Do Positive Externalities Always Justify Government Subsidies? Some Insights From the Austrians and Public Choice

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Thom Lambert, Do Positive Externalities Always Justify Government Subsidies? Some Insights From the Austrians and Public Choice, Truth on the Market (June 14, 2006),

The folks over at Lawyers, Gun$, and Money are chiding me for ignoring (or, as they say, never having heard of) positive externalities. A couple of days ago, I criticized a NYT editorial calling for the federal government to “throw its weight behind” private efforts to develop alternative fuels. My main point was that the best thing the government could do would be to let energy prices rise in response to forces of supply and demand. High prices, I argued, have spurred — and will continue to spur — private investment in alternative technologies. Government incentives to encourage R&D, I argued, could cause firms to make investment decisions aimed at appropriating government money rather than at pursuing the most fruitful avenues of research.

According to the folks at Lawyers, Gun$, and Money, this argument ignores the positive externalities (i.e., benefit spillovers) associated with research into alternative fuels: Because such research is likely to create public benefits that cannot be appropriated by the people doing the research, it is proper for the government to subsidize the research.

While I agree that research on alternative fuels likely does create positive externalities, I still believe the best policy is laissez-faire. If the mere existence of positive externalities could justify government subsidization of the process that creates them, the government would be subsidizing a heck of a lot of stuff. Seriously, think about it. All sorts of activities create benefits not appropriable by their creators, but the government subsidizes only a fraction of them. Now, one might argue that the externalities at issue here are so substantial that subsidization is warranted, but I’m not so sure. To see why I’m skeptical consider some insights from the Austrian and Public Choice schools of economics.

First the Austrians. A fundamental and profound insight of the Austrians (e.g., F.A. Hayek) was that the information necessary to determine how resources ought to be allocated to maximize social welfare is not given to anyone in its entirety. (See, e.g., here.) An implication of this insight is that centralized bureaucrats simply don’t know how the economy should develop — e.g., which technologies should ultimately dominate. Given their ignorance, bureaucrats should act modestly, attempting not to determine end states (i.e., how productive resources ultimately get allocated) but to create the sorts of institutions that allow markets to flourish. Markets, then, will generate prices that convey the information necessary to allocate resources their highest and best use.

Next, Public Choice. Theorists from that school have helped us see that individuals do not stop acting as rational self-interest maximizers when they step into the public square. Governmental power is a commodity to be bought and sold, as is government largess. An upshot of Public Choice theory is that a government that routinely doles out goodies is likely to be captured by well-organized interest groups, to the detriment of the general public. Interest groups that stand to gain from government hand-outs will reallocate resources away from production toward lobbying.

So it seems there are at least three relevant sources of potential welfare loss here: (1) the allocative inefficiency that occurs because of positive externalities, (2) the inefficiency resulting from bureaucratic mistakes in determining how productive resources should be allocated, and (3) the allocative inefficieny and deadweight loss that result when businesses chase after government hand-outs.

With respect to alternative fuels research, my hunch (and it’s admittedly a hunch) is that the last two potential welfare losses are, taken together, greater than the first. There’s huge money to be made by developing alternative fuels and, consequently, lots of private resources are being funneled toward such efforts. If government starts “throw[ing] its weight” around now, as the NYT suggests that it do, it’s likely to adversely affect how R&D dollars are spent. Governmental incentives are narrowly targeted, and legislators and bureaucrats at this point simply don’t know what’s the proper target. I’d rather see them stay out of the business altogether and let those closest to the action determine how productive resources should be allocated. Those folks will tend to send resources in the right direction, unless they’re distracted by the possibility of a governmental handout, in which case they’ll expend resources on lobbying (deadweight loss) and tailor their research efforts toward getting government’s goody.