1933). Coase, R. (1937). The nature of the firm. Economica, 4, 386–405. Cyert, R., & March, J. (1963). A behavioral theory of the firm. Englewood Cliffs, NY: PrenticeHall. Darwin, C. (1904). The descent of man (2nd ed.). New York, NY: Hill. Dawkins, R. (1976). The selfish gene (1 st ed.). Oxford: Oxford University Press.

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CHAPTER 6 ROBUST AGAINST WHOM? Nick Cowen

ABSTRACT Robust political economy (RPE) is a research program that combines insights from Austrian economics and public choice to evaluate the performance of institutions in cases of limited knowledge and limited altruism, or “worst-case scenarios.” Many critics of RPE argue that it is too narrowly focused on the bad motivations and inadequacies of social actors while smuggling in classical liberal normative commitments as part of a purported solution to these problems. This chapter takes a ­different tack by highlighting the ways that RPE as currently understood may not be robust against particularly bad conduct. It suggests that depending on the parameters of what constitutes a worst-case scenario, classical liberal institutions, especially a minimal state, may turn out to be less robust than some conservative or social democratic alternatives. Keywords: Robust political economy; public choice; tuism; altruism; perverse preferences; minimal state

I hate the Moor: And it is thought abroad, that ’twixt my sheets He has done my office: I know not if’t be true; But I, for mere suspicion in that kind, Will do as if for surety. Iago, Othello Act 1

Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 91–111 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023008

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Robust political economy (RPE) is an approach to comparative institutional analysis that examines the capacity of institutions to cope with worst-case scenarios (Boettke & Leeson, 2004; N. Cowen, 2016, 2017; Leeson & Subrick, 2006; Levy, 2002; Pennington, 2011, 2016). These scenarios are premised on the problems of limited altruism and limited knowledge within human interactions. These problems are taken to be the core challenges to social co-operation. It is on these robustness grounds that these scholars offer an innovative defense of a minimal state dedicated to protecting private property and voluntary exchange within a framework of the rule of law (Pennington, 2011, p. 6). These are contrasted with more extensive regimes that attempt to achieve broader social goals through public provision but rely on more idealistic assumptions about human agents, particularly when engaging in the political process. In this chapter, I argue that some agent behavior is potentially “worse” than RPE traditionally conceptualizes, as some people are inspired by outright malice and delusion. Recognizing this kind of conduct as a social challenge may alter how robust we view the minimal state after all. Shakespeare’s Iago, part of whose famous monologue is quoted above, inspires this case because of his fascinatingly malicious motivations. Ruthless, cunning, and manipulative, he makes others the instruments of a complex revenge plot to destroy his superior, Othello, to whom he is a close confidant. His diabolical plan succeeds, yet he is caught, injured, and faces torture and death as a result. Such an ultimately self-destructive end would only by justified by extraordinarily compelling motives. Yet his are remarkably insubstantial. To other characters, he discloses his anger at being passed over for promotion by a younger soldier. To the play’s audience, he admits he harbors a suspicion that his wife and Othello have had an affair. The veracity of this claim does not concern him very much. He acts with certainty, out of a kind of malign faith, to ruin others and then, inevitably, himself. Literary scholars have imputed both racial animus and subconscious homosexual attraction to explain Iago’s motives (Adelman, 1997). While fictional, Iago’s character chimes all too closely with humanity’s extremes of behavior. Perhaps at our own worst moments, we might recognize our own capacity to experience pathological jealousy or similarly damaging emotions, even if we typically resist from acting on them. Indeed, an assumption of my argument here is that these traits, though probably only outstanding among only a small minority, are present to some degree in almost everyone. One can readily hypothesize possible parallels between Iago’s psychological motives and some of the animating fears that inspire contemporary political activism and reaction (T. Cowen, 2017). The premise of this chapter is that many agents act on motivations that cannot be effectively comprehended as purposive, at least on the non-tuistic assumptions of most economic theory. If these are prominent features of human social interaction, then commendable institutions should be robust to this form of conduct as well. What sort of institutions are likely to be more robust than a minimal state? I think there are roughly three dimensions along which minimal statists generally wish to limit government: its size (how large the public sector is), its scope (what sort of goods it supplies and regulates), and its arbitrariness (lack of rule of law) (Gwartney, Holcombe, & Lawson, 1998; Mahoney, 2001). Research in historical

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and comparative political economy turns up few persistent examples of regimes limited on all three dimensions, itself a suggestion that minimal states may not be robust (Alves & Meadowcroft, 2013). States can be large, or they can be arbitrary (or they can be both), but seldom can they be neither (Johnson & Koyama, 2017). Fortunately, extensive markets can persist alongside large governments so long as private actors can rely on secure property rights. The implication is that widespread social cooperation is realistically protected by limiting the arbitrariness of government, and only secondarily its size and scope. This addendum points less in favor of the minimal state and more toward familiar liberal and social democratic regimes (as well as democracies with a more conservative outlook) that seem representative of the range of real-world well-performing, relatively peaceful regimes. In the section “RPE, public choice and Austrian economics,” I summarize the RPE framework and its relationship with the public choice and Austrian economics traditions, in order to point out a potential gap in its conception of worstcase scenarios. The section “The socially situated agent” develops an alternative, more perverse, agent that is socially situated rather than atomistic but, precisely because of this social orientation, can develop anti-social desires. The section “Institutional implications” discusses how this different agent may commend different institutional solutions and, in particular, how such agents may undermine the stability of a minimal state. The final section “Objections” discusses some possible objections to my case.

RPE, PUBLIC CHOICE AND AUSTRIAN ECONOMICS The RPE account contends that institutions aiming at human welfare should be capable of functioning in the presence of realistic challenges that are significant features of human political and social life: imperfect, dispersed knowledge, and self-interested motivation (Pennington, 2011, p. 18). In doing so, RPE combines the research programs of two related theorists: F. A. Hayek and James Buchanan. This aim of robustness, drawn from “catallactic” political economy, contrasts with the more common notion of optimality, the typical aim of “allocative” political economy (Marciano, 2009). As Buchanan (1964) and Fuller (1978) point out, the allocative model treats the economic system as a single unit, traditionally a metaphorical Robinson Crusoe figure (Evans, 2010, p. 5; Steele, 1992, p. 90). The economic problem is essentially one of calculation where the political community, conceptualized as a social agent, works out how to allocate given resources to a given range of ends in the most efficient way possible. This suggests the need for technical solutions that will be “one of applied maximization of a relatively simple computational sort” (Buchanan, 1964, p. 216). On an RPE account this represents: failure to take seriously such factors as the use of (and imperfections in) economic knowledge, the presence of ignorance and uncertainty, the passage of time, and changes in economic ­conditions. (Boettke, 1997, p. 17)

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For both Hayek and Buchanan, the economic problem is how individuals with limited knowledge and separate interests can engage in mutually beneficial exchange. On this account, what we identify as a community is primarily constituted by the spontaneous order of piecemeal economic and social co-operation between individuals. Instead of whispering into the ear of a sovereign to suggest policies optimized for given ends, the function of this kind of economic theory is to establish what kind of rules are commendable for a community composed of morally and epistemically fallible agents, including political actors, who do not yet know which ends they wish to pursue. RPE seeks not optimal outcomes but to avoid the worst-case scenarios into which fallible agents can easily fall. Buchanan (1999c, 2000) is most well-known for his application of incentive problems to the political process. Hayek (1937, 1945) and O’Driscoll and Rizzo (2015) are more closely associated with the knowledge problem and the unique role of the market process in overcoming it. There are, however, important overlaps between these programs. Hayek’s (2007) chapter in The Road to Serfdom, “How the worst get on top,” is a powerful account of how well-meaning conduct in a majoritarian democracy can be displaced by opportunistic political actors, and not just agents lacking knowledge (Boettke & Leeson, 2002). Meanwhile, Buchanan’s (1999a) Cost and Choice is a critical discussion of the role of the price mechanism in utilizing dispersed, subjective knowledge. In this sense, the descriptive label RPE reflects the shared program of these theorists (Boettke & Lopez, 2002; Ikeda, 2003; Martin, 2014, p. 93). The Critics Critics of these foundations of RPE have tended to accept the premise that it is indeed dealing with worst-case scenarios of a kind. Their response is that a worst-case scenario is not always relevant for some circumstances, and that an overriding focus on them may preclude the salutary impact of state action beyond the purely minimal state. When addressing the public choice analysis of political processes, the common response is that it is counter-productively pessimistic (Frank, Gilovich, & Regan, 1996). For example, Musgrave counters Buchanan as follows: I do not join Hume’s proposition that in viewing government “everyone ought to be considered a knave” … I would rather draw on people’s capacity to serve as responsible members of the community, so that government may do its important tasks and do them well. (Musgrave, 1999, p. 82)

Meade is similarly hopeful that self-interest can be overcome to a greater or lesser extent in the political sphere in a way that explicitly denies the constraints of behavioral symmetry: in a democratic polity the citizens promote certain economic policies with their votes just as in the market place they promote certain economic activities with their purses. Are we to believe that they have such split personalities as to vote altruistically solely for the general good and to spend selfishly solely in their own personal interest? There probably is some element of this split in many citizens’ minds; and the present reviewer would be prepared to make a case for the view that such a split should be encouraged in the interests of society. (Meade, 1972, pp. 1423–1424)

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More recent direct criticisms of RPE itself follow a similar pattern of challenging its underlying pessimism (Farrant, 2004; Layman, 2016). Such views are bolstered by empirical research suggesting that political actors, especially voters, behave very differently from what an economic conception of self-interest would predict (Kogelmann, 2015; Sen, 1977). Other criticisms suggests that proponents of RPE stealthily convey a normative commitment to classical liberalism within their approach to evaluating institutional performance (Bennett, 2016; Gamble, 2016). RPE does not offer or defend a worked-out normative standpoint. Of course, given the Smithian and Humean inspiration, one can take the implied aims of RPE to include reduction of conflict, social order, and a “weak utilitarianism” (Pennington, 2015, p. 484). However, without an explicit normative standpoint of some sort, there is little to answer groups or individuals who prefer institutions or policies that foster conflict. They could be rendered “well-performing” on those perverse grounds. Even if we accept the reduction of social conflict as a shared goal, it is not clear that a minimal state is necessarily the most robust form of governance for maintaining a sustainable social order or even protecting individual liberty (Taylor & Crampton, 2009). It could be unstable compared with various alternatives, such as some form of social democracy (Alves & Meadowcroft, 2014; Schumpeter, 1994). An Alternative Critique Recognizing this underlying assumption of RPE, that humans desire peace and quarrel merely over the terms of that peace, indicates the possibility of an alternative starting premise that is more consistently pessimistic. It comes from the opposite direction to the idealist critique. Rather than being attuned cynically to worst-case scenarios, it is possible that RPE is not robust enough to cope with other realistic challenges of human association. Individuals may not only wish to associate with one another in order to better achieve their own separate ends or shared goals. Some inevitably socialize with the desire and prospect of harming or even dominating others (Meadowcroft & Morrow, 2017). Fig. 1, a variation on a graph that Boettke (1999, p. xxvi) uses to illustrate the basic insight of Hayekian constitutional political economy, shows how this critique works. Traditionally, a great deal of debate about institutional performance focuses on the right of the figure, comparing socialism and liberalism in ideal and less than ideal circumstances. Boettke et al. argue that, even granting socialism’s superiority in ideal circumstances which still remains open to question, the key advantage of liberalism is its robustness. Departures from idealizing assumptions cause socialism’s performance to fall off rapidly while liberalism remains strong even as people’s conduct and knowledge worsens substantially. By contrast, comparatively little attention has been paid to the left side of the graph. Selfishness and limited knowledge is a baseline beyond which few institutional comparisons have been made. But it could be otherwise. I offer the provisional label of conservatism as a regime comparison to liberalism that may be expected to perform better at the pessimistic end of this scale. Conservatism is often a pessimistic undertaking (Kekes, 2001). It emphasizes the

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Fig. 1.  Illustrative Example of Comparative Performance of Conservative, Liberal, and Socialist Regimes under Different Behavioral Assumptions. The Worst-case Scenario Is on the Left Where No Beneficial Social Cooperation Is Possible. The Best-case Scenario Is on the Right Where Widespread Social Cooperation Is Strong Regardless of Regime.

importance of strict rules of personal conduct based around coercive and rigid social structures precisely to discourage anti-social behavior that are taken as given aspects of human nature. However, a case can equally be made for some sort of social democratic regime in conservatism’s place. Social democracies are more likely to emphasize collective economic goods when increasing the size and scope of government. Conservative regimes are more likely to focus on cultural values, enforcement of shared morality, and support for specific family structures, when expanding the size and scope of government. Structurally, however, both conservatism and social democracy justify the use of coercive rules beyond the minimal or liberal state (Narveson, 2008) and both deploy notions of moral economy, or some need for social embeddedness, to constrain or supplement liberal political economy (Blyth, 2002; Polanyi, 2001). The constraints of these regimes may prevent a society from reaching the prosperity and creative heights of a liberal society with systematically limited government in a more congenial scenario, but may still supply sufficient order to make social life more conducive to good living than relevant alternatives that might include a chaotic anarchy or despotism. This applies especially if the regime curbs arbitrary authority even if not the size and scope of that authority.

THE SOCIALLY SITUATED AGENT How can we conceptualize actors with anti-social ends? Anti-social conduct is a subset of socially engaged behavior aimed at achieving ends beyond the narrowly

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defined rational self-interest of individual agents. Social engagement in the form of attention to the needs and shared norms of other members of a community is built into the catallactic framework underlying RPE. To explain this, we can begin with a contrast between the “atomistic individualism” that is often imputed to economic theory and liberalism in general and the more refined individualism that motivates catallactic approaches to economics, including RPE. The notion of “atomistic individualism” is typically used pejoratively by communitarian theorists to disparage the analytic depth or normative content of a liberal social theory (Machan, 2000). It has some critical purchase when addressed to the framework of neo-classical economics that assumes given preferences and utility maximizing agents who act independently with complete information (Weintraub, 1993). The actor at the center of these formal economic models is a silent, price-taking chooser that McCloskey (2013) christens “Max-U.” These agents are atomistic because they approach social interaction with their preferences, ethical commitments, and knowledge pre-established (though they may not possess all relevant information). Agents cannot undergo a change of perspective as a result of social interaction. Scholars working within a neo-classical framework might reject this charge of “atomism” on the grounds that their models do not require preferences to be set in stone, only that they have sufficient durability to make modeling a strategic interaction between people with set preferences a useful exercise that yields predictions and explanations. If the charge of atomism is contestable when aimed at neo-classical economics, it is an even less appropriate challenge to RPE and the approaches that have inspired it. Pennington (2011, p. 56) identifies a close parallel between the “situated self ” of communitarian theories and the socially engaged agent that Hayek conceptualizes. Buchanan (1999b) emphasizes that agents participate in public life not only to achieve their given private ends but also to protect their capacity to pursue whatever they might want to do or become in the future. As Boettke (2014, p. 236) states: “we strive not only to pursue our ends with a judicious selection of the means, but also to discover what ends that we hope to pursue.” Ostrom (1993) makes a useful distinction between a Benthamite and Hobbesian conception of the individual. He does this in the context of attempting to liberate the enterprise of public choice from the confines of a neo-classical framework. Bentham’s individual is a passive recipient of pleasure and pain. The Hobbesian actor is reflective, communicative and purposive.1 What makes this Hobbesian actor different from a utility seeker? Principally, it is a tendency to imagine different experiences and different states of the world, some of which inspire desires and motivation to action: From Desire, ariseth the Thought of some means we have seen produce the like of that which we ayme at; and from the thought of that, the thought of means to that mean; and so continually, till we come to some beginning within our own power. And because the End, by the greatnesse of the impression, comes often to mind, in case our thoughts begin to wander, they are quickly again reduced into the way … [of an old adage] Respice Finem; that is to say, in all your actions, look often upon what you would have, as the thing that directs all your thoughts in the way to attain it. (Hobbes, 1996, chapter 3)

One can see parallels between this kind of actor and Kirzner’s (2009) “alert” entrepreneurial actor that participates in the market process. Hobbes’ description

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and the subjectivism that lies at the heart of market process theory are similar. As Shand and Shackle (1984) write: Subjectivism is the belief that human affairs – the takings-place in all their subtle complexity that we experience, see and hear of – begin as individuals’ thoughts, who use the suggestive impressions the world makes on their minds to imagine, each for himself, alternative feasible uses of the means he has at hand, and for each use, plural rival possible results …. There is no other source from which rival, choosable actions can present themselves. (p. xi)

Ostrom (1993) noted this parallel too, and suggested that both Austrian and Hobbesian subjectivism were needed to explain aspects of the political process that the formalist aspects of public choice could not. It is the extra-economic, creative capacities of the entrepreneurial agent that allows her to exploit profit opportunities, and close the gap between real market outcomes and their theoretical competitive equilibrium. It is the Hobbesian agent’s capacity for language and abstraction that allows her to establish public institutions with others. Whether anticipating future needs as part of the market process or developing institutions in a political process, these agents are necessarily socially oriented. It is these faculties that distinguish humans in civil society from humans (and animals) in a state of nature. The Even “Worse” Agent I have contrasted the rational, self-interested but bloodless, passive agents that populate mainstream neo-classical models, with the more creative agents that engage in the entrepreneurial market process and in institutional development. There is a dark side to these more socially engaged agents, who rely not on given preferences but also on intersubjective meanings to determine their motivations. They can develop a pre-occupation with their relative condition and status, cultivating desires to harm others independently of a desire for self-preservation and advancement. Why is this kind of agent a realistic problem? It is realistic because without the presence of malice, it is hard to explain distinctively wicked problems of political economy. A social theory premised on humanity’s limited sociability, but not motivation for anti-social conduct, struggles to explain the frequency of conflict. As Montesquieu (1777, chapter 2) observes: Man in a state of nature would have the faculty of knowing, before he had acquired any knowledge. Plain it is that his first ideas would not be of a speculative nature; he would think of the preservation of his being, before he would investigate its origin. Such a man would feel nothing in himself at first but impotency and weakness; his fears and apprehensions would be excessive …. In this state every man, instead of being sensible of his equality, would fancy himself inferior. There would therefore be no danger of their attacking one another; peace would be the first law of nature.

It would be easy for these sort of agents to converge consistently on relatively benign public institutions while leaving each other alone when gains from cooperation are not sufficiently high to justify the effort of association. In this sense, we might say they are naturally liberal. Montesquieu uses this starting point to argue against Hobbes’ case for the utility of a despotic government compared to

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a moderate government. This somewhat innocent view of the problem of political community contrasts with Hobbes’ more pessimistic vision. The Hobbesian account of the state of nature may easily be misread to imply that conflict essentially derives from competition over resources necessary for survival and the satisfaction of basic appetites. Contra Montesquieu’s conception, Hobbes’ agents are not merely rational, though fearful, agents. Although material beings, they have igniting passions and dispositions far beyond what we would consider physical self-preservation and wealth maximization (Frost, 2001, 2005). To borrow a phrase from Bejan (2016), these agents have “sensitivity, partiality and pride” (p. 576), while the standard economic agent is merely partial to their own interests. What results from pride? First, it is a source of perverse tuistic preferences. It adds a particular concern with cultivating and protecting relative status. This could include a desire to designate and affirm symbols and objects with meaning, then requiring others to recognize and respect those meanings. On this account, conflict over these meanings does not have to track underlying material interests. It merely helps to satisfy the agent’s desire for recognition which may be specified in arbitrary ways, just so long as the sense of their status can be communicated through it. Second, it motivates the acquisition of comforting and enjoyable beliefs about one’s importance in the social world. When these beliefs are frustrated or challenged, actors may engage in personally costly, and socially harmful, behavior to shore up their self-perceptions. Finally, for prideful agents, any constraints on action in the form of social rules, even if they are rules from which they benefit, represent a painful constraint on their will. Breaking rules is a way of exercising one’s individual will against an alien social world constituted by the expectations of others. In focusing on these motivational challenges in the context of understanding worst-case scenarios, I do not suggest that these traits are intrinsically bad. Some degree of self-delusion is plausibly a critical condition for orienting many successful personal plans of action. It also contributes to the extra-economic motivation to engage in collective action with other agents in the absence of coercive institutions. Altruism, benevolent concern for the interests of others, is a form of tuism. It is usually an admirable motivation. Of course, even pure altruism can have counter-productive outcomes (Hampton, 1993; Meadowcroft, 2007a). Meanwhile, deviance from common norms can help facilitate in-group solidarity. It can also be a source of benign cultural and institutional innovation. Nevertheless, all these characteristics have a dark side and this is the focus of worst-case scenario theorizing. Evidence for the presence of these human characteristics is not limited to literary fiction and political thought. Evolutionary psychologists have theorized and observed perverse tuistic behavior, such as spite (Hamilton, 1970; Kimbrough & Reiss, 2012), in humans, as well as widespread self-deception underlying a great deal of social activity (Simler & Hanson, 2018). These characteristics probably convey an evolutionary advantage in circumstances where humans developed. They cannot, however, be eliminated even when they no longer serve any productive function either for the individual or the community.

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Reflecting the typical casus belli of his experience, Hobbes is particularly fearful of conflict emerging from religious disagreement and competition for status among aristocrats. So pervasive were these problems for Hobbes that the only practical response was to support an absolute sovereign capable of determining the legality of public doctrines and inspiring dread among other powerful political actors. In other words, the worst-case behavior found in human nature ultimately justifies a sovereign, constitutionally unlimited state. This is the only regime that can prevent prideful agents from falling into conflict. Of course, we do not have to endorse Hobbes’ solution to recognize the problem.

INSTITUTIONAL IMPLICATIONS What are the implications of this kind of agent for comparative institutional analysis? Simply put, communities face underlying sources of instability beyond the misalignment of individual incentives with the public good. Fortunately, this exact challenge presents some potential lower-cost solutions. If agents can fall into conflict over symbolic disputes aside from material interests, then the solutions themselves may also draw on the manipulation of symbols and abstractions. If institutions cannot avoid conflict altogether, they can blunt them, by exploiting the subjectivity of status and the creative imaginations of perverse agents to channel them toward less destructive activities. A key observation of public choice is that political institutions established with the intention of correcting market failures and supplying public goods on fair terms can themselves become a site for collective action problems. They can allow people to impose costly externalities on others and divert public resources to private ends. The solution, on this account, is to design institutions that deter predation and rent seeking both in civil society and in the political process. These institutions reduce the personal gains that can be achieved through rent seeking. Once established, these institutions should be relatively stable because they offer many opportunities for productive social co-operation and fewer opportunities to acquire rents. The challenge that anti-social agents present is that receiving an uncompensated transfer is not the only thing that they find attractive about rent seeking and predation. Their perverse tuistic preferences means that they enjoy depriving others of their desired ends, whatever those ends happen to be (cf. Meadowcroft, 2007b). At some margin, they are prepared to bear personal costs in order to achieve this end. When confronted with a constitutional framework that protects people’s separate interests and facilitates social co-operation on the basis of nontuism, anti-social agents with political power or influence will seek to “reform” the framework so that there is less opportunity for co-operative production, and more opportunity to reward allies and punish enemies. Critically, once reformed, even people without any perverse preferences will be incentivized to engage in behavior that produces bad social outcomes in pursuit of securing their private interests. As with straightforwardly opportunistic selfish

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actors, anti-social agents can inflict harm on a community that is disproportionate to their numbers by altering the choice situation of those around them. This account offers a variation on the “bootlegger and Baptist” coalition model that productively explains many alliances between highly divergent interest-groups to push through specific legislation. On Yandle’s (1983) account, there are often two kinds of supporters of regulation. There are altruistic true-believers, for example, those genuinely, benevolently motivated to force others to reduce their consumption of alcohol. There are also rent seekers who believe they can exploit profit opportunities that regulation generates through inducing scarcity and restrictions on trade. A recent example of successful coalitions of this kind includes regulatory restrictions on vaping which are supported both by public health proponents who genuinely wish to discourage a new form of nicotine consumption, and tobacco and pharmaceutical companies, who wish to protect more dangerous or less effective products that vaping may otherwise displace. On my account, there is an additional coalition member type: the anti-social agent who wishes to deprive others of their ends but is indifferent as to precisely what those ends are or how it will impact on their personal material status. They have a preference to create aggravation for others. In practice, it can be hard to observe the difference between these agents and altruists since neither stand to benefit in an observable way from a particular policy. Mandeville (1970) famously, somewhat facetiously, claimed that they are one and the same kind of agent on the grounds that true altruism was impossible. Are there examples of these anti-social agents impacting on the real world? It is hard to locate a pure example of a policy in which absolutely no set of individuals derives any material benefit but nevertheless inflicts enormous social costs. Historical processes and institutions of slavery and colonialism may come close. They impose huge costs on the victims of predation and arguably cost the communities that are supposedly the beneficiaries of extraction. However, in each case there is at least a class of special interests, slave holders, soldiers, and empire administrators, who derive significant material benefits in addition to relative status. Nevertheless, it seems that a great deal of the attractiveness of these institutions is the imposition of an inferior status on an “other.” This generates opportunities to inflict harm sadistically for those directly involved in the practice, and a vicarious sense of superiority among some members of the dominant nation or race. It is plausible that these anti-social motivations contributes, at least, to the character and persistence of these institutions in a way that purely rational empire builders and economic beneficiaries could not have ensured alone. In other words, maliciously inclined agents are an active part of a coalition that establishes and supports predation and rent seeking. As Adam Smith (1981, p. 388) observed: The pride of man makes him love to domineer, and nothing mortifies him so much as to be obliged to condescend to persuade his inferiors. Wherever the law allows it, and the nature of the work can afford it, therefore, he will generally prefer the service of slaves to that of freemen.

One way of explaining the troublingly entwined history of colonialism and the expansion of commercial society is that broadly productive and protective institutions, including those of a limited state, can generate negative externalities beyond

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the borders of the community. By enriching one community through superior modes of co-operation, successful but exclusive institutions have the side effect of enabling its members to prey on groups with less protective capacities. Because of humanity’s darker tendencies, predation is attractive over and above its material gains. Even if gains from trade outstrip the gains from predation, some may simply prefer conquest. Samuel Johnson (1775, p. 89), noting this link between claims to republican liberty and colonial slavery, asked “how is it that we hear the loudest yelps for liberty among the drivers of negroes?” (cf. Morgan, 2003). A contemporary example is arguably found in features of modern criminal justice systems. The provision of law and order is commonly understood as a core function even of a limited state. Buchanan (2000), while trying to defend limited government, conceptualizes the provision of punishment as a public good problem. Indeed, he suggests that individuals will under-enforce laws unless rules regarding punishment are established at the constitutional level. This conceptualization misses out the possibility, even likelihood, that many people derive pleasure from enforcing laws and inflicting punishment even at a material cost to themselves (Herrmann, Thoni, & Gachter, 2008; Pfattheicher, Keller, & Knezevic, 2017; Rand & Nowak, 2011). The benign function of formal criminal justice institutions may not be to supply justice and security but to prevent spiraling feuds that take place under anarchy. While there is a genuine public good element to criminal justice, recent research suggests that its supply relates only very loosely to the demand for security, whether in terms of public preferences for more law and order, or observable changes in crime victimization. Instead, institutions determine the level of provision (Lacey & Soskice, 2015). For example, D’Amico and Williamson (2015) suggest that the relatively higher supply of criminal justice and punishment in common law countries (especially in the United States) is a result of political actors expanding state capacity in an institutional environment where the private sector is relatively protected from predation and the expansion of public welfare services constrained. On my account, even absent genuine public good problems or rent-seeking opportunities, anti-social political actors may seek out potential reforms that augment their relative status. In providing opportunities for rent seeking and political competition through the provision of welfare services, regimes may reduce demand for expanding the military, prisons, and police sectors of the state. That overinvestment has arguably a much more deleterious impact on the population than less coercive alternatives. Expanding the public supply of education and healthcare may not be ideal, equitable or efficient compared to voluntary alternatives in theory, but they may constitute a useful distraction for political entrepreneurs who are seeking to expand the state’s reach for their own reasons. In so far as the private sector is preserved and the market process only somewhat encumbered by the expansion of the state, this may be a “maximin” regime scenario. It is more robust because the worst-cases that it imposes on the population is still better than those of a regime that is constitutionally limited to the provision of security and thus, in the worst-case scenario, expands to be more militaristic.

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On the cultural and moral side, defenders of a minimal state will often point to the waste and injustice of imposing and enforcing laws that do not pass a costbenefit test, especially if they are based on paternalist justifications. However, if agents are perversely tuistic, then it may be preferable to give policy makers the opportunity to impose some pointless rules in areas that are mostly peripheral to social welfare. At the same time, this gives ample opportunities for other agents to challenge, break, or circumvent rules that satisfy their desire for rebellion and reaction in domains in which their disruption will cause little harm to wider social cooperation. In this sense, one might understand the state’s subsidizing and regulating cultural pursuits, including aspects of the arts and higher education, an area far beyond the domain of a minimal state, to represent relatively benign displacement activity for policy makers and rebellious activists alike. How can this displacement strategy lead to reductions in conflict rather than simply altering the form? In essence, what this strategy aims at is raising the costs of inflicting violence and physical harm on people (such as deprivation of liberty) and lowering the costs of obtaining symbolic sources of superiority and self-satisfaction. People replace direct satisfaction of their sadistic, power seeking, desires with vicarious satisfaction. Because satisfaction of such desires is ultimately subjective and with only a loose relationship with objective states of the world, this sort of substitution is possible. Critical to this strategy is reducing the arbitrariness of state intervention, which helps in three ways. First, the rule of law makes it harder for prideful agents to single out specific individuals for penalties (cf. Johnson & Koyama, 2013). It will encourage them to target behaviors or, better yet, abstract ideas rather than people as such. Second, by maintaining some level of predictability around the legal system, agents targeted by policies can take pre-emptive steps to avoid penalties (which is better, at least, to arbitrary arrest or punishment). Third, while perverse agents may be willing to take greater risks and pay higher costs in pursuit of power or status and to harm their enemies, under a framework of general rules, these agents have to persuade others, with much smaller stakes in the status game, to agree to policies with these perverse outcomes. Although I cannot present empirical evidence for this substitution argument, I can draw on some parallels from the existing literature. Rent seeking is generally conceived as socially damaging. Nevertheless, some public choice scholars have identified second-best cases where rent-seeking behavior has encouraged the production of public goods that would otherwise lack provision (Cowen, Glazer, & McMillan, 1994; Cowen & Lee, 1992). At the regime-level, productivity enhancing rent creation is plausibly essential to providing the political stability necessary for commerce to flourish (North, Wallis, & Weingast, 2009, p. 24). As a result, the extension of trade, and especially openness to global markets, is associated with the evolution of larger states and the expansion of state capacity (Johnson & Koyama, 2017; Rodrik, 1998). Existing accounts argue that states expand to secure public goods, to redistribute gains from growth, insure against economic uncertainty, and to secure the ongoing support of privileged interests (Alesina & Rodrik, 1994; Lindert, 2004; North et al., 2009, p. 141). These explanations draw on material incentives. My account differs only in suggesting

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an additional explanation based on the need to satisfy tuistic, non-material preferences. The growth of a complex state with impersonal governance helps blunt the activities of anti-social agents as well as purely self-interested agents.

OBJECTIONS There are a number of objections to this argument. The first is that it lacks the parsimony of the standard RPE approach. One of the attractive features of RPE is that it can explain a great deal of collective action problems and variation in welfare outcomes purely on the basis of institutions’ comparative capacities to cope with limited altruism and limited knowledge. There is no need to posit particularly bad agents in order to explain how rational individuals, absent an institutional framework conducive to co-operation, could unintentionally fall into desperate conflict or ruin. By comparison, a focus on outright malice may seem unnecessarily voluminous. In response, I suggest that RPE has already ceded ground to complexity compared with new institutional approaches that emphasize tighter theoretical models. A great deal of variation in welfare outcomes could be explained purely through epistemic challenges or incentive problems in separation and yet RPE is a productive approach partly because it considers them both within the same framework. My approach does not exclude the consideration of these problems but suggests perverse preferences as an additional stress test to apply when considering realistic “worst-case” scenarios. A second objection is that these psychological concerns are irrelevant to evaluating institutions that facilitate economic activity. On this account, political economy concerns itself with co-operation at the scale of an extended order where many social interactions are relatively anonymous, between strangers rather than friends and intimates. It is not possible for tuistic preferences, especially perverse ones, to influence economic processes. Even when they do seem to influence economic decisions, this does not alter the overriding case for market institutions. One could point to the power of competitive markets to blunt and penalize irrational racist preferences as an example of their robustness to my concerns (England & Lewin, 1989; Hutt, 1964). A response to this objection is that RPE is concerned not just with establishing the institutions that facilitate economic co-operation but also the broader constitutional or political framework that allows these institutions to emerge, including the political process. Critically, Kirzner specifies two limits to his analysis of economic co-operation. First, he describes his positive account of the market process as providing evidence for arguments in support of laissez-faire institutions, but not itself constituting such an argument (Kirzner, 1987). Second, he carefully distinguishes his account of the market process, the co-operative interactions that agents engage in within a set of facilitating institutions, and the establishment of a market order, the framework that permits this process to operate (Kirzner, 2000, p. 264). Political economy is concerned with the latter in addition to the former. Some theorists have suggested that socially beneficial institutions of private property and dispute resolution could emerge as a result of political entrepreneurship,

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in a way that parallels the market process within a pre-existing framework (Leeson  & Boettke, 2009). On my account, it is precisely this sort of activity, ­outside of the market process, where tuistic preferences may be more salient. A third objection is that my account overly complicates and confuses a more well-established interpretation of history and theory: liberal capitalist institutions, especially free trade, are responsible for domestic prosperity, orderly civil society, and international peace, and so far as the evidence can suggest, any departure from that increases the risk of social conflict rather than decreases it (de Soysa & Vadlammanati, 2013; McDonald, 2009). My account does not contest the historical record of liberal capitalism, especially since the second half of the twentieth century (cf. McDonald & Sweeney, 2007). What it questions is precisely what the salient features of these institutions are given the association between state capacity, relatively large welfare states, economic performance, and the character of criminal justice systems (D’Amico & Williamson, 2015; Lacey & Soskice, 2015; North et al., 2009; Rodrik, 1998). Growth of government, sometimes considered ancillary or impure aspects of liberal capitalism, may turn out to be critical for political stability (Ioannides, 2000). The Minimal State Symmetry Defense A final objection follows not from challenging these new “worst-case” agents, but by challenging the notion that this is a particular concern for proponents of the minimal state. A minimal state may indeed face almost intractable sources of instability and failure from malicious agents. However, any other regime would face similar or worse problems since they offer more mechanisms through which malicious agents can gain power over others. In a comparative analysis, the minimal state remains preferable on robustness grounds. A response to this criticism can be found by approaching it from the other direction and asking, “why even a minimal state?” D’Amico (2010, 2012) and Leeson (2008, 2014), working within the framework of comparative political economy, have identified anarchy as another possible “regime” type. They propose that anarchy, in some circumstances, is preferable to relevantly comparable forms of statehood. Leeson (2007) points out in one provocative case study that Somalia’s population exhibited welfare gains after its supposed “collapse” into anarchy from what was previously a devastatingly predatory communist dictatorship. On the whole, Somalia under anarchy is far from ideal or even minimally commendable. The patchwork of clans that provide social order means that securing property, and even protecting one’s person, comes at substantial expense. Travel is prohibitive and international trade with people in the territory is difficult and dangerous. A minimal state capable of protecting property and enforcing contracts is almost bound to be a relevant improvement on some of these margins. In addition, anarchy does not deliver an environment conducive to personal liberty. Protective institutions, based as they often are on kin relationships and religious communities, are often strikingly authoritarian and arbitrary. However, if for whatever reason, a limited government is off-the-table in some political circumstances, anarchy is apparently a better situation than some authoritarian states.

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Anarchy is the decentralization of authority away from any state and toward competitive private governing institutions. Critically, this does not lead to the ultimate devolution of responsibility and choice to the individual. The typical individual, faced with a security dilemma, will choose to submit to the prevailing norms of the community associated more closely with the private governance agency, typically the one with which their family is associated. In this sense, anarchy is inimical to personal liberty compared with some relevant state alternatives, including the minimal state (Taylor & Crampton, 2009). This renders anarchy not particularly robust either since the order it permits is not conducive to a competitive market process that facilitates trial and error learning. It also lacks the possibility of comparing alternative norms and lifestyles that one can see under liberal state institutions. The claim that the minimal state is preferable to anarchy, even when focusing on robustness as a condition, amounts to the claim that an efficient provider of peace and security is usually a monopoly or centralized provider (Cowen, 1992). The risks of individual enforcement or exclusively private governance outweigh the costs of minimal statehood. By commending the minimal state, Pennington implicitly accepts that it is preferable to anarchy. The case for the robustness of a more than minimal state is a relatively minor extrapolation of this account. It may be that it is more efficient and less coercive to provide security to the community indirectly through some tax-financed distribution of private goods; in other words to provide publicly some nutrition, shelter, education, and healthcare. This formalized redistribution of resources reduces incentives to engage in criminal predation. Moreover, the existence of a pool of taxed resources formally dedicated to welfare provision provides a defined sector in which anti-social individuals can engage in rent seeking and predation through the political process. This can distract anti-social agents from more costly forms of predation, especially regulation and intervention in the productive sectors of the economy. This is preferable either to outright conflict over resources under anarchy or rent seeking through a political process that is dedicated to police, criminal justice, and the military where the externalities of overinvestment are likely to be much higher. The strength of this argument is that it engages more directly with the problems of self-delusion and aggrandizement of people who seek to establish and fulfill public roles. On this account, we need to provide an institutional framework not just in order to seek resolution and compromise but to provide contained arenas of conflict through which people can satisfy their status-seeking desires within the constraints of the rule of law. In this sense, a more complex regulatory state with various welfare functions (albeit one that maintains generality in application of rules) may prove more robust than a minimal state.

CONCLUSION I have proposed that RPE should include actively anti-social agents as a stress test for institutions. These concerns lie outside the traditional parameters of RPE

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analysis, the premise that agents that are merely self-interested and ignorant. However, it does not fall outside the parameters of what I have argued elsewhere to be the ontological basis for RPE: subjectivism, methodological individualism, and analytical egalitarianism (N. Cowen, 2017). Accepting these concerns means accepting that institutions premised on the robustness of RPE as previously conceptualized have a somewhat restricted domain. This is a domain of strategic action where agents have preferences which, although not given and complete, have some level of individual independence and coherence (Kirzner, 1976, p. 64). Such domains plausibly include the relatively anonymous and impersonal interactions in large-scale market and bureaucratic settings. However, such settings do not exhaust relevant sites of human interaction in civil society and especially not the political process. It is even possible that increasingly personalized forums provided by social media may generate more places where this non-strategic, anti-social conduct is more easily prompted. Although my argument is aimed centrally at the RPE defense of a minimal state and its potential failure, there are implications for wider liberal political thought. There is a sometimes vain hope among liberals of all stripes that society might secure stable consensual terms of mutually beneficial co-operation in ways that are publicly understood and thus accepted as legitimate by all individuals subject to its rule. By contrast, there is a broadly conservative line of thought that tends to see society as too complex and organic for individuals to comprehend. Its legitimacy, as a result, necessarily rests on imagination, a set of false but socially necessary beliefs. On this account, neither a minimal state, nor a more expansive liberal welfare state will exhibit the stability and public legitimacy that its proponents ideally seek. Both will inadequately contain humanity’s tendency toward conflict. Robust institutions may have to deflect and channel these tendencies rather than simply deter them.

ACKNOWLEDGMENTS I am grateful to the two anonymous reviewers, Steve Horwitz, and all participants at the 2017 Wirth Workshop in Austrian Economics at McGill University for helping me strengthen the paper.

NOTE 1.  Curiously, Hobbes-inspired scholarship arguably succumbed to a similar process of spurious formalization that economic theory underwent with the emergence of the neoclassical framework (Boettke, 1997; Machan, 2000). In the latter half of the twentieth century, Hobbes was frequently read alongside models of prisoners’ dilemmas and assurance games (Moehler, 2009; Piirimäe, 2006). While the atomic, deductive aspects of Hobbes’ framework lends itself to game theoretic analysis and to a narrow homo economicus interpretation of human agency (Gaus, 2013), Hobbes’ account contains other dimensions.

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Lacey, N., & Soskice, D. (2015). Crime, punishment and segregation in the United States: The paradox of local democracy. Punishment & Society, 17(4), 454–481. Layman, D. (2016). Robust deliberative democracy. Critical Review, 28(3–4), 494–516. Leeson, P. T. (2007). Better off stateless: Somalia before and after government collapse. Journal of Comparative Economics, 35(4), 689–710. Leeson, P. T. (2008). Do markets need government? In S. F. Copp & N. Barry (Eds.), The legal foundations of free markets (pp. 42–64). London: Institute of Economic Affairs. Leeson, P. T. (2014). Anarchy unbound: Why self-governance works better than you think. Cambridge: Cambridge University Press. Leeson, P. T., & Boettke, P. J. (2009). Two-tiered entrepreneurship and economic development. International Review of Law and Economics, 29(3), 252–259. Leeson, P. T., & Subrick, J. R. (2006). Robust political economy. The Review of Austrian Economics, 19(2–3), 107–111. Levy, D. M. (2002). Robust institutions. The Review of Austrian Economics, 15(2–3), 131–142. Lindert, P. H. (2004). Growing public: Social spending and economic growth since the eighteenth century. Cambridge: Cambridge University Press. Machan, T. (2000). Liberalism and atomistic individualism. In J. Narveson & S. Dimock (Eds.), Liberalism (pp. 79–99). New York: Springer. Retrieved from http://link.springer.com/chapter/ 10.1007/978-94-015-9440-0_5 Mahoney, P. G. (2001). The common law and economic growth: Hayek might be right. The Journal of Legal Studies, 30(2), 503–525. Mandeville, B. (1970). The fable of the bees. Harmondsworth: Penguin Books. Marciano, A. (2009). Buchanan’s catallactic critique of Robbins’ definition of economics. Journal of Economic Methodology, 16(2), 125–138. Martin, A. G. (2014). Where are the big bills? Escaping the endogenizer’s dilemma. The Review of Austrian Economics, 27(1), 81–95. McCloskey, D. N. (2013). A Hayekian/Kirznerian economic history of the modern world. In R. Frantz & R. Leeson (Eds.), Hayek and behavioral economics (pp. 35–69). Basingstoke: Palgrave Macmillan. Retrieved from http://www.palgraveconnect.com/doifinder/10.1057/9781137278159.0007 McDonald, P. J. (2009). The invisible hand of peace: Capitalism, the war machine, and international relations theory. New York, NY: Cambridge University Press. McDonald, P. J., & Sweeney, K. (2007). The Achilles’ heel of liberal IR theory: Globalization and conflict in the pre-world war I era. World Politics, 59(3), 370–403. Meade, J. E. (1972). Theory of public choice: Political applications of economics. The Economic Journal, 82(328), 1423. Meadowcroft, J. (2007a). Altruism, self-interest, and the morality of the private sector: An Austrian approach. Journal of Markets and Morality, 10(2), 357–373. Meadowcroft, J. (Ed.). (2007b). Prohibitions. London: Institute of Economic Affairs. Meadowcroft, J., & Morrow, E. A. (2017). Violence, self-worth, solidarity and stigma: How a dissident, far-right group solves the collective action problem. Political Studies, 65(2), 373–390. Moehler, M. (2009). Why Hobbes’ state of nature is best modeled by an assurance Game. Utilitas, 21(03), 297–326. de Montesquieu, C. L. S. (1777). The complete works of M. De Montesquieu (Vol. 1). London: T. Evans and W. Davis. Morgan, E. S. (2003). American slavery, American freedom: The ordeal of colonial Virginia. New York, NY: W.W. Norton. Musgrave, R. A. (1999). Constraints on political action: Response. In J. M. Buchanan & R. A. Musgrave (Eds.), Public finance and public choice: Two contrasting visions of the state (pp. 129– 138). Cambridge, MA: MIT Press. Narveson, J. (2008). You and the state: A fairly brief introduction to political philosophy. Lanham, MD: Rowman & Littlefield Publishers. North, D. C., Wallis, J. J., & Weingast, B. R. (2009). Violence and social orders: A conceptual framework for interpreting recorded human history. Cambridge: Cambridge University Press. O’Driscoll, G. P., & Rizzo, M. J. (2015). Austrian economics re-examined: The economics of time and ignorance (Expanded ed.). New York, NY: Routledge.

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Ostrom, V. (1993). Epistemic choice and public choice. In C. Rowley, F. Schneider & R. D. Tollison (Eds.), The next twenty-five years of public choice (pp. 163–176). New York, NY: Springer. Pennington, M. (2011). Robust political economy: Classical liberalism and the future of public policy. Cheltenham: Edward Elgar Publishing. Pennington, M. (2015). Constitutional political economy and Austrian economics. In P. J. Boettke & C. J. Coyne (Eds.), The Oxford handbook of Austrian economics (pp. 464–490). Oxford: Oxford University Press. Pennington, M. (2016). Robust political economy revisited: Response to critics. Critical Review, 28(3–4), 517–543. Pfattheicher, S., Keller, J., & Knezevic, G. (2017). Sadism, the intuitive system, and antisocial punishment in the public goods game. Personality and Social Psychology Bulletin, 43(3), 337–346. Piirimäe, P. (2006). The explanation of conflict in Hobbes’s Leviathan. Trames, 10(1), 3–21. Polanyi, K. (2001). The great transformation: The political and economic origins of our time (2nd Beacon Paperback ed.). Boston, MA: Beacon Press. Rand, D. G., & Nowak, M. A. (2011). The evolution of antisocial punishment in optional public goods games. Nature Communications, 2, 434. doi:10.1038/ncomms1442 Rodrik, D. (1998). Why do more open economies have bigger governments? Journal of Political Economy, 106(5), 997–1032. Schumpeter, J. A. (1994). Capitalism, socialism, and democracy. London: Routledge. Sen, A. K. (1977). Rational fools: A critique of the behavioral foundations of economic theory. Philosophy & Public Affairs, 6(4), 317–344. Shand, A. H., & Shackle, G. L. S. (1984). The capitalist alternative: An introduction to Neo-Austrian economics. Brighton: Wheatsheaf Books. Simler, K., & Hanson, R. (2018). The elephant in the brain: Hidden motives in everyday life (1st ed.). New York, NY: Oxford University Press. Smith, A. (1981). An inquiry into the nature and causes of the wealth of nations. Indianapolis, IN: Liberty Classics. Steele, D. R. (1992). From Marx to Mises: Post-capitalist society and the challenge of economic calculation. La Salle, IL: Open Court. Taylor, B., & Crampton, E. (2009). Anarchy, preferences, and robust political economy. Available at SSRN 1340779. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1340779 Weintraub, E. R. (1993). Neoclassical economics. In D. Henderson (Ed.), The concise encyclopedia of economics. Library of Economics and Liberty. Retrieved from http://www.econlib.org/library/ Enc1/NeoclassicalEconomics.html Yandle, B. (1983). Bootleggers and Baptists: The education of a regulatory economist. Regulation, 7(3), 12–16.

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CHAPTER 7 THE ROLE OF CULTURE, INFORMATION, AND EXPECTATIONS IN POLICE SELF-GOVERNANCE Jennifer Dirmeyer and Alexander Cartwright

ABSTRACT Several recent incidents of highly publicized police misconduct in the United States have intensified interest in controlling police behavior. Administrative control of police use of force is difficult because police officers are often the primary and most credible witnesses to police misconduct, effectively giving them enforcement power over rules they are subject to; police cooperation as both rule followers and rule enforcers is necessary for effectively constraining police misconduct. The authors develop a framework for examining how organizational and institutional variables can affect individual decision making. Using this framework, the authors identify three avenues for reducing police misconduct – increasing the information generated by non-police sources, increasing the incentive for officers to cooperate with external enforcement efforts, and changing the expectations of officers regarding the attitudes and behaviors of their peers – and present a case study of Oakland California Police Department to illustrate the implications. Keywords: Police misconduct; internal inforcement; expectations; Blue Wall of Silence; culture; self-governance

Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 113–129 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023009

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1. INTRODUCTION Several recent incidents of highly publicized police misconduct in the United States have intensified public interest in controlling police misconduct, especially the use of unnecessary force.1 However, dissatisfaction with local administrative control of police protection of citizens’ civil rights has been a consistently recurring issue. In 1985, the Supreme Court decision Tennessee v. Gardner found that police use of deadly force is prohibited unless “the suspect poses a significant threat of death or serious injury,” resulting in changes to most local police departments use of force policies (Tennenbaum, 1994, p. 224). In 1995 passage of Title XXI gave the federal government the ability to sue police departments for failing to protect the constitutional rights of its citizens. Since the passage of Title XXI, the federal government has investigated more than 55 police departments, and more than 25 have reached negotiated settlements that involve federal oversight and recommendations that control police violence and abuse of power (Rushin, 2014). Others have looked to organizational characteristics such as policy and strength of administration to explain variance in an important measure of police quality: use of force (Lee & Vaughn, 2010). While there is a debate as to whether more restrictive, prescribed policy or more informed discretion is appropriate for police officer operations (Slothower, Sherman, & Neyround, 2015), research has shown that more restrictive policies have reduced the use of lethal and nonlethal force (Bishopp, Klinger, & Morris, 2014; Nowacki, 2015; White, 2001). Cao and Huang (2000) find requiring officers to file use of force reports for every incident in which force is used significantly reduces citizen civil rights complaints. Further, Alpert and MacDonald (2001) show that the specific method by which use of force reports are filed affects the amount of force reported by police (pp. 403–406). While administrative policy is clearly able to have some impact on police behavior, its effectiveness appears limited. Boettke, Lemke, and Palagashvili (2016) argue that federal intervention in police policies will often result in greater external costs (as described in Buchanan, 1999) since federal policies are influenced by a wider array of interest groups than local policies and the opinion of the majority at the national level is unlikely to match that of an individual locality. One possible reason may be the location in which the officers are assigned. Lee, Vaughn, and Lim (2014) find that neighborhood crime levels have a significant positive effect on the amount of force used in police–citizen interactions. This research is consistent with the previous work that finds a relationship between crime levels and the use of force (Lawton, 2007; Lee, Jang, Yun, Lim, & Tushaus, 2010; Terrill & Reisig, 2003). Phillips and Sobol (2011) argue that high crime areas may affect the way that police officers see themselves and the public (p. 45). Alpert, Dunham, and McDonald (2004) along with Rojek, Alpert, and Smith (2012) show that the way police view themselves, especially in relation to the public, can affect their use of force. Terrill, Paoline, and Manning (2003) also find that officers who see themselves as “enforcers” in the traditional view of police culture, rather than “reciprocators,” are more likely to employ coercive policing techniques (pp. 1012–1013).

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Some researchers have looked to department culture to explain police misconduct. However, McCluskey, Terrill, and Paoline (2005) found that, within a single police department, when situational factors, especially suspect resistance, were taken into account, the aggressiveness of a peer group was not a factor in determining force (pp. 28–29), suggesting that department culture supersedes an individual’s peer group culture. Phillips and Sobol (2011), argue that officers may develop “workgroup rules” that differ from official policy and that these rules may differ across departments, especially with regard to the level of crime in the jurisdiction (pp. 49–50 and 52). Similarly, Kraska (2007) points to the increasing militarization of the police as a potential reason for a shift in department culture toward more use of force. From the depth of the literature above, it is clear that police misconduct is likely affected by a host of different factors. While the individual characteristics of the citizens, the police officers, and the patrol neighborhoods may matter in some circumstances, it is also clear that incentives created by law, policy, and culture could have mitigating impacts. In this chapter, we argue that interjurisdictional competition is necessary but not sufficient to create incentives for quality policing – especially when quality includes excessive use of force. We argue that department culture plays a disproportionately important role in determining police abuse of civil rights, as opposed to other departmental rules, because police peers have access to information about the circumstances under which alleged misconduct of this type takes place, while administrators and external enforcers do not. This asymmetry of information means that administrative enforcement of rules against police abuse depends on the cooperation of police officers, turning police departments into de facto self-governing bodies with regard to police abuse of power. Therefore, policy aimed at limiting police abuse of civil rights must either increase the information that administrators and external law enforces have about police behavior or must encourage a culture of informing within police departments. Using this framework, we identify three avenues for reducing police misconduct – increasing the information generated by non-police sources, increasing the incentive for officers to cooperate with external enforcement efforts, and changing the expectations of officers regarding the attitudes and behaviors of their peers. The remainder of this chapter proceeds as follows: In Section 2 we establish the self-governing elements of police departments. In Sections 3–5 we draw out the major implications of this self-governance in police departments, and in Section 6 we conclude.

2. INTERJURISDICTIONAL COMPETITION AND THE POLICING PROBLEM Interjurisdictional competition has been shown to have positive effects on the quality and efficiency of public services in several different areas. Much empirical research shows that the presence of multiple jurisdictions within close distance to

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one another, especially in a situation such as a metropolitan area where they share an economic center, results in lower taxes (Craw, 2008; Eberts & Gronberg, 1990; Sjoquist, 1982; Zax, 1989). Policing services appear to be an excellent candidate for the dual effects of increased incentives for providing quality service and the learning opportunities that interjurisdictional competition creates. Police officers are the quintessential example of street level bureaucrats – those who interact directly with citizens on behalf of the state. Therefore, controlling police behavior requires aligning the incentives of the police officers with the values and goals of the administration and ultimately the citizenry whom they are charged to serve. Police violation of citizen’s civil rights includes many different specific types of misconduct, including unnecessary use of force, unwarranted search and seizure, racial profiling, extortion, etc. The advantages of police use of force, unwarranted search, etc., often decrease officers’ risk and increase effectiveness in the course of the normal performance of duties. For example, searching a citizen without cause can decrease the risk of being injured on duty. In these cases, since the police officers will not necessarily incorporate the costs to the citizens of unwarranted incursions on civil liberties, police officers may have an incentive to consider as “necessary” pre-emptive tactics at higher levels and with less provocation than the public would prefer. In fact, the empirical literature suggests that police do, in fact, use more invasive tactics in neighborhoods with more violent crime. Alpert et al. (2004) find that officer misconduct increases when suspects appear to have less authority (as measured by age and race) than officers. Lawton (2007) finds that crime causes officers to use more force. Phillips and Sobol (2011) find that officers themselves are more tolerant of use of force in high crime areas. This indicates that both use of force and citizen complaints increase when police perceive a higher advantage to engaging in prohibited behavior. The incentives of police administration, prosecution, and the entire judicial system are also not necessarily aligned with the incentives of officers. Administrators must negotiate with police unions regularly, there is often difficulty keeping police departments adequately staffed for the wages that they are authorized to offer, and a crackdown on police behavior can have a negative impact on police performance.2,3 It is for this reason that interjurisdictional competition is necessary to provide elected officials and police administration with the incentive to regulate police behavior. However, even this incentive is not enough to guarantee the absence of police misconduct. The familiar implications of the Beckerian framework show that in order to reduce police brutality we must either increase the penalty for the behavior or increase the chances of being caught (Becker, 1968).4 However, the actual behaviors that signify misconduct may only be deemed misconduct within a specific context. For example, the use of force is often necessary in the performance of police duties, so it is impossible to designate an act as “misconduct” simply by proving that the behavior occurred. What constitutes “misconduct” is dependent on the situation and the officer’s perception of the situation. Administrative control, therefore, requires rules to be enforced in subjectively defined situations

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where the most frequent and, often, most credible witnesses are also subject to those rules. It is difficult to determine what constitutes legitimate use of force. Since the Supreme Court case Tennessee v. Garner in 1985, most police departments have guidelines for officers to determine how force is appropriate in different situations (Nowacki, 2015, p. 644). For example, police are allowed to use bodily force, for example, grab a suspect, when that suspect is passively refusing to comply with an order, and are only allowed to use deadly force, for example, fire a weapon, when a suspect poses a direct threat of physical violence to the officer or another citizen (Bishopp et al., 2014, p. 729). Other types of force: punching, use of a blunt instrument, discharging a taser, or using pepper spray, are allowed when the situation falls between those two extremes (Bishopp et al., p. 728). The highly context specific definition of misconduct in this situation means that enforcers must have detailed knowledge about the specific circumstances under which the behavior occurred, as well as knowledge about the perspective of the officer in question. The ability for administration or external enforcers to obtain reliable information about this type of misconduct is largely limited to what witnesses, most often police witnesses, are willing and able to provide.5 This information may be gleaned from the report of the officer being accused as well as the reports of witnesses and any external information coming from citizen witnesses and video or audio recording. Outside of the possibility that recording devices are used extensively, this information requirement means that administrators and external law enforcers are often reliant on the testimony of other policy officers to enforce rules against the police officer abuses of civil rights in order to effectively enforce rules. The special nature of police misconduct then implies that effective enforcement of rules against police abuse of civil rights requires, disproportionately to other forms of police misconduct, a willingness of police to self-govern, or enforce the rules on their peers.

3. A CULTURE OF ENFORCEMENT Department culture can be thought of as the prevailing attitudes of police officers concerning specific behaviors including misconduct and informing. Several studies have investigated the “code of silence” (Miller, 2015) or “Blue Wall of Silence” whereby officers are not to cooperate in the punishment of another officer with the threat of retaliation. Because an officer’s peers are likely to be present when an act of brutality transpires, officers give each other license to act unconstrained by mutually agreeing to remain silent regarding acts of brutality; this could be by not being transparent in court, or by modifying (or falsifying) police reports. Surveys about police behavior also indirectly support the code of silence thesis. A national survey of police officers reveals that more than 50% of officers reported that reporting another officer’s misconduct would likely earn them the “cold shoulder” (Weisburd & Greenspan, 2000; Westmarland, 2005). Similarly, more than 50% of police reported that it is commonplace for police

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to turn a blind eye when a peer officer uses excessive force; nearly 60% disagreed with the statement that police officers always report serious criminal violations of authority by peer officers (Weisburd & Greenspan, 2000). Ultimately, a commanding officer will decide whether or not to endorse a code of silence in the men he oversees; empirical evidence also reveals that the attitudes of commanding officers have significant impact officer behavior (Weisburd & Greenspan, 2000). For failing to enforce the code, costs of retaliation may include failure to receive back up, professional sanctions, etc., while the probability of facing retaliation is a function of the number of officers who are willing to participate in retaliation. The “Blue Wall of Silence” can best be understood as creating a high probability that there will be retaliation for informing, significantly decreasing the advantages of informing. An officer who witnesses a fellow officer committing misconduct must decide whether he will cooperate with the administration in the enforcement of the rules. The benefits to informing could include satisfying a public-spirited desire to have a good police department or to protect citizens, a personal desire to avoid future uncomfortable situations, or a desire to avoid potential punishment for not cooperating. However, given the “code of silence” that may exist in a police department, the informer could experience retaliation as a result of his cooperation. Retaliation could manifest itself, for instance, in a failure to receive backup, physical harassment, or even administrative sanctions. Similarly, when an officer has committed misconduct and another officer has decided to cooperate with the administration and become an informer, the remaining officers in the department now have to decide whether to retaliate on the informer. The nested nature of these decisions means that existing department culture will incentivize behavior that reinforces that department culture. If there is a culture against informing, a potential informer has good reason to believe that others will be willing to retaliate. This will reduce the incidence of informing, increasing the amount of misconduct. On the other hand, if there is a strong culture of accountability, a potential informer has little to fear from retaliation. Therefore, we would predict more informing and less misconduct. This suggests that it is possible that there will be more incidents of informing in a police department with little misconduct than in a department with much misconduct. The existence of the feedback loop implies that not only individual behavior but also culture will be “sticky.” This analysis suggests that the possibility of a feedback loop leading to extreme levels of either informers or retaliators in a department. While the feedback loop will tend to make a culture that has developed persist, there is still the question of how a particular culture develops in the first place. It is possible, though not satisfying, to explain culture as a function of preferences. It is also possible to explain it as a function of random initial conditions. If most people in the department believe that the expected costs of informing are higher than the benefits, then there will appear to be a “code of silence” that keeps officers from informing. However, it is also possible that conditions are biased toward a “code of silence.”

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Recall that the expected utility of informing is a function of the value of the benefits and the expected costs of facing retaliation from one’s peers. The benefits of informing are a mostly public good. When an officer informs on another officer for committing misconduct, the department functions better. While the officer will receive some of the benefit, most of the benefit accrues to the citizenry and to other officers who also did not like the behavior. The social benefit is specific to the type of misconduct the officer is informing about. The familiar public goods results state that with a positive cost and absent any subsidy for informing or penalty for failing to inform, the level of informing will be inefficiently low. The cost of informing is the expected costs of facing retaliation, given by the harm created by the retaliation discounted by the probability of facing it. The expected costs of retaliation are a function of the number of potential retaliators in the department, which is determined by the expected utility of retaliating. The decision as to whether or not to participate in retaliation is, similar to the decision to inform, dependent on the difference between the social benefit to retaliating and the expected costs of doing so. The costs, like those of committing any kind of misconduct, are a function of the resources spent on enforcement and the number of potential informers in the police department. The benefit, while also a social benefit, is a fraction of the benefit of a club good rather than a public good as is the case with informing. The result of this analysis is that the number of informers depends on the number of retaliators and vice versa. Furthermore, since the cost to informers is a function of the expected utility of retaliating, the level of informers in the department will depend on the relative abilities of the two groups to solve the collective action problems of incentivizing informing and retaliation. Solving the public goods problem at the department level requires adding a punishment for failing to inform, or significantly reducing the expected costs of informing to below the fraction of the public benefit. This benefit, however, depends on the current level of informers, meaning that it will be most effective when the number of informers is already high, and least effective when the number of informers is low. Consuming the benefits of the wall of silence is non-rivalrous while excluding non-contributors (in this case informers) from the code is relatively low cost. First, it is probably very easy to identify an informant who can be considered a non-member of the club. The small number of police present at any single incident, and formal complaint requirements make maintaining anonymity unlikely. Secondly, most retaliation techniques can be directed so that only the informer internalizes the inconveniences. For example, retaliation often involves neglecting to award the informant with a rightly earned promotion, demoting the retaliator, or providing an inadequate response (either by responding slowly or not at all) when the informant requests back-up or assistance in the field. Also, retaliation has relatively direct low costs for the retaliators. Deciding not to promote a particular officer, responding to his calls more slowly, or giving him the cold shoulder in the office do not require exerting much effort, but they do impose a large cost

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on recipients. Further, the code of silence functions like a network good in that the more people who take part in it, the stronger the good becomes; the more benefit it is able to offer to each member all while the marginal cost of enforcement decrease as club size grows. Hence, the optimal club size, in this case, would be the entire police department. This analysis suggests that police departments will tend toward a culture or permissibility, or the “code of silence,” whereby police officers are unwilling to inform on each other. Attempts to change this culture by creating costs for not informing will have limited effect since those costs also depend on the ability to enforce rules that also require police witnesses. In order to act as an effective motivator, police policies must add a benefit to informing that is not dependent on police witnesses or make the operation of the “code of silence” costlier by making it harder to identify potential informers, require more reporting of routine behavior, etc. The Los Angeles Police Department’s recent policy move to pay whistleblowers for informing on their fellows is such a policy but will only work to the extent that benefits paid are higher than the expected costs of retaliation. Other policies that would improve the anonymity of informers and increase the costs of enforcing the code of silence would include: rotating partners relatively frequently, regular auditing of reports, etc. Lastly, as the behavior of peers is instrumental to decision making and much of the decisions are made without full and complete knowledge of what peers will do, the expectations of peer behavior are just as important to the formation of department culture. We investigate this mechanism below.

4. THE REAL EFFECTS OF EXPECTATIONS Any effort to control the level of misconduct, including the use of force and abuse of civil rights, within a police department must account for the need to rely on the cooperation of police officers themselves. This implies, therefore, that the individual incentive to use excessive force and engage in other types of misconduct is largely dependent on perceptions of department culture. When police officers believe that their view of misconduct is stricter than their fellows, they would expect severe retaliation as a consequence of informing. On the other hand, if police officers expect that their view of misconduct is more lenient than others than they might expect consequences from not informing. Therefore, expectations of a culture of accountability can create a feedback loop decreasing the incentives for brutality while expectations of a code of silence can create a feedback loop leading to greater and greater levels of misconduct and brutality. Furthermore, we have argued that the decision to inform is also dependent on the overall level of informing in the community at the time of the decision. If we assume that the greater the level of informing, the lower the probability of experiencing retaliation, then the level of informing in a community will tend to be self-reinforcing. Higher levels of informers support more cooperative behavior and lower levels of informers support less cooperative behavior.

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This characteristic of cooperative behavior then feeds into the decision to commit an offense, since the expected utility of committing an offense is a function of the expected level of informers in the population as a whole. Since individuals will not know the exact level of misconduct in the population when deciding to cooperate or to commit a primary infraction, they will, instead, estimate the expected level of misconduct when making their decisions. This implies that individual expectations about the level of informers and misconduct can have real effects on the actual levels of informers and misconduct. To see how, assume that all individuals in the population choose to commit an offense whenever the expected utility of the commission is greater than zero, calculated using the expected level of cooperation in the population as a whole. Fig. 1 shows the reaction function relating the individual’s choice to commit an offense, ym, to the expected level of misconduct among the population as a whole. In this instance, we have assumed a standard inverse sigmoid function whereby at low levels of misconduct individuals have more to fear from witnesses cooperating than cooperators have to fear from retaliation while at high levels of misconduct individuals have little to fear from witness cooperation because the threat of retaliation is also high. In this situation, risk-averse individuals choose a level of misconduct that is at or lower than their estimation of the population and higher than their estimation of the level of misconduct at high levels of misconduct. This is consistent with risk-averse utility preferences where individuals would tend to err on the safe side when choosing to cooperate or commit an offense based on their estimate of what the prevailing behavior is.

Fig. 1.  The Impact of Individual Expectations on Group Behavior.

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As is indicated in the figure, there are multiple steady state levels of cooperation. The individual chooses his level of misconduct based on his expectations. If his expectations are not met then he will adjust his level of cooperation. The 45-degree line is the locus of points for which expectations concerning the level of cooperation in the population turn out to be accurate. Any point where the individual choice function crosses the 45-degree line is a potential steady state. In order to see how small differences in expectations can lead to large differences in eventual cooperative outcomes imagine that the initial estimate of misconduct levels was at point M1e yielding a choice to commit misconduct at level m1, a lower level of misconduct than level M1e. However, since all individuals have the same utility function, all individuals actually choose to inform at level m1, and the expected level of misconduct is higher than the actual. Individuals will then adjust their misconduct down in order to accommodate the new information. This process of adjusting downward will continue until they reach the low misconduct steady state where expectations coincide with actual misconduct levels at ML. Similarly, imagine that the initial estimate of misconduct levels is a point M2e, slightly higher than M1e and that this yields a choice to commit misconduct at level m2, higher than point M2e. Again, since all individuals have the same utility function the actual level of misconduct will be higher than expected, leading individuals to increase their misconduct to accommodate the new information. This feedback process will continue until they reach the high misconduct steady state at Mh. In this way, small differences in expectations can lead to large differences in actual rates of misconduct. There are two things affecting the equilibrium level of force; the initial tolerance of force in the department and expectations that officers have about the tolerance of others. A police officer has an initial tolerance for force. That combined with his expectations of others tolerance will determine how much force he uses as a matter of standard operating procedure. The shift factors, those that affect the placement of the reaction function, are the payoffs and punishments for force and the probability of getting caught that is not a function of the attitudes of others. The probability of getting caught that is associated with the attitudes of others moves us along the reaction function. Therefore, it is possible that a general attitude in a police department where officers avoid use of force but expect that others will be liberal in the use of force. This expectation can begin a feedback loop whereby the general attitude matches or goes beyond the initial expectation. It could also be the case that the general willingness to use force is so low that even if the one initially expects there to be frequent use of force, the feedback process will bring the expectations in line with a low willingness to use force. Mutadis mutandis, it is also the case that even with a moderate willingness to use force the expectations can be so high that the feedback process generates a matching high tolerance for force. According to the model above, the effect of expectations on the level of misconduct is positive but driven by the position of the S curve as well as the initial

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expectation. The evidence on police expectations about the conduct of their peers is mixed. There is evidence that police believe that their peers take force seriously. Klokars, Ivkovich, Harver, and Haberfeld (2000, pp. 7–8) surveyed officers in 30 departments and found that attitudes toward excessive force were unfavorable, and that officers would be willing to report other officers for that sort of behavior. However, in reviewing the same evidence Micucci and Gomme (2005) found that the attitudes toward excessive force varied by tenure on the force and that officers believed their peers had higher standards for what constituted excessive force than they did. This variance between individual attitudes and the expected attitude of their peers was greatest in new recruits. This would suggest that police officers, especially new recruits, expect their peers to have a more permissive attitude toward force than they do. According to the model, this gap in expectations could lead to a reticence with regard to cooperation, especially when the gap is matched by a similar gap in the expectation of others’ willingness to cooperate with administration, as it is (Micucci & Gomme, 2005). In fact, the expectations regarding others willingness to cooperate may be more important than the expectation of other officers’ willingness to engage in misconduct. If that expectation of other officers’ willingness to cooperate is low enough, the conditions for a self-enforcing “code of silence” are present. The above analysis suggests that policy aimed at managing the expectations of officers, especially new recruits, concerning the likely behavior and attitudes of their fellows is necessary to creating a culture of accountability and pushing back against the development of a code of silence. Policies that might accomplish this are those that provide a means for new recruits to get a clear and unambiguous statement of officer preferences that align with the goals of the department.6

5. THE IMPORTANCE AND LIMITS OF (EXTERNAL) INFORMATION Given the limited ability of the administration to externally create a culture of accountability within the department, the role of external information sources increases in importance. Recall that the probability of being caught and punished for committing an act of misconduct is a function of the external information generated by departmental expenditures on enforcement resources, and internal information, generated by the willingness of officers to cooperate in the enforcement of rules against their peers. In fact, it is not only these two types of information but also the relationship between them that determines the expected costs of misconduct. Recently, police departments appear to be employing a strategy of reducing misconduct by increasing resources spent on surveillance of police/citizen interactions through the use of dashboard cameras and body cameras. If external information (camera footage) and internal information (officer testimony) act

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independently on the probability of prosecuting wrongdoers then this strategy should be unambiguously effective. However, if the two sources of information are interdependent then the effectiveness of increased expenditures on resources will depend on the willingness of police officers to cooperate. Dashboard cameras and Body-worn cameras have obvious appeal in this area since they provide a video recording of events. Some police departments have policies that help to separate the internal and external influences on body cameras, but other departments do not. Because Body Worn Camera (BWC) technology is new, and newly subsidized by the federal government, BWC use and policies that govern their use are vary greatly among police departments. Several recent studies that point to positive effects of body worn cameras on both the use of force and citizen complaints7 against officers (Ariel, Farrar, & Sutherland, 2014; Katz, Choate, Ready, & Nuno, 2014), the evidence comes from just two police departments over short periods of time.8 The BWC scorecard, produced jointly by 35 academic and policy organizations, reports that half of the 25 cities they investigated do not have a formal BWC policy yet their officers use BWCs. Of those departments which have BWC policies there are at least eight significant margins on which the policies differ: (1) the amount of discretion an officer has over determining when recording, or failing to record, is justified; (2) the extent to which the policy protects citizen privacy; (3) the limits to officers viewing BWC footage before writing a report about an incident; (4) the limits on the department’s retention of the footage; (5) discipline procedures for breaking BWC policy rules; (6) protection of stored footage that might include access logs and audits to protect footage integrity; (7) extent to which those filing complaints against the police are allowed to view all relevant footage to the incident in question; and (8) limits on biometric technologies that can scan stored footage to detect and analyze facial features of those recorded. The success of these technologies will depend on the extent to which the policies minimize the amount that internal information can influence external information recorded by the camera. In terms of the eight policy margins described above, policies should be crafted to maximize policing transparency and the video footage available to citizens. This is true because the police administration as well as the judicial system often act as if they are part of the peer group of the police officers themselves and are reticent to enforce rules against misconduct. If the police administration and the judicial system refuse to view police misconduct as troublesome then the ability of citizens to view the video can greatly increase the expectations of being prosecuted for misconduct. The policies governing video footage usage are therefore very important to this effect. Unfortunately, cities are unlikely to independently make rules prohibiting officers from viewing footage before writing a report. Contradictions and inconsistencies between an officer’s initial report and the scenario as shown on video are very valuable to citizens brining civil suit against police departments for misconduct since they discredit an officer’s honesty and judgment; hence such

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a policy can substantially increase a city’s exposure to civil liabilities resulting from officer misconduct. In fact, on the BWC scorecard not one of the cities are scored to be in compliance with appropriately limiting officer viewing footage before constructing a report; of the three cities in partial compliance, two (Okaland, CA and Blatimore, MD) have been under close supervision by the federal government. Even with more established techniques, such as early warning systems and civilian oversight of complaints against police, the empirical evidence is difficult to decipher. Early warning systems, programs that use data about police performance to identify particular officers that are more likely to have problems using force, vary enormously in the particulars of their implementation, and evidence of their effectiveness is department specific. The problems with empirical tests of civilian oversight programs are even more severe, as the quantitative measures of success such as the number of citizen complaints, or the percentage of sustained complaints could go either direction as citizens’ trust in the oversight agency changes (Prenzler, 2000; Prenzler & Lewis, 2005). Department policy can have a large impact on the interdependence of enforcement resources and police cooperation. Policies that allow police to determine when and where to turn cameras on, or that allow no external review of footage, make the efficacy of these devices almost entirely dependent on police cooperation. In a department with a strong “code of silence,” or a very low I, these policies will in effect render the marginal product of each dollar spent on enforcement negligible. For example, in Oakland California, a city with relatively high reports of police misconduct allegations, the police department purchased lapel cameras in an attempt to reduce misconduct. Though the Oakland Police Department had owned lapel cameras for years, officers infrequently used them. In response, the Chief of police mandated a change in policy such that if a cop was not wearing a camera during an incident that lead to a citizen complaint, whatever the citizen writes in the complaint would be presumed to be true. In other words, the police were presumed guilty until proven innocent when it came to use of force allegations. Since that change in policy the department reported a 40% drop in use of force complaints (Johnson, 2015). Simply increasing the resources spent on enforcing conduct guidelines, in this case by purchasing lapel cameras, did not reduce misconduct. However, once the policy was changed to presume guilt until an officer could prove his innocence, if an officer neglected to wear his camera, citizen allegations regarding excessive force would very likely lead him to be sanctioned since the policy places little weight on officer witnesses, and if an officer was wearing his camera, officer witnesses are constrained in their desire to report a situation significantly different from what the camera footage reveals. It is also the case that too little spent on enforcement can limit the effectiveness of officer cooperation. If an officer cooperates with administration and informs on a fellow officer who has committed an act of misconduct but does not see results because the administration inadequately investigates or sanctions the

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wrongdoer, the informing officer may not get even the small benefit that drove him to inform. This will have a negative impact on I causing the probability of being caught to fall. It is clear that expenditures on external enforcement may be necessary to curb misconduct in police departments, but expenditure alone is not sufficient. The nature of police work and misconduct requires that police are willing to cooperate by internally enforcing the rules against misconduct against their peers. Given that external and internal information are interdependent, a police department attempting to drastically reduce misconduct by increasing expenditures on enforcement should attempt to disentangle the effects of the two sources of information as much as possible. A full investigation of the decision to commit misconduct requires further analysis of the number of officers willing to inform.

6. CONCLUSION The nature of police misconduct makes external monitoring costly and often unfeasible, leaving police officers the most credible witnesses to police misconduct. As a result, police departments are, in many important respects, selfgoverning orders and, therefore, department culture plays a disproportionately important role in determining police abuse of civil rights. The above analysis shows that disciplinary threats alone will not be able to influence police behavior because the cooperation of other police officers is necessary to discover and prove transgressions. Therefore, policy aimed at limiting police abuse of civil rights must either increase the information that administrators and external law enforces have about police behavior or must encourage a culture of informing within police departments.

NOTES 1.  Citizen dissatisfaction with police conduct sparked protests leading to more than $4 million in property damage in 2014 in Ferguson, Missouri. Similar protests in Baltimore, Maryland in 2015 lead to more than $9 million in property damage. 2.  While the causality is not established, Baltimore continues to see increased crime following the Freddy Gray controversy in 2015 (Prudente, 2017). 3.  Even if administrators did not have such a tenuous position, the prosecutors and judges have a similar predicament. All parts of the judicial system rely on the police officers to enforce law and prosecute criminals. 4.  The rational choice model of police behavior that underlies the incentive effects has also been used to predict police behavior outside of the misconduct context. DeAngelo and McCannon (2015) have shown that experience can affect the decision to sanction, Makowsky and Stratmann (2009) have shown that citations increase when budgets are tight, and others have shown that police respond to incentives in all sorts of areas. 5.  Obviously, external enforcers have access to some amount of information that does not originate with police witnesses. Examples include physical evidence, citizen witness

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accounts, and video or audio recordings. As we will expand upon below, to the extent that there is more of this external evidence, the limitations on external enforcement are less severe. 6.  One method of achieving this might be the use of “peer mentors,” as exist in the Charlotte police department. These mentors, chosen by the department, can help new recruits form expectations about the likely behavior of their peers that would be deemed credible, as not coming directly from the administration. 7. While Katz, Choate, Ready, and Nuno (2014) found similar results in a controlled experiment with Phoenix PD, they also found that officers were using the cameras during at most 42% of interactions (p. 1). Police discretion in camera use limits their effectiveness as an oversight mechanism. 8.  In addition to police BWC, the increasing popularity of citizen owned portable cameras, like cell phone cameras, has also placed a new check on police behavior. However, to date there has been no academic study on the impact cell-phone cameras have on police misconduct.

REFERENCES Alpert, G. P., Dunham, R. G., & MacDonald, J. M. (2004). Interactive police–citizen encounters that result in force. Police Quarterly, 7(4), 475–488. Alpert, G. P., & MacDonald, J. M. (2001). Police use of force: An analysis of organizational characteristics. Justice Quarterly, 18(2), 393–409. Ariel, B., Farrar, W. A., & Sutherland, A. (2014). The effect of police body-worn cameras on use of force and citizens’ complaints against the police: A randomized controlled trial. Journal of Quantitative Criminology, 31(3), 1–27. Becker, G. S. (1968). Crime and punishment: An economic approach. Journal of Political Economy, 76(2), 169–217. Bishopp, S. A., Klinger, D. A., Morris, R. G. (2014). An examination of the effect of a policy change on police use of TASERs. Criminal Justice Policy Review, 26(7), 727–746. Boettke, P. J., Lemke, J. S., & Palagashvili, L. (2016). Re-evaluating community policing in a polycentric system. Journal of Institutional Economics, 12(02), 305–325. Buchanan, J., & Tullock, G. (1999). The Calculus of Consent. Indianapolis, IN: Liberty Fund, Inc. Cao, L., & Huang, B. (2000). Determinants of citizen complaints against police abuse of power. Journal of Criminal Justice, 28(3), 203–213. Craw, M. (2008). Taming the local leviathan: Institutional and economic constraints on municipal budgets. Urban Affairs Review, 43(5), 663–690. DeAngelo, G., & McCannon, B. (2015). Public outcry and police behavior. The B.E. Journal of Economic Analysis and Policy, 16(2), 619–645. Eberts, R. W., & Gronberg, T. J. (1990). Structure, conduct, and performance in the local public sector. National Tax Journal, 43(2), 165–173. Henriquez, M. A. (1999). IACP national database project on police use of force. In Use of force by police: Overview of national and local data, NCJ 176330 (pp. 19–24). Washington, D.C.: U.S. Department of Justice, BJS, NIJ. Retrieved from https://www.ncjrs.gov/pdffiles1/nij/ 176330.pdf Holmes, M. D. (2000). Minority threat and police brutality: Determinants of civil rights criminal complaints in US municipalities. Criminology, 38(2), 343–368. Johnson, S. C. (2015) How a dirty police force gets clean. POLITICO. Retrieved from https://www. politico.com/magazine/story/2015/03/oakland-police-reform-115552?paginate=false. Accessed on May 3, 2018. Katz, C. M., Choate, D. E., Ready, J. R., & Nuňo, L. (2014). Evaluating the impact of officer worn body cameras in the Phoenix Police Department. Phoenix, AZ. Center for Violence Prevention & Community Safety, Arizona State University. Retrieved from https://publicservice.asu.edu/ sites/default/files/ppd_spi_feb_20_2015_final.pdf

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Klokars, C. B., Ivkovich, S. K., Harver, W. E., & Haberfeld. M. R. (2000). The measurement of police integrity. Washington, D.C.: US Department of Justice, Office of Justice Programs, National Institute of Justice, Department of Justice, BJS, NIJ. Retrieved from https://www.ncjrs.gov/ pdffiles1/nij/181465.pdf Kraska, P. B. (2007). Militarization and policing—Its relevance to 21st century police. Policing, 1(4), 501–513. Lawton, B. A. (2007). Levels of nonlethal force: An examination of individual, situational, and contextual factors. Journal of Research in Crime and Delinquency, 44, 163–184. Lee, H., Jang, H., Yun, I., Lim, H., & Tushaus, D. W. (2010). An examination of police use of force utilizing police training and neighborhood contextual factors: A multilevel of force utilizing police training and neighborhood contextual factors: A multilevel analysis. Policing: An International Journal of Police Strategies & Management, 33, 681–702. Lee, H., & Vaughn, M. S. (2010). Organizational factors that contribute to police deadly force liability. Journal of Criminal Justice, 38(2), 193–206. Lee, H., Vaughn, M. S., & Lim, H. (2014). The impact of neighborhood crime levels on police use of force: An examination at micro and meso levels. Journal of Criminal Justice, 42(6), 491–499. Makowsky, M. D., & Stratmann, T. (2009). Political economy at any speed: What determines traffic citations. The American Economic Review, 99(1), 509–527. McCluskey, J. D., Terrill, W., & Paoline, E. A. III. (2005). Peer group aggressiveness and the use of coercion in police–suspect encounters. Police Practice and Research, 6(1), 19–37. Micucci, A. J., & Gomme, I. M. (2005). American police and subcultural support for the use of excessive force. Journal of Criminal Justice, 33(5), 487–500. Miller, M. (2015). Police brutality. Yale Law & Policy Review, 17(1), 149–200. Nowacki, J. S. (2015). Organizational-level police discretion an application for police use of lethal force. Crime & Delinquency, 61(5), 643–668. Phillips, S. W., & Sobol, J. J. (2011). Police attitudes about the use of unnecessary force: An ecological examination. Journal of Police and Criminal Psychology, 26(1), 47–57. Prenzler, T. (2000). Civilian oversight of police. British Journal of Criminology, 40(4), 659–674. Prenzler, T., & Lewis, C. (2005). Performance indicators for police oversight agencies. Australian Journal of Public Administration, 64(2), 77–83. Prudente, T. (2017). Baltimore crime up across the board as third quarter closes for 2017. Baltimore Sun Online. Retrieved from http://www.baltimoresun.com/news/maryland/investigations/bs-md-cisun-investigates-crime-data-20170928-story.html Rojek, J., Alpert, G. P., & Smith, H. P. (2012). Examining officer and citizen accounts of police use-offorce incidents. Crime and Delinquency, 582, 301–327 Rushin, S. (2014). Federal enforcement of police reform. Fordham Law Review, 82(6), 3189–3246. Sjoquist, D. L. (1982). The effect of the number of local governments on central city expenditures. National Tax Journal, 35(1), 79–87. Slothower, M., Sherman, L. W., & Neyroud, P. (2015). Tracking quality of police actions in a victim contact program a case study of training, tracking, and feedback (TTF) in evidencebased policing. International Criminal Justice Review, 25(1), 98–116. Tennenbaum, A. (1994). The influence of the garner decision on police use of force. Journal of Criminal Law and Criminology, 85(1), 241–260. Terrill, W., Paoline, E. A., & Manning, P. K. (2003). Police culture and coercion. Criminology, 41(4), 1003–1034. Terrill, W., & Reisig, M. D. (2003). Neighborhood context and police use of force. Journal of Research in Crime and Delinquency, 40, 291–321. Weisburd, D., & Greenspan, R. (2000). Police attitudes toward abuse of authority: Findings from a national study. National Institute of Justice: Research in Brief, NIJ# 181312. Retrieved from https://www.ncjrs.gov/pdffiles1/nij/181312.pdf Westmarland, L. (2005). Police ethics and integrity: Breaking the blue code of silence. Policing and Society, 15, 145–165.

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White, M. D. (2001). Controlling police decisions to use deadly force: Reexamining the importance of administrative policy. Crime & Delinquency, 47(1), 131–151. Zax, J. S. (1989). Is there a leviathan in your neighborhood? The American Economic Review, 79(3), 560–567.

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CHAPTER 8 THE SPONTANEOUS ORDER OF POLITICS David J. Hebert

ABSTRACT Traditional public choice analysis implicitly views political outcomes as the intention of a single-minded person. This view is seriously misguided. Rather than viewing politics as being done by one person or a group of persons acting in concert, this chapter presents an Austrian economist’s thoughts on what an Austrian theory of public choice would look like. Particular attention is paid to the emergent, rather than additive, quality that political outcomes exhibit. Keywords: Austrian economics; spontaneous order theorizing; use of knowledge; public choice; emergence; entanglement; political economy

1. INTRODUCTION This chapter seeks to provide some sketches of viewing political outcomes as having an emergent quality to them and in doing so, pushes back on the idea of the centralized mindset Resnick (1994) that pervades both Austrian and public choice literatures today. The centralized mindset is the idea that observed, macrolevel phenomena are attributable to some order-imposing agent even though in reality, no such agent exists. A hallmark of the Austrian approach to economic science is its emphasis on the emergent quality of observed social phenomena. This emphasis derives from

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Austrian scholars’ recognition that knowledge is always and everywhere divided among participants in society. Indeed, several of what are widely considered to be classic texts in the Austrian body of literature discuss this issue.1 Not all observed phenomena in the world are emergent. That my office exists and has drywall, for example, is not an emergent phenomenon but is the intended result of some planning committee in years past who determined that the office building would be located where it is and would look how it looks. Given the age of the building and its relatively modern interior decor, it is safe to surmise that at some point there was a remodeling effort, but even still, we would not characterize my office as emergent. Other phenomena, however, clearly are emergent. A familiar example can be found in the recognition that Paris gets fed every single day without someone coordinating all the necessary activity to actually accomplish this task (Bastiat, 1848). The difference here is not one of scope. Returning to the example of my office that my office looks old and dated on the outside but modern and trendy on the inside is due to the fact that several individual people caused it to be so. In principle, one person could have decided to build an old looking building with a modern interior, but these decisions were likely made by different people at different times and under different circumstances. The overall style of my office is, essentially, the sum of individual decisions – nothing more, but also nothing less. Instead, the difference between emergent phenomena and directed phenomena lies in whether one person could accurately possess all the relevant knowledge to coordinate the activity necessary to produce the outcome. In the case of constructing the office building, the relevant knowledge is contained within the prices of the building materials, the contractors’ wages, the price of the land, etc. That multiple people were involved in bringing about this final result does not ipso facto make my office an emergent phenomenon. With feeding Paris, however, the relevant knowledge is dispersed across all of Paris (and beyond) and must be discovered through the workings of the price mechanism and the continual adjustments of entrepreneurs. It would be a mistake to view Paris getting fed as merely the sum of the different types of food and drink being brought into the city, for each of those decisions is impacted by the others. To the extent that scholarship in public choice discusses political outcomes as being the result of multiple people instead of one single mind, it is almost universally described in the additive sense. Tax codes are complex because the sum of each individual piece of legislation is large. Loopholes in the tax code are the result of special interest groups lobbying to have them added to a hypothetical draft of the tax code that did not have loopholes. The number of bureaucratic steps necessary to accomplish a given task is large because each step was deliberately put in place. In other words, to the extent that public choice addresses political outcomes as being the result of multiple people, it more closely resembles an accounting exercise – in the sense that scholars merely add the actions of politicians/committees together – rather than an economic exercise, which studies the interactions of the politicians with other politicians and the outside world.

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This chapter seeks to rectify this by discussing what the components of an “Austrian” public choice theory might consist of. Boettke and Leeson (2003) provides an excellent discussion of Austrian economists’ anticipation of many “public choice” insights that would later be articulated, showing that the two fields have more in common than perhaps is recognized at first blush. In providing this contribution, however, the authors fall short of describing what an Austrian public choice theory would consist of. More critically, Holcombe (2015) highlights an important oversight in the Austrian literature: that there currently exists no Austrian theory of public choice, or at the very least, that there exists no self-sustaining literature in Austrian public choice. As he notes, given that George Mason University is the home to the Center for Study of Public Choice as well as having a “concentration of members of the Austrian school,” the lack of a well-developed and understood theory of Austrian public choice could be characterized as odd.2 Today, the scholar whose work most closely resembles a theory of Austrian public choice is Richard Wagner (see, e.g., Eusepi & Wagner, 2017; Wagner, 2007, 2010, 2012b, 2017).To briefly summarize, Wagner’s work explores the fields of public choice and public finance from an individualistic perspective. In his work, there are no median voters nor are there representative agents. Instead, following De Viti De Marco (1936) and especially the work of James Buchanan (1969), his work traces out the individual decisions of individual people within a framework of rules and institutions and explains how these small decisions aggregate up into the observed political outcomes. Traditional analysis misses this important step, instead analyzing the political outcomes as if they were the choices of some entirely fictitious individual. A key insight of Wagner’s is the part-towhole relationship of systems. Within a market system, there is an overarching relationship among all the composite parts of this system which reconciles each with one another: the price system. Within politics, there exists no such system to accomplish this task. Because of this, political outcomes produce parts that are incongruent with one another. This essay will proceed as follows. Section 2 provides a brief summary of prototypical approaches to public choice and Austrian analyses of political outcomes. Section 3 provides some outlines of a theory of political outcomes as an emergent phenomenon. Section 4 applies these insights to the case of tax codes within democratic societies. Section 5 gives concluding remarks.

2. TRADITIONAL APPROACHES Since at least the time of Edgeworth (1897), applying economic insights to the realm of politics has been a version of applied statecraft. In this view, the economist is little more than a social engineer, whose job it is to fix society’s problems through the design of either a policy or regulation. In this framework, scholars view the state and society as analytically separate, with the state appending fixes onto society and the goal being to move society into a more desirable location as in Samuelson (1954, 1955). To illustrate this, Wagner (2012b, pp. 24–25) gives

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the example of a billiards player striking the cue ball to move the object ball. The goal is simple: the object ball is, by some measure, in the wrong place and through skillfully striking the cue ball, the player can move the object ball into a morepreferred location. Scholars in both the Austrian and public choice veins emphasize that, insofar as market failure theory has come to be accepted in the literature, so too should the notion of government failure theory, which would critically examine the outcomes of government policies in the real world. In the romantic version of politics, government is constituted by rulers who are both benevolent and omniscient. The Austrian and public choice traditions recognize that the real world is not constituted in such a way and both seek to explain the real world implications of these limits. To do this, scholars in either tradition will go down one of two paths, either (1) granting the benevolence assumption and focusing on what has come to be known as the knowledge problem (the Austrian approach) or (2) granting the omniscience assumption and focusing on what incentives individual politicians face when making any type of political decision (the public choice approach, Fig. 1).

Fig. 1.

Regardless of which path is chosen, scholars in either tradition presume that the state is a sort of goal-oriented entity which has well-defined goals that are (or at least in principle, could be) specified ex ante and a variety of means through which those goals could be accomplished. Or, to explain this using the billiards balls example, the question becomes one of what factors led to the object ball not moving to the desired location. 2.1. Standard Public Choice Within the standard public choice framework, the scholar will assume away any cognitive difficulties and will focus on the incentives that politicians face.3 In doing so, an optimal policy is initially considered and then deviations from this ideal theory are explained as a result of misaligned incentives. Within this framework, politicians are presumed to be concerned with getting policy right only when doing so results in an increased likelihood of getting (re)elected. If there is a tension between “being right” and “getting (re)elected,” then it is likely that the politician will do that which will lead to them being reelected (Fig. 2).4 Within this framework, cases where the political outcome fails to produce a desired effect are the result of one of two broad categories. In the first scenario,

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Fig. 2.  A Typical Public Choice Account.

perhaps there was no failure at all but instead the political apparatus delivered exactly what it was that voters wanted, as Caplan (2007) and Wittman (1995) both argue, despite their differences in the judgments of the political outcome. Crucial to their debate is the idea of rational ignorance on the part of voters (Tullock, 1967) where the disagreement between them being the (un)biasedness of the median voter with Wittman contending that the median voter is unbiased and Caplan arguing that the median voter is not only biased but biased toward “bad” economic policies. The alternative explanation for undesirable political outcomes within this framework would be that there were significant lobbying efforts by particular special interest groups. Because of their highly organized nature, these groups are able to exert tremendous pressure on politicians to change policies in such a way that was privately beneficial to the group yet costly to the rest of society.5 For example, perhaps the optimal policy for society would be to enact some form of sin tax that would reduce consumption of alcohol and tobacco products. If the tobacco lobby were powerful enough, they might be able to convince politicians to give them some form of an exemption, thereby causing a deviation from the “optimal” tax policy. 2.2. Standard Austrian Approach Should the scholar be more interested in applying Austrian insights to political failure, then they will presume that the incentive problem has been solved and they will instead focus on the lack of economic knowledge. Here, the scholar emphasizes a lack of rational economic calculation within government as well as the lack of profits and losses to provide an objective feedback mechanism. Disappointments in the actual result of a political outcome would be explained in this framework as a result of the hindered price mechanism within particular markets and the subsequent misallocation of resources that results from this hindrance. Fig. 3 provides an illustration of the economist-as-social-engineer mentality. If an undesirable political outcome were to be observed within this framework, there can only be two explanations. Perhaps the social engineer misjudged a situation as problematic and the resulting solution amounted to “fixing something that wasn’t broken.” Or perhaps a problem was correctly identified but the solution that was calculated was, to put it bluntly, wrong. This type of reasoning

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Fig. 3.  A Typical Austrian Account.

can broadly be characterized as the “Austrian approach” to public choice critiques and is articulated well in Mitchell and Simmons (1994), Boettke and Leeson (2014), and later in Holcombe (2015) in that it emphasizes the problem of correctly identifying a genuine market failure and/or correctly identifying the optimal solution. 2.3. Overlap Between the Two Approaches In both cases, assuming only one problem away places a greater evidentiary burden on the scholar. Mises (1922) was so brilliant because he accepted all of the then-socialist theorists’ assumptions about the transformation of socialist man into a beneficent being and the resulting transformation of all of society into a benevolent one and still demonstrated that rational economic calculation could not take place and that the resulting political outcomes would fail. Likewise, Buchanan and Tullock (1962) assumed that rational economic calculation was possible within a democratic process and focused purely on the incentives of the individual politicians and how those would lead to failings of political outcomes. In doing so, while their models still failed to match the real world, granting their opponents as much as possible and still demonstrating a critical error in the analysis made their arguments stronger, not weaker. But notice that in both cases what is being critiqued is some entity known as the state and either the incentives that this entity faces or the epistemic constraints that it faces. While scholars in both traditions make reference to “politicians,” they do so in a way that is synonymous with representative agent models. Take, for example, the archetypal public choice explanation for persistent federal deficits: that each politician has a strong incentive to concentrate spending on their district while dispersing the taxes to finance that spending on other districts. In this model, it makes no difference if there is one politician or 535. They are all the same and so their behavior can be reduced down to the behavior of one individual which can then be analyzed. An Austrian approach to public choice would explain political outcomes not as an intended or unintended outcome, but rather as an emergent outcome (Hebert, 2016; Hebert & Wagner, 2013; Wagner, 2007, 2012b, 2012c). Within this framework, intentionality of the political outcomes plays no role because there is no role for intentionality at this level of theorizing. Consider the point raised about Paris getting fed in Bastiat (1845). Is Paris being fed an intentioned outcome or an unintentional outcome? The answer is neither because market outcomes by their very definition cannot be a goal, but instead are a result. They are, as Ferguson (1782) remarked, “the result of human action, but not the execution of any human design.” Where intentionality does come in is at the individualistic level (Buchanan, 1949). Here, there is no representative agent or social welfare function guiding an entity known as “government” toward some decision, but rather there are

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individual people interacting with one another within a framework of rules out of which the political outcome results. In the framework to follow, political outcomes exhibit a similar emergent quality to market outcomes, but one which has peculiar characteristics. Where markets tend to produce a form of cohesion and congruous decisions across all participants, politics tend to produce incohesion and non-congruous decisions.

3. POLITICS AS AN EMERGENT PHENOMENON Despite noting that Austrian economists tend to slip into the centralized mindset when providing analyses of political outcomes, Austrian economists are the most capable of resolving this issue due to their deep understanding and appreciation for spontaneous order theorizing. This enables them to not only make useful comments within the realm of existing public choice scholarship but to also influence the questions that are asked and the types of methodologies taken in answering them. In doing so, a greater set of questions will be able to be pursued than are currently allowed within the context of the prevailing models. This is not to suggest that the current models of public choice are in some way wrong or incorrect. All models are abstractions from reality that allow the analyst to answer some questions more fully than would otherwise be possible. In granting access to these deeper insights, however, some questions are necessarily precluded from the analysis. An Austrian approach to understanding public choice issues is not a theory that rejects or seeks to otherwise supplant the models that are currently in vogue. A better understanding of what Austrian public choice theory would do compared to the current models is to think of the two approaches as being orthogonal. Or to use a familiar Wagnerian metaphor, they would be akin to the twin parabolas of x2 and −x2 in that they would share a common origin but point in different directions. Austrian public choice theory would make no deference to unanimity at either the pre- or post-constitutional level but would instead begin with the recognition that, as Buchanan so often reminded us, “we have no option but to start from where we are,” (Wagner, 2017). In doing so, it would allow scholars the ability to ask questions such as, “what causes the tax code to grow ever larger each year despite simplifying the tax code being a perennial issue?” or more popularly “why do governments persistently run deficits?” Austrian public choice theory would necessarily be based on three concepts: first, it would begin with the recognition that knowledge is necessarily divided among the various political participants within the political system just as knowledge is divided among the various market participants. In recognizing this, it would then have to describe the aggregation and communication of this divided knowledge within the political process in a way that is similar yet different to how the price mechanism aggregates and communicates relevant knowledge to market participants (Wagner, 2016, pp. 163–173). Second, it would emphasize the role of individual politicians and the patterns of interaction created by the institutional rules of the parliamentary body. These rules often lie beneath the surface of analysis in traditional public choice work and go unexamined (Wagner, 2012b, pp. 99–106).

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Third, it would recognize the emergent quality of public policy in that policy is not something that appears mysteriously but is instead brought about as the result of human action but not of human design. In other words, political activities are organized through a pattern of transactions with no central mind at the helm (Hebert & Wagner, 2013). Because of this, there is a catallactical feature to political outcomes. While this catallaxy differs in its manifestation from the market catallaxy most familiar to Austrian economists, this difference is not the result of an entirely different Economics but is instead the result of the different institutional setting (De Viti De Marco, 1936; Wagner, 2016). There still exists exchange among differing politicians as there is not an infinite pool of resources for political actors to draw upon and these exchanges create, from the bottom-up as it were, the observed political outcomes that are so often the study of conventional public choice analysis. In recognizing this catallactical approach to understanding observed political outcomes, we must emphasize the role of exchange more fully and elucidate what, exactly, it means to exchange within the political realm. Ordinarily, an exchange means a transference of property rights and the creation of mutual benefits. In the political arena, this description must also hold, but manifests itself differently because there are no privately held property rights. As Wagner (2007) points out, governments do not produce goods and services like ordinary market participants do but instead act as a peculiar form of an investment bank which serves to connect some people who have money with other people who wish to have access to that money in order to accomplish some task. So the property rights within a political arena do not refer to rights to any particular good in the sense, but rather to a right to extract resources and/or direct those resources toward specific projects. Podemska-Mikluch and Wagner (2013) describes this as a triadic exchange. In parliamentary assemblies, many such triadic exchanges take place, just as in markets, where many dyadic exchanges take place. In markets, there is an overarching mechanism that reconciles each dyadic exchange with each other dyadic exchange: the price mechanism. This is not to say that there is some Walrasian auctioneer that ensures that some notion of general equilibrium is brought about. Here, I simply mean that the price mechanism imposes some overarching discipline. Each of these exchanges can be viewed as a part of a whole, with each part providing some input into the whole outcome. For example, per Article 1, Section 7 of US Constitution, all tax bills must originate in the House of Representatives. Since its formal inception in 1802, the House Ways and Means Committee has had jurisdiction over all revenue bills created by the House, meaning that any bill pertaining to revenues collected by Congress must pass through this committee. Thus, while the members of this committee do not own any good in their capacity as political actors, they do have jurisdiction over any bill pertaining to revenue collection, which includes any special or specific reductions of taxation. Through similar logic, the various appropriations committees and subcommittees do not own any goods in their capacity as political actors but do have jurisdiction over the specific directions in which spending will occur. To be sure, there are also legislative committees

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on education, health, and urban development, to name but a few, meaning that it is likely that multiple committees will have at least some claim of jurisdiction over any proposed bill. Thus, a person who wishes to sponsor a bill and see it get passed must engage in some form of exchange with multiple persons across multiple committees and garner sufficient support for the bill in order to see it passed (Wagner, 2016). The difference is that this exchange takes place not over goods or even the use-rights of goods but rather over the direction of the flow of goods. With any policy, taxpayers are analogous to investors in the policy’s proposal and the private firm designated to fulfill the policy proposal are analogous to the borrowers. However, unlike in the realm of private investment, there is no guarantee that the investors consent to making the investment, making at least some of them forced investors (Wagner, 2012c). In markets, each dyadic exchange constitutes a part of the whole that is what Austrian economists (in particular) refer to as the market outcome. In politics, each triadic exchange constitutes a part of the whole that could similarly be described as the political outcome. In politics, however, there is no mechanism that reconciles or coordinates the various triadic exchanges with one another. Austrian public choice theory would also recognize this lack of plan coordination/reconciliation within the political arena as opposed to its central place in Austrian market theory. Within market systems, the price mechanism not only serves as a means of matching buyers with sellers but it also serves to reconcile the various and competing plans that members of society have by reflecting the opportunity cost of scarce resources. For example, in the market place, the price mechanism steers people away from using titanium for railroad tracks by reflecting the opportunity cost of the titanium in competing uses such as in airplanes (Heyne, Boettke, & Prychitko, 2010). Within markets, scarcity is omnipresent and an unavoidable fact of life. Within the political arena, however, this is not as clearly the case.6 For example, there is no scarcity over the tax code as in principle there is no limit to what can be included in the tax code. Because of this, various competing uses of the tax code do not need to be reconciled at all. The tax code can be used to raise revenues to finance various operations. It can also be used to curb the behavior of individuals, such as by imposing a sin tax on, for example, the consumption of cigarettes. In the market example, using the titanium as a railroad track as opposed to in an airplane represented an alternative use of the titanium, where using a piece of titanium for one purpose necessarily precludes using it for another purpose. Within an Austrian public choice literature, it is here – where the various triadic exchanges of political actors fail to be reconciled – that we observe political outcomes being met with bewilderment. In the following section, I detail this by describing the US tax code, which currently occupies over 70,000 pages of text.

4. TAX CODE COMPLEXITY Understanding political outcomes as emergent is exhibited by looking at tax codes in democratic settings, as Hebert and Wagner (2013) explores. Within the public

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finance literature, it is often surmised that taxes are analogous to the price that citizens pay for publicly provided goods. Various modes of revealing demand for these public goods have been proposed since Samuelson (1954) famously declared the task as being impossible.7 In principle, there is nothing terribly wrong with viewing taxes this way. Thomas (1933) describes how English town government in the sixteenth century was tasked with removing garbage from yards and streets in response to the failure of private carters to take trash all the way to the dump. Hebert and Wagner (2013) notes that “while the town bureaucracy might perhaps be less efficient technically than private carters, it would also be clear who to blame for mislaid garbage,” thus resembling a solution to the problem of identifying the shirking garbage carters. Other solutions likely existed, though this was the solution selected at the time. However, collecting revenue for publicly provided goods and services is not the only use of taxes and the tax code. Taxes can also be used as a means of social control. For example, suppose that a politician wishes to see less smoking or consuming of alcohol in society. One solution, which was tried in the United States with respect to alcohol and ultimately rejected, is to prohibit such activity. Another is to impose special taxes on either the production or consumption of goods deemed to be sinful. Taxes can also be used, as Pigou (1920) demonstrates, to correct for market failures arising from uninternalized externalities. The classic case of this is pollution, where taxes are used as a means of reducing this socially undesirable by-product of manufacturing. Paul (1997) notes that these various and often contradictory uses of the tax code generate a certain degree of incoherence of the tax code as there ceases to be one, overarching goal that the tax code seeks to accomplish. In markets, that there are various and often contradictory goals does not cause a collapse because the price mechanism serves as a coordinator of these various and often contradictory goals. In politics, however, no such mechanism exists. Using the tax code to curb certain behavior is not an alternative use of the tax code nor does it preclude the use of the tax code for raising revenue. However, it may be the case that using the tax code to curb undesirable behavior may impinge on the ability of the tax code to actually collect revenue. For example, imagine that a tax on tobacco was set so high that the Washington bureaucrat’s dream of a cigarette-less world was achieved. Workers in the tobacco industry would be displaced, resulting in their accepting a job with lower salaries/benefits than their tobacco job, thus reducing their taxable income. In this admittedly hyper-stylized example, the high tax on tobacco would result in less income tax being collected and would therefore impinge on the accomplishment of using the tax code to raise revenue. This outcome is clearly not the intention of either political actor involved in putting these taxes on the books, and yet is the result of their actions. It should also be clear that to treat the tax code as if it were the result of one person’s efforts or imagination is fictitious. No single person wrote the US tax code. Instead, it is the result of various committees and subcommittees writing the parts over which they have jurisdiction and stitching these parts together to

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form a tax proposal. This proposal is essentially an amalgamation of the various goals and aspirations of each individual committee member involved in writing the proposal.

5. CONCLUDING REMARKS There is significant scope for the existence of an Austrian public choice theory. This chapter provides but a brief description of one such avenue for an Austrian exploration into issues in public choice: the emergent quality of political outcomes. There is still much room for development of such a theory that would further differentiate it from the standard approaches that Austrian economists and public choice scholars take in describing political outcomes. The approach advocated here is not merely acknowledging that politicians must face both a knowledge problem and an incentive problem. It is primarily concerned with the flow of knowledge through a political system governed by institutional rules. These rules establish peculiar forms of property rights, wherein these property rights establish an ability to direct resources from one person (the taxpayer) to another (the tax receiver). Accomplishing this task requires that the would-be organizer of such a transfer obtains sufficient support within the parliamentary assembly to pass such legislation decreeing that this transfer is to happen. In doing so, some members of this assembly will oppose the measure, which will necessitate that at least a subset of these members be convinced to support a measure they would otherwise oppose. Just how those deals are made, and the content of those deals, is the result of a pattern of exchanges and is thus catallactic, just as the market is typically described. The difference here is that, within the market, this catallaxy extends not only across various parts but also to the whole through the price mechanism. In politics, while a similar type of mechanism must exist within individual parts of political outcomes, there is no comparable mechanism that extends this catallaxy to the whole of a political outcome. It is this relationship of the parts to the whole, and the failure of the parts to be reconciled in conjunction with the whole, where political processes result in outcomes that would otherwise seem bizarre. This was exemplified by examining the US tax code, which comprised some 70,000 pages containing such loopholes and complications as to spawn an entire industry of tax-preparation experts are certainly not intended outcomes of any individual politician. Yet, because the wants and desires of individual politicians and the parts of the political outcome over which they have influence lack an overarching process of reconciliation leads, perhaps inevitably, to such outcomes. Finally, this approach is not meant to reject or otherwise supplant canonical models of Austrian economics or public choice. Rather, it is meant to provide an examination and explication of another analytic window through which to examine the world. In doing so, new questions can be explored and old questions can be explored in new ways which highlight new issues and new insights.

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ACKNOWLEDGMENTS I wish to thank participants at the 2017 Wirth Conference for their insightful comments and feedback. I would like to give special thanks to Richard Ebeling, Steve Horwitz, Peter Lewin, and Jennifer Dirmeyer for their especially detailed comments, suggestions, and discussion as well as two anonymous referees for their highly valuable and well-taken suggestions. All remaining errors are my own.

NOTES 1.  See, for example, Mises (1922), Hayek (1937, 1945, 1980), and Kirzner (1997) for just a small sampling. 2.  To be sure, Holcombe notes that there are several Austrian scholars who produce work in public choice, this work “tends to use the general Austrian approach to economics to critically examine mainstream ideas in public choice.” 3. This is typically accomplished through the use of a social utility function, which effectively transforms an economic problem into a technical problem as Buchanan (1964, pp. 216–217) describes. 4.  Regardless of whether this is true, within the economics profession this explanation may be desirable even if only because it provides a form of comfort to theorists writing large in the sense that they are not incorrect, but rather the non-economists of the world are behaving in a way that is “wrong.” See Wagner (2012a) and Boettke, Coyne, and Leeson (2014) and their discussions of the economics of economic theory. 5.  Grossman and Helpman (2001) provides an excellent summary of this literature, as does Munger and Mitchell (1991). 6.  Wagner (2016, pp. 163–164) describes how scarcity exists within the parliamentary bazaar if only because, to support a higher appropriation for one enterprise requires supporting lower appropriations for other enterprises, or else either supporting higher taxes to be imposed on some people or supporting increased borrowing.

I do not dispute this type of scarcity. 7. See Hylland and Zuckhauser (1970), Clarke (1971), and Groves (1973) for some of the more famous examples and Mueller (2008) for a more detailed discussion.

REFERENCES Bastiat, F. (1845). Economic sophisms. Irvington-on-Hudson, NY: Foundation for Economic Education. Bastiat, F. (1848). Economic harmonies. Irvington-on-Hudson, NY: Foundation for Economic Education. Boettke, P., Coyne, C., & Leeson, P. (2014). Earw(h)ig: I can’t hear you because your ideas are old. Cambridge Journal of Economics, 38, 531–544. Boettke, P., & Leeson, P. (2003). An Austrian perspective on public choice. In C. Rowley & F. Schneider (Eds.), The encyclopedia of public choice (pp. 27–31). Dordrecht, The Netherlands: Kluwer Academic. Boettke, P., & Leeson, P. (2014). An Austrian perspective on public choice. In C. Rowley & F. Schneider (Eds.), The encyclopedia of public choice (pp. 27–31). Dordrecht, The Netherlands: Kluwer Academic. Buchanan, J. (1949). The pure theory of government finance: A suggested approach. Journal of Political Economy, 57, 495–505. Buchanan, J. (1964). What should economist do? Southern Economic Journal, 30, 213–222. Buchanan, J. (1969). Cost and choice: An inquiry into economic theory. The Collected Works of James M. Buchanan (Vol. 6). Indianapolis, IN: Liberty Fund.

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Buchanan, J., & Tullock, G. (1962). The calculus of consent: Logical foundations of constitutional democracy. The Collected Works of James M. Buchanan (Vol. 3). Indianapolis, IN: Liberty Fund. Caplan, B. (2007). The myth of the rational voter: Why democracies choose bad policies. Princeton, NJ: Princeton University Press. Clarke, E. (1971). Multipart pricing of public goods. Public Choice, 11, 17–33. De Viti De Marco, A. (1936). First principles of public finance. New York, NY: Harcourt Brace. Edgeworth, F. (1897). The pure theory of taxation. In Classics in the theory of public finance (pp. 119–136). London: Macmillan. Eusepi, G., & Wagner, R. E. (2017). Public debt: An illusion of democratic political economy. New Thinking in Political Economy. Cheltenham: Edward Elgar Publishing. Ferguson, A. (1782). An essay on the history of civil society (5th ed.). Indianapolis, IN: Liberty Fund. Grossman, G., & Helpman, E. (2001). Special interest politics. Cambridge, MA: MIT Press. Groves, T. (1973). Incentives in teams. Econometrica, 41, 617–631. Hayek, F. (1937). Economics and knowledge. Economica, 4, 33–54. Hayek, F. (1945). The use of knowledge in society. American Economic Review, 35, 519–530. Hayek, F. (1980). Individualism and economic order. Chicago, IL: The Chicago University Press. Hebert, D. (2016). Micro-level catallactic public finance. Journal of Public Finance and Public Choice, 32(1–3), 123–148. Hebert, D., & Wagner, R. E. (2013). Taxation as a quasi-market process: Explanation, exhortation, and the choice of analytical windows. Journal of Public Finance and Public Choice, 31, 163–177. Heyne, P., Boettke, P., & Prychitko, D. (2010). The economic way of thinking. Upper Saddle River, NJ: Prentice Hall. Holcombe, R. (2015). Public choice and Austrian economics. In C. Coyne & P. Boettke (Ed.), The Oxford handbook of Austrian economics. Oxford: Oxford University Press. Hylland, A., & Zuckhauser, R. (1970). A mechanism for selecting public goods when preferences must be elicited. KSG Discussion Paper, 70D. Kirzner, I. (1997). Entrepreneurial discovery and the competitive market process: An Austrian approach. Journal of Economic Literature, 35, 60–85. Mises, L. (1922). Socialism: An economic and sociological analysis. Indianapolis, IN: Liberty Fund. Mitchell, W., & Simmons, R. (1994). Beyond politics: Markets, welfare and the failure of bureaucracy. Boulder, CO: Westview Press. Mueller, D. (2008). Public choice: An introduction. In C. Rowley & F. Schneider (Eds.), Readings in public choice and constitutional political economy. Dordrecht, The Netherlands: Kluwer Academic Publishers. Munger, M., & Mitchell, W. (1991). Economic models of interest groups: An introductory survey. American Journal of Political Science, 35(2), 512–546. Paul, D. (1997). The sources of tax complexity: How much simplicity can fundamental tax reform achieve? North Carolina Law Review, 76, 151–220. Pigou, A. C. (1932). The economics of welfare (4th ed.). London: Macmillan. Podemska-Mikluch, M., & Wagner, R. E. (2013). Dyads, triads, and the theory of exchange: Between liberty and coercion. Review of Austrian Economics, 26, 171–182. Resnick, M. (1994). Turtles, termites, and traffic jams. Cambridge, MA: MIT Press. Samuelson, P. (1954). A pure theory of public expenditure. Review of Economics and Statistics, 36, 387–389. Samuelson, P. (1955). Diagramatic exposition of a theory of public expenditure. Review of Economics and Statistics, 37, 350–356. Thomas, J. (1933). Town government in the sixteenth century. London: George Allen & Unwin. Tullock, G. (1967). Toward a mathematics of politics. Ann Arbor, MI: University of Michigan Press. Wagner, R. (2007). Fiscal sociology and the theory of public finance: An exploratory essay. Cheltenham: Edward Elgar Publishing. Wagner, R. (2010). Mind, society, and human action: Time and knowledge in a theory of social economy. London: Routledge. Wagner, R. (2012a). The social construction of theoretical landscapes: Some economics of economic theories. The American Journal of Economics and Sociology, 71(5), 1185–1204. Wagner, R. (2012b). Deficits, debt, and democracy: Wrestling with tragedy on the fiscal commons. Cheltenham: Edward Elgar Publishing.

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Wagner, R. (2012c). Democracy and the theory of public finance: A polycentric, invisible-hand framework. Public Finance and Management, 12, 298–315. Wagner, R. (2016). Politics as a peculiar business: Insights from a theory of entangled political economy. Cheltenham: Edward Elgar Publishing. Wagner, R. (2017). James M. Buchanan and liberal political economy: A rational reconstruction. London: Lexington Books. Wittman, D. (1995). The myth of democratic failure: Why political institutions are efficient. Chicago, IL: University of Chicago Press.

CHAPTER 9 PRINCIPLES OF THE AUSTRIAN TRADITION IN THE POLICY CYCLE Rosamaria Bitetti

ABSTRACT This research explores the relevance of the Austrian tradition within the field of public policy studies. Policy studies is a research field about what governments can do. Austrian economics, conversely, mostly highlights the shortfalls of government intervention: as such overlapping seems limited. However, broadly speaking Austrian principles have indirectly influenced two aspects of policy studies: the conceptualization of the policy cycle as an imperfect process driven by actual individuals with limited knowledge and bounded rationality, and the creation of a regulatory framework that forces policy makers to reflect upon unintended consequences, by using evidence and data. This regulatory framework, assessed in this chapter by reading several regulatory guidelines through Austrian lenses, provides a new window of opportunities for Austrian economics to be relevant in the policy process. Austrian economist can be taking part in the regulatory process and also help select regulatory tools and institutional infrastructures that minimize the unintended consequences of government intervention, while contributing to the definition of social problems that enter the policy agenda from an individualistic perspective. Keywords: Austrian economics; methodological individualism; public policy; regulation; impact assessment guidelines; problem definition

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A ROSE BY ANY OTHER NAME… Austrian economists are not among the most quoted influences in public policy studies. Quite the opposite, there is a natural diffidence from both sides. This is not surprising, since the main contribution of Austrian economics to social sciences has been a deep scepticism toward what policy makers can do to solve social problems (Leeson & Boettke, 2002). Policy studies refer to research on how the policy process works and on policy topics with the goal of assessing past, present, and proposed policy settings. It is based on many disciplinary and cross-disciplinary settings, with a wide range of analytical and interpretative methodologies. It is a peculiar field of research because its goal is policy advice, that is, to provide knowledge-informed advice to decision makers; as such it is an effort that involves not only academics but also government officials and practitioners. Mainstream microeconomics is of course one of the most important influences in the field: economists can provide strong technical skills to assess the dimensions of problems and costs of interventions. This set of tools – for example, assessing individual choices and trade-offs, analysis of market and market failures, cost-benefit analysis – still constitute the mainstream approach to public policy analysis. However, there is a growing search for further methodologies and theoretical tools to challenge some unrealistic premises and gather more realistic information about how real actors of the policy system make choices in a dynamic environment (Araral, Fritzen, Howlett, & Ramesh, 2015). This opens a window of opportunity for Austrian economics to contribute to this discipline. While policy studies still refer to what government can do, and Austrian economics mostly highlights the shortfalls of government intervention, I will argue that Austrian-friendly concepts have influenced or are compatible with this discipline, and that there is a window of opportunity for Austrian economics to improve the outcome of the policy process. In order to find compatibilities with the field of policy studies, a strict definition of the Austrian School of Economics, and strong requirements for authors to be considered Austrian card holders, is not helpful. Hayek, and even more so Mises or Menger, will not get a high citation count in this field. But a rose by any other name would smell as sweet, and so core principles of the Austrian tradition have influenced other economic schools and other fields of study. Austrian economics explained the difficult coexistence between a spontaneous order, where institutions arise unintentionally from individual actions, in a trial and error process that gathers dispersed knowledge, vis à vis non-spontaneous solutions, which are characterized by cognitive limitations, when not poorly oriented by bad incentives. Hayek termed cosmos this spontaneous order and taxis the exogenous order, resulting from interventions by organizations (Hayek, 1973). Methodological individualism is the core of this tradition: this means that all social phenomena should be explained as resulting from the actions and beliefs of individuals. Each individual has a limited access to a unique piece of knowledge

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of the world. Exactly because of people’s limited knowledge, norms, rules, and institutions should be discovered in a competitive bottom-up process. Markets, competition, and entrepreneurship are valuable because they gather and create knowledge which builds better solutions. Methodological individualism is not unique to the Austrian school of economics, historically, which arose in the larger milieu of the nineteenth century sociology, which was based on the study of human action, with Weber, Simmel, and Spencer. But while the paradigm of sociology shifted toward holistic approaches, methodological individualism became the main methodology of economics (Boettke & Coyne, 2005). It was however a different brand of methodological individualism, that of neoclassical economics, grounded on hypotheses of substantial rationality and perfect knowledge (Friedman, 1953), which became less and less accepted with time. Therefore, with time this institutional breed of methodological individualism (Agassi, 1975), able to explain institutions arising from limited knowledge, norms, and frictions, came back into mainline economics. And this thanks to thinkers and authors who are not officially Austrian economists, but rather fellow travelers from Austrian-friendly schools. Just to name a few, James Buchanan and the school of public choice; Mancur Olson, Elinor, and Vincent Ostrom with collective action; Vernon Smith and experimental economics; Alchian and Demsetz and property rights economics; and Douglass North and neoinstitutionalist scholars. In the following section I will argue that these broadly speaking Austrian principles have indirectly influenced two aspects of policy studies, i.e. the way we think about the policy process, and the prescriptive theory of better regulation as adopted by most governments. I will argue that while, at the moment, collective concepts distort how public policy problems are discussed in the public arena, this implies further need for Austrian influence – and particularly of methodological individualism – in the early stages of policy initiation. The Austrian tradition greatly contributed to the intellectual battle against central planning by affirming the importance of spontaneous orders and the unintended consequences of political intervention. It was, by contrast, a holistic conception of societal transformation that provided the theoretical basis for utopian and totalitarian projects aimed at regulating every aspect of society in order to improve it. But while the socialist calculation debate and the age of great totalitarian planning might seem distant in time, the debate is still relevant today. Even when it comes to smaller regulatory projects, the lessons from the calculation debate about knowledge and incentive’s limits of taxis still apply. But this doesn’t mean that “let’s avoid regulation” is all Austrian economists can say today. Before the new challenges of hypertrophic regulation, the Austrian tradition can help us understand the proper scope of regulatory intervention: marginal and incremental. And while a few scholars and practitioners in public policy might refer to Hayek in their works, these principles have sunk deeply, albeit not completely, in the discipline and its practice. In the final section, I try to trace an intellectual agenda for current and future Austrian intellectuals to bring our core principles to the heart of policy making.

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SPACES FOR AUSTRIAN ECONOMICS IN POLICY MAKING While the first insight of Austrian economics has been traditionally to define the boundaries of what policy intervention can, or rather, cannot do it can also be helpful in improving the policy cycle. To some extent, Austrian-friendly concepts have already had a role in the development of the discipline. The conceptualization of the policy process has for long suffered from both mistakes deriving from a collectivistic definition of problems and goals, and those deriving from an atomistic and strictly rational definition of actors. Issues about the assumptions of rationality and perfect knowledge distorted for a long time the conceptualization of the policy process, namely the idea that the public decision maker works like an omniscient and unbiased utility maximizer, whose modus operandi can be expressed by five sequential activities: 1. A problem which requires action is identified and goals, values, and objectives related to the problem are classified and organized. 2. All important possible ways of solving the problem or achieving goals and objectives are listed – these are alternative strategies, courses of action, or policies. 3. The important consequences which would follow from each alternative strategy are predicted and the probability of those consequences is estimated. 4. The consequences of each strategy are then compared to the goals and objectives identified above. 5. Finally, a policy or strategy is selected in which consequences most closely match goals and objectives, or the problem is most nearly solved, or most benefit is got from equal cost, or equal benefit at least cost (Carley, 1980, p. 11). This way of conceptualizing the policy process was overcome in public policy literature mostly thanks to Herbert Simon theory of bounded rationality (Simon, 1955). Influenced by Hayek’s theory of dispersed knowledge, Simon highlights the fact that decision makers in public offices face the same cognitive limits as those in any other organization. Policy making can be modeled as a limited way to escape problems with solutions whose availability is restricted by limited information, path dependency in ways of thinking and ideology, as well as time and resources. It is a rather imperfect and multivariate phenomenon rather than an ideal computation of all costs and benefits to find solutions to well-defined, and commonly agreed upon, problems. Aware of the inaccessibility of perfect knowledge about social problems, policy studies became more aware of the fact that policy objectives are achieved through piecemeal measures, rather than major changes. This bounded-rationality, incremental model of policy making has been incorporated in the way policy interventions and regulations are – or at least should be – actually drafted. Another misconception in policy studies was derived from the collectivistic conception of social phenomenon: the use of holistic concepts like “the government,” “the general welfare,” and “national interest” has for a long time carried

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public policy analysis on idealistic grounds. The idea that “states create, organize and regulate societies. States dominate other organizations within a particular territory, they mould the culture and shape the economy” (Przeworski, 1990, p. 47) implies that governments have their own autonomy to implement their own objectives. The fact that this organization has unmatched financial, personnel, and eventually coercive resources would shield it from the pressures arising from society. With the assumption that collective concepts such as the state are all-knowing real actors able to pursue a general interest, which is different from that of the members of the collective, it is necessary to expect from these actors to produce centralized regulations an ability to improve over those dispersedly selected in society. Welfare economics and Public interest theory – which still lie at the core of public policy studies and actions – are based on this assumption. This gave rise to policy instruments based on what Ronald Coase (1988) named “blackboard economics” (p. 19), a system in which all the information and all the incentives needed to produce desirable outcomes are available, and all the teacher (the government) has to do is to draw the solution, and apply the regulation in real life. Of course, these unrealistic premises were not often met. The increasingly prevailing practice of policy evaluation “often found policies not producing their intended outcomes, or worse, creating whole sets of unintended and negative consequences” (Mintrom & Williams, 2015, p. 7). There was increasing demand for a theory that could explain regulatory failures, and Public Choice theory proved to be a useful instrument to overcome the collectivist distortion in the way policy analysts theorized the policy process: Much traditional reasoning has turned on totally unrealistic ideas about the efficiency of government. The student of public choice will not think that government is systematically engaged in maximizing the public interest, but will assume its officials are attempting to maximize their own private interests. (Tullock, Seldon, & Brady, 2002, p. 16)

Public choice allowed for a departure from the “organic State” model of collective action to an individualistic model (Buchanan & Tullock, 1962, pp. 11–15), and while the compatibility of Public choice and Austrian economics has been debated (Boettke & Lopez, 2002; Ikeda, 2003) they share methodological individualism as a common ground, and both played a fundamental role in overcoming the idea of a “benevolent government” which aims at maximizing public welfare. This contributed to the birth of a new trend in policy analysis, which aims at assessing regulatory failures as well as market failures. This awareness has been incorporated into current regulatory practices as well as in literature. The literature on government failures has led to greater interest in government efforts to simulate market processes, or to reform government and contract out aspects of government supply that could be taken up by private firms operating in the competitive marketplace (Osborne & Gaebler, 1993). The importance of moving away from the assumptions about the omniscience and benevolence of policy makers can be traced to the way governments from all around the world have progressively created programs to improve the quality

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of regulation. Principles for better regulation are needed as the international community becomes more aware of the inflation of regulation: [t]he history of regulatory governance is not one of coherent government strategy, but rather of reactions to changing needs and opportunities in different countries, industries, and policy contexts. Following massive growth in the scope and scale of regulatory interventions through most of the twentieth century, shifts in the economic environment began to reveal more clearly the previously hidden costs of out-dated, low quality and constantly expanding regulatory structures. (OECD, 2002, p. 21)

Accordingly, in the last 35 years most countries and international organizations have started to draft a common regulatory agenda, a set of principles which would institutionalize the decision-making process in a systematic and analytical framework. Also, when not explicitly mentioned, the whole purpose of this process is to reduce the unintended consequences of public policies, by better defining the problems, understanding the relevant incentives, and assessing the costs which are both directly administrative and resulting from reduced competition. The cornerstone of this framework is the instrument of impact assessment, an ex ante analysis of potential effects of regulation. It was adopted by regulatory agencies during the late 1970s in the United States, and then in Europe and most developed (and also developing) countries (Luchetta, 2012; OECD, 2015, chaps. 1–2). According to the OECD guidelines, Impact assessment is an information-based analytical approach to assess probable costs, consequences, and side effects of planned policy instruments […] the results are used to improve the quality of policy decisions and policy instruments, such as laws, regulations, investment programmes and public investments. Basically, it is a means to inform government choices: choices about policy instruments, about the design of a specific instrument, or about the need to change or discontinue an existing instrument. (OECD, 2001, p. 10)

Given our methodological premises about knowledge and interest-based limitation of decision makers, it is important not to confuse a prescriptive agenda for better regulation with a description of the policy-making process: impact assessment does not substitute for political decisions and does not overcome knowledge limitations. It rather creates a structured way of thinking about policy intervention. What is relevant to our discussion, is that this structure is quite compatible with Austrian principles under at least three aspects. First, the whole point of impact assessment is indeed to reduce unintended consequences. Second, impact assessment guidelines prescribe the framing of policies around individual incentives, motives, and reactions – a rather important point in light of what we’ll see in the section regarding the definition of social problems. Third, they push regulators to find a balance between taxis and cosmos by forcing them to recognize the costs of using top–down regulations. Of course, not every country formulates guidelines and principles for better regulation in the same way. Some country guidelines highlight competition aspects more than others (e.g., Australia, New Zealand), while some are more interventionist, for example, they require policy makers to consider the no policy option as a benchmark only (Ireland) or to calculate costs of regulations mostly in

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administrative terms – rather than opportunity costs (Germany). Together with a sample of national requirements for impact assessment, I will use OECD’s guidelines as a roadmap to understand the regulatory agenda and its compatibility with Austrian core principles. These guidelines are useful in light of the OECD role as intergovernmental think tank and its concerted way of producing international guidelines, which are drafted by expert but approved by all members: OECD member countries collectively adopted a set of principles for effective regulatory management in 2005, and then updated it frequently. The European Commission Guidelines on Better Regulation, for instance, require that the first question to face before approving a regulation is whether the problem it is meant to solve exists and it is well defined. Better regulation is about regulating only when necessary and in a proportionate manner. High quality policy proposals are built on a clear problem definition and understanding of the underlying factors and behaviours (so-called “problem drivers”). The first step of an IA, therefore, is to (i) verify the existence of a problem and identify who is affected; (ii) estimate the problem’s scale and analyze its underlying causes and consequences; and (iii) identify the EU-dimension and assess the likelihood that the problem will persist. (EU, 2015, p. 19, italics added).

Most impact assessment guidelines warn the regulator that defining a problem without understanding the behaviour adopted by actors will result in a misunderstanding and produce regulations that fail to address it. This provides a good platform for understanding how “blackboard problems” start with individual choices and incentives, and only by understanding those elements correctly can this problem be addressed. Impact assessment guidelines ask regulators to foresee in advance how people will react to a regulation, and whether this can create unintended consequences: Regulation will often cause people to change their behaviour and it is important to try to understand these changes. If regulation results in an increase in the price of a product (for example, by increasing product standards), people will usually respond by buying less of that product and switching instead to other substitute goods. Such substitution activity reduces the costs in utility terms to consumers, at least in the first instance. However, substitution effects may also create unintended problems. For example reducing the risks in one area may create higher risks in another. (OECD, 2008, p. 8)

New Zealand guidelines ask policy makers to identify “who is likely to be affected by the adverse outcome, including how widespread it is likely to be (i.e., how many individuals, groups, firms etc. are affected), what harm or injury is likely to occur, and the magnitude of these impacts” because [v]oluntary arrangements between parties are often the best way to promote the long-term interests of consumers, employees, entrepreneurs, investors, government and wider society. However, there are circumstances when voluntary transacting can fail. Good problem definition requires an understanding of the failures that can arise from voluntary transacting, and self- or co-regulatory initiatives, and government regulatory arrangements. (New Zealand, 2013, pp. 29–30)

Problem definition is thus a useful exercise in methodological individualism, requiring policy makers to focus on individual choices, voluntary transactions, spontaneous arrangements, and institutions as well as the unintended results of policy intervention.

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Indeed, impact assessment guidelines suggest focusing not only on market failures: Identifying one or more significant sources of market failure provides evidence of a potential case for regulation. However, regulation frequently fails to address the identified market failure effectively and efficiently. There is a risk that market failure may be supplanted (or compounded) by regulatory failure. (OECD, 2008, p. 7)

The EU Commission lists this set of regulatory failures as: Inadequately defined property rights/legal framework; Poorly defined targets and objectives; Unintended consequences resulting from public intervention; Regulatory capture of public authorities; Implementation and enforcement failures. (EU, 2009, p. 21)

Impact assessment guidelines thus provide a very good platform to focus on institutional design problems arising in the governmental sphere, an area on which Austrian economics contributed with important insights. A few important features of the impact assessment framework can be read through Austrian lenses as a way to find a balance between taxis and cosmos, since they require the regulator to identify the costs of interfering with spontaneous solutions. The search for efficient regulation should start with the definition of a baseline scenario, that is, the exercise of assessing trends of development of a specific problem without public intervention. If a problem is already finding a spontaneous solution through voluntary agreements and innovation, then the net incremental benefit of the regulation is reduced, and will be less likely to pass a cost-benefit test. Canadian guidelines provide a good example: The baseline situation does not necessarily mean that nothing will happen to the current situation over time if the policy is not implemented. Business will go on as usual and the resources of the economy will be allocated according to the forces of the market within the existing legal and regulatory environment. Over time, there will almost certainly be innovation and technological progress. Some of these changes may improve in the baseline scenario, while others may exacerbate the problem. To the degree possible, the impact of the technological changes that are in the pipeline, but not necessarily in the market, should be incorporated into the baseline scenario. For example, the development of wide-bodied jet aircraft was known for a decade or more before they were introduced. Airport planners were aware at that time that the noise pollution and runway congestion associated with large volumes of travellers would be greatly reduced through the use of these jet aircraft and the new engine technologies. As a consequence, the relocation of airports away from major cities such as Toronto and Montréal was made unnecessary. In the case of Toronto, this element was an important factor in the decision not to relocate the Toronto airport to the Pickering area. (Canada, 2007, p. 8)

From this follows the necessity of always comparing policy options to the baseline scenario, or the “no policy” option, which should always be kept in mind as a benchmark to establish possible improvements. Australian guidelines even describe no-regulation as “the most important regulatory option,” prompting regulators not to treat this option lightly or consider it a token gesture. It is mandatory to give it serious consideration as a way of challenging you to broaden your thinking on the policy options available to you. (Australia, 2014, p. 27)

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Furthermore, in the better regulation framework there has been a constant stress on using not only command and control regulation, but a broader range of regulatory instruments: When regulating, one should consider alternative regulatory options within the regulatory framework, non-regulatory options, and the combination of regulatory and non-regulatory instruments. This is because the recommended regulatory policy has to be proven superior not only to other regulatory options, but also to the non-regulatory alternatives and their combination. (Canada, 2007, p. 8)

In the recommendations, there is a lot of emphasis on alternative regulatory instruments: regulatory tools which allow for less market distortion, or gathering more information from the regulated sectors (OECD, 2002, Annex II). Performance-based regulation, co-regulation, and voluntary standards, for instance, recognize that organizations and actors external to government can have better knowledge, as well as better incentives, to innovate. So rather than dictate a top-down solution, regulators should let it arise from the market. Information requirements and guidelines acknowledge how additional information can help the well-functioning of the market more than strict regulation. According to what the OECD suggests: You may find it wise to move first to a “light handed” approach, such as requiring consumers to be given certain information that does not disrupt market behaviour. You can adopt regulation at a later point, if it is concluded that the “light handed” approach has not been effective enough in dealing with the problem. (OECD, 2008, p. 9)

Economic or market-based instruments also come with the recognition that they allow consumers and businesses to solve policy problems in the least costly manner, and reward the use of innovation and technical change to achieve this aim: these instruments have become mainstream in the field of environmental regulation (Anderson & Shaw, 2000). Of course, none of these instruments is exempt from knowledge limitations, costs, and unintended consequences. However, they are marginally better than old-fashioned regulation, and at least recognize the importance of mimicking, rather than altering, the functioning of the market. An awareness for which, a rare occurrence for this non-academic oriented literature, OECD guidelines directly credit to Friedrich von Hayek (and Milton Friedman) (OECD, 2010, p. 15). The agenda for better regulation is of course a wish list. Yet it is significant that those in charge of designing regulation now wish for things compatible with the Austrian tradition. Shortcomings in the current practice of regulatory impact assessment are well documented in the literature (Hahn & Dudley, 2007), as well as doubts about the effectiveness of this framework to impact the quality of regulation (Hahn & Tetlock, 2008). They are probably inherent in a process by which any decision maker tries to restrain his or her own ability to make decisions, a general critique that can be made to any form of self-restraint rule to those who are in power which is susceptible to being changed, ignored, or overlooked by the same people whom is supposed to constrain (de Jasay, 1985, chap. 4). But while impact assessment might not have the direct effect of constraining bad regulation,

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it might improve the policy cycle in a more indirect way: by structuring a public discussion (albeit imperfect) about problems in regulation, by increasing knowledge about social problems and regulatory instruments, and bridging the gap between regulators and regulated entities. In this way it fosters a better-informed regulatory culture. Hayek’s (1945) knowledge problem does not disappear: the sort of knowledge with which I have been concerned is knowledge of the kind which by its nature cannot enter into statistics and therefore cannot be conveyed to any central authority in statistical form. (p. 251)

No amount of statistical research of economic impact assessment can convey decentralized knowledge, by its very nature diffuse and private, to a regulator any more than it can to a central planner. But conceptualizing the policy cycle as an imperfect process driven by actual individuals with limited knowledge and bounded rationality, and building a framework that forces policy makers to use evidences and data, is still better than grounding regulations on the faith that any policy intervention will provide a positive outcome. Ideas have consequences, and the way we think policy making affects the way policy making is done: for this reason, the impact assessment framework is important for reaffirming constantly that there is a cost of using public intervention, namely that of distorting the market, and that even well-intended regulations can have unintended consequences. It reminds regulators that several instruments can have different marginal costs, and the boundaries between spontaneous and designed solutions, the balance between taxis and cosmos, must be re-thought every time a policy maker is asked to devise a new policy. And this, from a cultural perspective, is not a small win.

THE SOCIAL CONSTRUCTION OF PUBLIC POLICY ISSUES There is yet another angle from which Austrian economics, and especially methodological individualism, can help improve the quality of regulation: by dismantling a series of common conceptual mistakes which fashion wrong definitions of social issues and solutions among the population. Again, insights from the Austrian tradition are important from both an instrumental perspective and a practical one. As for the former, it is relevant to the conceptualization of how social problems enter the policy cycle. The fact that a certain issue may suddenly enter the political agenda has been explained for a long time in holistic and deterministic terms: until the 1980s it was assumed that policy choices were largely dependent on economic conditions and on the achieved level of economic and technological development (Kerr, 1983). Later on, a range of different explanatory approaches recognized the role of ideas, interests, and ideologies as additional influences on the policy process. Before even getting to the point when policy makers decide how to intervene, a problem

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has to enter the policy agenda – which is the set of problems that decision makers think should be addressed. A problem can either be initiated inside the policy arena, or outside, when governments respond to citizens’ requests directly or, more likely, through “policy entrepreneurs,” individuals, or organizations who mobilize resources to activate the policy cycle to solve a problem they consider urgent (Howlett & Ramesh, 1995). This more dynamic and individualized conceptualization of the policy initiation casts new attention to the subjective aspect of the way problems are defined. The assumption underlying this new approach is that any request for the policy makers to solve a problem is a social construct, having (1) a cognitive element, that is, a causal theory about what provoked the problem in the first place; (2) a normative element, that is, a value judgment that the situation is intolerable and needs be modified; and (3) an element of prognosis, meaning that the way we define a problem entails one or more alternative solutions (Kingdon, 1995, pp. 109–110). If policy problems are not automatically determined by external circumstances, but rather through individual and collective elaboration of them, then ideas do actually matters. And here the methodological individualism of the Austrian tradition can play a substantial role: so many policy mistakes could be avoided if problems were not thought through the lenses of collectivistic concepts. According to Mises (1966), From the pluralis logicus (and from the merely ceremonial pluralis majestaticus) we must distinguish the pluralis gloriosus. If a Canadian who never tried skating says, “We are the world’s foremost ice hockey players,” or if an Italian boor proudly contends, “We are the world’s most eminent painters,” nobody is fooled. But with reference to political and economic problems the pluralis gloriosus evolves into the pluralis imperialis and as such plays a significant role in paving the way for the acceptance of doctrines determining international economic policies. (p. 44)

This tendency is strong in public debates about economic policy. The reification of concepts such as “interest rate,” “inflation,” “unemployment rate,” and “spread” presented as things independently existing in society and not merely as measurements of consequences of human choices, reinforce the idea that they could be easily manipulated by the policy maker, with no dynamic consequences for people acting in society. From these interpretations of reality, poorly designed demands are directed to the policy cycle. Policies such as currency depreciation, or deficit spending plans contrived to reduce unemployment, so often advocated, would not make any sense if the public was trained to think in terms of individual actions, choices, and incentives. On the contrary, today social science research but also media and the public discourse are dominated by the use of national aggregates. In overt disagreement with the father of macroeconomics, John Maynard Keynes, Hayek argued that if we try to explain economic phenomena by means of aggregates, we will be unable to understand what happens at the more basic level of individual choices. We won’t be able to understand what happens to individual entrepreneurial plans when one of those aggregates is changed – for instance, when trade flows are altered, which variations can be absorbed and which will be distorted by public intervention and thus generate frictions in the economic cycle (Hayek, 1937).

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Holistic reasoning prevents citizens and decision makers from understanding not only economic phenomena, but also social change: the adoption of collective notions such as “the country,” “the poor,” “the migrants” does not allow us to understand social issues, and thus result in cycles of ineffective policies. A case in point is the abused concept of “national interest” to justify public expenses benefiting only a minority – for example, the tutelage of so-called “national champions,” which disguises the expenditure of public resources to keep alive inefficient businesses under the alleged “protection of the strategic interest of the country.” From an individualistic perspective, it is easy to see how citizens are twice harmed. First as taxpayers, for those firms are rescued by coercively collecting private resources; then as consumers, for this sort of protectionism slows down the allocation of resources towards more productive uses, resulting in worse services and higher prices due to reduced competition. The same line of argument applies to what we may label “showcase projects”, such as sport or cultural events, periodically financed with public funds under the false assumption that they benefit the whole country by providing exposure and enhancing tourism. In most of these cases, the cost of the project will exceed the one planned (Flyvbjerg, Stewart, & Budzier, 2016), and the benefits will be limited. In most cases, it makes no sense to think about benefits of these projects disbursed to all the citizens of a country. Instead, someone will benefit from a World Cup or the Olympics or an Exhibition. But it is a small minority of sellers, builders, and workers employed in the touristic sector. Not all taxpayers will benefit in any way from public policies of this sort, but they will still be called to pay their cost: this process would be much more difficult if, instead of being presented as a project aimed at the national welfare, they were indeed perceived as programs of redistribution from the general taxpayer to a specific sector. There is no need of advanced economics or in-depth research to sustain any of these points. It is rather a matter of thinking about social problems from an individualistic perspective, a skill simple enough to be acquired by the public, and yet still so uncommon.

POLICY PROCESS, AUSTRIAN ECONOMICS, AND THE DIVISION OF INTELLECTUAL LABOR: A BROADER AGENDA The most popular contribution to the history of economic thought by Austrian economists was that of explaining the shortfalls and limitations of government intervention in the economy, effectively proving that any policy intervention acts on the basis of limited knowledge and thus might create unintended consequences. Not surprisingly, most economists involved in the Austrian paradigm are skeptical about policy making. But we live in a world where regulation and policy making do exist, so for this paradigm to keep being relevant it is important to learn answers to current problems, and to participate in a dialogue with people and institutions involved in the process of understanding and producing regulation.

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In this chapter, I have argued that the core principles of Austrian economics, starting from methodological individualism and through indirect influences, have been and can be useful in at least three aspects of policy studies. First, by helping conceptualize the policy cycle in a realistic way, that accounts for limited knowledge and rationality of the actors involved, rather than through holistic concepts and deterministic mechanisms. Second, Austrian economics is compatible with the most widely adopted framework for policy making, namely the Impact Assessment agenda. Albeit an imperfect restraint, this set of tools contributes to the public space by bringing typical issues of Austrian economics into the process of regulation. Third, once we conceptualize policy problems as social constructs arising from society, we have a window of opportunity for ideas to help better shape the way people think about social problems: in this field, methodological individualism becomes not a weird obsession for economists who do not like mathematical functions, but a fundamental tool to avoid mistakes in assessing problems. From this, I can deduce at least three useful ways Austrians, and Austrianfriendly intellectuals, can contribute to better policy making. Providing a more individualistic and realistic conceptualization of the policy process was a necessary step to forge humbler policy making, and envision devices that at least try to constrain poorly written regulation and reduce unintended consequences. This is a job for researchers and academics: keep thinking about policy making in a nonromantic way, developing arguments and tools to find a better balance between spontaneous and non-spontaneous solutions. Another important job is as disseminators: economists, political scientists and philosophers are public intellectuals, with a duty to contribute to the public debate with sound scientific ideas. Probably the most useful piece of advice for communicating economics comes from Frank Knight (1921): if our social science is to yield fruits in an improved quality of human life, it must for the most part be "sold" to the masses first. The necessity of making its literature not merely accurate and convincing, but as nearly “fool-proof ” as possible, is therefore manifest. (p. 18)

Social sciences are a living matter, which can influence the way problems are perceived and constructed in the society: the intellectual battle is thus not confined to papers and academic conferences, but should extend also to newspapers, blogs, and social networks. There is a fundamental role for Austrian-friendly ideas in explaining how collective concepts hamper the understanding of social problems, how they obscure even the most obvious unintended consequences play a fundamental role. It is not just policy makers who decide when to regulate, it is also citizens and organizations who agitate for state intervention. Academic intellectuals talk to an elite of people who can decide what to do, but they should not forget that the same elite must answer to the demand of common citizens, thus influencing political culture is a fundamental step toward improving the policy cycle. Finally, the hardest job is as practitioners, officials, and even regulators. The regulatory agenda adopted by most government provides a useful framework for exploring Austrian topics. The lack of Austrian-friendly economists to

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actually contribute in it might be one of the reasons why the regulatory process does not always follow these premises. Austrian economists of the current generation inherited from this tradition a healthy scepticism or an outright refusal of regulation. And of course it is undeniable that the Austrian tradition lied the underworks for this rejection. However, until we live in a world uniquely based on individual responsibility and voluntary agreements, regulation is there, and needs be constrained or drafted in the best possible way. After all, Austrians believe in the division of labor as a way to set entrepreneurial ability free to develop innovative solutions. There is no reason it shouldn’t apply to intellectual labor as well. The Austrian tradition makes us aware of the limits of central planning and the unintended consequences of distorting spontaneous order. However, it does not prescribe the best way to pursue an intellectual agenda to reduce this distortion. It is up to each intellectual committed to this tradition to find the best way he or she can contribute. Probably the marginal utility of an Austrian-friendly regulator or influencer is as high as that of an academic researcher, even though his space to quote Mises and produce sound academic analyses is minor. For Austrian intellectuals, a more inclusive definition of what Austrian economics is, as well as a more diversified agenda, both in terms of themes and fields of action, will probably allow for an enhancement of individual abilities to contribute to the advance of a free society.

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Ikeda, S. (2003). How compatible are public choice and Austrian political economy? The Review of Austrian Economics, 16(1), 63–75. Kerr, C. (1983). The future of industrial societies: Convergence or continuing diversity? Cambridge, MA: Harvard University Press Kingdon, J. (1995). Agendas, alternatives, and public policies. New York, NY: Harper Collins . Knight, F. H. (1921). Risk, uncertainty and profit. Boston, MA: Houghton Mifflin Company. Leeson, P. T., & Boettke, P. J. (2002). The Austrian school of economics, 1950–2000. In Biddle, J., Davis, J., & Samuels, W. (Eds.), The Blackwell companion to history of economic thought. Oxford: Basil Blackwell Publishers. Luchetta, G. (2012). Impact assessment and the policy cycle in the EU. European Journal of Risk Regulation, 3(4), 561–575. Mintrom, M., & Williams, C. (2015). Public policy debate and the rise of policy analysis. In E. Araral, Jr, S. Fritzen, M. Howlett, M. Ramesh, & X. Wu (Eds.), Routledge handbook of public policy (pp. 3–16). London: Routledge. Mises, L. (1966). Human action (4th rev. ed.). San Francisco, CA: Fox and Wilkes [1949, 1963]. Osborne, D., & Gaebler, T. (1993). Reinventing government: How the entrepreneurial spirit is transforming the public sector. New York, NY: Penguin Books. Przeworski, A. (1990). The State and the Economy under Capitalism. London: Routledge. Simon, H. A., (1955). A behavioral model of rational choice source. The Quarterly Journal of Economics, 69(1), 99–118. Tullock, G., Seldon, A., & Brady, G. L. (2002). Government failure: A primer in public choice. Washington, DC: Cato Institute.

IMPACT ASSESSMENT GUIDELINES AND DOCUMENTS Australia, Department of the Prime Minister and Cabinet. (2014). The Australian Government Guide to Regulation. Retrieved from http://www.cuttingredtape.gov.au Canada, Treasury Board. (2007). Canadian cost-benefit analysis guide. Retrieved from https://www. tbs-sct.gc.ca/rtrap-parfa/analys/analys-eng.pdf European Commission (EU). (2009). Impact assessment guidelines. Retrieved from http://ec.europa. eu/smart-regulation/impact/commission_guidelines/docs/iag_2009_en.pdf European Commission (EU). (2015). Better regulation guidelines. Retrieved from http://ec.europa.eu/ smart-regulation/guidelines/docs/br_toolbox_en.pdf Germany, Federal Government. (2012). Guidelines on the identification and presentation of compliance costs in legislative proposals. Retrieved from https://www.bundesregierung.de/Content/ DE/_Anlagen/Buerokratieabbau/2013-01-02-erfuellungsaufwand.pdf ?__blob=publicationFile Ireland, Department of the Taoiseach. (2009). Revised RIA guidelines – How to conduct a regulatory impact analysis. Retrieved from http://govacc.per.gov.ie/wp-content/uploads/Revised_RIA_ Guidelines_June_2009.pdf Israel, Governance and Social Affairs Department. (2013). Governmental handbook – Regulatory impact assessment. Retrieved from http://www.pmo.gov.il/SiteCollectionDocuments/mimshal/ Regulatory%20Impact%20Assessment.pdf New Zealand, Treasury. (2013). Regulatory impact analysis handbook. Retrieved from https://treasury. govt.nz/publications/guide/regulatory-impact-analysis-handbook OECD. (2001). Improving policy instruments through impact assessment. Sigma Paper: No. 31. Paris, France: OECD Publishing. OECD. (2002). Regulatory policies in OECD countries: From interventionism to regulatory governance. Paris, France: OECD Publishing. OECD. (2008). Introductory handbook for undertaking regulatory impact analysis (RIA). Paris, France: OECD Publishing. OECD. (2010). Regulatory policy and the road to sustainable growth. Paris, France: OECD Publishing. OECD. (2015). Regulatory Policy in Perspective: A Reader’s Companion to the OECD Regulatory Policy Outlook. Paris, France: OECD Publishing.

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CHAPTER 10 THE FALL AND RISE OF INEQUALITY: DISAGGREGATING NARRATIVES Vincent Geloso

ABSTRACT In this chapter, I attempt to extend insights regarding statistical aggregates from scholars, such as Hayek (1931) and Mises (1947), to the topic of inequality. Using the work of Lindert and Williamson (2016), I show that a disaggregation of inequality into some of its many subcomponents alters our reading of its evolution. While I only work with stylized facts from the field of economic history, and the authors argues that the promising implications derived from disaggregation militate in favor of more effort being directed toward decomposing the evolution of inequality. Keywords: Inequality; measurements; aggregation bias; economic history; living standards; welfare economics

In the field of macroeconomics, there is a tradition (not shared widely enough though) of being skeptical of aggregates. Macroaggregates like total output, monetary indicators, and inflation measures may conceal rather than reveal important microfoundations crucial to understanding any event or phenomenon (Hayek, 1931; Mises, 1947).1 This concealment could be the result of mixing too much information into one estimate, or it could also be the result of a design which

Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 161–175 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023012

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may be suited ideally to one very precise question, but which may not be used efficiently for other purposes.2 When this concealment takes place, incomplete or false conclusions may be reached. Measures of inequality are, by definition, aggregates. They encompass countless individual persons or households in order to create an image of the distribution of wages, earnings, compensation, consumption or total income. Contained within these distributions are different forms of inequalities which, when aggregated, are concealed from our sight. The increase in inequality that has taken place in the United States since the 1970s has generated important debates within academic circles. Many scholars have weighed in with their personal qualms regarding measurements of inequality and the interpretation of the movements of these measurements (Atkinson, 2015; Burkhauser, Larrimore, & Simon, 2012; Burkhauser, Feng, Jenkins, & Larrimore, 2012; Chetty et al. 2016; Corak, 2016; Lindert & Williamson, 2016; Piketty & Saez, 2003; Reynolds, 2006, 2012). From these debates, a broad pattern of the evolution from the late nineteenth century to the present day has been agreed upon: from the high points of the nineteenth century, inequality fell steadily up until the 1950s at which time it reached a plateau and only began to increase after 1975. Another point of agreement is that the decline and low-plateau phases, described by Lindert and Williamson (2016, p. 194) as the “Great Leveling,” were largely the result of the rise of redistributive policies. The intuition behind the prudence of using aggregates in macroeconomics has generally centered around business cycle analysis. This intuition has rarely been extended to the subject of income distribution and inequality. This should be remedied. The study of inequality, like that of the business cycle, can be foiled by overreliance on aggregates. In fact, the rise of mechanistic models and interpretations of the impacts of inequality on society (Piketty, 2014; Wilkinson & Pickett, 2011) where inequality measures are taken to represent the same thing regardless of context is reminiscent of macroeconomic models used prior to the econometrics credibility revolution. In this chapter, I disaggregate the macroinequalities into smaller components in order to analyze the evolution of the pattern described above. These smaller components, which I will dub microinequalities, are related to the evolution of the gender and ethnic earnings gaps, regional differences in incomes and prices, and the effects of immigration. In the light of this more focused analysis, I propose a different interpretation of the fall and rise of inequality. Rising wages and earnings for women and black Americans relative to male and white Americans until the early 1970s were heavy contributors to the Great Leveling. (This appears to have reversed at some point between 1970 and 1980, see notably Kopczuk, 2015 for a summary.) Simultaneously, convergence in regional incomes (adjusted for regional prices), resulting in the rise of the Southern states, contributed to the leveling of living standards within the United States. Finally, this was also a period in which immigration was more restrictive which had the effect of limiting increases in inequality.3 All these factors were unrelated to the rise of redistributive policies. As such, I argue that government policies, on net, had a limited influence. On closer inspection it appears that a large part of the

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Great Leveling would have materialized regardless of state intervention (albeit, not its entirety). Since 1970, reversals on the front of the relative economic conditions of blacks have been observed which, in concert with moderate increases in immigration levels and minor divergence in living standards between states, have increased inequality. This post-1970 increase in inequality appears in a dramatically different light since it occurred simultaneously with a significant increase in state intervention.

THE GREAT LEVELING, ITS REVERSAL AND DISAGGREGATION The history of American inequality suggests the colonial era was a low point for economic inequality (Hanson Jones, 1980; Lindert & Williamson, 2016; Main, 1977). However, during the Antebellum era, there was a steady increase in income inequality (Buettinger, 1978; James & Thomas, 2000; Lindert & Williamson, 2016; Steckel & Moehling, 2001). The Civil War leveled off inequality and it either increased modestly, or remained stable through 1910 (Lindert & Williamson, 2016; Steckel & Moehling, 2001; Stelzner, 2015). Afterwards, the Great Leveling described by Lindert and Williamson began. By all accounts, inequality fell dramatically up to the late 1960s (see also Kuznets, 1953; Smiley, 1994). So much so, that the share of total income represented by the top 1% of tax units fell back to the level observed in the 1860s (Stelzner, 2015, p. 896). It was only in the 1970s that inequality began inching back up, and the increase picked up steam in the 1980s to the point that, by 2010, income inequality measures were back to the high level observed at the beginning of the twentieth century. Many scholars are tempted to describe the causes of the evolution in mechanical terms. Piketty (2014) ascribed it to the simple equation that g < r where g represents the growth rate and r the return on capital. This implies that capital-owners constantly obtain returns greater than economic growth and thus a growing share of all incomes. Moreover, in these mechanical narratives, government actions affecting redistribution generally account for the lion’s share of the explanation regarding the evolution of inequality.4 While wars can reorganize the composition of the capital stock in ways that level inequality, scholars like Piketty argue that tax policy is the most efficient channel for permanent reduction of inequality. In general, this mechanical description is the norm with one striking exception within the mainstream, that of Lindert and Williamson (2016). In their work on the economic history of American inequality, they eschew the temptation to ascribe general laws of inequality. Rather, they propose that an understanding of inequality requires a multidimensional cluster of concepts: immigration, relative factor price, discrimination, regulation, international trade, urbanization, labor force participation, skill-biased technological change, market integration, and many others (Geloso, 2016, p. 3). In essence, they lay out all the theoretical tools that may be relevant to the analysis of inequality, and there are many. They argue

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that in a given context, one theoretical tool may not be relevant to explain the evolution, but it may hold relevance in another context. In fact, their latest book is the culmination of a long string of publications on the many facets and intricacies of both the history and economics of inequality. For example, alongside Timothy Hatton and Williamson (2005) considered the role that international migration played in domestic inequality. Later, Williamson (2011) tied the evolution of inequality to deindustrialization and terms of trade during the late nineteenth century. Heavily referencing the work of Kuznets (1955) who emphasized the role of internal population migration and urbanization as forces behind the evolution of inequality, Williamson (2002) also devoted considerable attention to the role played by urbanization and the urban–rural real wage gap. As for Lindert (2004), he devotes two volumes to documenting the many aspects of welfare state policies and their effects. He also documents the role of rent-seeking (along with Kristov, Lindert, & McClleland, 1992) in redistribution processes, as well as demographic changes related to reproductive behavior (Lindert, 1978). In fact, one particularly important article produced by Lindert (alongside Hoffman, Jacks, & Levin, 2002) created group-specific price indices to measure “real” inequalities that account for the role of relative price changes affecting different layers of the income distribution differently. Taken as a whole, each of these works (and the list is not exhaustive) represent microfoundations to the macroeconomic topic of inequality. As such, Lindert and Williamson are using an approach to economic history very similar to that advocated by Ludwig von Mises in Theory and History (1957 [2005]). The core argument of Theory and History is that axiomatic statements can be applied to historical events. The goal of historians and economic historians is to sort out which “theory” applies to a clear event that has already occurred. Two theories can be axiomatically true. However, they can compete to negate each other, one may be minimal or irrelevant in a context, or they may even amplify each other. Each theory has microfoundations (i.e., why some actions were taken instead of other actions) that must be studied to ascertain the relevance of each. To explain which of these two axiomatic statements applies to the event (and in what dosage), one needs data, quantitative and qualitative. In Human Action (1947), Mises applies this logic of decomposition by arguing for the necessity of examination of innate differences (134), differences in effort (134, 158), institutions (158, 287–289, 737–739), and constraints in the immediate environment (158). Implicitly, as soon as one disaggregates to consider each of the microinequalities, one ends up going to microfoundations. As such, Lindert and Williamson end up accidentally following Mises’s footsteps. Each source of inequality is explained by microfoundations that cannot be fully captured in aggregated statistics. By definition, such efforts to avoid mechanistic interpretations of inequality require the use of disaggregation. The implication of the Lindert, Williamson, and Mises approach is that one must constantly look at the subcomponents of inequality, dividing it into its many sources and considering contextual forces in order to form sound interpretations. While one can disagree with some of their interpretations (or policy recommendations), this approach makes it easy to see the salient points of contention.

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THE ROLE OF GEOGRAPHY, RACE, GENDER AND IMMIGRATION TO 1970 To explain the transition from the high plateau of income inequality of the late nineteenth century to the low point of the 1970s, Lindert and Williamson disaggregate their explanations into five broad categories. The first, and most easily explained, relates to the role of redistributive policy. This era was marked by a progressive increase in the size of government (Beito, 1989; Higgs, 1987; Lindert, 2004) which included a wide variety of redistributive or public insurance schemes as well as the introduction of progressive taxation.5 However, some have argued that tax policy may not be as efficient in the reduction of inequality as initially believed (Scheidel, 2017). This should not be surprising, as tax policy, like other policy realms, is prone to rent-seeking (Tullock, 1967). Actors can seek exemptions, special treatments or unfavorable treatments against rivals in ways that benefit them. There is great evidence of this especially in the 1920s (Smiley & Keehn, 1995) as witnessed by the large number of deductions and exemptions that existed. However, since most of our measures of United States inequality from 1917 to today (Piketty & Saez, 2003) emerge from tax records, the measures themselves are sensitive to this problem. This has been explicitly demonstrated by recent research in which corrections are made to adjust for changes in the manner incomes are reported (Armour, Burkhauser, & Larrimore, 2014; Auten & Splinter, 2017; Auten, Splinter, & Nelson, 2016; Bricker, Henriques, Krimmel, & Sabelhaus, 2017; Mechling, Miller, & Konencny, 2017). All these corrections show that the recent trend in inequality has been overestimated. Although evidence is more limited for the pre-1960 era, there is some evidence that the same occurred (Smiley, 1998, 2000). It is also worth downplaying the role that government policies overall may have played, as some of them may have been regressive. For example, tax policy has been shown to have been regressive in the 1930s (Folsom, 2009; Renaghan, 1984), while Katznelson (2005) and Rothstein (2017) showed that numerous government programs explicitly discriminated against blacks who tended to be poor even though their taxes served to finance the policy that benefitted others. The other four channels (geography, gender, race, and immigration) require some explanation. Two of these factors, geography, and race, are intimately related. A significant share of the high level of income inequality in the United States prior to the 1970s emanated from differences between regions of the country. Lindert and Williamson (2016) found that during the colonial era the national-level Gini coefficient was higher than the state-level Gini coefficients because of the large income differences between regions. By the late nineteenth century, this feature was not as pronounced, but there remained substantial regional income differences as can be seen through the coefficient of variation in Fig. 1 at the point associated with 1880. That high-level of regional difference progressively collapsed through the last decades of the nineteenth century and continued falling right through to the 1970s (see notably Michener & McLean, 1999). One important contributing factor for convergence between the different states was the mobility of capital which progressively moved to where the returns

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Fig. 1.  Coefficient of Variation, Average Income per Capita at the State Level, 1880–1975. Sources: Income for 1880 to 1910 are from Klein (2013) while 1929 to 1975 are from FRED (2017).

were greater, exactly as standard growth theory would suggest (Turner, Tamura, & Mulholland, 2013). However, a substantial portion of the convergence resulted from the migration of Southern individuals, especially black Americans, to the North (Boustan, 2016; Wright, 1987, p. 174), which had an important effect on convergence between the North and the South. This migration had the double effect of reducing inequality both between regions and between ethnic groups. Throughout the period, the migration of blacks to the North created a convergence in the earnings of blacks to whites nationwide (although the gap remained constant in the North, it fell dramatically in the South). The estimates conflict (see notably Higgs, 1977 vs Margo, 2016), but the trend is unmistakable: the income gap between whites and blacks fell. Higgs estimated that the per capita income ratio of blacks to whites was slightly below 25% while Margo pointed to a slightly higher proportion closer to 30%. By 1940, Higgs estimated a ratio of 34% while Margo placed it at 38%. By 1970, the proportion made available through census data placed the proportion north of 55%. A gap remained, but it had nonetheless diminished appreciably and it would have acted as a significant force in favor of reducing overall inequality. Simultaneous with the convergence between ethnic groups and regions was the convergence between genders. As was documented by Goldin (1990), the wage gap between men and women shrank progressively from the beginning of the twentieth century up to the 1970s, while the labor force participation rates of all women (married and single) increased dramatically. Among the contributing factors, changes in state policy did have an impact (Oreffice, 2007), but many

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important contributors to the relative improvement of the economic condition of women were mundane: the contraceptive pill (Bailey, 2006), running water (Cardia, 2008), household appliances (Coen-Pirani, León, & Lugauer, 2010), and technological changes affecting the workplace (Phillips, 1982). All these forces would have encouraged the shift from the family economy to the market economy (Rotella, 1980), which, in turn, would have compressed income inequality. The remaining element of importance is that of immigration. By definition, immigration will increase inequality. Unless entrants into a country have an income distribution identical to that of the overall population, immigrants increase inequality by pure mathematical definition. Unskilled immigrants earning low wages swell inequality at the bottom. Allowing only high-skilled immigrants does the same if it swells inequality at the top. In fact, as soon as an immigrant diverges from the median, he is likely to increase inequality. As such, if the immigrant share of the total population increases, then inequality increases as well. Conversely, a reduction in the immigrant share of the population will tend to reduce inequality. This has nothing to do with economics, it is a purely mathematical fact.6 In the late nineteenth century, there were very high levels of immigration relative to the population (Hatton & Williamson, 2005) and this was logically a contributing factor to the high level of inequality (Steckel & Moehling, 2001; see also Card, 2009 for modern day estimates). However, from the early twentieth century up to the 1970s, there were significant restrictions on immigration (relative to the late nineteenth century levels): the immigrant share of the population fell from 13.2% to 4.7% between 1920 and 1970. All by itself that would have been an important contributor to the reduction of inequality in the United States.

THE ROLE OF GEOGRAPHY, IMMIGRATION AND RACE SINCE 1970 Since 1970, gender differences have continued to shrink (Goldin, 2014). This channel has actually acted in favor of minimizing inequality within the country. However, the other channels have reversed themselves and are now contributors to inequality. On regional convergence, Young, Higgins, and Levy (2008) have found no evidence of sigma-convergence (i.e., reduction in the dispersion of levels of income across regions) for 3,000 United States Counties between 1970 and 1998. In fact, they found some evidence suggesting the presence of sigma-divergence between those counties. Other researchers (Ganong & Shoag, 2017) have also found such a reversal in terms of regional integration. Of great importance in the measurement of this regional disintegration (albeit modest) is the role of regional price disparities. There are significant price differences across the United States: prices in New York are 15 percent higher than the national price level while those in South Dakota are 13 percent lower than the national price level (Aten, Figueroa, & Martin, 2013). Thus, there are important adjustments to make for regional prices in order to properly account for “real” differences in incomes. The problem

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Fig. 2.  Coefficient of Variation of Regional Prices in the United States (1880–2012). Sources: Michener and McLean (1999) for the years up to 1980 and Aten and Figueroa (2014) for the estimate in 2012.

is that while regional prices were converging along with incomes prior to 1940 – which amplified the regional convergence forces prior to that point–prices have begun to diverge again since (Fig. 2). This amplifies regional differences and thus contributes to pushing inequality upwards. While this modest regional divergence occurred, there were also modest increases in the size of the immigrant population of the United States. David Card (2009) found that 5% of the increase in inequality in the United States stemmed from an increase in the size of the immigrant labor forces. A similar result has been found in Canada by Moore and Pacey (2003). They found that once immigrants were excluded from censuses between 1981 and 1996, the level of inequality in Canada was lower and it increased at a slower rate. As for inequalities between ethnic groups, the rate of earnings convergence between blacks and whites has slowed down since the 1970s (Margo, 2016). However, the official statistics are misleading on this. Since they are based on surveys including individuals in the workforce or outside institutions, black Americans who are in jail are excluded. Because the number of incarcerated people has been growing (relative to the population), and because they tend to be poorer than those who do not end up in jail, this affects the statistics on earnings through a cream-skimming effect in surveys. The distribution of measured black wages and incomes consists only of those with the top wages and incomes in the black population. When scholars like Pettit (2012), Lyons and Pettit (2011), and Western and Pettit (2005, 2010) attempted to make corrections for this problem, they found that there were signs of reversals in black–white convergence in the

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United States, which indicates that this is acting as a long-term force contributing to increases in inequality.

THE IMPLICATIONS OF DISAGGREGATION Through disaggregation of the underlying components of inequality, we find a wide variety of causes. There are some more that could be discussed,7 but in the case of the United States the few forces discussed here are heavy contributors. Had we not disaggregated, the impact of these forces may have been hidden to the naked eye. However, now that they are seen, they force us to draw implications that would otherwise have been elusive, but which can now be seen plainly. The first implication is that the decrease in inequality from the late nineteenth century to the 1970s is largely the result of non-governmental forces. After all, the migration of blacks from the South to the North can hardly be painted as the intentional result of governmental policy. In fact, most convergence between ethnic groups prior to the 1960s occurred in spite of government action. Not only were the Jim Crow laws in action in order to openly discriminate against black Americans, but the first welfare programs in the United States (those of the New Deal and Fair Deal of the 1930s and 1940s) were created in a deeply discriminatory manner (Katznelson, 2005; Rothstein, 2017). Convergence between regions also resulted from largely non-governmental forces; the migration of capital from the North to the South, as well as better integration of markets which permitted the realization of arbitrage opportunities. As for convergence between men and women, as indicated previously this resulted mostly from mundane forces related to technological changes. Thus, an important share of the Great Leveling must be attributed to non-governmental forces. In fact, these forces could even have been more significant had it not been for governmental policies hindering them, as, for example, in the case of the Jim Crow laws (Halcoussis & Lowenberg, 1998; Roback, 1984, 1986, 1989) and laws concerning the legal and fiscal status of women (McCaffery, 1997). The second implication is that the portion of the decrease that resulted from government action resulted in part from the imposition of immigration restrictions. True, the rise of the welfare state during the Progressive Era would have been a factor, but the importance of this channel should not be oversold. For example, the commonly used Piketty and Saez time series for the share of total income captured by the top 10% shows a reduction in income inequality during the 1930s. This conflicts with other evidence whereby most of the tax changes for the 1930s are found to be fiscally regressive (Folsom, 2009; Renaghan, 1984). Another example is the role of income taxation in discouraging work by women by unevenly favoring single-earner families (McCaffery, 1997). To this we must also add that there was the extension of the income tax to lower and lower levels of income from the 1930s to the 1950s. As such, it is hard to identify the amplitude of the decrease in inequality caused by tax and redistribution policies. The large reduction up to the 1970s would have been influenced by immigration restrictions. While this would have reduced inequality, it is hard to praise such an outcome.

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As indicated above, immigration is bound to increase inequality unless the distribution of immigrants is identical to the distribution of the host population. Since most studies find that (generally) immigration has a positive effect on wages through increased demand effect and greater scope for specialization (Clemens & Hunt, 2017; Ottaviano & Peri, 2012; Peri, 2017), it is doubtful that immigration is harmful to the lower rungs of the income ladder. Inequality thus only increases because we added more rungs at the bottom or at the top. The reduction in inequality up to the 1970s was thus in part a composition effect. And it came with a cost to potential immigrants who were deprived of the opportunity to move to where their incomes could have been greater (Clemens, 2011). Indirectly, this means that restricted immigration implied lower inequality in the United States, but more inequality globally. By opposition, a part of the increase in inequality in the United States since 1970 would have resulted from increased immigration. But this would have been accompanied by a global reduction in inequality. The third implication is that since the 1970s, many of these forces have reversed. In many cases, the reversals were caused by government policies. In the case of the divergence between ethnic groups, the “War on Drugs” is a strong explanatory force. As indicated, when corrections are made to account for the imprisoned population when measuring wages and incomes, we find that there is divergence between blacks and whites in the United States . Given that blacks are predominantly those who end up in jail (relative to their weight in the population) for drug-related offenses, this explains the role that this set of government policies (it would be presumptuous to assert that it the “War on Drugs” is one unified and consistent policy) contributes to the surge in inequality. As for differences between states, housing, and zoning policies that restrict the supply of housing are strong government-produced forces that push up inequality. First of all, the restrictions in supply generally tend to benefit homeowners who already present in the market when the restrictions are implemented. Because the restrictions reduce the elasticity of supply, any increase in demand implies that the value of their property increases more than it otherwise would. This represents equity gains for them which appear in the form of (largely tax-exempt) capital gains when the property is sold. Secondly, since low-income individuals are generally renters, restrictions on supply imply that the cost of housing will go up more for them than for homeowners. This means that their consumption basket is getting more expensive relative to the consumption of homeowners. This pushes up inequality by pushing down the real incomes of individuals on the lower rungs of the income ladder. Thirdly, it limits mobility (Cebula, 2014) by creating a barrier to movement. More importantly, if restrictions on housing supply are applied in high-productivity areas, it limits the ability of individuals in low-productivity areas to earn more by moving to high-productivity areas (Ganong & Shoag, 2017; Hsieh & Moretti, 2015). Basically, these restrictions allow already established individuals to capture the gains of productivity in one area. This explains why some scholars find a large role for housing in the measurement of inequality (Albouy & Zabek, 2016; Rognlie, 2016). In those two cases, the trends in inequality result from government-produced forces.

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The final, and probably most depressing, implication is that the increase in inequality since the 1970s has occurred in spite of a greater scope for government redistribution (Geloso, 2016). Indeed, government spending on education, health care and social welfare (relative to GDP) is up since the 1970s. While it could be that inequality would have been at even higher levels without these interventions, in light of the earlier points, it seems that these efforts at reducing inequality were at odds with other government policies which increased it. This last implication is akin to saying that the left hand is unaware of the actions of the right hand, which leads to contradictory actions. All of these implications are logical derivations from an attempt to disaggregate inequalities as Lindert and Williamson (2016) do. The relative strength of each component would have be carefully assessed and measured to produce a ranking of their relevance. It is telling that, with the recent exception of Lindert and Williamson (2016), no scholar since Simon Kuznets (1953) in the 1950s has attempted to do this disaggregation in order to better interpret the surge in inequality. Many take the aggregate measure that is inequality at face value and provide little interrogation of its subcomponents. Important interpretative nuances go unobserved and, as a result, improper policy responses are proposed. However, by incorporating the Austrian skepticism of aggregates, it becomes possible (though arduous) to discern these nuances. The relative strength and direction of changes in each subcomponent of inequality provides us with the ability to disentangle the many elements of relevance in the inequality debate. More efforts toward disaggregating inequalities according to these forces (and many others also at play) would provide much clarity in the debate over causes, effects, and (especially) responses.

CONCLUSION In this chapter, I surveyed the economic history of inequality in the United States with the intention of highlighting the relevance of incorporating Austrian insights regarding statistical aggregates into the debates over inequality. Largely inspired by Lindert and Williamson (2016), I disaggregated inequality into some of its many components (immigration related, regional, ethnic, gender, etc.) and showed that a different interpretation of the U-curve of United States income inequality can be gleaned. Rather than being a function of government actions, many of the forces that acted to reduce inequality up to the 1970s were more or less mundane and unrelated to government. In fact, some of these forces would have been stronger had it not been for government interference. I have also argued the post-1970 increase in inequality to be in part the result of government policies negating the effects of redistributive policies. By virtue of disaggregation, I painted a different portrait of inequality and its evolution, a portrait which differs from most popular (and, to a lesser extent, scholarly) interpretations of inequality. Obviously, this portrait is not perfect and it relies heavily on a considerable literature from the field of economic

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history. Ideally, one would attempt to provide an empirical decomposition of these forces to assess the past evolution of inequality. While this would imply a tremendous amount of work for the enterprising scholar, the rewards would be equally tremendous as it would provide a wider and deeper perspective on American inequality.

NOTES 1.  Hayek (1931, p. 277) pointed out, in a rebuttal to J. M. Keynes’s A Treatise on Money, that “aggregates conceal the most fundamental mechanisms of change.” While he was referring to macroeconomic debates, his admonishment can be easily extended to inequality. Indeed, the citation need only be modified to say that aggregate measures of inequality conceal the sources of changes and the proper interpretation of these changes. 2.  For example, price indices are well known to be designed to capture the evolution of price levels given a certain consumption basket. This measure may be an efficient deflator for capturing the evolution of living standards. However, it may not – because of the manner in which it is constructed – be adequate for the purposes of measuring inflation in the process of studying the effects of monetary policy. This is why the Federal Reserve uses the Personal Consumption Expenditures deflator as a monetary policy tool instead of the Consumer Price Index. 3. Immigration tightening occurred from the 1910s onwards but the apex of these restrictions was reached in the 1920s. The loosening began in the 1970s. This can be seen by charting the share of the population in the census that reports another country than the United States as birthplace which follows a U-curve from 1910 to 2010. 4.  There are other explanations that are less mechanistic that Piketty’s. For example, Scheidel (2017) argues that increases in inequality generally correlate (he is careful about attribution) with subsequent wars or disasters that will level these inequalities. Nevertheless, this is a mechanistic explanation as well which implies regularities in the form of increases up to a point where shocks brings the level crashing down. Non-mechanistic explanations of inequality need rely only on microeconomic concepts to explain non-random changes. As argued below, the relevance of different microeconomic concepts to particular event will affect the evolution and interpretation of inequality. 5.  Now, I personally disagree with the weight they attribute to state-redistribution in the process, but it would be senseless to assert that state redistribution had no effects. As I have expressed elsewhere (Geloso 2016), I am skeptical of generally attributed to that channel in comparison with the four others. 6.  It is necessary to point out that there is nothing wrong with this form of inequality. First of all, it implies that there is global reduction in inequality since those who move do so because they gain relative to their prior situation. Thus, a migrant from nineteenth century Norway to the United States increased inequality in his new country but since he earned more than if had he remained in Norway, the income distribution encompassing the individuals within Norway and the United States became more equal. Secondly, in such a situation, the wages of everybody who was there prior to the arrival of immigrants could increase in equal proportions–which would normally imply no increase in inequality. However, because the immigrants swell one end of the distribution more than the other, there will appear to be an increase in inequality. 7.  Population aging could be added to this. Research research by Almås and Mogstad (2012) and Almås et al. (2011) confirms that a substantial share of the increase in economic inequality results from population aging which creates a composition bias in the population. See also Schirle (2012) on the case of the United States, which removed one eighth of the increase in inequality through a correction for composition bias resulting from aging.

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Ottaviano, G., & Peri, G. (2012). Rethinking the effect of immigration on wages. Journal of the European Economic Association, 10(1), 152–197. Peri, G. (2017). The impact of immigration on wages of unskilled workers. Cato Journal, 37(3), 449– 460. Pettit, B. (2012). Invisible men: Mass incarceration and the myth of black progress. New York, NY: Russell Sage Foundation. Phillips, P. (1982). Gender-based wage differentials in Pennsylvania and New Jersey manufacturing, 1900–1950. Journal of Economic History, 42(1), 181–186. Piketty, T. (2014). Capital in the twenty-first century. Cambridge, MA: Harvard University Press. Piketty, T., & Saez, E. (2003). Income inequality in the United States, 1913–1998. Quarterly Journal of Economics, 118(1), 1–41. Renaghan, T. (1984). Distributional effects of federal tax policy, 1929–1939. Explorations in Economic History, 21(1), 40–63. Reynolds, A. (2006). Income and wealth. Westport, CT: Greenwood Publishing Group. Reynolds, A. (2012). The misuse of top 1 percent income shares as a measure of inequality. Washington, DC: Cato Institute. Roback, J. (1984). Southern labor law in the Jim Crow era: Exploitative or competitive? University of Chicago Law Review, 51(5), 1161–1192. Roback, J. (1986). The political economy of segregation: The case of segregated streetcars. Journal of Economic History, 46(4), 893–917. Roback, J. (1989). Racism as rent seeking. Economic Inquiry, 27(5), 661–681. Rognlie, M. (2016). Deciphering the fall and rise in the net capital share. Brookings Papers on Economic Activity, 50(1), 1–69. Rotella, E. J. (1980). Women’s labor force participation and the decline of the family economy in the United States. Explorations in Economic History, 17(2), 95–117. Rothstein, R. (2017). The color of law: A forgotten history of how government segregated America. New York City, NY: Live Right. Scheidel, W. (2017). The Great Leveler: Violence and the history of the inequality from the stone age to the twenty-first century. Princeton, NJ: Princeton University Press. Schirle, T. (2012). Age-adjusted measures of earnings inequality in the United States, 1980–2010. Economics Bulletin, 32(3), 2662–2669. Smiley, G. (1994). The American economy in the twentieth century. Cincinnati, OH: South-Western Publishing. Smiley, G. (1998). New estimates of income shares during the 1920s. In J. H. Haynes (Ed.), Calvin Coolidge and the Coolidge era: Essays on the history of the 1920s (pp. 215–232). Washington, DC: Library of Congress. Smiley, G. (2000). A note on new estimates of the distribution of income in the 1920s. The Journal of Economic History, 60(4), 1120–1128. Smiley, G., & Keehn, R. H. (1995). Federal personal income tax policy in the 1920s. The Journal of Economic History, 55(2), 285–303. Steckel, R. H., & Moehling, C. M. (2001). Rising inequality: Trends in the distribution of wealth in industrializing New England. Journal of Economic History, 61(1), 160–183. Stelzner, M. (2015). Income inequality in the United States in the late 1860s. Journal of Economic History, 75(3), 889–900. Tullock, G. (1967). The welfare costs of tariffs, monopolies, and theft. Western Economic Journal, 5(3), 224–232. Turner, C., Tamura, R., & Mulholland, S. E. (2013). How important are human capital, physical capital and total factor productivity for determining state economic growth in the United States, 1840–2000? Journal of Economic Growth, 18(4), 319–371. Western, B., & Pettit, B. (2005). Black–White wage inequality, employment rates, and incarceration 1. American Journal of Sociology, 111(2), 553–578. Western, B., & Pettit, B. (2010). Incarceration & social inequality. Daedalus, 139(3), 8–19. Wilkinson, R. G., & Pickett, K. (2011). The spirit level. Old Saybrook, CT: Tantor Media. Williamson, J. (2002). Coping with city growth during the British industrial revolution. Cambridge: Cambridge University Press. Williamson, J. (2011). Trade and poverty: When the third world fell behind. Cambridge, MA: MIT Press. Wright, G. (1987). The economic revolution in the American South. Journal of Economic Perspectives, 1(1), 161–178.

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CHAPTER 11 THE CHALLENGES FACING EVIDENCE-BASED POLICY MAKING IN CANADIAN AGRICULTURE Predrag Rajsic and Glenn Fox

ABSTRACT Several governments in Canada have made commitments to adopting evidence-based policy development. Several obstacles to the adoption of this approach have been identified in the policy literature. However, this literature has lacked an economic perspective. This is unfortunate, since economics has produced the most fully developed normative theory of government policy in the social sciences and humanities. The main elements of this theory are the theory of market failure and the theory of non-market failure, and the integration of those two elements in what Charles Wolf called implementation analysis. The Austrian economics tradition also offers the implications of what is often called Hayek’s knowledge problem and the lessons learned from the economic calculation debate as contributions to the understanding of the challenges facing the application of evidence-based policy. The authors propose adding four economic elements to the current model of evidence-based policy development: (1) providing sufficient and convincing evidence that a market failure has occurred; (2) providing sufficient and convincing evidence that a non-market failure is unlikely to occur or if it does occur the damages from the non-market failure will be less serious than the harm resulting

Austrian Economics: The Next Generation Advances in Austrian Economics, Volume 23, 177–195 Copyright © 2019 by Emerald Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134 /doi:10.1108/S1529-213420180000023014

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from the market failure; (3) an appreciation of the distributed and conflicted character of social knowledge; and (4) the technical challenges involved in constructing a social preference order. The authors illustrate the application of the economic approach to evidence-based policy with an example from rural land use policy in Ontario. Keywords: Evidence-based policy; rural land use policy; market failure; non-market failure; economic calculation; knowledge problem

INTRODUCTION Evidence-based policy is a paradigm for government policy making that is attracting support in many OECD countries. In the United Kingdom, this approach has been advocated by the Centre for Evidence and Policy; in the United States, leadership has been provided by the Coalition for evidence-based policy; and in Canada that cause has been taken up by Policy Horizons Canada (formerly the Policy Research Initiative). The origins of the evidence-based policy approach can be traced to educational and public health policy contexts. More recently, the approach has been promoted in other fields. While the official regulatory narrative seems to imply that both the definition and the application of evidence-based policy making are settled issues, available research indicates that the application of evidence-based policy making in fields outside public health and education is limited, and that there are numerous and often conflicting definitions of what constitutes proper evidence. The available literature identifies several obstacles to the effective application of evidence-based policy making, including disagreements about appropriate policy goals and appropriate means for achieving those goals. Policy Horizons Canada (also referred to as Horizons) (2013a) describes itself as an agency within the Government of Canada that “conducts strategic foresight on cross-cutting issues that informs public servants today about the possible public policy implications over the next 10–15 years.” In its description of the role of evidence-based policy, Horizons identifies a need for the best available objective evidence [emphasis added] from research to identify and understand issues so that policies can be crafted by decision makers that will deliver desired outcomes effectively. (Policy Horizons, 2013b)

This evidence “improves policy development in many ways, including by reducing uncertainty, increasing logical clarity and consistency, providing new perspectives and understandings of policy issues, providing increased accountability to the public, providing reliable facts and knowledge, and improving the quality, inclusiveness, and constructiveness of public policy debate.” In agricultural policy, the Canadian federal agriculture department, Agriculture and Agri-Food Canada (AAFC) (2013) states that [t]he growing expectations around accountability and value for money as actualized through program review processes, auditor general reports, and evidence-based policy and program

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development have provided further pressure for objective evidence linking public investment to outcomes.

The Canadian Centre for Agri-Food Research in Health and Medicine (CCARM) is an agency within AAFC that researches the health-related effects of functional foods and nutraceuticals (FFN). AAFC (2014) states that the mandate of CCARM is “to develop reliable, scientific, evidence-based information concerning FFN’s.” At the provincial level in the province of Ontario, the Ministry of Finance Commission on the Reform of Ontario’s Public Services (2012) refers to evidence-based policy in its report on the reform of employment and training programs and states that “a recurring theme in this report is the need to base policies and programs on a defensible evidence base.” So, it would appear that the Canadian federal government and the Ontario provincial government have made high level commitments to evidence-based policy development. On the other hand, recent literature has challenged the depth or the genuineness of these commitments. Economists in general and Austrian economists in particular have been absent from these discussions. The purpose of this chapter is to bring an economic perspective to both the characterization of evidence-based policy making and to the identification of obstacles to its implementation. We begin with a discussion of the rationale for and the distinctive characteristics of evidence-based policy making. We then proceed to link the economic theory of policy to this topic. We also discuss the implications of Hayek’s knowledge problem and the lessons learned from the economic calculation debate that are relevant to this issue. Finally, we use selected examples from rural land use policy in the province of Ontario to illustrate the application of an economic model of evidence-based policy making.

THE STATE OF APPLICATION OF EVIDENCE-BASED POLICY MAKING IN CANADA Shaun Young (2013) recently edited a collection of eight essays on the state of evidence-based policy making in Canada. Contributors to the collection include authors with backgrounds in Public Policy, Education, Political Science, Law, Sociology, Criminology, and Environmental Studies but not Economics. In a revealing foreword to this collection, Mel Cappe1 (2013) contrasted evidence-based policy development with two approaches that he judged to be inferior. He captured the essence of one of those approaches as statement from a hypothetical minister, “Here are my policy conclusions. Go find some evidence to base them on.” If evidence-based policy development reverses this process, then it is difficult to find fault. Cappe’s other rationale, however, foreshadows some of the obstacles to evidence-based policy making. In a critical reference to a change in governing party Cappe with clear disapproval states, “in the recent past, some governments have privileged ideology and doctrine over evidence.” Previously, he described a prior golden age, in which government departments employed large research staffs dedicated to long-term research programs in collaboration with academics who “shared their interests and passion for policy and making

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Canada a better place” (Cappe, 2013, p, xi). In Cappe’s mind, the situation that he is describing in such positive terms is non-ideological and non-doctrinal. Anyone familiar with the ideas of the progressive movement, however, will recognize that the situation that he is describing is the embodiment of the ideology and doctrines of the progressive movement. Our point is that pitting evidence-based policy making against ideology is a false dichotomy. Ideology is inevitable in policy making, and ideological differences lead to contrasting views on what constitutes evidence. In his Introduction to the edited volume, Young identifies two types of disagreements about policy that are commonplace in liberal democracies: (1) disagreements about the policy goals or ends or purposes, and (2) disagreements about the means for achieving the goals. Young argues that these disagreements cannot be eliminated and they are an integral part of what he calls reasonable pluralism or reasonable disagreement. He argues that one of the implications of reasonable pluralism is the need for justifying policy choices, and that evidence-based policy making is part of this justification process. Young’s evaluation of the Canadian situation is that the progress toward the implementation of evidence-based policy making has been limited. He first reviews definitions of evidence-based policy making and finds that the common feature of these definitions is the idea that evidence-based policy needs to be grounded in “best available” evidence. However, what constitutes best available evidence is, Young argues, not well defined. Young goes on to say that most definitions tend to invoke evidence from natural or behavioral sciences, while the gold standard of evidence seems to be defined by the methods of evidence-based medicine. However, Young argues that evidence-based policy making in other fields is not a straightforward extension of evidence-based medicine. The key difference between evidence-based policy and evidence-based medicine, according to Young, is that evidence-based medicine targets individuals while evidence-based policy targets populations. He argues that, because the decision on a medical intervention is ultimately up to the individual who will be subjected to the intervention, this individual informed choice provides justification for the treatment decision. Since policy interventions affect groups of people, there is a different type of need for justification of a policy intervention. Disagreements about proper evidence and quality of evidence are, in Young’s view, at the heart of the limited implementation of evidence-based policy making. Furthermore, he finds that, for many policy issues, evidence has not yet been produced. As another impediment to the implementation of evidence-based policy making, Young notes that evidence is only one of the factors that policy makers take into account, alongside with time constraints, public opinion, political strategy, and election campaigns. Young concludes that implementation of evidencebased policy making may also be impeded by the lack of capacity (i.e., resources, technical expertise) or, in federal states, by a lack of coordination or conflicting policy objectives across different levels of government. The first essay in Young’s collection, by Howlett and Craft (2013), provides an assessment of policy advisory systems in evidence-based policy in Canada. Howlett and Craft’s thesis is that the theory of policy advisory systems is based

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on an outdated model of demand for and supply of evidence, where the demand for evidence comes from various government agencies, while the supply of evidence is provided by sources internal or closely linked to the government. In this model, which Howlett and Craft call the locational model, the importance and influence of evidence on policy is primarily determined by how closely linked the source of evidence is to the demand for evidence. They identify a number of mutually related alternative emerging models that account for the content of evidence and how this content influences the propensity of regulatory agencies to use evidence. Also, these alternative models account for the fact that evidence and policy advice come from a diverse set of sources (i.e., think-tanks, NGOs, colleagues, friends and relatives, members of the public and political parties). The emerging models also consider the “politicization of policy-making” (Howlett & Craft, 2013, p. 37). Related to the politicization of policy making, Howlett and Craft identify two main types of policy advice content: long-term content and short-term content. They argue that Canadian policy tends to be focused on short-term advice, which tends to reflect a politicized reaction to an immediate crisis. However, Howlett and Craft point out that the short-term type of advice is ill suited for addressing complex, long-term issues like health care or environmental issues. They conclude that policy advisory systems in many Canadian sectors may have low propensities and preferences for evidence-based policy making, and thus may not be conducive for the application of evidencebased policy making. The second essay in Young’s collection, by Levin (2013), explores the institutional infrastructure for knowledge mobilization and research use in education policy. To represent the components and the process of knowledge mobilization in education, Levin uses a conceptual framework with three partially overlapping and interacting segments: (1) production (of knowledge) by universities and others; (2) mediation of knowledge (by individuals and organizations); and (3) use of knowledge (by policy makers and practitioners). The main interactions that affect the way in which research knowledge is used and applied, Levin argues, include the personal experiences and relationships of individuals within the three segments, collegial knowledge and organizational cultures, and social pressures in the workplace. The implication that Levin draws from this is that research knowledge itself is a necessary but not a sufficient condition for policy change. The sufficient condition is that there are favorable conditions for the use of research knowledge, but Levin argues that in many cases the conditions are not favorable. For example, he provides evidence that “many research-producing organizations are not effective at communicating their findings or the implications of those findings” (Levin, 2013, p. 53) either due to a lack of incentives or due to resource constraints. At the same time, research users “do not read very much original research” (Levin, 2013, p. 55) due to a lack of time or skill to interpret and apply research in daily practice. Levin points to various studies document that “school systems, as well as departments and ministries of education, are also quite weak in this regard” (Levin, 2013, p. 55). When it comes to intermediaries, who translate and transmit research knowledge to potential users, little is known about their nature and work, Levin notes. The role of media as knowledge

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intermediaries, including social networks like Facebook and Twitter, although it could be significant, is unclear at this point, Levin continues. One often overlooked potentially powerful source of knowledge mediation between researchers and practitioners, according to Levin, are graduate students employed as temporary practitioners. Levin (2013) concludes that despite much rhetoric on the importance of evidence and a reasonable degree of activity as well … much less has been done to build the take-up capacity of the education sector. (p. 63)

In the next essay, Cooper (2013) explores further the nature, structure, and functioning of research-brokering organizations in education in Canada. Cooper first identifies examples of research-brokering organizations, including ministry research branches, district-level research service teams, standards and evaluation organizations, national funding agencies, university research centers, advocacy groups, issue-based organizations that focus on one particular area, think-tanks, textbook publishers, instructional program vendors, research consulting companies, and various media outlets. Then, she outlines three main research-brokering activities: (1) producing research summaries; (2) knowledge mobilization events; and (3) knowledge mobilization networks, and argues that producing research summaries is less effective in knowledge transfer compared to knowledge mobilization events and networks. Cooper also finds that most research-brokering organizations, except for think-tanks, predominantly engage in producing research summaries and posting them on their websites. When it comes to dissemination of research, research-brokering organizations use a variety of methods, including face-to-face interactions, media outlets, online platforms (websites, Facebook, Twitter, online forums, blogs, and YouTube channels). Cooper (2013, p. 89), however, had little to say about “what strategies and functions are most effective with different audiences in different contexts.” The remainder of the essays in Young’s collection provides five evaluations of the extent to which evidence-based policy making is used in various policy areas: early childhood education, crime prevention, poverty reduction, tax design, and environmental protection. Prentice & White (2013, p. 96) argue that there is a vast evidence that early childhood intervention policies (i.e., public child care or kindergarten programs) result in higher IQ scores, better performance in school, higher high school completion rates, and, in later years, … higher incomes earned, fewer arrests, higher rates of both home ownership and ownership of a second car, lower use of welfare and other social assistance, longer marriages, and fewer births outside of marriage

for “vulnerable populations of children.” They use this to argue that the level of public provision of all-day kindergarten and child care in Canada is too low, which they mainly attribute to the “reversal from an evidence-driven path” (Prentice & White, 2013, p. 105) by the Harper government. Waller (2013) argues that crime prevention policies are more cost-effective ways of reducing crime rates compared to the traditional system of prosecution and punishment through the court system. Waller focuses specifically on programs aimed at young persistent offenders. According to Waller (2013, p. 134),

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these programs would include enabling parents to “provide more consistent and caring family education to their children,” “enable victims to achieve a greater degree of satisfaction with the justice system,” “address bullying, dating violence, and peer violence.” Waller’s view is that Canada has made some progress toward the implementation of evidence-based policy, mainly through the creation of the National Crime Prevention Centre (1998) and the Policy Centre for Victim Initiatives (2001). However, Waller goes on to say that Canada “needs to develop a profession of preventive practitioners equivalent to the public health profession.” Laforest (2013) compares poverty prevention initiatives in Ontario and Quebec in the late 1990s and 2000s. She argues that the nature of Quebec’s initiatives was less conducive to the application of evidence-based policy making compared to Ontario. The Quebec initiatives involved a wide range of non-governmental organizations, including feminists, religious groups, unions, anti-poverty associations, student organizations, co-operatives, local economic development groups, and popular education groups whose main political strength was in the widespread and loud public support, which eventually put pressure on the provincial government to translate most of the proposals put forth by these groups into policy. According to Laforest, this setting was not conducive to the implementation of evidence-based policy, whereas in Ontario, policy formation was topdown, with the government having consultations with selected stakeholders who needed to back their proposals by some evidence of potential effectiveness. This resulted in the public announcement by the Ontario government that it will reduce child poverty by 25% within five years on December 8, 2008. Laforest concludes that this case study illustrates the importance of social context in the unfolding and implementation of policy changes. Phillips (2013) assesses the application of evidence-based policy making to the process of redesigning Canadian research and development tax credit policy for businesses. The application of evidence in this case had the purpose of determining whether the status quo system of promoting research and innovation through tax credits had a greater impact on innovation compared to an alternative system of direct subsides. Although research efforts, as Phillips (2013) states, were extensive, the “critical finding was that available evidence was inadequate to permit rigorous, comparative performance evaluation of different programs or estimate reliably their economic benefit or cost” (p. 184). However, Phillips (2013) still considers this case study as an example of a successful application of evidence-based policy in the sense that decisions are not directly determined by clear and conclusive evidence, but rather the presentation of evidence creates pressures for a reframing of policy problems and potential solutions. (p. 188)

The last essay in Young’s collection by Winfield (2013) evaluates the application of evidence-based policy making in Canadian environmental policy. Winfield’s thesis is that the Harper government has undermined the application of evidencebased policy making in Canadian environmental policy by introducing the set of policies known under the banner Responsible Resource Development, which,

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according to Winfield, dramatically undermined the Environmental Assessment Act. The Responsible Resource Development policies were, according to Winfield, designed to circumvent the requirements for environmental assessment for most development projects involving natural resources. Winfield (2013, p. 199) goes on to say that the Harper government was “demonstrating unusual hostility to evidence-based policy making relative to ideological or political factors.” Implicit in Winfield’s claim is that the arguments for conducting evidencebased policy making are inherently non-ideological. The other authors in Young’s collection (Laforest, 2013; Prentice & White, 2013; Waller, 2013) also tend to view evidence-based policy as an objective enterprise that could, but generally should not, be tainted by ideological considerations. The analysis of the normative aspects of evidence-based policy making is beyond the scope of this chapter, but our view is that policy is inherently a normative enterprise. One of the arguments for evidence-based policy is that this form of policy making would provide greater overall benefits to society as a whole. Fox (2012) explains that this view is derived from the utilitarian moral philosophy. However, there may be other normative theories that recognize other evidence. Barnett (1992) argues that the purpose of public policies should be to protect individual property rights. From the property rights perspective, some policies that may increase total welfare might be deemed unjust and the evidence that supports those policies might be considered irrelevant. Fox (2012) recognizes at least five different normative theories used for justification of public policies: classical-liberalism, utilitarianism, pragmatism, legal-positivism, and modern libertarianism. When applied to the same policy issue, the five normative theories often come to different conclusions as to whether a policy would be justified or not. Therefore, in the context of evaluating different policy options, we are not facing a choice between evidence-based policy on one side and ideology on the other, or some mix of evidence-based policy and ideology. Rather, we are facing a multitude of belief systems which then shape the scope and aim of evidence-based policy. These belief systems also shape the set of evidence that is considered valid or useful.

EVALUATION OF RESEARCH METHODS IN EVIDENCE-BASED POLICY MAKING Cartwright and Hardie (2012) describe evidence-based policy as an alternative to policy by anecdote or magic bullet policy (assuming a singular mapping of policy cause to desired effect or outcome). They explain that “the temptation [to assume magic bullets] is very powerful for politicians, the public, and the media” (p. 73). Cartwright and Hardie maintain that reality is generally more complex than the magic bullet model of causality admits. In their view, evidence-based policy consists of two elements: effectiveness and relevance. Effectiveness refers to policies that worked somewhere. Relevance refers to a policy that has a reasonable chance of being effective in the new context for which it is being considered.

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In the literature on evidence-based policy, randomized controlled trials (RCT) are generally seen as the standard for determining effectiveness. However, Cartwright and Hardie maintain that RCTs offer evidence of effectiveness but do not address the requirement for relevance. More than RCTs are needed to really do evidencebased policy. The model of evidence-based policy described by Cartwright and Hardie could be represented as a multivariate regression model. This is not the way that they present or explain their model, but it would seem to be a reasonable interpretation of what they are saying, at least when viewed through and economic lens. Defining the relevant policy outcome for individual i as Yi, the model can be written as I

Yi = αi + ∑ (β j xij ) + εi j =1

where αi is an intercept term which is unique, potentially to individual i, xij is the value of one of the factors thought to influence outcome variable for individual Yi, one of which, say xio, is the policy action, βj is the effect of marginal variations in xij on the outcome variable for individual i, and εi is a random error term. There is no necessary reason that the relationship needs to be specified as linear, however, non-linear effects don’t figure prominently in Cartwright and Hardie’s analysis. For the most part, the policy variable, xio, takes on the same value for all individuals in the model. One of the authors’ frequently used examples has to do with the effects of elementary school class sizes on academic achievement, as measured with reading scores. In this example, in the representation above, Yi would be the reading score for student i. Variations in the policy variable, class size, xio, influence the reading score of student i through the coefficient βj. For example, suppose the policy under consideration is to decrease class size from 30 to 25 students. The hypothesis behind this policy change is that Yi will increase for students in smaller classes. This implies that βo is negative. The value of the multivariate regression interpretation of the Cartwright–Hardie model is that it becomes quickly clear that the reading score outcome for any particular student will also reflect the values of the other x variables, some of which may be unique to that student, and some of which might be common to sub-populations or sub-samples of students. Consequently, the reading score outcome for a particular student may go up or down when class sizes are reduced, depending on variations in the values of those other x variables that occur contemporaneously with the change in class size. The regression model interpretation also makes us aware of long recognized problems like identification and endogeneity associated with empirical estimation of these types of relationships with historical social data. Pawson (2009) also recognizes the problems inherent in applying multivariate relationships to unique social contexts. As an alternative, he proposes an approach that he calls realism, which “provides the most comprehensive account of principles and practice, theory, and method” as a foundation for the theory of

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evidence-based policy. By realism, Pawson (2009, p 21) means the application of the “generative model of causation” for explaining social phenomena, where generative model of causation looks “for causal powers within the objects or agents or structures under investigation.” According to Pawson, it is not empirical uniformity – the number of times we observe something happening – that convinces us of causality in social structures. Pawson uses this idea to critique the empiricist perspective on the “What works?” question. According to Pawson (2009, p. 21), what works is not discovered by “pooling data in search of programs with consistently powerful effects.” Rather, he argues that empirical observations should be used only as a guide for identification of causal relations, but not an ultimate test of causalities. To understand the causal effects, according to Pawson, social scientists need to use outcome patterns rather than outcome regularities when selecting optimal policies. Outcome patterns refer to all policy outcomes, successful, unsuccessful, and partially successful, while outcome regularities refer to looking for policies that consistently produce desired outcomes. Pawson’s (2009) central idea is that the key determinant of whether a policy will give desired results is “if the subjects go along with the programme theory and choose to use the resources as intended” (p. 24). Pawson argues that context affects policy outcomes by constraining the choices of stakeholders in a program, which then determines the three sources of evidence: (1) choice mechanisms; (2) characteristics and circumstances of subjects; and (3) patterns of impact. So, the question of what works should be rephrased to “what works for whom in what circumstances” (Pawson, 2009, p. 25). The lessons that Pawson draws from this is that implementation matters. The power of different stake holders needs to be considered and the institutional setting in which intervention is introduced needs to be taken into account. The current approach in meta-analyses is to classify evidence in a hierarchy where some types of evidence (i.e., RCT) are valued more than others (i.e., professional and expert opinion). Pawson argues that this value scale is inappropriate and that it should be context-specific. Expert opinion, or even gossip, is, in Pawson’s view, sometimes as important as other forms of knowledge for successful program implementation. Pawson’s major objection here is that RCTs are not, in his view, the best method for inferring causal relationships in social settings. While RCTs in medicine are designed with the intention of removing the influence of human will (i.e., placebo effect) on the experimental outcomes, Pawson (2009, p. 52) stresses his earlier point that “human intentionality is not the confounding factor but the very medium through which such [policy] interventions work.” Therefore, the RCT is not appropriate for testing whether a policy intervention works or not, Pawson concludes. As a better alternative to meta-analysis of policy interventions, Pawson proposes a method that he calls a realist synthesis. This method is based on his view of policy mechanisms as highly context-dependent so that the factors like policy history, policy theory, mechanisms, and the reasoning of the stakeholders play an important role in shaping policy outcomes. Therefore, Pawson’s realist synthesis does not give a categorical verdict on whether a program works or not. Rather, the aim of this method is to improve the theory on which a particular policy is

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based, by synthesizing the available evidence, on how the policy, or a set of conceptually related policies, worked or might have worked in different settings. Pawson applies his realist synthesis to three policies that differ in scope and complexity: (1) Megan’s Law, (2) youth mentoring, and (3) a set of policies that he calls “naming and shaming” (Pawson, 2009, p. 151). For each of these cases, Pawson provides a compelling case for his realist synthetic approach. For example, in assessing the effectiveness of Megan’s Law,2 Pawson first lays out the official theory of how the law was intended to work. This theory is broken down in four steps. Each of the steps contains a number of hypotheses about how the law would be implemented in practice, what incentives for different stakeholders (i.e., the public, the sex offenders, the police departments) this implementation would produce, and how these incentives would lead to outcomes. Pawson then examines evidence, which includes legal documents, case studies, reports, and community briefings, to assess the hypotheses contained in the official theory of the case. Pawson finds that most of the hypotheses need to be either rejected or modified to more accurately reflect reality. For example, the intended outcome of releasing the identity of a registered sex offender to local residents was increased security in the area (i.e., reduced rates of sexual recidivism by registered offenders). However, the actual outcome was increased harassment of registered offenders by local residents and no change in the rates of sexual recidivism. Pawson’s take-home message is that to be able to give reasonable predictions about the effectiveness of a given policy, we need to compare the intended outcomes of the policy with the actual intentions, capabilities, constraints, and motivations of the stakeholders.

MARKET AND NON-MARKET FAILURE APPROACH TO EVIDENCE-BASED POLICY MAKING In our view, Pawson (2009) offers a valuable alternative that can address some of the important shortcomings of the standard theory of evidence-based policy making. His alternative provides a more insightful method for developing the understanding of the mechanisms through which policies lead to specific outcomes. We would call this aspect of Pawson’s analysis the functional analysis of evidence-based policy. Functional analysis takes the intended policy goals as given and then determines whether a proposed or actual policy will lead to a given policy goal. While this method can help in developing the understanding of why certain policies lead to certain outcomes in certain situations, it does not offer a clear theory for evaluating the intended policy outcomes or for determining the kinds of evidence that would be needed for such an evaluation. In some cases, the desirability of outcomes can hardly be disputed. For example, in the case of Megan’s Law, it is implicitly assumed that a reduction in sex offender recidivism is a desirable goal. When the costs of achieving this goal are negligible, it is hard to dispute its desirability. However, the implementation of most policies requires significant resources, and if the cost of achieving a policy goal is prohibitively high, then that policy cannot be implemented. There is a

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range of policy goals that fall somewhere in between having negligible implementation costs and having prohibitive implementation costs. The standard theory of evidence-based policy does not offer a framework for evaluation policy goals within this range. The economic theory of policy, on the other hand, provides a framework that could be useful in policy development. Given the lack of involvement of economists in this literature, however, the potential contributions of this approach have yet to be recognized. Two of the elements of the normative economic theory of government policy are the theory of market failure and the theory of non-­ market failure. The theory of market failure is generally traced to Pigou’s (1920) The Economics of Welfare, but which is developed more fully in any contemporary welfare economics textbook. Various categories of market failures have been characterized. Their common structure is that voluntary market exchanges will not lead to efficient outcomes when market failures occur. Another way to think about the effects of market failures is that potential mutually beneficial exchanges are not taking place. The role of policy is to correct for these market failures. The theory of non-market failure, which historically followed the development of the theory of market failure, identified analogous causes of inefficiency in the policymaking process. This theory grew out of public choice theory and the economics of regulation pioneered by Buchanann and Tullock (1962), Peltzman (1976), Niskanen (1971), etc. Wolf (1979) combines and integrates these two elements in what we suggest should be considered as an economic model of evidence-based policy development. According to Wolf’s synthesis, market failure is a necessary but not a sufficient condition for policy action. Without a documented and persistent market failure, there is no economic justification for policy action. The sufficient condition is that the proposed policy interventions do not result in non-market failure consequences that are worse than the original market failure consequences. Along with the well-established sources of market failure – externalities and public goods, increasing returns, market imperfections, and distributional inequity – Wolf identifies four sources of non-market failure: (1) internalities and private goals; (2) redundant and rising costs; (3) derived externalities; and (4) distributional inequity. Internalities and private goals refer to the incentives of the members of non-market organizations to incorporate their personal self-interest into the functioning of an organization. Wolf lists the incentives for budget growth and incentives for the adoption of newest technologies as examples of internalities. Since the output of non-market organizations is measured by how much money they spend on different programs, increasing the budget of a non-market organization would be considered desirable by its employees. This often leads to “pressures to spend rather than save resources” or to “to spend funds quickly and plainly” to justify further budget growth (Wolf, 1979, p. 119). Incentives to acquire the newest technology without considerations for the relative costs and benefits of the new technology are also related to budget growth. Wolf uses health care and the military as prime examples of the pursuit of technical excellence without regard for the resulting social costs and benefits. Redundant and rising costs refer to the tendency “for production to take place within production possibility frontiers and for cost functions to rise over time”

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due to the lack of the profit and loss pressures (Wolf, 1979, p. 124). As one of the major sources of redundant and rising costs, Wolf sees in incoherent agency goals (i.e., bringing all students’ reading scores up to the mean) or goals for which no known technology is available (i.e., providing “dignified” work for everyone). Derived externalities are the unintended consequences of actions of non-market organizations. For example, regulations that limit permissible profits, which are generally calculated on the basis return on capital, may cause inefficient substitution of capital for labor as an unintended consequence. The last source of non-market failure, distributional inequity, refers to the political decision-making process, which is by its nature hierarchical, and therefore gives more decisionmaking power to some people relative to others. This unequal distribution of power, Wolf argues, creates opportunities for inequity and abuse (i.e., government contract obtained through bribery or discretionary favors to some groups and neglect of other groups). Because of potential non-market failure, a policy action might lead to outcomes that are inferior to the putative market failure that the policy was initially intended to fix. These unintended consequences, Wolf argues, can be reduced by applying what he calls the implementation analysis. The implementation analysis aims at identifying potential sources of market and non-market failures at different stages of policy implementation. The application of market and non-market failure theory to evidence-based policy making has important implications. First, before any policy interventions are even considered or proposed, there needs to be credible evidence that one of the types of market failures has occurred.3 Second, even if there is credible evidence that market failure has occurred, this is only the necessary, but not the sufficient condition for policy intervention. The sufficient condition for policy intervention is that there is enough evidence to suggest that a potential nonmarket failure would not be worse than the market failure that the policy was intended to address. While the concept of market failure offers a viable economic theoretical framework for evidence-based policy making, this concept is not without controversy. The concept of the competitive market underpins the concept of market failure. Lavoie (1981) discusses the fundamental differences in the understanding of market competition between the “Austrians” and the “neoclassicals” that were at the center of the economic calculation debate. Before we describe an example of the application of our non-market failure framework of evidence-based policy making to Canadian land use policy, we will discuss the implications of the economic calculation debate for our application of evidence-based policy making.

INSIGHTS FROM THE ECONOMIC CALCULATION DEBATE The economic calculation debate took place roughly between 1920 and 1950. The major point of contention in the debate was the possibility of rational economic

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organization in centrally planned economies. The major contributors to the debate include Lange and Lerner on the affirmative side and Mises, later joined by Hayek and Robbins, on the negative side. Mises argued that without private ownership of the means of production, there would be no prices for the factors of production. Without prices of factors of production, allocating resources to alternative uses would ultimately be arbitrary. Hayek argued that private ownership of factors of production is necessary but not a sufficient condition for the coordination of economic activities. If the owners’ freedom to engage in market exchanges is constrained by centralized decisions, the owners will not be able to use their unique knowledge of the particulars of time and place and incorporate that knowledge into market prices. The absence of market prices that reflect time- and place-specific knowledge of market participants, according to Hayek, puts serious constraints on the coordination of individual production plans within an economy. Pawson’s (2009) view that the success of economic policy depends on the timeand place-specific context in which policy is applied echoes Hayek’s view on the use of knowledge in society. The knowledge of which policy mechanisms work in different time- and place-specific contexts may not be available to any given central mind or agency, and this knowledge may be changing over time. Hayek viewed market prices as imperfect but necessary means of communicating bits of dispersed knowledge across market participants. Hayek’s (1945, 2002) views on the informational content of prices are not based on those prices satisfying the assumptions of perfect competition. Hayek (2002) understood competition as a discovery process, the outcome of which can only be known through experience, as the individual plans of entrepreneurs, consumers, and resource owners are implemented and tested experimentally in the market process. Hayek (2002, p. 9) viewed competition as “a procedure for discovering facts which, if the procedure did not exist, would remain unknown or at least would not be used.” The concept of market failure is based on the deviations of actual market outcomes from the outcomes predicated by the prefect competition model. The perfect competition model assumes that market participants have the necessary knowledge about other market participants’ preferences and production plans. Hayek argued that this knowledge is never available to anyone in its totality. This has implications for evidence-based policy. The knowledge needed to determine the hypothetical perfectly competitive outcome is never available to anyone in its totality. This implies that the estimates of the extent of deviation of actual market outcomes from those predicated by the perfect competition ideal have an inherent and unknown degree of uncertainty. Policies aimed at correcting market failure face similar knowledge problems. These policies need to consider the extent of market failure as well as the extent of potential nonmarket failure. The knowledge problem in assessing the extent of market and non-market failure puts constraints on the interpretation of evidence used for evidence-based policy making. Since there is an inherent degree of uncertainty on the extent of market and non-market failure, qualitative interpretation of evidence is more

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consistent with the nature of this evidence. This is also consistent with Pawson’s case-by-case realist synthesis approach to evidence-based policy. We extend Pawson’s realist synthesis by nesting it in an economic framework.

ILLUSTRATION OF THE NON-MARKET FAILURE APPROACH TO EVIDENCE-BASED POLICY: ONTARIO RURAL LAND USE POLICY Rural land use planning is practiced widely in North America, and, for that matter, in most OECD countries. This section explores the application of the economic model of evidence-based policy making that we described earlier. Fox and Wang (2016), following Rajsic and Fox (2015), apply this model to provincial rural land use policies in Ontario, including reviews of the following pieces of provincial4 rural land use legislation in Ontario: The Planning Act (1980) and its subsequent amendments, The Provincial Policy Statements issued between 1986 and 2014, The Niagara Escarpment Planning and Development Act (1990), The Oak Ridges Moraine Conservation Act (2001), and The Greenbelt Act (2005). The Provincial Policy Statements were developed under the legal authority of the Planning Act, and the other three Acts listed above provided the legal authority for the subsequent provincial rural land use policies: Niagara Escarpment Plan, Oak Ridges Moraine Conservation Plan, and the Greenbelt Plan. Fox and Wang assessed all the above policy documents as well as related reports and literature. Fox and Wang reviewed the policy statements and documents listed above looking for indications that at one or more categories of market failure were provided as rationales for land use policy actions. They find appeals to public goods theory, to externality theory and to excessive future discounting. Provisions related to ecological functions of the landscape, aesthetics of open space, and natural heritage areas are frequent throughout the reviewed Acts, Plans, and Policy Statements. For example, the Oak Ridges Moraine Conservation Plan emphasizes the moraine’s unique environmental, geological, and hydrological functions, and one of the objectives of this Plan is to preserve these functions. The text of the Greenbelt Plan contains provisions for the protection of natural heritage, hydrologic and landform features, open space, and water within the Greenbelt Area. These objectives, broadly understood, contain elements of the public goods rationale. Fox and Wang also identify elements of the externality rationale in the three Acts and the subsequent Plans. For example, one of the objectives of the Oak Ridges Moraine Conservation Plan is to reduce noise and traffic congestion by limiting urban expansion. Limiting urban expansion into the countryside would likely reduce the exposure of urban residents to agricultural sources of dust, noise, and odour. One of the objectives of the Oak Ridges Moraine Conservation Plan is also to “protect the Moraine’s ecological and hydrological features and functions” (Fox & Wang, p. 37). This objective is broadly consistent with the excessive discounting rationale.

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While the Acts, Plans, and Policy Statements appeal directly or indirectly to market failure rationales, Fox and Wang find no evidence of the severity or duration of these externality problems in the reviewed Acts, Plans, Policy Statements, and related reports and literature. There was also no reference to cost-benefit studies in the reviewed documents. This indicates that the reviewed rural land use policies are lacking the first step in what we call the non-market failure theory of evidence-based policy. They are missing evidence that market failure has occurred. Fox and Wang then assess whether the policy documents make any reference to potential sources of non-market failure, particularly distributional inequities and derived externalities. The rationale for assessing derived externalities as a source of non-market failure stems from the idea that land owners may bear a disproportionate burden of the costs of land designations. Derived externalities may result if land use restrictions result in increased prices of the surrounding housing and infrastructure or if the prices of agricultural land fall because of the restrictions. As none of the three Acts has provisions for the compensation of landowners for the losses, Fox and Wang suggest that this is evidence of distributional inequities. They also list empirical studies that found a negative effect of the Green Belt Act on the prices of farmland within the protected area and an increase in land prices in the area directly adjacent to the protected area. Finally, Fox and Wang assess whether any of the Acts, Plans, or Policy Statements make any reference to policy implementation analysis before policies were implemented. They find limited evidence of the awareness of the potential problems related to policy implementation. There phrase “doing things right the first time can avoid the need for costly remedial measures to correct problems” from the 1996 Provincial Policy Statement broadly indicates this awareness. Similarly, the phrase “consideration shall be given to both economic and social benefits and costs” found in the Oak Ridges Moraine Conservation Plan indicates the intent for performing a cost-benefit analysis. However, Fox and Wang did not find evidence that implementation analysis was performed in related reports or literature. The Fox and Wang evaluation of the Ontario land use policy since the 1980s offers important lessons for the application of our economic model of evidencebased policy making. The general lesson is that the theory can be used consistently for evaluating an existing body of land use policy, and this evaluation offers coherent results. The more specific lesson is that the last three decades of rural land use planning in Ontario provide little evidence to justify policy intervention under the non-market failure theory of evidence-based policy. While the reviewed policy documents and related reports and literature refer to market failure justifications for policy intervention, Fox and Wang found no evidence to support these justifications in the reviewed Acts, Plans, Policy Statements, and related reports and literature. These documents make some limited reference to potential sources of non-market failure, but offer no evidence of the extent and severity of a potential non-market failure. This indicates that the recent policy developments in Ontario rural land use planning score low on meeting the standards of evidence-based policy making.

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SUMMARY AND CONCLUSIONS The purpose of this chapter was to provide an economic perspective on the emerging practice of evidence-based policy making. The available literature suggests that the theory of evidence-based policy making is incomplete and that its application is limited at best. There seem to be several potential reasons for the lack of application of evidence-based policy making, including disagreements about appropriate policy goals and appropriate means for achieving those goals. We articulated the economic theory of evidence-based policy making as one way of overcoming some of the obstacles to implementation of this emerging approach to policy making that have been identified in the policy literature. In the economic approach, both market failure and non-market failure need to be diagnosed using the best available evidence, but the current versions of evidencebased policy making theory do not consider these types of evidence. Rather, it is taken as given that some policy intervention is needed, and the task of evidencebased policy making is to select the best policy among the competing alternatives. The implication is that this process is missing at least four steps: (1) providing sufficient and convincing evidence that a market failure has occurred; (2) providing sufficient and convincing evidence that a non-market failure is unlikely to occur or if it does occur the damages from the non-market failure will be less serious than the harm resulting from the market failure; (3) an appreciation of the distributed and conflicted character of social knowledge; and (4) the technical challenges involved in constructing a social preference order. The extent to which these four policy development steps have been used in Canadian land use policy is not well understood. Fox and Wang (2016) are the first to apply our non-market failure theory of evidence-based policy making in Canadian context. They evaluate rural land use policies in Ontario developed since the 1980s and find that these policies score low on meeting the standards of evidence-based policy making. The Fox and Wang study also demonstrates that the non-market failure theory of evidence-based policy can be used consistently for evaluating an existing body of land use policy, and that this evaluation offers coherent results. We also recommend using the non-market failure theory of evidence-based policy for ex ante evaluation of prospective agricultural policies.

ACKNOWLEDGMENTS We are grateful to Tor Tolhurst, Anil Giri, Lars Brink, Douglas Hedley, Danny LeRoy, Aaron DeLaporte, Mathieu Bedard, and Steve Horwitz for their comments on the earlier versions of this chapter.

NOTES 1.  Mel Cappe, at that time he wrote this forward, was an academic. But previously, he was Clerk of the Privy Council, Secretary to the Cabinet, and Head of the Public Service in the Government of Canada.

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2.  Megan’s Law was the popular name of the US sex offender and registration and community notification programs, introduced in 1996 after the rape and murder of Megan Kanka. 3.  We have in mind here a standard that goes beyond mere assertion of the existence of a market failure. Coase’s (1974) insightful analysis of the pitfalls of economists pronouncing market failures without conducting due diligence is instructive. 4.  Non-marine natural resources in Canada are generally areas of provincial jurisdiction so rural land use policy, under Canadian constitutional law, is largely administered at the provincial level.

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ABOUT THE EDITORS Daniel J. D’Amico is the Associate Director of The Political Theory Project and a Lecturer in Economics at Brown University where he teaches and coordinates student programs dedicated to the study of institutions and ideas that make societies free, prosperous, and fair. Steven Horwitz is the Distinguished Professor of Free Enterprise in the Department of Economics in the Miller College of Business at Ball State University. He is also an Affiliated Senior Scholar at the Mercatus Center in Arlington, VA, and a Senior Fellow at the Fraser Institute of Canada. He is the author of three books, including, most recently, Hayek’s Modern Family: Classical Liberalism and the Evolution of Social Institutions. Adam Martin is an Assistant Professor in the Department of Agricultural and Applied Economics at Texas Tech University. His research interests are located at the intersection of philosophy, politics, and economics, and include Austrian economics, economic methodology, economic development, and public choice.

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