Every area of knowledge has boundaries of effectiveness, situations beyond which it does not provide good answers. To solve real-world problems outside of those limits you need a different tool.

Arithmetic is a great tool, as far as it goes. For most of history arithmetic was adequate for solving most problems, but it proved inadequate to meet the needs of advancing technology.

If, for example, you want to calculate the velocity of a rocket at a specific point in time where the vehicle’s weight is constantly decreasing as fuel is burned, arithmetic fails. For that you need calculus.

Like arithmetic, classical economics has its own limits, and there are serious issues that it does not and cannot address.

What Is Economics?

Economics is the study of how people manage the conflict between humanity’s unlimited desire for goods and services versus the limited quantity of goods and services available to fill those needs.

An Economic System is the collection of the rules and practices that govern the allocation of resources and the creation and distribution of products and services.

Classical Economics is considered to have begun with Adam Smith and John Stuart Mill. It promoted a belief in market competition, the theory of supply and demand pricing, and the principal of “laissez-faire” that is, the absence of government business regulation.

When Conditions Change, Behaviors Change

Classical market economics has primarily been focused on two-party transactions, understanding the interactions between buyers on one side and sellers on the other — How do buyers respond under these circumstances? How do sellers respond under those conditions?

Price Is Set By Buyer Vs. Seller Bargaining Power

To determine a price, the buyer’s bargaining power is pitted against the seller’s bargaining power.

Components of each side’s bargaining power include:

  • How great is the supply of the good?
  • How great is the demand?
  • How perishable is the good?
  • How vital is the good to the buyer?
  • How unified are the buyers?
  • How unified are the sellers?
  • What is the seller’s cost to produce the good?
  • How much value/income will the good generate for the buyer?

Based on these and other factors economic theory provides rules that help model how the price will be struck between the buyer and the seller.

Nowhere in this list of pricing factors is the cost that the transaction imposes on third parties nor the benefits the transaction provides to third parties.

Transactions Can Create Material Costs & Benefits To Third Parties

But two-party transactions generate costs and benefits to third parties beyond the above buyer-specific and seller-specific factors.

In the modern world where transactions have large secondary and tertiary economic effects, a price that considers only the buyer and only the seller fails to include these third-party costs and benefits in its calculation.

Economists call such third party costs “negative externalities” and it is generally acknowledged that there is no comprehensive theory that can accurately calculate them, include them in product costs, or automatically enforce their payment to the affected parties.

The pricing rules of classical economics do not and cannot consider these real, material costs and benefits to third parties.

Factoring these third-party costs and benefits into the price is beyond the universe of classical economics in the same way that calculating the velocity of an ICBM at any given point in its flight is beyond the competency of the rules of arithmetic.

Examples Of Third Party Costs & Benefits

Fire Protection Services

An example of a transaction’s third-party costs and benefits from my column The Market System’s Inherent Inability To Accurately Price Mandatory Products & Services is fire-fighting services.

Suppose we had no municipal fire department in our city. Instead, suppose that if a property owner wanted fire-fighting/protection services he/she had to pay a subscription fee to a private fire department. Suppose half the property owners paid that fee and half did not.

Purely based on factors affecting the two parties (cost, demand, etc.), the provider would offer fire-fighting services to property owners for so many dollars per month per square foot.

That price would not and could not consider the cost to third parties from Mr. Smith not having fire-protection coverage nor could it consider the benefits to third parties from Mr. Smith having fire-protection coverage.

The price offered to and rejected by Mr. Smith could not include a component representing the losses suffered by both covered and uncovered property owners from a fire that started in Mr. Smith’s uncovered home, which then engulfed the entire block of largely unprotected shacks, and then spread halfway across the city, burning down both covered and uncovered properties.

Those secondary and tertiary costs of that fire would include such things as:

  • the cost of city buildings that may be destroyed;
  • businesses that may be destroyed leaving citizens unemployed and unable to pay their bills;
  • the loss of taxes from the closed businesses and unemployed workers;
  • hospital and other medical costs to treat the injured citizens;
  • insurance claims for insured structures that were destroyed;
  • higher casualty-insurance premiums charged in the future

Even if classical economics could calculate all these potential third-party costs, it would still have no ability to factor any of those costs into the private, fire-protection subscription price offered to Mr. Smith because those costs are not costs directly incurred by the fire-protection company in providing its service to Mr. Smith.

They are costs to other people.

Pollution Costs

If a manufacturer is not legislatively prevented from releasing toxic substances, the price negotiated between a manufacturer and the buyers of its products does not and cannot reflect (nor compensate) the cost to the seller’s neighbors from the toxic materials that the seller’s factory spews into the air.

Public Health Costs

The unit price set between the seller and the buyer of a flu vaccine cannot and does not reflect the cost to the rest of the population of a flu epidemic among the unvaccinated nor the benefit to the rest of the population from the absence of a flu epidemic.

Traffic Congestion, Pollution, Increased Police Services Costs

There are no classical-economics formulas that factor into the landlord’s rental rate the costs to both neighbors and the city from the greatly increased traffic congestion, air pollution, and criminal activity generated by the new building, nor is there any general mechanism for reimbursing the city or other merchants for the costs they suffer in connection with that increased traffic congestion, police services, and decreased available parking.

If, in advance of construction, those costs could be reasonably calculated as a known liability of the developer/owner, he/she would have to factor them into the anticipated rental rate calculation and the building might have been determined not to be economically viable in the first place.

Low Wages

All industrialized countries have some sort of social-safety-net to provide a basic level of food, housing and medical care to every citizen. While you may think that they shouldn’t have a social-safety-net, as a practical matter they all do.

While the standard work week in industrialized countries is generally forty hours or less, people can and do work extra jobs, so we might expect some people to work up to sixty hours per week.

But when a wage rate is so low that forty to sixty hours work per week is insufficient to provide enough money for a basic standard of living, including medical care, the taxpayers end up making up the difference in the form of food stamps, Medicaid, etc.

The costs of these public benefits plus the additional overhead of the government bureaucracy to collect, process and distribute them are charged to third parties, namely, the taxpayers.

The two parties to the employment transaction, the company and the employee, set the wages to be paid, but the costs to third parties, the taxpayers who subsidize those wages through the social-safety-net programs, are not considered when setting that wage rate.

Put differently, the low wage agreed to by the company and employee does not take into account the third-party costs it imposes on the citizens in the form of additional taxes. Essentially, the taxpayers subsidize the employer’s business by assuming part of the company’s labor costs in the form of higher taxes.

Medical Costs

Insured medical care — a three or four sided transaction consisting of a patient, provider, insurer and in some cases the taxpayer — is another transaction where costs and benefits accrue outside of a classical buyer-seller price negotiation.

In this same multi-party category is the sale of prescription drugs where the transaction consists of five parties — drug manufacturer, insurer, retail seller, patient, and the government/taxpayer.

Paying For What You Get, Paying For What You Cost

Generally, proponents of classical economics believe that people should pay for the benefits they receive from third parties and bear the cost of the expenses that their conduct imposes on third parties, but nothing in classical economics is able to reliably calculate or allocate those costs and benefits to persons beyond the two direct participants in the transaction.

Classical economics can no more calculate and allocate these third-party economic costs and benefits than traditional arithmetic can calculate the volume of water in an irregularly shaped lake.

This is not the only area that is beyond the competence of classical economic theory.

Other Gaps In Classical Economic Theory

What’s Good For Managers Isn’t Necessarily Good For The Company

The classical economics’ theories about market pressures giving sellers an incentive to increase quality and provide good service are based on the nineteenth-century assumption that the humans controlling the sellers are all motivated to do what is in the long-term best interests of the entity, that there is a unity of interest and purpose between the executives and the company they operate.

While this might be true when the seller is directly controlled by its owner/founder, it is not necessarily true when the executives who control the entity have no significant ownership interest in it. It becomes even less true when the executives’ compensation is dependent on the company’s short-term rather than long-term performance.

It is common for executives who lead corporations into bankruptcy to be paid substantial bonuses in spite of the fact that the company went broke on their watch. It is common for executives to be paid substantial bonuses based on short-term profits even though the actions they took that led to the short-term profits resulted in massive long-term losses.

Classical economic theories about sellers’ behavior do not match today’s real-world seller conduct when the seller is controlled by a class of professional managers whose compensation is not dependent on the company’s long-term performance nor on the quality of its products and services.

Leveraged Buyouts

Classical economic theories were not designed to deal with business tactics such as a leveraged buyout where a successful company is purchased with massive debt financing and the target becomes saddled with that debt obligation. The excessive financing payments immediately curtail the company’s ability to modernize and expand and often result in the degradation of both products and services.

Because of the debt-service obligations it’s not unusual for the target company to end up in bankruptcy even though the transaction is considered a success by the investors who reaped millions from the deal.

New Theories Needed

Environmental protection legislation is an attempt to deal with the costs of pollution to third parties by prohibiting those activities altogether rather than calculating those costs and adding them into the price of the product.

The welter of regulations regarding the healthcare industry are in part an attempt to deal with the complexity of four-way and five-way transactions.

Building-permit fees, environmental impact reports, fees imposed on developers for street improvements in the vicinity of their projects and the like are all attempts to deal with the costs to third parties arising from new developments.

I have to wonder if there isn’t a better way to deal with these gaps in classical economic theory. I certainly do not have the answer. I wonder if there isn’t another a Newton or Liebniz out there somewhere who might be able to do for economics what calculus did for mathematic