Public Sector Economics Critically Evaluate the Views of the Austrian School, the Market Failure Approach and

the Public Choice School to the Role of the State in Market Economies.
Sebastian Storfner
www.storfner.com

Index
1. Introduction 2. Methodologies 2.1. Neo-classical School of Economics 2.1.1. 2.1.2. 2.1.3. 2.1.4. Distribution Effect Production Effect Economic Efficiency Perfect Competition and Market Failure

2.2. Public Choice School of Economics 2.3. Austrian School of Economics 3. Evaluation 3.1. Poverty 3.2. Education 3.3. Privatisation and Monopolies 4. Conclusion 5. Bibliography

1. Introduction When economists argue about the economy everyone wants only the best for it. But even if economists have a common aim most of the time they do not have the same opinion because nearly every economist follows different theories and approaches. Since the government is more or less involved in most of the economic activities, the role of the state is and was studied extensively. However, depending on the school of thoughts, economists have different opinions about the government and its role in the economy. Therefore this essay will critically evaluate the Neo-classical, Public Choice and Austrian view of the role of the state in a market economy. The first part of the essay will introduce the different methodologies the three schools are built on. Only by knowing them we can understand why the schools see the state in a particular way. In the second part we will evaluate the different views by applying their concepts to issues like market failure, bureaucracy, education, healthcare and poverty.

2. Methodologies 2.1. Neo-classical Neo-classical economists define economics as the study of allocation of scarce resources among alternative ends. Human beings are seen as rational and the concept of profit maximising is accepted. It is a positive theory because it is subjecting economic phenomena to study by similar methods to those of natural science such as chemistry. It uses mathematics and statistics since many economic variables are seen as quantifiable. For Neo-classicals four market types exist: monopoly, monopolistic competition, oligopoly and perfect competition1. As we shall see later only in perfect competition markets work optimal for them. In any other cases the market fails and need to be corrected. A sub branch of Neo-Classical Economics is Welfare Economics to which all neo-classical assumptions can also be employed. Welfare Economics is normative because value judgments about the desirability of a certain outcome are made. Its main purpose is to study the possible effects of various economic policies on the welfare of society. Therefore the objective is to maximise welfare, respectively allocate and distribute scarce resources in the best way. However the problem involved is that welfare cannot be measured. Through indifference curves2 it can only be said if an individual is better or worse off but interpersonal comparisons of welfare cannot be made. This means that the Utilitarian practise cannot be employed because it is not measurable. Therefore it is not possible to assert objectively.

Perfect Competition: unlimited amount of firms without market power, all are price makers rather than price takers A curve that shows all combinations of goods or services that provides the same level of utility

To avoid this problem, Neo-classical and welfare economists introduced a set of assumptions, which is known as optimality conditions based on the Paretian premise. The social optimum (also known as economic efficiency or Pareto optimality) is a situation in which it is impossible, by changing the existing resource allocation or distribution of output, to make an individual better off (in his own estimation) without making some other individual worse off. This leads to the necessary assumptions of economic efficiency, which require both, distribution and exchange efficiency.

2.1.1. Distribution Efficiency Distribution efficiency is reached when further exchange between individuals cannot make one person better off without harming others. Thus no mutual gain from exchange can be made. Technically the ratios of marginal utilities (MU) are the same for both individuals: (MUx/MUy)A = (MUx/MUy)B The slope of the indifference curve is dy/dx = Ux/Uy = MRSyx and since marginal utilities of both individuals are equal their indifference curves must have a common tangent: (Ux/Uy)A = (Ux/Uy)B. An Edgeworth box3 visualises this condition. Chart 1 shows different indifferent curves of individual A and B. Each point individual As indifferent curve is tangent to Bs (a, b and c) is a Pareto efficient allocation. All these points lie on the efficiency locus or contact curve.

0B

Y b a

c Y

0A

Chart 1: Distribution Efficiency illustrated via an Edgeworth box When we plot all points from the efficiency locus we receive UPF (Utility Possibility Frontier).

Edgeworth box is a 2x2 model in general equilibrium where two goods and two individuals are assumed. The whole amount of goods is represented by the box.

UB

0
Chart 2: Deriving the UPF from production efficiency

UA

2.1.2. Production Efficiency The second condition for economic efficiency is production efficiency and must be met to avoid waste of resources and achieve technical efficiency. When it is achieved it is impossible, by reallocating factor inputs, to expand the output of one good or service without other goods output falling. Again, by assuming two individuals (A and B) and two products (Labour and Capital) marginal productivity (Marginal rate of Substitution) of the two factors must be the same: (MRTSL/MRTSK)x = (MRTSL/MRTSK)y Here the factor inputs are equally productive in all uses to which they can be put, therefore: (MRTSLK)x = (MRTSLK)y To visualize this condition we use the concept of an Edgeworth box (Chart 3) again, however in this case not with indifference curves but with isoquants4, since we are on the production side.

Isoquant: Trade-off between two goods

0B

K b a

c K

0A

Chart 3: Production Efficiency illustrated via an Edgeworth box When isoquants are tangential to each other (a, b and c) we receive production efficiency according to the previous stated definition. When we plot all possible combinations of the efficiency curve we receive the Production Possibility Frontier (PPF), as shown in Chart 4.

UB a b

0
Chart 4: Deriving the PPF from production efficiency

UA

2.1.3. Economic Efficiency If production and distribution efficiency is reached at the same time we get economic efficiency, which is the condition concerned with determining what the given bundle of goods and services should be.

Under this condition no change in the goods total or its distribution can make one person better off without harming another. Visually it means selecting the best point on the PPF plus the one which satisfies distributive efficiency. This means that the rate at which individuals in society are willing to substitute one good for another (= MRS) is equal to the rate at which society is able to transform one good into another (=MRT). Therefore: (MRSxy)A = (MRSxy)B =( MRTxy)FOR SOCIETY Putting all together we can derive the Grand UPF

UB F UB2

UB1

0
Chart 5: The grand UPF

UA1

UA2

UA

Looking at Chart 5, all points on the grand UPF are Pareto efficient. Here the question arises how we can chose between two points, e.g. F and G since both are efficient but have a different distribution of income and wealth. In this case Welfare Economics provides us with two theorems, the Efficiency and the Equity theorem. The Efficiency theorem argues that, as long as P=MC (perfect competition) markets are superior and automatically take a position on the UPF in terms of economic efficiency. In contrast to that the Equity theorem states that it is possible to get any efficient point on the UPF by redistribution of income and wealth. However, this intervention (done by the government) is highly subjective because, as soon as the markets decision is not taken as given anymore, the question arises which the right distribution of wealth and income is. One suggestion to solve this problem is the Kaldor-Hicks Compensation test (1939), which ought to be a reaction to the Paretian nihilism that it is impossible to say anything scientific or positive about an economic change if it makes some people worse off at the same time as it makes others better off

because individual utilities cannot be compared.5 Basically the test says that if government reallocates income and wealth from F to G (F was automatically chosen by the market [Efficiency theorem] but G is also Pareto efficient [Equity theorem]) then there is a gain in welfare from UA1 to UA2 and a welfare loss from UB2 to UB1. If gainers can overcompensate losers in monetary terms then there is a Pareto improvement. The Scitovskys reversal test (1941) studies under what conditions the result was achieved by looking backwards, i.e. from G to F. Through applying indifference curves to the grand UPF it can be seen in which point a higher indifference curve can be reached. This point where the indifference curves tangent the grand UPF is called Optimo Optimoto.

2.1.4. Perfect Competition and Market Failure The previous mentioned economic efficiency, (MRSxy)A = (MRSxy)B =( MRTxy), however needs perfect competition (P=SMC) to work perfectly (Chart 6). Under perfect competition no participant can influence prices and information is freely flowing, no barriers to entry or exit, and a large number of buyers and sellers exist.

Price SMC

D=MC

Output Chat 6: Perfect competition P=SMC According to Neo-classicals markets fail if there is any other structure (PSMC), Public Goods6, external effects, incomplete markets, imperfect competition, uncertainty and macroeconomic disturbances like unemployment. The idea here is that the rational, fully in the public interest acting government detects these failures and corrects them, i.e. brings the economy back to economic efficiency. This will be discusses through this essay.

2.2. Public Choice School of Economics The second analysed school of thoughts is the so-called Public Choice or Virginia School of economics. The most prominent authors are next to Walter Niskanen, Buchanan and Tullock. By
5 6

A.P. Thirlwall. Charles Kennedy 1923-1997: An Appreciation (1998) Public goods: Nonexclusive and no rival

applying neo-classical tools to political markets Public Choice theorists come to the conclusion that governments fail in an efficient allocation of resources and decreasing costs. According to Bailey7 () intervention necessarily distorts economic activity to a greater extent than unregulated private markets, even if they are less than competitive. This has two major reasons. Firstly, there are technical problems of interventions, e.g. imperfect information and secondly behavioural problems. Through taxation and government expenditure consumers and producers behaviour might be changed. Even more important governments may abuse their position and seek no longer allocation efficiency. In their analysis Public Choice theorists see the individual as the fundamental unit. Furthermore individuals pursue their self-interest, viewed as whatever ends enter into their utility function. This means that government agents (ministers, bureaucrats and regulators) try to maximise their own utility, which could be, for example, votes or larger budgets to spend. Therefore the welfare economics assumption of governments acting in public interest is simply wrong. Moreover the theory discovered that certain benefits of government spending tend to concentrate on particular socioeconomic or demographic groups and lobbies. This is often related to the concept of political business cycles (PBC). W.D. Nordhaus (1975) introduced the idea that political parties behave purely opportunistic to maximize the probability for their re-election. Chart 7 of the Dow Jones and the 4-year election cycle from 1897 to 2004 shows clearly that in stock markets gain most in election and pre-election year, while they stagnate or even decline in pots-election years and in the midterm. Douglas Hibbs (1977) took a different approach arguing in favour of a partisan theory. In his view, political parties are not purely opportunistic but are driven by different preferences over the trade-off between inflation and unemployment (the Phillips-Curve) as these have important redistributive consequences. His model predicts a causal relationship in between macroeconomic variables and the partisanship of government.

Stephen J. Bailey. Public Sector Economics (1995)

Chart 7: Dow Jones and the 4-year election cycle from 1897 to 2004 To describe and simplify the different positions of governments Public Choice theory uses a few models. Until the 1960s the despotic benevolent government model was widely supported. Basically it says that the omniscient government acts in the public interest, seeking first best allocation of resources so as to maximise welfare by offsetting specific instances of market failure. Moreover it assumes that government may even know what is best for individuals, which is against the Pareto Optimum assumption (Bailey 1995). Since the 1980s the leviathan model is emphasised in which the government is made up of self-serving individuals who manipulate and distort public choices to reach its own ends8. Niskanen argued that objects of budget maximisation combined with the organisational structure of bureaucracies will result in allocation inefficiency, where excess supply of service exists and x-inefficiency, where production costs are higher than necessary. Chart 8 illustrates that allocation efficiency exists in q1 where Marginal Benefit is equal to Marginal Cost. But bureaucrats have an incentive to increase output beyond q1 and it is pushed to a point where Total Benefit is equal Total Cost (q2). In that point bureaucrats have captured consumers surplus for themselves (G = H)9.

In addition to these two models Public Choice theory knows the fiscal exchange model, where neither allocation efficiency nor equity is reached since no account is taken of either market failure or equity and the fiscal transfer model, where the majority-voting is allowed to over-tax the minority and direct services to themselves.

9 The excess of marginal valuation over marginal cost (G) equals the excess of marginal cost over marginal valuation (H).

MC, MB

MC

q1 Chart 8: Bureaucratic empire building

q2

Output

Nevertheless, being in the tradition of neo-classical economists, Public Choice theory identifies market failures10 because of monopolies or externalities11 like national defence, public goods, and the environment. This is why Buchanan argues for a position between anarchy and Leviathan. Although Buchanan does not want to override individuals value judgments he suggests a strict constitution (requiring, for example, a balanced budget). Hence public sectors function should be limited to a precise definition of property rights (Anderson 1982), privatisation and management reforms should be introduced.

2.3. Austrian School of Economics To fully understand Austrian School of Economics it is necessary to be aware of the methodological fundamentals this school of thoughts is built on. The Austrian School emerged when economists (Carl Mengers Principles of Economics in 1871) started to focus on the concept of the marginal cost and value. This is why Austrian theorists see economics as the study of human action. This is called Praxeology and was first introduced by Ludwig von Mises12. The fundamental axiom is that individuals act purposefully to achieve chosen ends. So the ultimate end of action is always the satisfaction of some desire of the acting man (Mises 1949). Secondly Austrians are advocates of subjectivism, which takes the private experience of an individual to be the sole foundation of factual knowledge13. The important implication of this is that there is no

10

Market failure: In economics, a market failure is a case in which a market fails to efficiently provide or allocate goods and services. More generally, market failure refers to situations where market forces do not serve the perceived "public interest." The effect of one partys economic activities on another party that is not taken into account by the price system Ludwig von Mises. Human Action (1940) Alexander H. Shand. The Capitalist Alternative (1984) p.3

11 12

13

objective standard of values because objectives of human action are not objective facts but what people think they are. Hence Austrians see what people think (e.g. their evaluations) as the main object of study for economists. Austrian economics is built on Methodological Individualism. Taken into extreme this means that all statements about groups are reducible to statements about the behaviour of the individuals composing those groups in their interaction (Shand 1984). This is why Austrians, as well as Karl Popper14, reject holism (the existence of social wholes, which have purposes or needs) and macroeconomics dealing with interacting aggregates. This means that Austrians seek inequality because it secures a rich variety in the world. In defence of individualists, Hayek (1952) argued that society or an economy could continue unchanged in respect of the interactions of all the individuals within it, even if somehow there was no outside observer to see it as a whole. Critics often emphasize that the existence of phenomena like crowd hostility cannot be denied. However instead of analysing the group behaviour, Austrians go one step further than mainstream economists and take each hostile individual, whose human action is unpredictable, as the centre of their analysis. In other words instead of looking at a whole forest Austrians see each individual tree (Nagel 1961). This implies that there exists no social tendencies which are beyond the power of individuals to alter provided they have the will and the necessary information (Shand 1984). According to Hayek (1952) Austrian economics rejects concepts of scientism in economics because on the one hand facts of social science are subjective and therefore not susceptible to the object methods of natural science. Economic laws expressed in equations are only arbitrary statements. On the other hand markets have far too many variables and are too complex to be measured so it is not unusual that data is forgotten or overseen. However, if (political) decisions assume such empirical tests, they can be highly dangerous. In contrast the market incorporates all data, known and unknown. Last but not least there is an inherent unpredictability and determinacy in human action and so the future is impossible to predict. Moreover humans can never get all available and unavailable information in their decision-making process (no omniscience), which always leads to a degree of uncertainty and risk. Therefore entrepreneurs play a vital part for Austrians in the economy because they take the risk in order to make profits (even supernormal profits possible). That is way entrepreneurs are the prime movers of progresses in a market economy (IEA 1980). In contrast to the two previously mentioned schools of thoughts, Austrian economists start their analysis with the assumption of a totally free market without any kind of government intervention. Property rights, private ownership and free and competitive markets (absence of interventions and regulations) are the basic assumptions for a working economy, where the market automatically allocates scarce resources and individuals voluntarily trade with each other driven by the profit motive. Austrians agree with Public Choice theorists that bureaucracy is inefficient, however for them the problems are not the individuals but the system itself. Mises wrote: Public administration () must
14

Sir Karl Popper (1957)

necessarily be formalistic and bureaucratic. No reform can remove the bureaucratic features of the governments bureaus () [because a] vast majority of men [has] to find that incentive to utmost exertion that the money calculus of profit-seeking business easily provides. The absence of cost calculation makes the public sector necessarily inefficient and political business cycles will continue as long as there is democracy because the system provides individuals incentives to act in that way (Hoppe 2001).

3. Evaluation In order to critical evaluate the role of the state in the views of the three discussed schools we will analyse various problems like poverty, education, healthcare, social security and monopolies.

3.1. Poverty In neo-classical theory governments have to fight against poverty because of the equity argument. It is the right, acknowledged by the welfare state, that every citizen has a right to social security (R. Titmus). Note here that this view of the government is highly against individually responsibility. However if someone believes in the omniscience of the government and that their subjective interventions come closer to the equity argument than leaving everyone to his own responsibility, then the market fails because it provides an incomplete insurance and capital market, depending on the income maintenance. Under perfect competition, the first best solution, an optimal allocation would exist. But the economy is characterized by imperfection. Capital and insurance markets fail because of innovation, transaction costs and asymmetries of information, enforcement costs and adverse selection. For poor people it is impossible to lend money or get insurance. Therefore it is up to the government to provide insurances (e.g. for unemployment or healthcare). Furthermore, according to the Income Maintenance Scheme (second best solution) government should introduce a minimum income for everyone and redistribute money from the non-poor to the poor to correct inequalities. Here the adverse effects on incentives to work and save should be minimised as well as the abuse of it. However this pro-active interpretation of the government involves some complications. Of course government faces problems like transaction costs and asymmetries of information, enforcement costs and adverse selection the same way as private companies. Furthermore interventions always increase costs, which have to be paid by the taxpayer and although government wishes to, it cannot effectively reduce unemployment and poverty traps15. Ironically the cause for the two traps are government interventions. In general Public Choice economists agree with the neo-classical Paretian analysis. However they stress the point that government intervention will lead to inefficiency. An increase in welfare raises bureaucratic policy and so the influence of bureaucrats. Bureaucrats then are more interested in earning prestige, power and patronage. On the other hand, by introducing a public social security system the government becomes the monopoly supplier of social output, which is in neo-classical
15

Unemployment Trap: Individuals are better off getting benefits rather than work since benefits > income; Poverty Trap: Individuals work and receive an income but because of taxes it is reduce and less than benefits

terms a market failure. Monopolies tend to reduce output and quality while increasing costs, in this case taxes. Hence government interventions also lead to a similar outcome like market failures while crowding out the private sector (although Neo-classicals do not see a power abuse in public monopolies). Although Public Choice can detect the weaknesses of Neo-classical economics with their analysis, it fails to suggest solutions. For Public choice theorists, governments are inefficient and work in their own self interest but how can this be changed. Here Buchanan suggests a strict constitution and a limited government. Hence value judgements have to be made, the actual status quo has to be supported16 and as soon as value judgements have to be made Public Choice is back at the beginning of its criticisms. Austrians however provide a contrarian view to Neo-classicals but agree on arguments of the Public Choice School but from a different perspective. For Austrians, as their methodology indicates, poverty is not a phenomena of the free market but a result of government intervention. Hence benefits (for unemployment or single parents) subsidise poverty. In the shot-run it may provide help but in the longrun there will always be more of the subsidised good produced and benefits tend to increase. The best way to solve this problem is economic growth. Sure, most government interventions show (eventually) effects in the short-run but harm the market in the long-run. To increase wages, in contrast to the neoclassical Income Maintenance Scheme, government should abolish pro-union legislation and leave the finding of the wage rate completely to the forces of the free market17. Further it should liberalise licensing legislation, which also serves artificially to reduce employment opportunities in many fields (Reisman 1996). So Austrians argue that inequality does not result from inequalities in skill, ability, or the amount of work done, but from government intervention and the monopolistic protections it gives to favoured groups at the expense of the rest of the population, particularly the poor. Less government intervention leads then to a rising take-home wage and prices decline when government decreases its subsidies and regulations, which would prevent the poor from paying unnecessary high prices. But what about a security net? As Jos Piera18 argues, a social security system can be fully privatised, as the example of Chile shows, where the state owned system (operating from 1925 on) was replaced by a private social security system in 1980. Within 15 years of operation pensions are 50 to 100 % higher than in the old public system, Chilean savings rate has increased to 27% of GNP, the unemployment rate has decreased to 5% and average GDP growth increased from 3 to 6.5%. In another argument Austrians stress the point that the previously mentioned benefits and subsidies lead to the destruction of families, the basis of our society19. Since every kind of support is given by the government families

16

Marie Leigh Livingston. Evaluating the Performance of Environmental Policy; Journal of Economic Issues (1987)

Because raising the minimum wage would only add to forced unemployment and cause the lack of any wages at all on the part of those added to the unemployment rolls. It would add to unemployment, because every rise in price (a wage rate is a price) serves to reduce the quantity of the good or service demanded George Reisman. Capitalism: A Treatise on Economics (1996)
18 19

17

Jos Piera. Empowering Workers: The Privatization of Social Security in Chile (1996) Allan Carlson. What Has Government Done to Our Families? Essays in Political Economy (1991)

are no longer required. What was originally invented to help individuals ended up in transferring from the "dependency" function from families to state employees 3.2. Education20 The next crucial point in an economy is education. For Neo-classicals education is a merit good21 and indeed the education system strongly affects the economy. Therefore government should provide its citizens with education because of two reasons. Firstly, according to the equity argument, every individual should have equal chances. For example, why should a child not be allowed to go to school only because his or her parents cannot afford it or do not take it serious. Secondly, following the efficiency argument, markets do not provide enough education and therefore economic efficiency is not achieved anymore. To prevent parents from taking their childs future chance away (direct or indirect) a national minimum standard is required. Education can be seen either as an investment (future yield because of higher income) or consumption good (learning and studying for leisure). Hence more education increases social welfare. In Chart 9 E is the quantity of education markets produce. At lower prices individuals are willing to consume more (B). Therefore if government subsidises gap A-B individuals can consume more education at a lower price.

P S A P1 E B

D2 D1 0 q 1 q2 Q

Chart 9: Market VS subsidised education

The same arguments applied to Education and Poverty can also be used for other field like Healthcare or Environment. While Neo-classicals stress market failures and the equity argument for an intervention in the healthcare sector, Public Choice critics governments selfish behaviour, which leads to inefficiency and Austrians stress the point that in a free market economy healthcare would be cheaper (e.g. licensing for doctors, tariff protection for medicament imports), the need for private insurance makes the healthcare system more efficient and since people are forced to take care of their insurance individuals responsibility would increase.
21

20

Merit good: good which is so important that an underconsumption is seen as bad

It is often argued that each individual (for children the parents) knows best, what to do with his life and therefore which level of education has to be achieved. Furthermore it is questioned why individuals should pay for education (taxation) even if they do not use it (e.g. higher education). However, education produces externalities like languages, reading and writing skills from which the whole economy profits in an immeasurable way. Nevertheless allocation inefficiency exists (MSV > MPV) because compulsion is treating people unnecessarily22. Moreover education provides positive spillover effects23. Last but not least it is argued that education could be supplied privately. As already mentioned, the equity and efficiency argument resists this as the danger of geographic monopolies emerge, which will affect the quality of education negatively in the long-run. In contrast to that Austrians argue for a free educationa system without government intervention. Public education is a monopoly and therefore leads to resource misallocation and inefficiency. Even if private schools are allowed, the curriculum is still provided by the government, which make private schools just an extension of the public system (Rothbard 1971). Therefore the rights of the parents (which are responsible for the education of their children) and children to choose are violated. Secondly a public system has always ideological dangers because the curriculum is written only by one institution, which cannot be controlled by independent watchdogs. Missing alternatives make it easy for interest groups to manipulate individuals by putting emphasis on certain topics and/or using propaganda in the education system24. In the free market everything that is demanded will be supplied and so would education. Without interventions, not one static system but a diversified, competitive, specialised system with different kinds of schools and curricula according to pupils and students needs would emerge. If only free markets can allocate efficiently then public education produces negative externalities because it does not educate optionally and a wide range of abilities is getting lost, which a private system would boost. A recent example for governments failure is the PISA study25, which showed the weaknesses of the German public education. The critical aspect in this theory is however to finance this system in terms of equity. But if education was private, taxes would be lower. This leaves more money to individuals, which they could allocate for things like education. But what is if that is not enough? Since education and loan schemes are public there is no incentive for the market to provide these goods. Private sponsorship and private loan schemes would emerge, which a) reduce tax burden of society and b) give individuals an incentive to work harder (and finish school and university earlier) since they either get paid by sponsors or have to pay for education on their own. Lastly Public Choices problem with bureaucracy would even not exist since schools would be private firms and run more efficient.
A second opinion would be subsidies but the costs of subsidising positive externalities might outweigh the benefits (Bailey 1995).
23 22

Spill over effect: an activity or situation begins to affect another situation or group of people either in a positive (positive spill over) or unpleasant or unwanted way (negative spill over).

24 It might seem impossible at the moment, however in Germany only 70 years ago National Socialists got into power even under democratic conditions. For them the education system was the easiest way to spread their ideology and propaganda among the population because the government had and still has a monopoly for education. 25

www.pisa.oecd.org

3.3. Privatisation and Monopolies Over the years nearly all economists recognised that there is a problem with government and efficiency. A common way to solve this problem is privatisation of public organisation. As the telecommunication market has shown (in contrast to the prior monopoly BT) efficiency and freedom of choice could be increased, a wider share of ownership reduced government and therefore is no space for gaining political advantages in these companies anymore. Welfare economists argue however that privatisation might increase unemployment plus social costs and so decrease social welfare. That might be true in the short-run but in the long-run Austrians argue that workers are laid off from inefficient labour and are free for efficient jobs. As previously described in a free labour market wages would decrease and so stimulates demand for worker. Hence unemployment is not seen as a major problem. Lastly Neo-classicals fear the rise of private monopolies because profit maximising firms adjust output to the point where MC=MR, which increases the price while output decreases. In general Austrians agree that monopoly is undesirable but in their analysis monopoly is properly applied only to governmental grants of privilege, direct or indirect (Rothbard 1970). Therefore monopolies can only be sustainable if they are supported by the government. If a company reaches monopoly in the free market it is consumers choice and every intervention is against their free will.

4. Conclusion As the essay has shown Neo-classical welfare economics, Public Choice and Austrian Economics have fundamentally different views on governments role in the economy. For Neo-classicals no intervention is required as long as the market is in perfect competition due to allocation efficiency. But as soon as markets are away from perfect competition, allocation is not superior anymore and markets fail. Furthermore markets fail because of public goods, externalities and imperfect information. This movement away from economic efficiency has to be corrected by the government. Here government have to make subjective value judgements but since it is assumed that it works 100% in public interest and knows best what to do, corrective interventions are desired. This is where Public Choice School comes into the discussion. As a sub-branch of neo-classical economics they accept the tools however use them to analyse government behaviour. This analysis criticises governments of not acting in public but in its own interest. Since interventions are always linked to value statements government tends to use its power to maximise its own welfare. As a solution public function should be limited to a precise definition of property rights. Lastly the Austrian School of Economics believes in a free, capitalistic market economy. As Mises already pointed out in 1921 a third way, the combination of economic efficiency with social justice26, is not sustainable. In the long-run a society will either drift towards extreme capitalism or socialism.
The current, most prominent defender for the third way is Amartya Sen, 1998 Nobel Prize winner in economics
26

Mises foresaw the drifts towards more interventions27, because interventions create unforeseen bad effects, which seem to cry out for still other interventions. As the previous examples have shown most market failures neo-classical detect (including such explosive areas as poverty and education) are results of these interventions and leaving markets alone would solve these problems. Nevertheless Austrians recognise that markets can fail. But markets are made by humans and humans are not perfect. However instead of intervening, Austrians believe that markets will solve the problems on their own since an on-going learning process is involved. It is true that many might be sceptic about the superior function Austrians see in the market and label their view of the world as a never reachable nirvana. Furthermore for many the individualistic approach might not be desirable. However, in contrast to other schools Austrian Economics is logical in itself. Without any intervention there is no room for value judgments, which solves all critics of the Public Choice School. In order to guarantee this Austrians argue at least for a minimum government (night-watchman state) with a solid law system build on natural order28 to protect property rights and enforce contract law. However, theoretically, even an anarchy of private property could be possible (Hoppe 2001).

27

In Mises days it was the establishment of the communistic Soviet Union and recently there are massive problems arising in Europes welfare states like France or Germany.

28

Natural order: the physical universe considered as an orderly system subject to natural (not human or supernatural) laws

Bibliography Alexander H. Shand. The Capitalist Alternative (1984) Ludwig von Mises. Bureaucracy (1944) Ludwig von Mises. Human Action (1940) Gregory B. Christensen. James Buchanan and the Revival of Classical Political Economy (1988) Marie Leigh Livingston. Evaluating the Performance of Environmental Policy; Journal of Economic Issues (1987) A.P. Thirlwall. Charles Kennedy 1923-1997: An Appreciation (1998) W.D. Nordhaus. The Political Business Cycle (1975) Blankart and Koester. Virginias Public Choice versus Cambridges Political Economics (2004) George Reisman. Capitalism: A Treatise on Economics (1996) Jos Piera. Empowering Workers: The Privatization of Social Security in Chile (1996) Hans-Herman Hoppe. Democracy The God that Failed (2001) Allan Carlson. What Has Government Done to Our Families? Essays in Political Economy (1991) Stephen J. Bailey. Public Sector Economics (1995) Walter Nicholson. Intermediate Microeconomics and its Applications, 9th edition (2004) Murray N. Rothbard. Education, Free and Compulsory (1971) http://www.kent.ac.uk http://www.foase.org/ http://www.mises.org/