When illegitimate is legitimate

Over at Not PC a number of economic and social concepts are termed “illegitimate” namely:

1. Externalities,
2. Opportunity cost,
3. Free-rider problems,
4. Stake-holder theory.

However, these are some of the most important – and legitimate – concepts that should be looked at when forming policy.  I don’t like to use the word should lightly – but in this case these are central legitimate concepts.  Ignoring them would simply lead to bad policy.

So, to illustrate this, let me briefly discuss each concept:

Externalities

Externalities are the costs or benefits of a choice that fall on someone who isn’t directly involved in the transaction associated with that choice.  In essence, an externality occurs when someone is given a cost and benefit even though they are not involved with the market in question.  Since we are interested in outcomes that maximise the happiness of all of society, we know that the market price does not represent the costs and benefits placed on this person/group – as a result a tax or subsidy could improve matters.

Now we need to carefully analyse when this is the case.  Coase bargaining may provide a free market solution for the externality.  The cost of setting up the tax/benefit may exceed the social benefit from doing so.  The externality may not even exist.

However, it is extreme to say that an externality which can be improved by government intervention would never exist – as a result, the concept is useful and relevant.

Opportunity cost

Skipping to opportunity cost, the opportunity cost is the benefit associated with the “second best choice” among a set of choices.  Only one thing has a positive “economic benefit” and that is the best choice of the agent.

The purpose of opportunity cost is to help us understand choice theory – someone chooses the first best alternative.  It is a legitimate cost in the sense that if the first best alternative was removed from their “choice set” then the cost to that individual would be the difference between that and the benefit associated with the first best alternative NOT the full benefit of the first best.

Ignoring opportunity costs means we would run around saying that anything that had a positive return is something we must have immediately – we would miss the point that there is scarcity, and that there are trade-offs associated with choices as a result.

Free-rider problem

I am surprised that this would be called an illegitimate concept by someone who is so supportive of property rights – this is the main justification for having property rights.

The free-rider problem states that if you have a common good it will be “over-used” compared to what is optimal.  Think of it with fish:  If you are the sole owner of a stock of fish, you will be interested in maximising the lifetime benefit of the fish stock – by letting them breed and regenerate.  However, if it is a public resource, letting the fish stock regenerate benefits you a little bit but it also has a benefit for all the other people who will fish (externality) – as a result, the individual tends to “over-fish” compared to what is optimal.

This implies that, in order to ensure that such common pool resources are used efficiently we would like a situation where property rights are defined.

Stake-holder theory

This is not so much an issue of economic theory – it is a general social issue.  However, the idea that part of society is owned by everyone is not necessarily contentious, and it ties in nicely with the free-rider problem and property rights discussed above.

In essence, we can have property rights and something like communal land – in so far as society is renting the land to a private owner to use in perpetuity.  Furthermore, if social capital and/or socially provided goods were used to create private value it is difficult to argue that 100% of the benefit should go to the single private agent.

These are issues of fairness and distribution – who owns the land, who owns infrastructure, who owns social capital.  And these, in essence, are the main justifications for taxation.  This concept is legitimate in so far as you need to make a normative assumption regarding this before you can make any sort of conclusion regarding taxation and redistribution.

Now defining the value of these normative judgments is not the role of economists – so this is a concept that I am not defending on the grounds of economic analysis, but I am defending on the grounds of more normative considerations.  Even so, the scope for such considerations should be included in economic models.

Conclusion

These concepts, as described above, all provide value when framed appropriately.  They are far from “illegitimate concepts” as they help us to frame the situation we are in and understand the trade-offs associated with both individual choice and social agreements.

Ignoring these concepts is the same as making an extreme assumption about them – and I am not convinced that such assumptions are legitimate.