David R. Henderson  

Harold Demsetz on the Draft as an Externality

Big Government is young. Let's... Asking the wrong question...
Perhaps one of the most significant cases of externalities is the extensive use of the military draft. The taxpayer benefits by not paying the full cost of staffing the armed services. The costs which he escapes are the additional sums that would be needed to acquire men voluntarily for the services or those sums that would be offered as payment by draftees to taxpayers in order to be exempted. With either voluntary recruitment, the "buy-him-in" system, or with a "let-him-buy-his-way-out" system, the full cost of recruitment would be brought to bear on taxpayers. It has always seemed incredible to me that so many economists can recognize an externality when they see smoke but not when they see the draft. The familiar smoke example is one in which negotiation costs may be too high (because of the large number of interacting parties) to make it worthwhile to internalize all the effects of smoke. The draft is an externality caused by forbidding negotiation.
This is a quote from Harold Demsetz, "Toward a Theory of Property Rights," American Economic Review, Papers and Proceedings of the Seventy-ninth Annual Meeting of the American Economic Association. (May, 1967), pp. 347-359.

I highlight this for two reasons.

1. The less-important "inside-baseball" (actually "inside-academia") reason is that, although I read this article early in my time learning economics (actually, at around age 19) and it is, I believe, one of Demsetz's most referenced articles, this is the first time that I've noticed that it's in AER's Papers and Proceedings. Why is that significant? Because academic economists tend to put a much smaller weight on articles in Papers and Proceedings because such articles are not peer-reviewed. I'm not challenging that smaller weight in general. I'm simply pointing out that it's interesting that a classic in economics was not peer-reviewed in the narrow sense. My guess, though, is that Harold showed it before giving it, or before signing off on the final publication, to some pretty heavy-hitting peers at the University of Chicago.

2. The more-important reason for citing this paragraph is that it reminds us that there is nothing inherent in the concept of externalities that says that externalities occur only in the private sector. The biggest externalities, in fact, occur in the government sector. Think of Stalin, Hitler, and Mao. Or, even in less dramatic terms, think of the huge costs to the world due to Woodrow Wilson getting the United States into World War I.

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CATEGORIES: Property Rights

COMMENTS (8 to date)
ThomasH writes:

Fair enough that the logic of a decision being distorted by the decision maker not bearing the full costs and receiving the full benefits of the decision is common to both the draft and CO2 emission, but the former is not usually defined as an "externality." I think "externality" is most usefully restricted to a market transaction that is distorted by the transactor not bearing the full costs and receiving the full benefits of the transaction.

Indeed all voting has the same problem; the taxpayer-voter does not pay the full cost or receive the full benefit (whatever that might mean) from the effects of his vote. It's not clear that the issue of establishing a draft or conscripting men and women is different from any other tax and expenditure issue for the voter.

AlexR writes:

This is another classic example of linguistic bias in favor of government action. I agree that externalities are "usually" associated with market "failure," but not with ThomasH's conclusion that it therefore isn't "useful" to apply the term to government action. (I put "failure" in scare quotes because, as Hal would say, it's no failure for a trade not to occur if the transaction costs outweigh the gains!)

David quite correctly points out that government frequently creates externalities by *prohibiting* trades that would otherwise have occurred.

Sam Grove writes:

In the case of voters, it's not so much that they don't bear the full cost as it is that they don't perceive that they do.

ThomasH writes:

@ Ales R

I also do not think it is useful to use the more general "market failure" rather than the more specific "externality" (no separate quotes on "failure" are necessary) when the problem is that the participants in a market transaction do not internalize all the costs and benefits.

Nathan W writes:

@ Alex & Thomas

I think "market failure" is altogether appropriate, considering that it stands beside theories of "perfect markets" a la econ-101 which in almost all chapters of almost all texts fail to introduce all manner of externalities.

"Externalities" is a far more useful word when you get into more advanced analysis, but considering that most people who have studied some economics only take a couple lower year courses, I think introducing the concept as "market failure" rather than "externality" is far better. My reasoning is that you get loads of people who take a couple economics courses and think that markets are perfect and that any government action NECESSARILY makes things worse, with very little reasoning on externalities. While I think markets are good, I think the language of undergrad economics does "too good" of a job of selling the benefits of markets, by failing to regularly use language which captures the downsides of unfettered capitalism.

It should be broadly understood that markets fail to reach an "economic optimum" in the absence of intervention. Asserting this as a matter of "market failure" rather than "externalities" is more easily understood and remembered by the tens of millions who take just a couple courses in the field.

Thomas B writes:

Alex, Thomas, Nathan W,

I see no reason to limit "externality" to market transactions. A single person can cause externalities (no market involved). Indeed, the only reason I can think of NOT to include government within the scope of "externality" is because "government non-externality" may be an oxymoron.

"Market failure" is a term with multiple meanings, but surely it means that a price cannot be established by market mechanisms. It may mean that there are no buyers, no suppliers, or too few of either - consider the example of "vertical market failure" when you have a single buyer, with a single supplier. Or it may mean that the transaction costs of negotiation are higher than the value of negotiating (the usual cause of externalities).

"Imperfect market" is a good term for the situation when markets are not "perfect markets": this is not a true market failure. Imperfect markets are the best we have: labeling them "failures" gives up far too much of the rhetorical high ground to the forces of government diktat.

Nathan W writes:

@ Thomas

I agree with your reasoning. Perhaps "perfect markets" could be presented as useful theoretical constructs, in particular for building the mathematical tools at the root of a lot of empirical analysis, especially in macro modelling, while regularly interspersing mentions of "imperfect markets" as the reality we generally deal with.

Jack PQ writes:

@Inside Baseball: You raise an interesting question. What's so bad about not having the paper refereed, if you are a serious researcher and if you've shown it to several good people who provided feedback?

I think in Demsetz's case, and this being U Chicago, no punches were pulled and his paper was effectively refereed, just not in the narrow sense.

But in general, people don't wish to be too critical. It's one thing to find mistakes or weaknesses in a paper during a seminar, but to tell someone in person "your paper is not publishable" is harsh and maybe only at the U Chicago are people game enough to say so.

Lastly, maybe obviously, established scholars taking research risks have mostly downside: they have a reputation to keep, and a stupid mistake will cost them dearly. New or unknown scholars have no reputation and thus have only upside. This suggests it is reasonable for AER P&P to publish mostly work by established scholars and not by newbies.

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