The Online Library of Liberty

A project of Liberty Fund, Inc.

• Foreword
• Preface
• The Reason of Rules
• 1.: The Constitutional Imperative
• I.: Introduction
• II.: Reasons For Rules
• III.: Rules of Games
• IV.: Rules of the Road
• V.: Rules of the Market Order
• VI.: Rules of Political Order
• VII.: The Importance of Rules
• 2.: The Contractarian Vision
• I.: Introduction
• II.: Noncontractarian Constitutionalism
• III.: Individuals As Sources of Value
• IV.: Contract and Exchange
• V.: Politics In the Exchange Perspective
• VI.: Unanimity As the Contractual Ideal
• VII.: Agreement On Rules and the Veils of Ignorance and Uncertainty
• VIII.: Conclusions
• 3.: The Myth of Benevolence *
• I.: Introduction
• II.: Private Good and Public Good
• III.: Science, Truth, and Politics
• IV.: The Authoritarian Imperative
• V.: Majoritarian Democracy In the Noncontractarian Paradigm
• VI.: The Aim of Politics
• 4.: Modeling the Individual For Constitutional Analysis
• I.: Introduction
• II.: Homo Economicus In Politics: the Argument For Symmetry
• III.: Science and the Empiricist Defense
• IV.: A Methodological Defense of the Differential Interest Model of Behavior
• V.: Social Evaluation and Quasi-risk Aversion
• VI.: Gresham’s Law In Politics
• VII.: Summary
• 5.: Time, Temptation, and the Constrained Future *
• Preface
• Part 1.: Individual Private Choice
• I.: Introduction
• II.: The Ultimate Z ’s
• III.: Preferences For Preferences
• IV.: Past, Present, and Future
• Part 2.: Individual Public Choice
• I.: Introduction
• II.: Society With a History
• III.: Temporal Interdependence
• IV.: An Illustration
• V.: Moral Rules And/or Constitutional Commitment
• 6.: Politics Without Rules, I: Time and Nonconstrained Collective Action
• I.: Introduction
• II.: The Social Discount Rate
• III.: The High-tax Trap
• IV.: The Inflation Trap
• V.: The Public-debt Trap
• VI.: Other Examples
• VII.: Conclusions
• 7.: Rules and Justice
• I.: Introduction
• II.: Just Conduct and the Notion of Desert
• III.: Justice and Promise Keeping
• IV.: Justice Among Rules
• V.: Just Rules, Agreed-on Rules, and Just Conduct
• VI.: Conclusions
• 8.: Politics Without Rules, II: Distributive Justice and Distributive Politics
• I.: Introduction
• II.: Distributive Justice: the Conventional View
• III.: The Constitutional Perspective and Institutional Incidence
• IV.: The Incidence of Unrestricted Majoritarianism
• V.: Tax Rules and Distribution Under Majority Rule
• VI.: Direct Constitutionalism and Distributive Justice
• VII.: Summary
• 9.: Is Constitutional Revolution Possible In Democracy?
• I.: Introduction
• II.: Pareto-superior Change and Wicksellian Unanimity
• III.: Distributional Limits and Prospective Rules
• IV.: Status Quo Entitlements and Distributional Envy
• V.: Constitutional Change and Free Riders
• VI.: The Role of Norms
• VII.: Toward a Civic Religion

V.

Social Evaluation and Quasi-Risk Aversion

We shall proceed with a somewhat varied elaboration of the theme introduced in Section IV. We have perhaps not yet fully established the case for the use of Homo economicus in the generation of normative conclusions about the choice among alternative sets of rules. In particular, we have not discussed the implications of the elementary fact that more restrictive rules will not only help to prevent the occurrence of disaster but also often preclude actions that may be intended to promote desirable outcomes.

Consider an issue that was widely discussed in the early 1980s: the proposed “balanced-budget amendment” to the United States Constitution. We can analyze the role of constraints within existing political institutions8 by means of the self-interest behavioral model for actors. We can make some predictions as to the effects of the existing constraints of electoral competition on the proclivity of political agents, or coalitions, to create budget deficits. We can then ask how the behavior of these agents might be modified by the introduction of an enforceable balanced-budget constraint. But any complete analysis would also have to reckon with the possibility that such a balanced-budget rule, if operative, might sometimes restrict well-intentioned and far-seeing politicians from securing macroeconomic stability. (We do not propose to enter into the debate concerning whether systematic governmental intrusion in the macroeconomy can, even in theory, exert a stabilizing influence.) In one perspective on politics at least, any implied reduction in the governmental flexibility of response to unforeseen circumstances will embody potential costs that must be taken into account.

It is obvious that the degree of disinterested and far-seeing behavior on the part of political agents will be relevant to the comparison of expected costs and benefits of alternative fiscal rules. The model of self-interest, or Homo economicus, will tip the balance of argument in favor of assigning less discretionary power to political agents than would be the case under the benevolence model. In this sense, the Homo economicus model is not innocent, and its claim to empirical relevance must be addressed.

Even at this level of inquiry, however, the mere empirical record can be very misleading, particularly if this record is interpreted in a strictly predictive manner. That is to say, if we seek a model of human behavior that corresponds to some “best” prediction, either in the technical sense that the variance from observed values is minimized or in the heuristic sense that some fair average of observed behavior seems to fit, and then, at the second stage, try to compare institutions on the basis of such “best-fit” models, the results will be systematically biased in the direction of inadequate constraints. For these reasons, the Homo economicus model may be justified despite the fact that it embodies more cynicism about persons’ behavior patterns than the simple evidence warrants. To put the same point differently, if we array models of behavior along a conceptual spectrum from “worst-case” to “best-case” poles, the model that is appropriate for making a comparison among social arrangements is somewhat closer to the worst-case pole than that corresponding to the simple “average” description of behavior.

The line of reasoning here is that there is, in the evaluation of institutional alternatives, an intrinsic feature that imposes a sort of risk aversion on the evaluator. We should emphasize that we do not assume that individual citizens, either behind some veil of ignorance or as located in society, are inherently risk-averse in the normal meaning of this term. For our argument here, we may take individuals to be strictly risk-neutral. It is the peculiar setting of choice that causes the individual to behave as if he were risk-averse—hence, our use of the phrase “quasi-risk aversion” in the title of this section.

Our claim is that because of the nature of what is to be evaluated, the gains attached to an “improvement” secured by departures of behavior from the modeled are less than the losses imposed by corresponding departures of behavior in the opposing direction, that is, toward behavior worse than that represented in the model itself. To express the argument in terms of the worst-case, best-case spectrum, as we move from the best-case pole to the worst-case pole, predicted social losses (costs) increase at an accelerating rate. The harm inflicted on his fellows by a person who behaves “worse” than the average person in the community is greater than the benefits provided by another person who behaves “better” than the average person. Accordingly, the average-person model understates the average harm done. In imagining scenarios that might emerge under various sets of rules (a process that is essential before a choice is made), citizens will act as if they were risk-averse. There will be a rational “bias” toward avoidance of the worst-case prospects.

Nothing more is required to sustain this claim than the elementary apparatus of economic analysis. We need only assume, first, that sets of rules are instrumentally valued in the sense that they are expected to facilitate the provision of what can be conceptualized as valued goods and services. From this assumption it follows that these goods and services can be quantified, in terms of more or less. Second, we assume that goods and services are not costless; the polity-economy operates within an overall scarcity constraint. Finally, we assume that the demand curves for these goods and services slope downward.

1.

The monopoly example

We shall elaborate the argument by means of an extended example, the results of which can then be generalized to institutional comparisons of all types. The example involves a comparison of competition and monopoly. Elementary theorems in welfare economics demonstrate that efficient resource usage occurs when there is complete freedom of entry given specified technical conditions that must be satisfied. In the equilibrium of such an industry, there are no unexploited gains from trade. Implicitly, this model of competition assumes that all persons are net wealth maximizers. By extending the same behavioral assumption to (nondiscriminating) monopoly organization of the same industry, the analysis demonstrates that efficient resource usage does not characterize the equilibrium results. There will be welfare losses, in comparison with the ideal outcome, that stem from restriction on entry: There are unexploited gains from trade.

The magnitude of these welfare losses will depend, however, on the assumptions made about the monopolist’s behavior. In the textbook models, monopolists are modeled as net wealth maximizers, but other possibilities are no less plausible a priori. For any number of reasons, the monopolist may refrain from charging the profit-maximizing price—to discourage entry by other firms, out of sheer inertia, or to further the perceived “public interest.”

If the purpose were to develop a theory of monopoly behavior that would be of assistance in predicting the pricing and the output strategies of firms that are in monopoly positions, appeal to the empirical record would seem entirely appropriate. From such a record, we might be able to derive a maximand for the simple monopolist that would yield the best prediction of price-output behavior, a maximand that would embody both private-interest and public-interest arguments, as empirically relevant. Our point is that such a predictive model is not, in general, appropriate for the estimation of welfare losses from monopoly organization.

For the sake of simplicity, assume that all monopolists fall in two groups. One-half of all monopolists are strict profit maximizers in the pure textbook sense; the other half are pure “public-interest” firms, and these set prices and outputs at the level attained in full competition. In this setting (and assuming linear demand curves), the best single model is one in which price is set halfway between the profit-maximizing price, say, p*, and the competitive price, say, p_c. If the good is provided under monopoly conditions, in many separate locations, and the demand curve in each location is that labeled D in Figure 4.1, then the best single prediction of price in any location will be p_e = ½(p* + p_c), with the corresponding output q_e.

If this best-fit model of monopoly behavior is now used to estimate the welfare losses of monopoly organization in general, we should proceed to estimate welfare loss for each location in the amount ABC in Figure 4.1, with total welfare loss being this quantity summed over the n locations. This total would then purport to measure the excess value that all persons (consumers and monopolists) would be prepared to pay (in terms of the value of other goods forgone) to secure a guarantee of the efficient outcome.

Such analysis would, however, simply be wrong. The area ABC does not provide the best measure of the per-location welfare loss of the monopoly form of organization. The expected per-location loss attributable to monopoly is one-half of the loss under the profit-maximizing model plus one-half of the loss under the public-interest model of behavior (the latter is zero by assumption here). In other words, the expected welfare loss per location is one-half of the area CEF (Figure 4.1), which is larger than the area ABC.

If we measure welfare loss as a function of output over the relevant range, we obtain Figure 4.2. The W curve shows the relation between welfare loss and output and is based on the measurement of the triangles subtended in Figure 4.1. We use the more or less conventional formula9W = (½dp/dq)(q - q_c)². The central point is that W is a “convex function” of the difference between actual and ideal output. This means that the welfare loss at the best-fit output level q_e, which is W(q_e) in Figure 4.2, is characteristically less than the best-fit welfare loss, which is ½[W(q*) + W(q_c)]. That is, the expected cost of monopoly is greater than the cost associated with expected monopoly behavior, because the profit maximizers do proportionately more harm.

There is, of course, a single model of monopoly behavior that will yield an appropriate estimate of the costs of monopoly—namely, the model that generates q′ in Figure 4.2 as the average monopoly output choice. Our basic point here is that this model of monopoly behavior is systematically more cynical (that is, closer to the worst-case end of the spectrum) than simple empirical inspection of monopoly behavior would suggest. Consequently, something reasonably close to the simple textbook model of the profit-maximizing monopoly may be justified, even though at least some monopolists behave in a way more congruent with “public interest” provided that the objective of the model is to lay a basis for the normative evaluation of alternative institutional forms.

2.

The general case

The central point is much more general than the monopoly example. Models of behavior used in social analysis are often evaluated simply by appeal to the “facts.” It seems clear that to many analysts these “facts,” distilled from simple observation, from introspection about themselves in policy roles, or more elaborately from consultation of the historical record, suggest that those who hold discretionary power under a particular institutional regime will often be constrained by internal moral considerations from acting in a self-interested way. Suppose that this is so. Nevertheless, any model of behavior derived from a simple “average” of observed behavioral patterns will not be sufficient for comparative institutional analysis. An appropriate behavioral model will have to reckon with the fact that the harm inflicted by those who behave “worse” than the notional average will be proportionately greater than the “good” done by those who behave “better” than the average. Accordingly, a bias toward the worst-case end of the behavioral spectrum is entirely justified. Specifically, Homo economicus can be used as a model for comparative institutional analysis even when the empirical record (however described) indicates that its allowance for the relevance of public-interest motivations is inadequate.

We have presupposed that political and market institutions are valued not in themselves but for their potential capacity to allow the generation of desired goods and services. If this analytical framework is accepted, it seems natural to conceptualize individuals at the constitutional level as making determinants over possible institutional arrangements in a manner analogous to the choice between monopolistic and competitive market forms. Using the Homo economicus behavior model in constitutional analysis, and justifying this use on analytic rather than empirical grounds, is a procedure we have borrowed from the classical political economist-philosophers in their analysis of political institutions. And we can, perhaps, do no better in this connection than appeal to David Hume: “In constraining any system of government and fixing the several checks and controls of the constitution, every man ought to be supposed a knave and to have no other end, in all his actions, than private interest.”10

[8. ]We have made several efforts to do so. See, particularly, James M. Buchanan and Richard E. Wagner, Democracy in Deficit (New York: Academic Press, 1977); and Brennan and Buchanan, Power to Tax.

[9. ]See Arnold Harberger, “Three Basic Postulates for Applied Welfare Economics,” Journal of Economic Literature 9 (September 1971): 785-97.

[10. ]David Hume, “Of the Independency of Parliament,” in Essays, Moral, Political and Literary, Vol. 1 (London: Oxford University Press, 1963).