Economics is fundamentally about exchange. If you have something that I value more than you do, there are potential gains from trade to be had. For example, if you have an apple and I am willing to pay $1 for that apple and you value the apple at 50 cents, then we can each be better off from trade. Economists typically believe that people will exhaust any potential gains from trade.
But what happens if there are transaction costs that preclude exploiting the gains from trade? If I am willing to pay $1 for your apple, but it will cost me 51 cents in the process of exchange, then there are no gains from trade. All I will have left is 49 cents, which is less than your value of the apple.
Some people might argue that transaction costs are like any other cost, so the potential gains from trade are illusory. We cannot simply ignore certain costs.
Others, however, might argue that the role of public policy is to reduce transaction costs or even to facilitate gains from trade that would be exploited in the absence of those transaction costs. In other words, imagine an exchange as a contractual arrangement. Such an arrangement might not occur if the transaction costs are too high. Nonetheless, policymakers might be able to implement the terms of that contractual arrangement through an alternative means. In today’s Economic Forces, I’d like to explore this idea a bit by considering an example.
Let’s consider an obvious example of transaction costs getting in the way of an exchange: the family. Parents care about themselves, but they also care about their children. Children care about themselves, but also care about their parents. To the extent to which each party cares about themselves, there might be a need for a contractual arrangement. For example, children might want a good education. They might want to accumulate some human capital. This will help them to get a good job and earn a good income. Parents know that they will eventually retire and/or need to be cared for in old age or due to some ailment.
Altruist parents and children might simply provide these services to one another. Parents might provide their kids with a good education. Children might provide their parents with attention and care in their old age. However, one cannot always rely on altruism. This is not only because some people are not altruistic, but also because of commitment problems and budget constraints.
For example, when parents commit to getting their children a quality education, this is an investment in human capital. This investment yields benefits in the form of higher income to the child. The parent only benefits through the utility that they get from seeing their child succeed. For some parents, that might not be a sufficient incentive. For other parents, obtaining that quality education might not be affordable.
At the same time, parents might invest in their children only to find out that their child reneges on caretaking duties. In fact, “renege” is probably the wrong word since one cannot expect a small child to keep a promise some 30 or 40 or 50 years later.
Herein lies the problem. Since children cannot commit to future actions, an alternative would be for parents and children to sign a contract. The parents agree to provide a quality education in exchange for receiving caretaking from their child when the parents are in old age. Of course, not only can small children not commit to future actions, they do not have the cognitive ability to agree to contracts at such a young age. The transaction costs of contracting in this scenario is too high.
Nonetheless, the issues that I raise remain a problem. Some parents might underinvest in their child’s education. Some children might fail to provide caretaking services to their parents.
Given this context, both Earl Thompson and Wayne Ruhter as well as Gary Becker and Kevin Murphy argue that public policy in the U.S. directed towards the family looks a lot like the terms of the sort of contractual arrangement that I just described.
For example, consider that the state has public schools and schooling is compulsory. The state also has child labor laws and punishes parents who abuse their children. At the same time, the state provide Social Security benefits and Medicare to the elderly.
If one were to think of a contractual arrangement between parents and children, it is hard to imagine that it would look any different from these policies. Children are guaranteed a particular level of education, they are excluded from work, and protected from abusive parents. In exchange, when these children grow up and earn the income generated by this human capital acquisition, the children pay payroll taxes that are used to directly and currently fund Social Security and Medicare for their now elderly parents.
This seems like exactly the sort of contractual arrangement we would expect from parents and children, if such contractual arrangements weren’t impossible.
At the same time, this all seems circumstantial. In fact, neither Thompson, Ruhter, Becker, Murphy, nor I can prove that these policies are an efficient response to the transaction costs associated with parent-child negotiations. Nonetheless, the typical rationales of political outcomes do not seem to provide a better explanation. For example, political commentary often argues as if different generations are competing for the same resources from politicians. If this is the case, then why the gains from trade?
The interest group theory that seems to dominate political discourse is also lacking here. Current and future generations of children cannot form interest groups to protect their interests. As a result, what is to stop the current generation from spending money at the next generation’s expense? In fact, people like James Buchanan and Richard Wagner have argued that one reason to have a balanced budget amendment is to prevent current generations from creating benefits for themselves while imposing costs in the form of high future taxes on subsequent generations. This view sees a battle of generations over resources in which some generations aren’t represented in the decision-making.
If this theory were correct, it is not clear that any of these policies other than Social Security and Medicare would exist since the initial generation of recipients would have received all the benefits without any of the costs. Not only is this not true, but these policies actually emerged after the policies aimed at children. It is hard to reconcile this observation with a narrow generational interest group theory of politics.
Regardless, this is somewhat beside the point. What my example is designed to illustrate is that for all the flack that is given to democracy, there are instances like this in which it appears that democracies are capable achieving gains from trade when there is no market solution or when transaction costs preclude such a solution.
The idea that public policy might be a way of implementing contractual agreements that would otherwise be impossible due to transaction costs remains under-explored in economics. Yet, there are a great number of people who study the allocation of resources outside of markets. What I am arguing is that perhaps economists should not only think of politics as exchange, but also consider whether policies that emerge resemble contractual arrangements that otherwise wouldn’t be possible — and how democracies settle on those types of outcomes.