Social Priorities, Economic Efficiency, and an Unexamined Premise of Alfred Marshall1 On Social Priorities Every society operates according to some agenda of social goals, either formally accepted through voting for the platform of one or another political party, or implicit. Once an economy is in motion, however, we tend to forget that such goals require periodic re-prioritization, just as tax laws must be revised from time to time to overcome revenue erosion arising from the learning effect, and as inflation indexes require occasional overhaul as the market basket of goods they represent changes over time to admit new products and drop old ones no longer bought in the same proportions by consumers. It's time that post-Keynesian economic revised the agenda of socio-economic priorities upon which we have been operating to give more attention to the central problems of contemporary American economics instead of debating such secondary, if important, issues as the Federal budget and foreign trade deficits. These are significant issues, it is try, but both a reflections of the inability of the American economy to compete efficiently. The late Otto Eckstein, a brilliant Harvard economics professor, founder of Data Resources, Inc ., and member of the Council of Economic Advisors in his early thirties, used to teach his graduate classes that economists must concern themselves not only with the pure theory of how goods are produced, priced, and distributed, but with the social objectives which guide the economic process. Eckstein identified some eight positive and normative objectives which apply to any society -- capitalist, socialist, or communist. The problem is, as Nobel Laureate Jan Tinbergen showed, that we need at least one policy tool (fiscal policy, monetary policy, trade policy) to direct towards achieving each socio-economic objective. And there simply aren't enough policy variables to achieve each policy objective. So we must neglect some and sub-optimize others, re-prioritizing from time to time to avoid neglecting any one goal until it jeopardized the operation of the system as a whole. Priorities will vary with the level of economic development, the conjuncture of the economy, differences in preferences among societies, how long a given objective has been neglected, what effect this neglect is having on the economy as a whole, and the immanency of external military threat. But sooner or later attention must be given to each of these goals for continued societal stability. Eckstein encouraged students to add to the list, insisting that his categories were not prescriptive. After twenty years, I've been able tentatively to identify only one social objective not clearly included in one or another of Eckstein's (see item 8 in list below). The Eckstein list (with my addition), numbered according to today's priorities -- as I see them: 1. Efficient Resource Allocation. I assign first priority to this item because it's been neglected for so long it's become a threat to the operation of our economy and society as a whole. Efficiency, which is the "economizing function" per se , was the main subject of attention of both classical and neo- classical economists, who saw it as the primordial subject of economic study. The 1. Published in Enclyclia , the Journal of the Utah Academy of Arts, Letters, and Sciences, Volume 64, 1987 whole thrust of the marginalists was to show how a freely operating market provided optimal resource allocation as a result of the marginal pricing of goods and services and factors of production. The consequences of efficient resource allocation is to minimize wasted effort, maximize productivity, and enhance competitiveness. (Consider the effects on the Balance of Payments and Central Government Budget of a return to an efficiently operating American economy.) This objective was the core of "supply side" economics, whose spokesmen unfortunately failed to articulate it clearly. (Comment following initial publication of this article in Encyclia in 1986: The American economy seems to have accomplished significant improvement as a result of even the half-hearted "supply side" reforms of the Reagan Administration, while the downfall of the Soviet Union appears directly attributable to the mounting economic cost of the failure of central planning efficiently to allocate factors of production and effectively satisfy both public and private demand for goods and services.) 2. Sustained High Growth to provide jobs for new entrants to the labor force, improve the standard of living, expand the range of human choices, minimize social frictions, and facilitate changing sectoral wages as new industries emerge and old ones decline. It is easier to reallocate wages by altering proportional shares in a growing pie (where it appears that everyone's wage is increasing), that to redivide a pie of fixed dimensions. (Post-initial publication comment: As a result of the attempt to emphasize supply-side programs in the mid-to late 80s, the U.S. seems to have led the world in creation of new jobs, giving force to Classical arguments according high growth a leading position as a national economic objective. Studies which appear to show Labor receiving a declining share of output, and arguing that this demonstrates the failure of supply-side measures, neglect the above argument that such declines may demonstrate nothing more than the altered proportionate share in the growing pie, which has served the socially important function of masking the reallocation of wages from the declining "smokestack industry" sector, to the "high tech" and service sectors.) 3. Full Employment . Labor and factory capacity not utilized today can never be recaptured. Lost production due to unemployment is, after chronic inefficiency, the worst loss an economy can experience. This is why many economists prefer an economy to operate slightly on the inflationary side of equilibrium rather than on the deflationary side. Regrettably, inflation tends to get out of hand, and there seems to be no solution other than a sever does of unemployment to restore wage and price discipline: so it seems we can't always enjoy uninterrupted full employment at the same time as our next priority: stability of prices. 4. Price Stability is always a top priority for savers, for those living on fixed incomes, and for retirees. Unfortunately, some benefit from inflation, not least governments who often find tax bracket creep and erosion of the cost of repaying accumulated debt operate in their favor. Excessive inflation is not a current problem in the U.S., but remains fairly high on this list because of recent experience and because of further inflationary pressures resulting from the still massive budget deficit. 5. Balance of Payments Equilibrium . Regrettably, governments often treat this item as a residual objective. A country can live with a deficit as long as its reserves last, or as long as its trading partners are prepared to accept its IOUs -- or give up their own savings to invest in the deficit country. This is the current position of the United States vis-a-vis Europe and Japan. A surplus country can run surpluses as long as its trading partners are prepared to accept an excess of its goods and services without retaliation and as long as they have resources to pay for them. This is the current situation in Germany and Japan. Problem is that the trading partners of the U.S. are beginning to feel ill at ease financing our enormous balance of payments deficits with their savings. And the U.S. and the rest of the world are starting to think that Japan isn't playing the game, given its large, chronic trade surpluses and its unwillingness to admit the goods and services of others on conditions of reasonable equality. Aside from a more efficiently operating economy, an attractive exchange rate, and a degree of international cooperation, the only apparent solution to a chronic b/p deficit is controls -- which interfere with the efficient allocation of resources and the efficient exchange of goods and services. We should therefore avoid protectionism, seeking to make the American economy more efficient through attention to objectives 1, 2, 3 and 4 and through further efforts to persuade Japan that it must open its economy to competition or suffer the consequences (see related paper on Second Best and Foreign Trade Theory ). Japan, too, must review its list of economic priorities. Since a permanent solution to the trade deficit depends on achieving other objectives, B/P equilibrium has been placed only mid-list, despite its importance and the fact that it can't be ignored much longer. 6. Equitable Income Distribution . Some think that the U.S. is suffering from a little too much social equity. It certainly has been a top priority for too long, leading to the neglect of goals 1, 2, and 4. The variance in income between ordinary production line workers and top managers and between clerks and senior officials in government is at least twice as large in Communist Russia than it is in the capitalist U.S. Japan seems to have recently elevated this item in its list of priorities, which might help redress the balance somewhat. (Post-publication comment: The wage-differential situation in Russia has of course altered dramatically, and while post-Marxist neo-capitalists are making huge financial killings, many common people have been "killed" in the financial scams which are inevitably a part of the "robber baron" capitalism which precedes effectively applied supervisory structures of a properly functioning government/market economy partnership. Regrettably, naive Soviet social reformers seemed to overlook the necessity for a reformed legal system to accompany a reformed market structure, believing that the blessings of the free market would operate automatically. It is to be hoped that confidence is not lost in the free market as well as in a free society as a result of these imperfection, and that Russian society will not fall back into the grossly inefficient command economy/command society mode before having the opportunity to taste the results of properly monitored freedom. In the meantime, the gap between greedy CEOs, who have taken no account of the recessionary conditions of recent years in setting their own reward structure (often unbelievably free of constraint by Boards of Directors or Stockholders) , and wages of production line workers, may have worsened by a factor of ten. For suggestions, see related paper A Proposal for a Graduated Corporate Income Tax Related to Corporate Performance. ) 7. Conservation of Natural Resources . Few would deny that the United States neglected this objective throughout too much of its history. Air and water pollution, overgrazing of public lands, mis-use of national forests, and wrongful disposal of toxic wastes were making severe inroads on the legacy we were leaving to our children. But, as with many abrupt re-orderings of social priorities, the pendulum may have swung too fast and too far. Cautious retreat is indicated in some areas, which is why in my prioritization of objectives I've lowered consideration to position 7. 8. The new item I've added to my personal list of socio-economic objectives is Preservation of a Desired National Life Style. I call this Social Product Differentiation , reflecting its relationship to the concept of Product Differentiation introduced into economic thinking by Professor Edward Chamberlain some fifty years ago to explain the role of trademarks and advertising. Based on experience with Canada and certain developing countries with strong cultural preferences and antipathies to accepting foreign investment out of fear of the effects this would have on the national culture, I see the demand for Social Product Differentiation as an important politico-economic element of our time. If a nation is informedly prepared to live with the somewhat less efficient lifestyle than that prevailing in more economically advanced nations, and is prepared to pay for this by giving up achievement of some other economic objectives, I see no reason why it should not do so -- just as an individual consumer might prefer Post Toasties to Kelloggs, -- or Fords to Chryslers. 9. National Defense . If a nation is overrun be a people of another political tradition and culture, there's not much benefit in having won high marks in achieving other socio-economic objectives. I place defense last on my own list of contemporary national priorities not from disregard for its importance, but simply because we're just experienced a period of costly military renewal, because I think the nuclear stand-off is likely to endure, and because American security is unlikely in any event to be enhanced by further high military spending. Others are of course entitled to differ with this judgment and assign a higher priority to defense. (Post publication comment: In retrospect, I think the low priority assigned this objective has been justified by events. The Soviet Union fell apart in large part because it was outspent by the U.S. (and in part because its inefficient economic system couldn't keep up with our deceptively-advertised success with the Reagan Star Wars program). The current danger [1994] is that we'll cut back too much, losing sight of the danger of nuclear proliferation to Third World and Terrorist Countries out of false relief at the disappearance of the Soviet threat). For too long, emphasis in the U.S. was on maximizing goals 3 and 6 -- areas given priority in the Keynesian economics which grew out of the conditions which characterized the Great Depression. These were the prime objectives of The New Deal and The Great Society. More recently, the excessive inflationary experience of the early '80s and the arguments of Supply-side Economists have elevated the importance of Price Stability. And, in the meantime, the competitive position of the United States has continued to deteriorate, both in terms of our lagging productivity and our falling per capita income ranking among world economies -- as well as with respect to our sever central government budget deficits, towering private debt, and national balance of payments disequilibrium. Clearly, this deterioration is traceable to long-deferred attention to objectives 1 and 2: Efficiency and Growth. But what to do? The first coherent economic thinkers, the French Physiocrats, placed special emphasis on the efficient use of Land as the ultimate source of all wealth. This was understandable in the preindustrial age where most wealth did arise from agricultural output. Classical economists, whose work was contemporary with the Industrial Revolution, identified two other "factors of production" -- Capital and Labor . Except for Marxists, who for social and historical reasons still choose to emphasize Labor as the ultimate source of value, attributing the difference between the cost of wage inputs and the sales price of finished products to capitalist exploitation, main-stream economics has continued to accept the classical tri-fold analyses of the factors of production. The Austrian economist Karl Menger, and the marginalist school which developed his ideas, identified the true source of profit as the difference between the cost of the last unit of labor productively used (which fixes the wages of all comparable workers), the marginal unit of capital (which fixes the interest rate, which is the cost of capital), and the marginal unit of land put to productive use (which determines land rent), and the subjective value ascribed to a good or service by the past purchaser who buys it (fixing product prices). Menger, and his contemporaries Eugen Bohm-Bawerk, and the Englishman Stanley Jevons, showed that a free market economy is a positive sum game in which there are no losers, both buyers and sellers benefitting from the exchange. Productive efficiency is reflected by the relative profit position of a producer. And all but the marginal producer and marginal buyer experience either cash profits ("producer surplus") or psychological satisfaction, i.e. "consumer surplus" (the difference between what one is subjectively prepared to pay and the less amount most of us are actually compelled to pay by the intersection of aggregate supply and demand). It turns out that by allowing supply and demand to determine the values of factors of production (wages, rents, and interest payments for capital) and prices of final products in a free market, the resultant prices constitute a highly useful index of the relative efficiency with which an economy is functioning, providing at the same time and essential guide to investors and bank lenders as to where additional inputs of scarce capital will be most efficiently employed. Market forces thus result in the most efficient allocation of productive resources as well as optimal distribution of final products to maximize consumer utility. Unfortunately, Marx died ten years before Menger's seminal insight which resolved the problem of value with which he and Engles had unsuccessfully wrested. So Communism has been stuck with a defective theory of value which provides no guidance with regard to the efficient allocation of manpower and materials, and which operates without a competitive price structure to ration goods according to consumer preferences. Most allocational decisions are made by committees whose criterion for membership is political reliability, not economic acumen. As a result, Marxist economies have suffered from chronic inefficiencies. In an attempt to resolve this problem, Communist china has introduced market pricing in limited sectors of its economy to create indices of efficiency and improve the functioning of its economy. In the Soviet Union, economists such as Yevgeny Friedman have been experimenting with new terminology and new approaches to setting wages and measuring the efficiency of production units paralleling the western concept of marginal productivity. An entirely new vocabulary is necessary to describe these processes since, of course, Marxists can't simply permit government-run factories to experience "profits" or "losses" or to allow free unions to negotiate competitive wages in order to introduce allocative efficiency into the Soviet system. In the meantime, the USSR "borrows" prices from free world markets in order to sell their products abroad. Of course these "prices" bear no relation to Soviet production costs, and are thus another source of confusion and inefficiency. The great Neo-Classical Economist Alfred Marshall considered entrepreneurial skill so important to the economic process that he once suggested that it be considered a fourth factor of production. More recently, Harvard psychologist/economist Professor McClelland, through observation and experimentation with children, has come to the conclusion that entrepreneurial talent is the scarcest of all economic inputs. If Marshall's suggestion had been enthusiastically accepted by the economics profession a hundred years ago and made a standard element in economic education and analysis, even Marxists would have by now realized that entrepreneurial skill contributes to the creation of wealth, as well as land and labor, and thus commands its own reward. And Free Market Economics might have waged a more decisive battle with the meretricious attractions of communism in the Third World. With both China and the USSR reexamining aspects of Western economic theory, it may not be too late to pick up Marshall's idea and run with it. Certainly it is an appropriate moment for the headquarters of free market economics to rethink the contribution of entrepreneurship to the functioning of our own muscle-bound economic structure. There is, according to Marshall (and McClelland) a qualitative difference between the true entrepreneur -- one who identifies and successfully brings to market a new product or new productive technology, such as An Wang, Edward Land, Stephen Jobs, or Ross Perot and high level industrial bureaucrats who, despite their specialized skills in finance, engineering, or marketing, simply carry forward the processes or ideas of others. Why then do our tax laws treat them the same? We differentiate between ordinary income and capital gains, with the objective of stimulating risk-taking investment. Why not promote the mergence of the rarest and most valuable economic input by establishing criteria to differentiate tax treatment of the earnings of entrepreneurs and conventional businessmen? The successful entrepreneur contributes to much in the way of added productivity and efficiency-generated profits (from which are derived government revenues to pay for social services and defense, as well as the dividends and interest payments which are important sources of income and purchasing power for savers and may retirees -- not to mention "consumer surplusses" to the benefit of all), that whatever fractional hundredths of a per cent of g ross sales enter the pockets of the entrepreneur personally, his/her gains are but a pale reflection of their contribution to social utility. If the U.S. is to complete successfully with the Japanese, Germans, and now it seems with the Koreans, can we afford not to provide incentives to draw out every entrepreneurial talent at our disposal in order to achieve maximum efficiency in the allocation and use of all other factors of production? We should without delay reexamine our agenda of socio-economic priorities to accomplish this.