Why Anarcho-capitalism Will Fail: Agency, Transaction Costs, and Other Good Stuff

Anarcho-capitalism is always a hot topic of discussion. Many respectable economists debate whether a free market is enough to allocate resources to their best possible use. On many occasions, it is considered a sin if the government were to intervene in the economy. Mainstream economists, utilizing neoclassical synthesis, consider the government to be useful in a limited fashion. The government must exist to provide public goods, law and order and to provide some stability in the economic sphere. However, there exists a strand in economics which believes the government to be an impediment to all that is good. Any government involvement is considered violent and intrusive. The state (government) is known as a parasite that thrives off the hard work of the masses. Other than the name calling, there is much to this branch of economics. The Austrian School of economics is just one of the examples. Even though the zeal for freedom is infectious, it is also a dangerous precursor for bad policy making. Indeed, the government is needed for transactions to occur in an increasingly globalized world. I will hope to show in this article that if the state were nonexistent, then any sort of worthy transactions would never occur. Transaction costs will prove to be too much of an impediment for people to make decisions. I will go through what anarcho-capitalism entails and how transactions would take place in an economy without a government. Then, I will try to refute this by using an agency model along with a few explanations for the existence of transaction costs. I hope to show that an economy would face too many problems if a state would cease to exist.
What is anarcho-capitalism in the first place? It is an economy in which the state is non-existent and the free market reigns supreme. Individuals would be responsible for themselves as long as they do no harm unto others.
Any state interference in the economy is considered a use of force that must be condemned at the first opportunity. Murray Rothbard, David Friedman, and other anarcho-capitalism theorists believe that anything done by the state can be fulfilled at a lower cost with better quality by the free market. Indeed, advocates for anarcho-capitalism believe it is the provision of the public goods that keeps the state in power.
Under this theory, law and order can be provided in a free market without the constraints of having to abide by the demands of a single ruler. Law can be set up through customs and traditions as “Anarchists maintain that the laws need not be imposed by a central authority—that is, laid down as authoritative law—but can and do arise through customary arrangements and understandings that evolve over time.”  This means that the customary law that will be most beneficial to the populace will spring up.
John Stuart Mill stated the same exact thing when he went against the detractors of utilitarianism that ‘this is just like saying: “Before acting, one doesn’t have the time on each occasion to read through the Old and the New Testaments; so it is impossible for us to guide our conduct by Christianity.” The answer to this objection is that there has been plenty of time [Emphasis added by author], namely, the whole past duration of the human species. During all that time, mankind have been learning by experience what sorts of consequences actions are apt to have, this being something on which all of morality on life depend, as well as all the prudence.’   So, law through customs and traditions would enable people to act decently in order to prosper in society.
This article states that transactions will not take place in an increasingly globalized state-free economy because of transaction costs. Conversely, Christopher Coyne attested that such transactions would in fact occur because people would be able to trust reputation. This is what every businessperson, entrepreneur and employer wishes to attain in his or her life. The reputation to carry out mutually beneficial transactions in a responsible manner helps a business attain more customers. Coyne explains that in “…the free market, entrepreneurs, driven by the profit motive, attempt to maximize profits and minimize losses. In an effort to maintain current market share and gain new market share, entrepreneurs attempt to meet customer needs best in terms of product quality, service, and price—crucial variables in determining a seller’s reputation.”  No firm would cheat, and why would they? If they are caught then they will be left with an irreparable reputation. From an entrepreneur’s point of view, the costs are too high to even deviate from an honest standpoint.
Anarchist Robert Murphy echoed these by indicating that arbitrage agencies will be set up to make sure contracts are followed and the right amount of restitution is paid to the injured party.  This will enable a market to run smoothly and transactions to take place. There will definitely be a few individuals who will still try to break the law, but the existence of arbitration (third party) institutions will catch the perpetrator and make him/her pay restitution to the injured party.
Agency Model
Reputation may be well and good but, we should consider a model that is represented in the Law & Economics Textbook.
A simple agency model should suffice to put my point across. Imagine a principal willing to invest $1. He hands over his money to an investor promising a net gain $1. The investor will pocket $0.5 of that gain while the principal would attain his original $1 plus the other half of the net gain: $0.5. The investor could steal the cash and the principal would never see it again. Or, the principal could end the game immediately by not investing at all. Both parties would attain nothing.
 Chart 1
The first number in the bracket is for the principal, and the second for the investor.  So, (-1, 1) means that the principal loses – $1, while the investor gains $1.
In this situation, as you can see from the total gains, it would be best for the principal to not invest. This is because the investor’s best choice would be to appropriate. Appropriation is just redistribution of funds, while investment would have been an increase in wealth. Thus, the principal’s only option would be to not invest.
Now let us introduce contracts that will compensate the principal for the amount that will be stolen and the investor will have to pay damages as well. This is how the situation would unfold:
 Chart 2
When the investor is caught appropriating funds, then he must refund the original $1 and pay an additional $0.5 as damages. This will make the investor’s best option to make a profitable investment, in which both parties would be better off. This is the use of contracts and a strong law system.
Transaction Costs
The reader may affirm that the free market can provide contracts and people will uphold them. This is true; however, there exists the problem of transaction costs. Transaction costs are ‘the costs of exchange.’  These can take the form of
1. Search Costs: The costs of actually searching for a bargaining partner.
2. Bargaining Costs: The specific costs of bargaining. The more information available to both parties, the easier the bargaining process.
3. Enforcement Costs: The costs of making sure that the promise is being fulfilled.
If these costs were zero then the market would facilitate every transaction and no problems would arise. However, we never see this actually take place. The market is fraught with transaction costs, especially with the rise in globalization.
Thus, a law system will have to be created that tries to lower these impediments to bargaining and contract making. We must structure the economy in such a way that it improves efficiency according to the Normative Coase Theorem:
‘Structure the law so as to remove impediments to private agreements.’
And additionally, we must adhere to the Normative Hobbes Theorem:
‘Structure the law so as to minimize the harm caused by the failures in private agreements.’
Transaction Costs in Perspective
1) In the market there exists plenty of transaction costs. When trading in foreign markets, it becomes very difficult to do so because of different cultures, times, and perceptions which increase the risk and uncertainty borne by the investor. Indeed, it is known that investors prefer investing in nations with a strong rule of law and a government able to battle corruption. The biggest governments are in those countries that are exposed to international trade .
2) The introduction of time could also be a problem. The cost of searching could be the time used to do something else, which is the definition of opportunity cost. If it takes too long to find an individual to trade with, then search costs are too high to facilitate the beginnings of bargaining.
3) If people are too emotional during contract signings, then the bargaining costs can rise rapidly. This could happen when asking for a loan to start up your small business or when divorces are present. When people are too emotional then they can become hostile and this will increase transaction costs. Bargaining becomes much more difficult.
4) When bargaining with an individual for a particular product, it becomes difficult to know all the specifics. Both parties would want to keep the information to themselves so that they can attain a greater surplus from their transaction. This information asymmetry would result in transactions not taking place.
Imagine this, if someone is so eager to sell something to you, wouldn’t you be skeptical of buying the good? Could there be a reason that the seller is so keen to sell the good?
The Need for Government to facilitate the ‘law of the land’
       Analyzing Christopher Coyne’s example (above) on the reputation of firms being an important reason to refrain from doing anything bad, there are many transaction costs that exist that could make bargaining almost impossible. If the transaction costs were higher than the net gain, then no one would make a decision even with high reputation. Uncertainty always exists.
       But, if one firm out of the pool of a hundred were to appropriate funds, then all consumers would become wary. Consumers would be unwilling to invest or buy from other firms because their trust in that sector has fallen.
       Robert Murphy’s example is something that prevails in our economy today. Having an arbitrator or a firm that makes sure things are going ‘according to plan’ is a mainstay in our contemporary economy. However, having one law system can also reduce transaction costs. Imagine the bother to search for firms that deal with different laws in different areas over different times in a domestic market. This would be an impediment by itself as it increases search costs. There is such a thing as too much choice.
       In the end, we do require Max Weber’s ‘monopoly of the legitimate use of force’. Indeed, it is of incredible importance that the government exists because it is a brand name. If a strong government makes sure its citizens uphold the law, then people would be willing to invest. If the rule of law is not strong enough, then people would be wary. But, just having one law system that exists would  lower search costs.
The state would make sure to keep in step because keeping the law in such a way maximizes its tax revenue. Tax revenue is maximized in the long run if a productive populace exists. One of the only ways to attain this is to have a strong legal system.
Christopher Coyne rebuts rebutted this by stating that the government will would try to maximize ‘psychic income.’ As Coyne states stated that it ‘…is critical to remember, however, that through action people attempt to maximize psychic income. This is not limited to monetary income but includes nonpecuniary forms of income as well. Rulers may gain (psychic) income by holding and wielding power even though they may not maximize monetary revenue by doing so. And, if they do so, their actions may conflict with the ruled group’s interests…’  However, this need not be true because the utilization of democracy will keep governments in step. If governments do not listen to their populace, then eventually they will be replaced. Even if the state is insistent on wielding its power, it will eventually fall if the populace decides to protest.  Where do you think the state gets its power?
       In the end, the government is of the utmost importance in order to make sure that transaction costs are lowered and the people who appropriate are brought to justice. In a timeless system with rational expectations, everything would work in the best possible manner. However, transaction costs and information asymmetries are the ways of life. We can never escape them. We must always hope to lower transaction costs and try to make information as ‘public’ as possible.  This is the way for an economy to grow with a strong legal system by its side.
Coyne, Christopher. “Order in the Jungle: Social Interaction without the State.” Independent Review. 2.4 (2003): 563-564 Web.
Mill, John Stuart. “Utilitarianism.” Early modern Texts. n. page. 16 <http://www.earlymoderntexts.com/pdf/millutil.pdf&gt;.
Murphy, Robert. Chaos Theory. 2. Aurburn: Ludwig Von Mises Institute, 2010. 14. Web. <http://mises.org/books/chaostheory.pdf&gt;.
Rodrik, Dani. The Globalization Paradox. New York: W.W. Norton & Company, 2012. Print.
Ulen, Thomas, and Robert Cooter. Law & Economics. 6. Boston: Pearson Education Inc., 2012. 88. Print.

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