Another excerpt from my book-in-progress, Economics in Two Lessons. To recap, the Two Lessons are
Lesson 1: Market prices reflect and determine opportunity costs faced by consumers and producers.
Lesson 2: Market prices don’t reflect all the opportunity costs we face as a society.
In this section, I’m working on Lesson 1, leading up to the point (my restatement of what’s usually called the First Fundamental Theorem of Welfare Economics) that an ideal competitive equilibrium is one in which there are no unexploited potential gains from technical improvements or mutually beneficial exchange. For reasons I’ve spelt out already I don’t want to use the term “Pareto-optimal” to talk about this. I also want to confine “efficient” to its normal meaning of “technically efficient” and avoid the common economist practice of extending this to cover various definitions of “market efficiency”. So, I’m talking about “free lunches” or, more formally, benefits with no opportunity cost.
In Lesson 2, I’ll be looking, among other things, at the Second Welfare Theorem, which says any outcome with no free lunches corresponds to a particular initial allocation of property rights, broadly defined to include taxation obligations and entitlements of all kinds.
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The acronymic adage TANSTAAFL (There Ain’t No Such Thing As A Free Lunch). The saying was popularized, particularly in libertarian circles, by Milton Friedman’s book of that name and, a little earlier by by Robert Heinlein’s science fiction classic, The Moon is A Harsh Mistress. The acronym is derived from a marketing ploy used in 19th century saloons, whereby a ‘free’ lunch was offered to customers, on the assumption that they would wash it down with beer or other drinks. Naturally, the cost of the lunch was incorporated in the price of the drinks.
The key idea may therefore be restated in terms of the broader point that it is opportunity cost, rather than just monetary cost, that matters when making economic decisions. Although there is no explicit charge for the lunch, patrons can only consume it at the opportunity cost of forgoing cheaper beer.
Libertarians commonly use the TANSTAAFL adage to point out that services provided ‘free’ by governments will, in general, have an opportunity cost. ‘Free’ provision of some service must be funded either by higher taxes or by reductions in other areas of public expenditure. The more general point, that it’s necessary to look at the full opportunity cost of any good or service, and not just the immediate price, is yet another version of Lesson 1.
But there is a contradiction here. Most economists think that improved economic policy could yield better outcomes for everyone, even though they may disagree about which policies would yield this result. Libertarians, who extol the benefits of rolling back the state and giving markets free rein, are no exception to this rule. The same is true of technological advances that allow us to do more with less, for example, by producing goods and services with smaller inputs of labor, energy and capital.
A free lunch is ‘something for nothing’, that is a benefit obtained with no opportunity cost. The TANSTAAFL adage embodies an important truth applicable to many apparent ‘free lunches’, in which the true opportunity cost is carefully hidden.
If TANSTAAFL were literally true, however, humanity could never have risen above a subsistence level of existence. Every technological advance since people first learned how to make flint tools and control fire has provided a potential free lunch, literally and metaphorically, for humanity as a whole. The same is true of improvements in social and economic organization that have allowed larger and larger groups to co-operate in mutually beneficial ways.
TANSTAAFL holds if and only if there are no free lunches left on the table, which in turn will only happen if all options for technological progress have been exhausted and, in addition, the economic system is functioning perfectly1. So, if outcomes can be improved for everyone, the correct statement is TISATAAFL, that is, There Is Such A Thing As A Free Lunch’.
Economists have understood this point ever since Adam Smith wrote The Wealth of Nations, the first serious study of economic growth, in the 18th century. Even the poorest person in a modern developed economy enjoys a range of goods and services that were unavailable to our ancestors, with less effort and toil and, at least potentially, with less use of resources and damage to the environment.
The improvements in living standards generated by a modern economy are, for us, a free lunch. In fact, economics tells us about two kinds of free lunch, technological innovations and improved allocation of resources.
Technological innovations are the most obvious kind of free lunch. Technological innovations that allow us to produce a given output with less of every kind of input, including labour, provide us with the classic example of free lunch. Adopting the new technology allows us to increase output without using any additional resources. So, the opportunity cost of the additional output is zero. To put this point the other way around, additional production entails opportunity costs only if it is technically efficient.
The second kind of free lunch, the core concern of economics, arises from improved allocation of resources. Lesson 1 leads us to think about improvements that can be generated by allowing markets to work. Lesson 2 shows how public policy can yield improved resource allocation when markets fail to match prices and social opportunity costs.
In this section we will look at Lesson 1, and the gains from exchange discussed earlier. Exchange through trade and markets can generate benefits for everyone, compared to a situation where everyone relies on themselves. When Crusoe trades fish for Friday’s goat, each obtains a meal that would have had a higher opportunity cost in the absence of trade. The improvement is a (partly) free lunch, or maybe a free dinner.
By contrast, the saloon story underlying TANSTAAFL, in which an apparent bargain turns out to be nothing of the kind, stands in stark opposition to the economic idea of exchange as a bargain in which both parties benefit. It is in line with the pre-modern view of trade as a zero-sum game, in which any gain to one part is a loss for the other.
With the correct economic analysis, the saloon story illustrates TISATAAFL. Suppose that the customer would be willing to pay the saloon’s price for the beer alone. Then the price must less than the opportunity cost of obtaining the beer some other way, for example, through home brewing. On the other hand, assuming the saloon is not operating at a loss, its price must cover the saloon’s opportunity cost of providing both the beer and the lunch. In these circumstances, compared to the situation in the absence of exchange, the lunch really is free.
Under ideal conditions, the market outcome will ensure that there are no free lunches left on the table. More precisely, there are no potential benefits that can be obtained unless an opportunity cost is borne by someone. These are the conditions of perfect competitive equilibrium, the subject of our next section.
1 More precisely, ‘functioning perfectly, given the initial allocation of wealth’. We will look at this point later in the book.