Ethics, economics, and freedom

Ethics, economics, and freedom

Journal of Socio-Economics 30 (2001) 375–377 Book review Ethics, Economics, and Freedom Timothy Roth; Aldershot, U.K, Ashgate, 1999, 111 pp., index a...

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Journal of Socio-Economics 30 (2001) 375–377

Book review Ethics, Economics, and Freedom Timothy Roth; Aldershot, U.K, Ashgate, 1999, 111 pp., index and bibliography Roth’s book is about the consequentialist social welfare theory. Indeed, Roth begins the book saying that social welfare theory rests on two assertions. Social welfare theorists claim that efficiency is the only evaluative standard they use in making policy recommendations. Hence, a corollary: social welfare theory is value-free or non-normative. Roth points out that the consequentialist social welfare theory rests on the body of knowledge we associate with neoclassical economics. The ability of social welfare theory to deal with a wide range of relevant policy issues then depends on the credibility of neoclassical economics. Predictably, Roth’s book ends up being an inquiry into the shortcomings of neoclassical economics. While not denigrating a theory that has made some important contributions to the stock of scientific knowledge, Roth shows, in a thoughtful and convincing way, how and why this outcome-oriented method of analysis has limited our understanding of the economic forces at work. The book has eight chapters: The Theoretical Foundations of the New Social Welfare Theory, The Neoclassical Behavioral Postulates, The Neoclassical Approach to Technology, The Implications for the Efficiency Frontier, Efficiency and Rights, The Implications for the Social Welfare Function, Alternatives to Consequentialist Social Welfare Theory, and Contractarian Analysis and Political Institutions. These chapters address a great range of significant theoretical and empirical issues. A short review cannot possibly cover all of them. To fully understand the importance of Roth’s contributions, the book should be read in its entirety. Neoclassical economics has little interest in the economic processes through which transactions are carried out. The focus of neoclassical economics is on the end results of economic activities (with emphasis placed on the constrained maximization of whatever is being maximized). To satisfy the requirement that its end results have to be non-normative or value-free, neoclassical theory is frictionless and institutionless. The former rules out positive transaction costs (or bounded rationality). The latter eliminates the necessity of recognizing the fact that formal and informal institutions have ethical roots. Roth demonstrated that neoclassical economics is wrong on both accounts. The neoclassical concept of efficiency is indeterminate, and the end results are not value free. By implication, the same conclusion applies to the consequentialist social welfare theory. The basic assumptions of neoclassical economics include unbounded rationality, exogenously determined and stable preferences, exogenerously determined technical knowledge, 1053-5357/01/$ – see front matter © 2001 Elsevier Science Inc. All rights reserved. PII: S 1 0 5 3 - 5 3 5 7 ( 0 1 ) 0 0 1 0 8 - 1

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Book Reviews / Journal of Socio-Economics 30 (2001) 375–377

maximizing behavior, and market equilibrium. Roth demonstrates the failure of those assumptions to explain a wide range of real world events. Let me summarize some of his major points. Unbounded rationality exists only in frictionless economic models. We live in a world of bounded rationality. Bounded rationality means that individuals have different subjective perceptions of real world, different abilities to process new knowledge, and limited ability to anticipate future events. The consequences of bounded rationality are then positive transaction costs, information asymmetries and opportunistic behavior. Moreover, theoretical research and empirical evidence have shown that different institutions generate different transaction costs. The maximization paradigm of neoclassical economics translates the desire for more utility, which is an observable trait of human behavior, into the search for the single maximizing solution (based on marginal equivalences). Roth argues that different property rights, incomplete knowledge and information asymmetries raise the transaction costs of identifying and pursuing maximizing behavior. Moreover, transaction costs are neither given nor constant. Market equilibriums are statements about what the end results of economic processes would have been if relative prices were able to inform utility maximizing individuals of the optimal strategy to be pursued in each situation. Once again, in a world of bounded rationality, different institutions and positive transaction costs, scarcity prices do not and cannot transmit information required to attain marginal equivalences. Instead of recognizing market equilibriums for what they are: the end results of economic processes in a frictionless and institutionless world, many economists have used the violation of marginal equivalences to justify public spending and controls. Neoclassical economics is silent about the effect of different institutions on the agents’ incentives to acquire and use new knowledge as well as the effect that new knowledge has on their incentives to create new exchange opportunities. An important consequence of this interplay between alternative institutions, incentives and the search for exchange opportunities is that the knowledge-creating process continuously changes our preferences. That is, utility functions are neither stable nor entirely exogenous. The presence of endogenous preferences raises, via their mutability, some serious doubts about the neoclassical concept of efficiency. It seems appropriate to mention at this point an alternative definition of efficiency. The New Institutional Economics and Public Choice School share the view that efficiency must be judged by the process through which transactions are carried out, not by the results. The issue then becomes what set of institutions provides incentives for transaction costs to be lowered by those who can do it at a lower cost. Roth also questions neoclassical concepts of the production function. The growth of knowledge, which cannot be predicted in advance, endogenizes changes in the production function, while cognitive limitations of economic agents imply technical constraints on the ability of individuals to acquire and process technical options. Thus, the production function is indeterminate. Given its focus on the end result of economic processes, neoclassical analysis has both encouraged as well as justified various public policies. In a world of different institutional arrangements and positive transaction costs, those policies have produced unintended out-

Book Reviews / Journal of Socio-Economics 30 (2001) 375–377

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comes. For example, neoclassical economics has provided the general framework for regulatory policies in the United States, the World Bank loans to developing countries, IMF bailouts, and privatization policies in Eastern Europe. The main result of all those policies has been to lower the costs of (1) creating rent-seeking coalitions and (2) maintaining inefficient property rights. It is tempting to go on and say more about this book. However, I will stop here and recommend Roth’s book to all social scientists wholeheartedly and without reservations. Svetozar Pejovic, Professor of Economics Texas A&M University College Station, TX 77843-4228, USA Senior Research Fellow International Centre for Economic Research Turin, Italy