As part of the research for Economics in Two Lessons, I’m looking in to the history of some of the ideas I’m talking about, including Pareto optimality, externalities and of course opportunity cost. I’m undecided as to whether I’ll include this material, perhaps as starred (skip if you feel like it) sections, or in an Appendix. Suggestions on this point are welcome.

My research on the intellectual history of opportunity cost has so far gone no further than Wikipedia, which attributes the term to Friedrich von Wieser, an Austrian economist in both the national (he was Minister for Finance there in 1917) and theoretical senses. Turning to the article on von Wieser, I was surprised to read that he put forward an argument very similar to mine regarding the relationship between opportunity cost and the distribution of wealth

Instead of the things that would be more useful, there are things that pay better. The greater the difference in wealth, the more striking are the anomalies of production. The economy provides luxury to the capricious and greedy, while it is deaf to the needs of the miserable and poor. It is therefore the distribution of wealth that decides what will be produced, and leads to a consumer of a more anti-economic variety: a consumer wastes on unnecessary, guilty enjoyment that which could have served to heal the wounds of poverty. —Friedrich von Wieser, Der Wert Natürliche (The Natural Value), 1914.

It turns out, even more surprisingly to me, that von Wieser was linked to a Viennese group of Fabians.

I’m still trying to digest this, and work out where to go next with it. Can anyone point to useful information about von Wieser?

Over the page, the draft preface for my book-in-progress, Economics in Two Lessons

I got some great comments first time round, but I can see it would be easier if I presented my drafts in a more orderly fashion, though not necessarily sequential. So, I’ll begin at the beginning. Comments, both critical and favorable, much appreciated.

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After a couple of preliminary posts, here goes with my first draft excerpt from my planned book on Economics in Two Lessons. They won’t be in any particular order, just tossed up for comment when I think I have something that might interest readers here. I’ll update as I go, in response to comments and criticism; this may create some difficulties reading the comments thread, but hopefully the improvement in the final product will be worth it.

To remind you, the core idea of the book is that of discussing all of economic policy in terms of “opportunity cost”. My first snippet is about

Pareto optimality

The situation where there is no way to make some people better off without making anyone worse off is often referred to as “Pareto optimal” after the Italian economist and political theorist Vilfredo Pareto, who developed the underlying concept. “Pareto optimal” is arguably, the most misleading term in economics (and there are plenty of contenders). Before explaining this, it’s important to understand Pareto’s broader body of thought, one which led him in the end to embrace fascism.

Pareto and the libertarian path to dictatorship

Pareto sought to undermine the version of liberalism that dominated 19th century economics, according to which the optimal (most desirable) economic outcome was the one that contributed most to human happiness, often (if somewhat loosely) summed up as ‘the greatest good of the greatest number’. Particularly as developed by the great philosopher and economist John Stuart Mill, this is a naturally egalitarian doctrine.
The egalitarian implications of the classical framework reflect the fact that the needs of poor people are more urgent than those of the better off. So, the happiness of the community as a whole all be increased by policies that benefit the poorest members of the community, even if these benefits come at the expense of those who are better off. It follows that a substantial degree of income redistribution will be social desirable and that large accumulations of individual wealth, which contribute only marginally to the happiness of a small number of people are undesirable in themselves, though they may in some circumstances be a by-product of desirable policies.
Pareto’s big achievement, further developed by a large number 20th century economists, was to show that much of economic analysis could be undertaken without invoking the concept of utility. Hence, interpersonal comparisons of happiness, which invariably lead to the conclusion that redistributing wealth more equally is beneficial, could be dismissed as ‘unscientific’.
Pareto didn’t stop with an attack on the economic implications of Mill’s approach. Mill’s philosophical framework implied support for political democracy, including the enfranchisement of women. Since everyone’s welfare counts equally in the classical calculus, the political process should, as far as possible, give everyone equal weight.
Pareto reversed this reasoning, arguing that a highly unequal distribution of income was both inevitable and desirable; he proposed what he called a power law, described by a statistical distribution which also bears his name. Pareto’s “Law” may be summed up the 80-20 proposition, that 20 per cent of the population have 80 per cent of the wealth.
The supposed constancy of income distribution implies that any attempt at redistribution must be essentially futile. Even the aim is to benefit the poor at the expense of the rich, the effect will simply be to make some people newly rich at the expense of those who are currently rich. Pareto called this process ‘the circulation of elites’. (In his dystopian classic 1984, Orwell has the Trotsky-like character Emmanuel Goldstein present the same idea as the starting point of The Theory of Oligarchical Collectivism. Orwell almost certainly derived the idea from James Burnham, an admirer of Pareto whose work Orwell saw as the embodiment of ‘power worship))
All of this led Pareto to become one of the first advocates of a political position combining an extreme free-market position on economic issues with hostility to political liberalism and democracy. Pareto welcomed the rise of Mussolini’s fascist regime, and accepted and accepted a “royal” nomination to the Italian senate from Mussolini. However, he died in 1923, less than a year after
Pareto was not really a fascist however. Rather, he developed a version of liberalism similar to that of his more famous successors, Hayek and Mises, both of whom embraced and worked for murderous regimes that had come to power by suppressing democratic socialist parties. Like Pareto, neither Hayek nor Mises can properly be described as fascists – they weren’t interested in nationalism or in the display of power for its own sake. Rather, their brand of liberalism was hostile to democracy and indifferent to political liberty, making them natural allies of any authoritarian regime which adheres to free market orthodoxy in economics. (Fn Supporters of Hayek and Mises commonly describe themselves as “libertarians”, but their alliance with brutal dictators makes a travesty of the term – they have been derisively described as “shmibertarian”).

Pareto optimality

Now back to “Pareto optimality”, and why it is such a misleading term. Describing a situation as “optimal” implies that it is the unique best outcome. As we shall see this is not the case. Pareto, and followers like Hazlitt, seek to claim unique social desirability for market outcomes by definition rather than demonstration.

If that were true, then only the market outcome associated with the existing distribution of property rights would be Pareto optimal. Hazlitt, like many subsequent free market advocates, implicitly assumes that this is the case. In reality, though there are infinitely many possible allocations of property rights, and infinitely many allocations of goods and services that meet the definition of “Pareto optimality”. A highly egalitarian allocation can be Pareto optimal. So can any allocation where one person has all the wealth and everyone else is reduced to a bare subsistence.

Recognising the inappropriateness of describing radically unfair allocations as “optimal”, some economists have used the description “Pareto efficient” instead, but this is not much better. It corresponds neither to the ordinary meaning of “efficient” nor to the meaning with which the term is commonly used in economics, which is also misleading, but in a different way.

The concept of opportunity cost gives us a better way to think about the possibility of making some people better off while no one is worse off. If such possibilities exist, then there are potential benefits that have no opportunity costs. Conversely, if there is a positive opportunity cost for any benefit, then we can’t make anyone better off without making someone else worse off. So, a “Pareto optimal” situation may be described, more simply as one where all opportunity costs are positive.

I’ve been promising for a long time to write a new book, framed as a reply to a free-market tract Economics in One Lesson by Henry Hazlitt, published in 1946, but still in print and popular among free market advocates. Its popularity reflects the fact that it’s a reworking of Bastiat’s “What is Seen and What is Not Seen”, still one of the best statements of the case for free markets.

Bastiat’s argument is implicitly based on the concept of opportunity cost but, since the term wasn’t coined until 1914, he doesn’t use it. Neither, more surprisingly, does Hazlitt. Once this is made explicit, Hazlitt’s rather ponderous, and misleading statement of his “One Lesson”

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

can be boiled down to the much simpler statement “Market prices reflect opportunity cost”. In important respects, this is true, particularly when we consider the problem from the perspective of choices about how to allocate an individual, family or government budget. With fixed aggregate levels of public expenditure, for example, more money for the military means less for schools, and vice versa.

There are plenty of other questions about private and public decisions for which Hazlitt’s One Lesson is useful. Another example is the well-supported finding that the best way to fight poverty is to give money to poor people. This is unsurprising given that poor people themselves will usually have a much better idea of the opportunity costs they face than will those seeking to help them.

But as a general statement, Hazlitt’s One Lesson is false, which is why my working title is Economics in Two Lessons”. Lesson Two is “Market prices do not reflect all the opportunity costs we face as a society”
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