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Stiglitz is Wrong on Government

Mises Daily: Wednesday, September 06, 2006 by


Joseph Stiglitz shared the Nobel Prize in 2001 partly on the basis of an important paper of his (with Greenwald): "Externalities in Economies with Imperfect Information and Incomplete Markets." In that paper he says: "There exist government interventions (e.g., taxes and subsidies) that can make everyone better off."

Stiglitz is a prolific, outspoken, and outstanding spokesman for the pro-government school. Stiglitz sees market imperfections that are remediable by government everywhere he looks; and this paper is supposed to provide the intellectual and analytical foundation for government intervention. I will argue that this important and oft-cited paper completely fails to prove the potential worth of government interventions.

Murray Rothbard's views directly oppose those of Stiglitz. In his paper "Toward a Reconstruction of Utility Theory and Welfare Economics," Rothbard writes: "We conclude therefore that no government interference with exchanges can ever increase social utility," (his emphasis).

Whose view is correct is tremendously important as it touches upon the entire realm of political organization. If Stiglitz's pro-state view is correct, it provides justification for the interventionist state. If Rothbard's anti-state view is correct, then it removes the justification for all government activities, including those supposedly justified by externalities. Since the set of externalities can be made almost indefinitely large by liberal interpretation, it is important to assess Stiglitz's arguments that the state should or can raise social utility by operating on externalities.

I will examine Stiglitz's views primarily on his home ground, that is, with reference to his theorizing or his model. This shall be done in a way that does not burden the reader with his mathematics yet is completely faithful to his equations. At the end of the argument, the reader will understand exactly why we can reject his conclusion.

The Stiglitz Model

The Stiglitz model has no mathematical errors in it that I know of. The equations follow one another correctly. The implications are correctly deduced from the premises. The problems with the model are deeper than mathematical. The fundamental problems with the model involve its treatment of government and the treatment of externalities. Stiglitz grafts these onto the standard neoclassical model of exchange and production. The grafts, however, are ad hoc, incomplete, and inconsistent with what they are grafted onto. The resulting theory provides no support for government.

Stiglitz starts with a standard timeless neoclassical model of general equilibrium under certainty, and part of the paper extends it to uncertainty. The paper's innovations include (1) a simple method by which to tell whether in the model there is a set of taxes, subsidies, and lump-sum transfers that indicate a positive net "government" revenue while leaving household utilities unchanged, and (2) applications of the model to several situations that had previously been treated in disparate fashion. These innovations, which I do not criticize, are responsible for the paper's fame.

Model Basics

There are two sectors in the basic model, households and firms. In standard neoclassical fashion, the households maximize utility and the firms maximize profits. Firms are "black boxes" that process inputs into outputs according to some fixed technology, so they do nothing interesting in the model. The paper's purpose is to explore the effects of externalities on the Pareto optimality of household and firm optimizations. The paper extends the neoclassical model. We could dismiss the whole exercise as flawed because of its neoclassical unreality, but, as I have said, I propose to entertain the neoclassical model core and show that even if we accept it, Stiglitz's extensions are unacceptable.

Stiglitz (and other neoclassical economists) model utility as depending on two sorts of items. One is goods that are produced, traded, and have prices. (Later in the model, the "government" will be alleged to do particular things regarding these goods such as tax them.) The second is items (called externalities) that are not traded and do not have prices in the model. They do not appear in the budget constraints of the households (or firms) as costing anything, but the household utilities are affected by them. Because they do not appear in budgets and cannot be traded but do affect utility, household optimizations leave possible utility gains on the table. The equilibrium is therefore not Pareto optimal when these externalities are present.

Government in the model is an entity that leaves each household's utility unchanged while maximizing its excess of tax revenues over lump sum transfers to households. This is its behavior function. The only way that it can have such an excess is when there are externalities. When such an excess occurs, it amounts to money or utility left on the table by households and firms. Such sub-optimization has to occur by the assumption that neither is able to trade certain goods that affect profits and utility. The implications follow implacably from the assumptions.

Four Main Criticisms

Now, what are the fundamental criticisms of this model? There are four big questions.

  1. In the model, the households and the firms optimize, yet somehow they are still not as well off as they can be. They leave gains on the table that are sopped up by government. Why don't households and firms fully optimize, that is, take into account the externalities?
  2. In the model, why is government able to recognize the externalities and compensate for them by a series of taxes, subsidies, and transfers while households and firms cannot and do not?
  3. In the model, what sort of entity is this government and how does it relate to the entities that it is taxing?
  4. What does the entity called government have to know in order to effect the taxes, subsidies, and transfers?

I consider each of these questions in turn.

Why don't households and firms optimize fully? Stiglitz posits that they optimize utility, which is standard neoclassical economic theorizing. Assume that there are externalities. A genuine theory would explain how the externalities arise even while households and firms optimize. It would introduce a theory of costs or some other factors that cause externalities. This is essential if it is to be argued that government can recognize and overcome these externalities. Stiglitz provides no such theory. He simply inserts the externalities into utility and production functions without prices and then allows households and firms to optimize. This procedure can be done mathematically, which is what Stiglitz does, but it is entirely ad hoc. It lacks theoretical justification because the externalities in the model do not themselves arise in the context of other optimizing actions of the economic actors.

I do not say that there should never be ad hoc theorizing. There is a cost and benefit to it, and there will be times when it is worth doing. But in a case where the central message is to promote government and downplay markets, it just will not do to introduce the reason for government in an ad hoc manner.

There is a further problem with introducing externalities in an ad hoc fashion, namely, model inconsistency. The Stiglitz model is an equilibrium model, which means that everyone has already done the best they can possibly do. From that perspective, private parties already have done the best they can do in order to internalize the externalities (create contracts, exchanges, and prices for them). It is then inconsistent with the spirit of optimizing models and equilibrium models to introduce ad hoc externalities. Where do they come from, and why aren't they already priced out? The Stiglitz model contains at its core an ad hoc element that drives all the results and that is inconsistent with the optimizing and equilibrium assumptions of the model. It assumes that actors who otherwise are absolutely punctilious about optimizing utility and profits ignore the potentialities of taking externalities into account. The model has inconsistent assumptions.

Why is government capable of optimally rectifying externalities? Households and firms ignore the externalities, but the optimizing government does not. Why is government so perspicacious? In fact, to Stiglitz his key equation "provides a simple set of necessary conditions characterizing the optimal level of taxes in the presence of externalities." It is true that this equation makes sense within the model — once one grants the existence of externalities and the existence of an entity called government with the properties that the model endows it with. It says that the government should push the tax to the point where its marginal cost (in terms of consumption and utility losses) equals its marginal gain (in terms of lowering a negative externality.) But why does the government optimize a measure of profits by taking into account the externalities and the other sectors do not? The theory provides no explanation.

Stiglitz introduces this optimization as a mathematical convenience, employing it as a simple way to test for Pareto optimality. But he also regards government as a separate entity that interacts with households and firms which are the other entities of the model. If government is a real entity as he supposes, how and why does it have an optimizing capability that households and firms lack? Stiglitz never tells us. He places another basic inconsistency at the heart of the model.

What actually is government in the model? This issue is very important because there is absolutely no doubt that Stiglitz considers the government in his model to be a basis for government policies and government interventions to improve upon market economies, not only in this paper but in many subsequent writings of his.

Logically, within the model's confines, the government is either a creature of the other economic actors (households and firms) or it is not. If it is an institution created and run by the household and firm sectors to rationalize externalities, then (assuming that it can and will do this and that it is the optimal means of doing this), we actually are not dealing with government at all in the usual sense of the word. We are dealing with a voluntary means of negotiating exchanges, a kind of a market, and we are not dealing with coerced taxes. There is in this case no warrant whatever for speaking of the model's government as representative of the state.

Real government is not an ongoing type of firm created and managed by the private sector to iron out certain problems. If it were, it would not be marked by the extensive power that it has to impose measures. It would not be marked by life and death debates over its every action. It would not be marked by divisions between one part of it and another and between it and society. It would not be marked by what seems to be its creation of conflicts and externalities that rive society. It would hardly be the destroyer of money or of wealth or the inefficient manager of every activity that it touches. On the other hand, if the government is the coercive institution in the model that we know it to be in reality, then how is this to be explained? What actors in the model create the government? What actors run the government? What are their optimizing behaviors in running it? What are their costs and how are they spread over the other actors?

The fact is that Stiglitz never describes what this government is or how it comes about. He never even describes its basic properties. Government in the model is basically ad hoc. It is motivated to produce taxes, subsidies and transfers to achieve optimality in a manner that is nowhere described. It simply does it. There is no warrant for making this assumption and there is no warrant for taking it to be characteristic of actual government. Stiglitz cannot sensibly talk about what government should or should not do without a theory of government.

What does government have to know in the model in order to accomplish its task? The list is staggering:

  1. For each and every household, the marginal effect that a tax has on each and every good that that household consumes;
  2. The rate of change of each firm's profits with a change in each externality (holding all else constant) and the rate of change of each firm externality with a change in tax, all else held constant;
  3. The rate of change of each household's spending with a change in each externality (all else constant) and the rate of change of each household externality with a change in tax (all else constant).

If we again stay within the confines of the model itself, there is nothing in it that tells us how the actors who govern are supposed to acquire this information or what the acquisition costs are. If we think of the model as being re-optimized as time passes, then there is variation in the parameters and the governing actors would have to acquire even more information.

In or out of the model, the information requirements present an impossible task. Where does the knowledge of the required rates of change reside? Preferences and production technologies are not self-evident. They are internal to human beings. It is not clear that humans either know them or can communicate them, certainly not in the detail required by a social planner. They possibly learn them over time and they surely alter over time. Under these conditions, the economic actors affected can surely not rely on a set of social planners or engineers to tell them what they, the actors, prefer or how they plan to produce a good, or even what goods they plan to produce. If a government is introduced into the model as a device to tax, subsidize, and make transfers, it is entirely an ad hoc device. There is no economic theory of how it can accomplish these tasks optimally, or how the actors expect it to do so, or empower it to do so.

In sum, in terms of real economic theory the Stiglitz model is about as empty on the issue of externalities and government as it can possibly be. It is simply a mathematical representation of ad hoc assumptions. Not only that, these assumptions conflict with the optimizing and equilibrating that goes on in the rest of the model.

Other Problems

I will now mention a few other serious problems that the Stiglitz model ignores, although my intent is not to provide a complete list.

There is not in reality a fixed set of goods or production technologies. The problem faced by a Stiglitz government is a dynamic one. But it can't even identify the sets of items that the household and firm sectors are optimizing over at an instant in time.

In or out of the model, it is not at all clear that government, however constituted, is somehow better suited to handling externalities than free markets. The real economic questions concerning externalities are why they arise, how they relate to property rights, what to do about them, or when it pays for interested parties to do something about them. In a sense, they are no different than any other kind of inefficiency. Therefore, the presumption is that free exchanges can address the perceived costs and benefits associated with them whereas government is ill-suited to the task. Stiglitz, by introducing externalities in an ad hoc way, simply assumes that free markets have already failed. This is why the Stiglitz government appears as the promoter of economic efficiency.

In the Stiglitz world, some goods are taxed, others subsidized, everyone adjusts, and then some find themselves better off as a consequence, and no one is worse off. This is done continuously as the economy evolves. As prices alter, the pertinent taxes and subsidies alter too. If it is not done continuously, quite possibly an imposed tax will lower welfare when tastes, conditions, and prices shift. So, logically, to assure betterment, it will have to be done continuously. This means an infinite cost of transacting.

Hans-Hermann Hoppe has correctly pointed out that so-called public goods can change their character and become private goods (and vice versa) depending on the state of mind of the actor. This adds to the burden of the government's already-impossible information requirements.

The model ignores the fact that future opportunities are altered when the government intervenes. With government in the picture preempting action, no private sector actor has an incentive to overcome the reasons for the initial inefficiency by internalizing the externalities. The means have been pre-chosen as the tax, subsidy, and transfer schemes. Therefore innovation is stifled. If a lower cost or superior method could have been found, it will not be if the solution is government.

In an economy with Stiglitz government interference, whenever any new product is invented, there is uncertainty about its relations with other products and processes. The producer has no way of telling what externalities the government will deem important enough to intervene in the markets. The presence of the state will chill many markets and potential markets. The chances are that future production, trade, and original appropriation will all be deterred.

Of course, Stiglitz entirely ignores any malicious acts by government. He ignores any power dynamics. If government is capable of intervening in markets across the entire economy on the basis of externalities, the chances of gains in power are greatly increased.

Stiglitz ignores any error-correction mechanism when government makes mistakes in its assessments, that is, government failure. If government were to be the institution to handle externalities, we can be quite sure that its incentive structure would make it inferior to free markets in correcting mistakes.


  The book that deserved the prize
Stiglitz believes that his theory (model) demonstrates an economic role for government in principle. Upon this basis he has for years promoted government solutions and denigrated free markets. Stiglitz believes only in mathematical neoclassical models. Even if we grant him his preference, he has still completely and entirely failed to prove his point that government has a potential role in alleviating externality losses. He has given us an inadequate and incomplete theory with inconsistent and ad hoc assumptions. His equations contain no theory of government whatever and for that reason alone they cannot possibly provide us with real-world prescriptions.

We can have no confidence that the Stiglitz model captures the essential aspects of real world economizing that it purports to. We therefore can have no confidence in any belief that rests upon this or similar theories that government has a proper role to play in increasing economic efficiency or social welfare by use of taxes, subsidies, and transfer payments.

Michael S. Rozeff is the Louis M. Jacobs Professor of Finance at the University at Buffalo. See his articles. Send him mail. Comment on the blog.