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An Inquiry Into Pigou And Welfare Economics Economics Essay

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Arthur Cecil Pigou (1877-1959) was among the last in the long line of classical economists associated with the Cambridge School. Pigou first entered King’s College, Cambridge on a Minor Scholarship in History and Modern Languages (1896). Observing his palpable brilliance, Alfred Marshall and Henry Sidgwick together encouraged him to pour his academic vigour into the study of political economy (Collard, 1981). Although significantly influenced by Henry Sidgwick, Pigou was foremost Marshall’s disciple and is often considered the ’embodiment and extension’ of Marshall himself (Walker, 1989). Like Marshall, Pigou was attracted to the practical value of economics and believed ‘the main purpose of learning economics was to be able to see through the bogus economic arguments of politicians’ (Champernowne, 1959: 264); he believed economics to be an instrument for social betterment not intellectual gymnastics.

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The numerous works by Pigou cover various fields of economic thought. Pigou’s marked interest in ‘how government policy could increase national well-being?’ is apparent throughout his work and led him to invented much of modern public finance especially arguments and rationale for government intervention in the economy (Pressman, 1999). Furthermore, his notable contribution, Economics of Welfare (1932) occupies a unique position in the history of economic thought and has earned him recognition as the father of modern welfare economics (Groenewegen, 2003). A study into Pigou’s writings on the economics of welfare requires one to be selective due to the wide-ranging scope of topics that may be covered; this paper will therefore concentrate on the ‘theoretical backbone’ of Pigou’s work and aim to analyse different critiques of his theory of welfare in Section I. Section II will consider the foundations of and influences on Pigou’s work and explore criticisms of a lack of originality in his writings. Finally, in Section III, we will investigate the Pigou’s position on government intervention and analyse his suggested policy prescriptions.


‘Welfare economics is concerned to investigate the dominant influence through which the economic welfare of the world, or of a particular country, is likely to be increased. The hope of those who pursue it is to suggest lines of action – or non-action – on the part of the State or of private persons that might foster such influences’ (Pigou 1951: 287)

Welfare economics is a normative subject, distinct from positive economics. Whilst the theoretical elements of positive economics provide theorems that can be tested, normative economics and the propositions of welfare economics have altogether a very different content (Graff, 1957: 2). The difference between normative and positive theory becomes apparent when we attempt to determine whether welfare actually increases or not; analysis of a positive theory requires testing of its conclusions which are clearly observable, conversely to test a normative theory of welfare one must look to test its assumptions rather than conclusions since welfare is not an observable quantity. Thus the assumptions attached to a normative theory must be carefully and thoroughly scrutinised and the credibility of a theory of welfare depends on how realistic and relevant its assumptions are (Graff, 1957: 3). This section will, in turn analyse the major assumptions made by Pigou for the development of his concepts of ‘economic’ welfare and national dividend which are key to his theory.

Economic Welfare

Pigou defined economic welfare subjectively as quantities of satisfaction or ‘states of consciousness…[with] psychic returns of satisfaction,’ (Pigou 1926: 10). Recognising that subsequent investigation into the causes that could affect welfare would be impracticable, he limits the scope of the inquiry to ‘that part of social welfare that can be brought directly or indirectly into relation with the measuring-rod of money’ (Pigou 1926: 11). To justify the restrictions on his scope of elements compiling the social welfare he postulates that since a person’s income is an observable money value, it could be inferred that, under certain conditions, people could enjoy a level of material welfare that could be purchased by their income (Mishan, 1969).

The connection between increased income and the other elements of welfare is much harder to define therefore Pigou explicitly recognises that ‘since economic welfare is only a part of welfare as a whole…so that a given change in economic welfare will seldom synchronise with an equal welfare as a whole’ (Pigou, 1926: 12). Thus, although a change in economic welfare may not measure the change in total welfare, it may always affect the change therefore Pigou concludes that economic welfare and total welfare are positively related (Durlauf and Blume, 2008).

UTILITY DEBATE? Doesn’t he assume something stupid about utility – interpersonal utility or something?

National Dividend

‘The conception of the National Dividend is not an academic toy, but a practical instrument of great power designed for service in the concrete solution of social problems’ (Pigou, 1912: 493)

In order to predict the effects of policies on material welfare at the aggregate level, an aggregate measure was required. Pigou identified the national dividend as the appropriate aggregate measure suggesting that ‘economic causes act on the economic welfare of any country, not directly, but through the making and using of the objective counterpart of economic welfare which the economists call the national dividend’ (Pigou, 1926: 31). The national dividend is described as the flow of goods and services annually produced after ‘maintaining capital intact’ and is a key concept for Pigou’s analyses of how policies or institutions affect economic welfare (Scott, 1984: 59). Pigou outlines the two criteria for detecting improvements in social welfare which reflect the importance of this key concept to his theory of welfare; firstly increases in the value of national dividend, provided the share for the poor is not thereby reduced, will result in an increase in social welfare. Secondly, transfers from the rich to the poor without any reduction in the national dividend will also yield higher social welfare (Pigou, 1926).

Several critics have voiced opposition to Pigou’s definition of national dividend specifically on the issue of ‘maintaining capital intact.’ [1] He states that if the quantity of every unit of a country’s capital stock remains unchanged over a certain period, then even is the money value has increased/decreased, the total capital stock has been exactly maintained. He argues that changes in the money value of the stock due to general price changes or changes in the rates of interest are irrelevant to the national dividend (Scott, 1984: 60). Only a decline in the physical quantity of capital has to be ‘made good’ (or replaced) with new capital of the same value (provided the valuation is made when the deterioration actually takes place) and depreciation due to interest rates or price changes are irrelevant (Pigou, 1926: 46). The national income in any period is therefore the sum of consumption and gross investment minus that portion of gross investment necessary to maintain capital intact (Scott, 1984; Pigou, 1926).

Myint (1948) highlights the inadequacies of transposing this concept of maintaining capital intact (which is essentially a physical level of analysis) to derive the value of capital from expected value of income yielded (essentially a subjective level of analysis) by merely ‘making good’ the physical wear and tear (Myint, 1948: 174). He finds fault with the fact that depreciation (due to obsolescence [2] ) must be allowed for even if capital goods are in perfect condition. This issue also sparked a heated debate between Hayek (1941) and Pigou (1941) in which Hicks (1942) also intervened. Hayek attacked Pigou on this point stating, ‘what is meant by ‘maintaining capital intact’ [according to Pigou] consists in effect of the suggestion that for this purpose we should disregard obsolescence [whether it is due to foreseeable or unforeseeable causes] and require merely that such losses of value of the existing stock of capital goods be made good as are due to physical wear and tear’ (Hayek, 1941: 276). Hayek finds Pigou’s procedure neither useful theoretically nor in actual practice (Hayek, 1941: 276). The root of the disagreement lies in their different conceptions of depreciation; while Pigou maintains that only a decline in the present value of capital due to factors which affect the expected quantity is relevant whilst Hayek argues the ‘the real problem of maintaining capital intact arises not after such losses have been made, but when the entrepreneur plans his investment’ (Hayek, 1941: thus a decline in expected quantity will count as depreciation regardless of whether it is due to factors affecting expected quantity or prices (Hill, 1999: 2). While Hayek’s biting criticism seemingly undermines Pigou’s conception of national dividend, Scott (1984) contends both arguments are in fact sound and it is the purpose for which the definition is of critical importance; whilst Pigou was concerned with net social income, Hayek was referring essentially to individual people or firms. READ HICKS ADDITION TO THE DEBATE AND ADD IN WHAT HE SAYS ABOUT THE DIFFERENCE IN PURPOSES FOR THE CONCEPT.


‘When a man sets out upon any course of inquiry, the object of his search may be either light or fruit – either knowledge for its own sake or knowledge for the sake of good things to which it leads,’ (Pigou, 1926: 3)

Pigou is widely considered the father of modern welfare economics and the basic concepts of early welfare theory are attributed to his work, Economics of Welfare (1926). However, there are commentators who speculate that no matter how innovative Pigou may have been, many of his major theoretical contributions to welfare analysis lacked originality and were based on pre-Marshallian concepts; O’Donnell (1979) implies Henry Sidgwick is a major influence who is not attributed sufficient credit.

O’Donnell (1979) argues that as a firm follower of Marshall, Pigou utilised his marginal analyses of market processes. However, they differed on their beliefs in the ability of competitive markets and economic freedom to stimulate economic growth and reduce poverty; Marshall was confident that competitive markets, left alone, would lead to efficient allocation and that government intervention would create so many disincentives that it may cause more harm than good (Walker, 1989). Conversely Pigou argued that fairness is only to be achieved through extensive government intervention. Moreover, when Pigou (1926, 1928) sought to formalise the problems of market failure and the appropriate government solutions, he turned to Sigdwick’s earlier propositions on government intervention. More than half a century before Pigou, Sidgwick and J. S. Mill initiated the transition from the non-interventionist approach of the classical tradition to the more interventionist orientation that characterised neoclassical welfare theory and influenced Pigou’s theory of welfare (Medema, 2007).

Subsequently it is argued that in defining welfare and the general qualifications for a welfare criterion (wherein the similarities between basic welfare considerations of Pigou and Sidgwick are obvious), Pigou is not original (O’Donnell, 1979). He was, however, genuinely innovative in introducing the terms Marginal Social Net Product (MSNP) and Marginal Private Net Product (MPNP); although Sidgwick (1897) expressed similar conclusions about divergences between private and social benefits marginal considerations were not part of his analysis and his generalised concept was not as concise as Pigou’s (O’Donnell, 1979). Therefore, whilst Pigou’s contribution to welfare economics is undeniable, he is criticised for developing what is essentially a synthesis of ideas and analyses from Marshall and Sidgwick. Yet, if we again invoke the purpose for his inquiry and his beliefs about the practical use of economics, the fruits of his contribution yielded an expansive literature on not only welfare economics but also public finance and environmental economics for which he is undeniably responsible; ‘the purpose is…that the fabric of theory shall be a yielding garment, fitting the varied and complex reality of economic life as closely as is demanded by the criterion that the conclusions to which the theory leads shall be both useful and general’ (Young, 1913: 686).


‘The working of self-interest is generally beneficent, not because of some natural coincidence between the self-interest of each and the good of all, but because human institutions are arranged so as to compel self-interest to work in directions in which it will be beneficent’ (Cannan in Pigou, 1926: 130)

We move now to the subject of government intervention in the economy. In his relatively unknown essay on ‘State Action and Laissez-Faire’ Pigou stated ‘the real question is not whether the State should act or not, but on what principles, in what degree and over what departments of economic life its action should be carried on’ (Pigou in Medema, 2009: 65). In Economics of Welfare (1926) Pigou controversially advocates the need for government intervention in the form of taxes and bounties to correct for market failures and our defective telescopic faculty.

External Economies

In Economics of Welfare (1926) Pigou originated the innovative theoretical distinction between social and private benefits and costs, illustrating how private production costs for a firm do not necessarily reflect total social costs of production. This analysis formed the basis for much of the analysis in modern environmental economics (Myint 1948). He states that when value of MSNP (marginal physical product of the factor as appropriated by the producer * market price of product) is greater than MSNP (total of products and services from employment of the additional factor no matter to whom they may accrue) external economies exist and the government must intervene in the market to ensure the industry contracts the optimum output may be reached and economic welfare may thus be maximised (Pigou, 1926).

Coase – what coase said economists have tended to overestimate the advantages of government intervention and that such intervention may not actually be desirable in certain situations?


Pigou says that monopolies are bad and that governments should intervene to make sure they don’t overrun? Something like this?

But people argue against that and say that this is not good and his assumptions are wrong!


General optimum and national dividend are major elements that constitute his theory of welfare.

Section I

National Dividend

National Dividend and General Optimum

National Dividend – he outlines the national dividend which is defined as _______. Is very important because it is the measure he outlines as the aggregate indicator of welfare.


Hayek criticised his conception of the national dividend because of his assumption of ‘Maintaining capital intact stating that __________________

General Optimum and Criterion for welfare maximisation

He says that anything that increases the national dividend, so long as it doesn’t reduce the share going to the poor will increase total welfare and anything that increases the share of the poor so long as it doesn’t affect the national dividend, will also increase welfare.


Buchanan ( outlines the difference between Pigou’s optimum and Pareto’s optimum

O’Donnell criticises Pigou for lack of originality, claiming that he has basically created a synthesis of Pre-Marshallian ideas and Marshallian analysis (the only thing original being his contribution of MSNP and MPNP). Myint criticises Pigou for trying to impose Marshalls physical analysis onto what should be a subjective level of analysis: since welfare theory, as argued by graff, is a normative theory.

Section II

External Effects

Pigou basically says that private firms do not always take into account the



6. I do not propose to say very much in this paper about the welfare economics of monopoly and imperfect competition, for this is altogether too large a subject to be capable of useful treat- ment on the scale here available. A very large part of the estab- lished theory of imperfect competition falls under the head of welfare economics, and it is actually much the strongest part of the theory which does so. Considered as a branch of positive economics, the theory of imperfect competition is even now not very convincing; the assumption that the individual producer has a clear idea of the demand curve confronting him has been justifiably questioned, and the presence of intractable elements of oligopoly in most markets has been justifiably suspected.’ When it is considered as a branch of welfare economics, the theory of imperfect competition has a much clearer status. Oligopoly and monopolistic competition fall into their places as reasons for the inequality between price and marginal cost, whose consequences are then a most fertile field for study along welfare lines. It is perhaps rather to be regretted that modern theories of imperfect competition have not been cast more overtly into this form; for the general apparatus of welfare economics would have made it possible to state some of the most important pro- positions in a more guarded way than usual. Take, for example, the very important question of the optimum number of firms in an imperfectly competitive industry, which is so near the centre of modern discussion. Since (ex hypothesi) the different firms are producing products which are economicaly distinguishable, the question is one of those which falls under the heading of our third set of optimum conditions-the totl conditions; we have to ask whether a reduction in the number of products would be conducive to a movement towards the optimum. Suppose then that a particular firm is closed down. The loss involved im its cessation is measured by the compensation which would have to be given to consumers to make up for their loss of the opportunity to consume the missing product, plus the compensation which would have to be given to producers to make up for the excess of their earnings in this use over what they could

earn in other uses. The loss is therefore measured by Marshall’s Surplus (Consumers’ Surplus 1 plus Producers’ Surplus). Under conditions of perfect competition, this loss is a net loss. For when the factors are transferred to other uses, they will have to be scattered about at the margins of those uses; and (since the earnings of a factor equal the value of its marginal product) the additional production made possible by the use of the factors in these new places is equal in value to the earnings of the factors (already accounted for). Under perfect competition, the marginal productivity law ensures that there is no producers’ surplus generated at the new margins; while, since the marginal unit of any commodity is worth no more than what is paid for it, there can be no consumers’ surplus either. Thus there is nothing to set against the initial loss; there cannot be a movement towards the optimum if the number of products is reduced. But if competition is imperfect, there is something to set on the other side. The earnings of a factor are now less than the value of its marginal product by an amount which varies with the degree of monopolistic exploitation; and therefore the increment to production which can be secured by using the factors at other margins is worth more than the earnings of the factors. There is a producers’ surplus, even at the margin, and this producers’ surplus may outweigh the initial loss. The general condition for a particular firm to be such that its existence is compatible with the optimum is that the sum of the consumers’ and producers’ surpluses generated by its activities must be greater than the producers’ surplus which would be generated by employing its factors (and exploiting them) elsewhere. The rule usually given is a special case of this general rule. If entry to the industry is ” free,” price equals average cost, and the producers’ surplus generated by the firm as a whole can be neglected. If the products of the different firms are very close substitutes, or merely distinguished by ” irrational pre- ferences,” consumers’ surplus can perhaps be neglected as well. With these simplifications, the number of firms in an impe

competitive industry is always excessive, so long as price is greater than marginal cost anywhere in the industry. (Or, if we can retain the identity of price with average cost, the number of firms is excessive until average cost is reduced to a minimum.) These, however, are simplifications; it is not always true that the number of firms in an imperfectly competitive industry is excessive, though very often it may be. Before recommending in practice a policy of shutting down redundant firms, we ought to be sure that the full condition is satisfied; and we ought to be very sure that the discarded factors will in fact be transferred to more productive uses. In a world where the most the economist can hope for is that he will be listened to occasionallY, that is not always so certain.

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In the absence of costs of movement – the allocation of resources by competitive markets achieves universally equal marginal private net products. However, the production of ideal output requires equality of marginal social net products. Where private and social net products diverge, there is a prima facie case for reallocation of resources (Economics of welfare page 136)

The Economics of Welfare

Pigou’s major work, Wealth and Welfare (1912) and Economics of Welfare (1920), developed Alfred Marshall’s concept of externalities (see Pigou, 1920), costs imposed or benefits conferred on others that are not taken into account by the person taking the action.

Pigou attributed welfare gains to the greater marginal utility a dollar of income had for the poor compared to the rich; a transfer of income from rich to poor increased total utility that could also be defined as increased “quality of life.” Pigou also argued that welfare gains came from improving the quality of the work force through changes in the distribution of income or by improved working conditions.

He argued that the existence of externalities was sufficient justification for government intervention. The reason was that if someone was creating a negative externality, such as pollution, he would engage in too much of the activity that generated the externality. Someone creating a positive externality, say, by educating himself and thus making himself more interesting to other people, would not invest enough in his education because he would not perceive the value to himself as being as great as the value to society.

To discourage the activity that caused the negative externality, Pigou advocated a tax on the activity. To encourage the activity that created the positive externality, he advocated a subsidy. These are now called Pigovian (or Pigovian) taxes and subsidies.

Let us now consider two excerpts that typify Pigou’s social policy, mentioned above:

One person A, in the course of rendering some service, for which payments is made, to a second person B, incidentally also renders services or disservices to other persons… of such sort that payment cannot be exacted from benefited parties or compensation enforced on behalf of the injured parties (Pigou 1932).

It is possible for the State… to remove the divergence [between private and social net product] through bounties and taxes (Pigou 1932).

In the Economics of Welfare, Pigou says that his aim is to ascertain how far the free play of self-interest, acting under the existing legal system, tends to distribute the country’s resources in the way most favorable to the production of a large national dividend, and how far it is feasible for State action to improve upon “natural” tendencies.

He starts by referring to “optimistic followers of the classical economists” who have argued that the value of production would be maximized if the government refrained from any interference in the economic system and the economic arrangements were those which came about “naturally” (Pigou 1932). Pigou goes on to say that if self-interest does promote economic welfare, it is because human institutions have been devised to make it so. He concludes:

But even in the most advanced States there are failures and imperfections… there are many obstacles that prevent a community’s resources from being distributed… in the most efficient way. The study of these constitutes our present problem… its purpose is essentially practical. It seeks to bring into clearer light some of the ways in which it now is, or eventually may become, feasible for governments to control the play of economic forces in such wise as to promote the economic welfare, and through that, the total welfare, of their citizens as a whole (Pigou 1932).

Pigou’s thoughts are further elucidated:

Some have argued that no State action is needed. But the system has performed as well as it has because of State action: Nonetheless, there are still imperfections. … it might happen… that costs are thrown upon people not directly concerned, through, say, uncompensated damage done to surrounding woods by sparks from railway engines. All such effects must be included-some of them will be positive, others negative elements-in reckoning up the social net product of the marginal increment of any volume of resources turned into any use or place (Pigou 1932)

To illustrate this discussion further, let us consider an example: Suppose a paper mill was being planned on a certain river and an economist was given all facts about the “river-in-question” and told that a paper mill was to be sited so that it could discharge oxygen-consuming waste into the river. Suppose further that the economist was asked to analyze the situation, offer a policy for siting the mill, and comment on the practical aspects of adopting the policy proposal as a general rule. The first approach involves an externality analysis, where the paper mill pollutes the river, imposing an unwanted cost on society, a cost that does not enter the mill owners’ profit calculations. This is the problem of social cost.

Following this line of inquiry, failure to consider the external cost leads to too much paper and too little environmental quality. This economist would be using an analytical framework developed by A. C. Pigou who would argue that pollution generates a social cost that should be dealt with by the central government. He would propose a system of taxes, bounties, and regulations for resolving the problem. Most likely, the economist using this framework would call for some form of effluent taxes or regulation to control the mill’s discharge.

Pigou’s solution spoke of market failure and the need for a central authority to fine-tune markets so that the appropriate level of pollution would emerge. This approach called for collection of complicated and rapidly changing information, translating the information into a tax or regulation, and imposing the tax or rule on the polluter.

In fact, modern environmental economics began with the work of Arthur Pigou, who developed the analysis of externalities. His name is attached to the traditional policy proposal, “Pigouvian taxes” on polluting activities, equal to the value of the damages.

Coase’s alternative solution

Pigou’s approach came under attack from Lionel Robbins and Frank Knight. The New Welfare Economics that arose in the late 1930s dispensed with much of Pigou’s analytical toolbox. Later, the Public Choice theorists rejected Pigou’s approach for its naive “benevolent despot” assumption. Finally, Nobel Laureate Ronald Coase demonstrated that efficient outcomes could be generated without government intervention when property rights are clearly defined. Coase presents his case in the article “The Problem of Social Cost” (1960).

To explain this alternative let us continue with the paper mill example. There is a second approach likely taken. In this line of thinking the economist considers the paper mill and others who wish to consume or enjoy water quality as part of a competitive market where people bargain for the use of rights to scarce property. This analysis has nothing to do with polluters’ imposing cost on society, but everything to do with competing demands for use of an asset.

If rights to the asset are defined and assigned to members of the river-basin community, then those planning to build the paper mill must bargain with the rightholders to determine just how much, if any, waste will discharge into the river.

If the rights are held by the mill, then the existing communities along the river must bargain with the mill owner for rights to water quality. Again, bargaining determines the amount of discharge to the river.

This approach relies on the work of Ronald Coase (1960). Using this framework, an economist might recommend a meeting of the mill owners and others who have access to the river. After organizing the parties, negotiations would ensue. If existing river users owned water-quality rights, the mill would have to buy the rights in order to discharge specified amounts of waste. If the mill had the right to pollute, existing river users would have to buy water quality from the mill, paying the mill to limit its discharges.

In other words, Pigouvian taxes do embody the important principle that polluters should pay for the damages they inflict on society. But in both law and economics, a more conservative analysis has gained popularity. Legal scholar Ronald Coase argued that taxes and regulation might be unnecessary, since under some circumstances polluters and those harmed by pollution could engage in private negotiation to determine the appropriate compensation. While Pigou’s examples of externalities often involved simultaneous harms to large numbers of people, Coase’s examples tended to be localized, individual nuisances, where one person’s behavior disturbed the immediate neighbors. The image of environmental externalities as localized nuisances serves to trivialize the real problems of widespread, collective threats to health and nature. Creative alternative readings of Coase have been suggested at times, but the dominant interpretation of his work has provided an intellectual basis for the retreat from regulation.

Comparison of Pigou’s and Coase’s approaches

Evidence of the record of Coase’s intellectual influence is seen in the count of citations to his 1960 article, which are shown in Yardley (1977). The citation data of Coase’s (1960) The Problem of Social Cost and Pigou’s (1932) The Economics of Welfare are superimposed on a count of Federal Register pages for the same years.

The data mapping suggests several things. First, Pigou’s influence on academics seems to operate at a steady state. There is no evidence that Pigovians were responding to the growth of regulation occurring around them. The Coase citations indicate the reverse. References to his ideas seem to be a reaction to th


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