Arthur Cecil Pigou (November 18, 1877 – March 7, 1959) was an English economist, known for his work in many fields and particularly in welfare economics. He served on a number of royal commissions including the 1919 commission on income tax.
However, A.C. Pigou’s fame stems from being responsible for the famous distinction between private and social marginal products and costs and the idea that government can, via a mixture of taxes and subsidies, correct such market failures—or "internalize the externalities." This "Pigou Effect," as it has become known, refers to the stimulation of output and employment caused by increased consumption as a result of government action. Pigou contributed significantly to the understanding of unemployment, often in disagreement with John Maynard Keynes, whose work revolutionized economic thinking in the twentieth century. Although theoretically opposed, often vehemently, Pigou maintained a warm and lasting personal friendship with Keynes, to their mutual benefit.
Pigou's goal was not to simply contribute to economic theory, his desire was to understand and thus solve the problems of poverty that plagued society. He believed that government has a fundamental responsibility to ensure the welfare of its people, and he strove to uncover the economic principles that would guide policies to that end. Although he did not achieve complete success, his work is an important stepping stone in our understanding of the economic and social forces that operate in society.
Arthur Cecil Pigou was born in the family home of his mother on November 18, 1877, at Ryde, in the Isle of Wight. He was the eldest son of Clarence and Nora Pigou. His father came from the Huguenot line and his mother’s family came from a line that had won fame and fortune in Irish administration. The pride and background of Pigou’s family helped to push him along his path later in life.
Like his father, Pigou attended Harrow. His abilities in academics gained him an entrance scholarship to the school. Athletics was also one of Pigou’s strong points. His talents in sports allowed him to be approved of by many at a time in history where athletics was looked at as being more important than academics. He ended his stay at Harrow as head of the school.
Afterwards, he went to King's College, Cambridge as a history scholar. There, he came to economics though the study of philosophy and ethics under the Moral Science Tripos. He studied economics under Alfred Marshall, and in 1908 Pigou was elected professor of Political Economy at Cambridge as Marshall's successor. He held the post until 1943.
One of his early acts was to provide private financial support for John Maynard Keynes to work on probability theory. Pigou and Keynes had great affection and mutual regard for each other and their intellectual differences never put their personal friendship seriously in jeopardy.
Pigou was a devoted expositor of Marshallian economics while he held the Cambridge chair. His most important work was published in 1912 as Wealth and Welfare, but was expanded to become the better known The Economics of Welfare in 1920. He became a Fellow of the British Academy in 1927.
Pigou pioneered welfare economics with his concerns for justice and the protection of the interests of the poor. These views were rejected by John Maynard Keynes. Pigou retaliated by producing a severe review of Keynes' book (Pigou, 1936). Despite their academic differences they remained firm friends. Later, Pigou began to appreciate the ideas of Keynes, acknowledging that he had come with the passage of time to feel that he had failed earlier to appreciate some of the important things that Keynes was trying to say.
Pigou loved mountains and climbing, and introduced to climbing many friends like Wilfred Noyce, who became far greater climbers. However an illness affecting his heart developed in the early 1930s and this affected his vigor, curtailed his climbing, and left him with phases of debility for the rest of his life. Pigou gave up his professor's chair in 1943, but remained a Fellow of Kings College until his death. In his later years, he gradually became more of a recluse, emerging occasionally from his rooms to give lectures or take a walk.
A. C. Pigou died in 1959 in Cambridge.
Pigou's work is notable in two areas: welfare economics and the theory of unemployment. As in his major work The Economics of Welfare Pigou was strongly influenced by his former teacher Alfred Marshall, we should start with his short comments on Marshall’s major publication as an introduction to his thinking.
In this excerpt, Pigou’s later logical and scientific approaches are clearly detected:
Prof. Marshall's work upon the National Dividend ... is perhaps even more important than his work on Time. 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. The National Dividend—the flow of economic goods and services made available during the year—is the centre of the whole of this reasoning. Itself a means, it serves, in fact, as a nucleus to which ends cohere, and in analysis, as a focus capable of concentrating together all discussion of economic forces and activities. ... Starting from the fact that the growth of the National Dividend depends on the continued progress of invention and the accumulation of superior appliances for production, we are bound to reflect that up to the present time nearly all of the innumerable inventions that have given us our command over Nature have been made by independent workers, and that the contributions from Government officials all the world over has been relatively small. (Marshall, Principles of Economics, p. 712) It is by patient concentration upon the activities underlying the National Dividend that deeper issues of this order are brought to light. The dividend constitutes the kernel of economic theory because—along with those moral and other aspects of practical problems which Prof. Marshall would be the last to neglect—it is the centre of sound philanthropic endeavor. It is to an analysis of this that we are driven when, throwing off the moral torpor of indolent optimism, we refuse, "with our modern resources and knowledge, to look contentedly at the continued destruction of all that is worth having in multitudes of human lives," and demand from social science guidance to social reform (Pigou, 1907).
We shall now continue with a discussion of A. C. Pigou’s own major works:
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.
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.
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 the growth of the regulatory state. There is a systematic relationship between Coase citations and new pages of federal rules. Coase challenges command-and-control regulation. Pigou's influence seems to be narrow and focused; his prescriptions are in harmony with the rise of the regulatory state.
These are evidence of positive transaction costs that limit direct Coasean bargaining. Among the world players are governments and other organizations that are immune to the spur of competition and have no need for quality assurance. It is this part of the world that Pigou was really addressing. It is government itself that must be controlled with government regulation.
Pigou’s classical theory of unemployment (Pigou 1933) is based on two fundamental postulates, namely:
That is to say, the wage of an employed person is equal to the value which would be lost if employment were to be reduced by one unit (after deducting any other costs which this reduction of output would avoid); subject, however, to the qualification that the equality may be disturbed, in accordance with certain principles, if competition and markets are imperfect.
That is to say, the real wage of an employed person is that which is just sufficient (in the estimation of the employed persons themselves) to induce the volume of the actually forthcoming labor; subject to the qualification that the equality for each individual unit of labor may be disturbed by combination between employable units analogous to the imperfections of competition which qualify the first postulate. Disutility here must be understood to cover every kind of reason which might lead a man, or a body of men, to withhold their labor rather than accept a wage which had to them a utility below a certain minimum.
This second postulate is compatible with what may be called "frictional" unemployment. For a elastic interpretation of it, we must legitimately allow for various inexactnesses of adjustment which stand in the way of continuous full employment. For example, unemployment due to a temporary loss of balance between the relative quantities of specialized resources as a result of miscalculation or intermittent demand; or to time-lags consequent on unforeseen changes; or to the fact that the change-over from one employment to another cannot be effected without a certain delay, so that there will always exist in a non-static society a proportion of resources unemployed "between jobs."
In addition to "frictional" unemployment, the postulate is also compatible with "voluntary" unemployment due to the refusal or inability of a unit of labor, as a result of legislation or social practices or of combination for collective bargaining or of slow response to change or of mere human obstinacy, to accept a reward corresponding to the value of the product attributable to its marginal productivity.
But in his thinking, these two categories of "frictional" unemployment and "voluntary" unemployment are considered comprehensive. The classical postulates do not admit of the possibility of the third category, which we might define as "involuntary" unemployment.
Subject to these qualifications, the volume of employed resources is duly determined, according to the classical theory, by the two postulates. The first gives us the demand schedule for employment, the second gives us the supply schedule; and the amount of employment is fixed at the point where the utility of the marginal product balances the disutility of the marginal employment. From this it follows that there are only four possible means of increasing employment:
What is now known as the Pigou effect was first popularized by Pigou in 1943. The term refers to the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation.
Pigou had proposed the link from balances to consumption earlier, Gottfried Haberler having made a similar objection the year after the publication of John Maynard Keynes' General Theory. In fact, Haberler in 1937 and Pigou in 1943 both showed that a downward wage-price spiral had the effect of increasing real money balances. As price declines drove up the value of the existing money supply, the increase in real money balances would at some point satisfy savings desires and result in a resumption of consumption.
Wealth was defined by Pigou as the sum of the money supply and government bonds divided by the price level. He argued that Keynes' General theory was deficient in not specifying a link from "real balances" to current consumption, and that the inclusion of such a "wealth effect" would make the economy more "self correcting" to drops in aggregate demand than Keynes predicted. Because the effect derives from changes to the "Real Balance," this critique of Keynesianism is also called the Real Balance effect.
Pigou later dismissed his “Pigou effect” or “real balance effect” as an academic exercise, because a government would not employ a downward wage-price spiral as a means of increasing the real money supply. In contrast, Karl Polanyi recognized the real world policy implications of the real balance effect. He dismissed the wage-price flexibility discussion as irrelevant and stated the “Pigou effect” in terms of constant prices and increases in the nominal stock of money. In Polanyi’s approach, the policy issue is not obscured by adverse effects on expectations caused by price level declines.
All this, moreover, has its reverse side. In an exchange economy everybody’s money income is somebody else’s cost. Every increase in hourly wages, unless or until compensated by an equal increase in hourly productivity, is an increase in costs of production. An increase in costs of production, where the government controls prices and forbids any price increase, takes the profit from marginal producers, forces them out of business, and means a shrinkage in production and a growth in unemployment.
Even where a price increase is possible, the higher price discourages buyers, shrinks the market, and also leads to unemployment. If a 30 percent increase in hourly wages all around the circle forces a 30 percent increase in prices, labor can buy no more of the product than it could at the beginning; and the merry-go-round must start all over again.
No doubt many will be inclined to dispute the contention that a 30 percent increase in wages can force as great a percentage increase in prices. It is true that this result can follow only in the long run and only if monetary and credit policy permit it. If money and credit are so inelastic that they do not increase when wages are forced up (and if we assume that the higher wages are not justified by existing labor productivity in dollar terms), then the chief effect of forcing up wage rates will be to force unemployment (Pigou 1933).
It is probable, in that case, that total payrolls, both in dollar amount and in real purchasing power, will be lower than before. For a drop in employment (brought about by union policy and not as a transitional result of technological advance) necessarily means that fewer goods are being produced for everyone. And it is unlikely that labor will compensate for the absolute drop in production by getting a larger relative share of the production that is left (Pigou 1933).
An important factor in this analysis is the elasticity in the demand for labor. In this case, elasticity is defined:
Elasticity is the percentage change in quantity (in this case employment) divided by the percentage change in price (or wage.) The labor elasticity should actually be defined in negative numbers. For the sake of simplification we shall use the positive coefficients here as well.
For example, an elasticity coefficient of two shows that the labor force responds a great deal to a change in wage. If, on the other hand, a ten percent change in wage causes only a five percent change in employment, the elasticity coefficient will be only one-half. Economists would say in this case that demand is inelastic. Demand is inelastic whenever the elasticity coefficient is less than one. When it is greater than one, economists say that demand is elastic.
While analyzing the elasticity of demand for labor, Paul H. Douglas in America from analyzing a great mass of statistics and Pigou in England, by almost purely deductive methods, arrived independently at the conclusion that the elasticity of the demand for labor is somewhere between three and four. This means, in less technical language, that "a one percent reduction in the real rate of wage is likely to expand the aggregate demand for labor by for labor by not less than three percent" (Pigou 1933).
Or, to put the matter the other way, "If wages are pushed up above the point of marginal productivity, the decrease in employment would normally be from three to four times as great as the increase in hourly rates" (Pigou 1933) so that the total incomes of the workers would be reduced correspondingly. In Pigou's view,
Even if these figures are taken to represent only the elasticity of the demand for labor revealed in a given period of the past and not necessarily to forecast that of the future, they deserve the most serious consideration (Pigou 1933, 96).
Pigou's major work, Wealth and Welfare (1912, 1920), brought welfare economics into the scope of economic analysis. In particular, Pigou is responsible for the distinction between private and social marginal products and costs. He originated the idea that governments can, via a mixture of taxes and subsidies, correct such perceived market failures—or "internalize the externalities." Pigovian taxes, taxes used to correct negative externalities, are named in his honor. Pigou's book is thoughtful and still worth reading today. In many ways, public finance has not moved much beyond Pigou's work.
Pigou had the hope, one reaching back to Francis Bacon, that human beings will be able to learn enough about the world (gain light) so that they can control it and to control for the benefit of all people (knowledge/light that gives fruit). Thus, Pigou identified economics as a fruit-bearing activity.
Pigou, strongly influenced by Millsian liberalism, saw the individual as the most important part of society and he wanted to respect people by respecting their individuality and, indeed, their subjectivity. Besides, when the rule of law is accepted by consensus, the role of government becomes clear. Government has a constitutional duty to protect property rights and accordingly to manage its own affairs so the unwanted costs are not imposed on citizens. When fundamental constitutional protections are compromised by the politics of expediency, we find ourselves at sea without an anchor.
Despite all of this, we live our lives in a world formed by statutes and rules. There is tension between the rule of law and rule by politics. Property rights and the market process affect and are affected by the political forces as they play through the larger social system. Political initiatives inspired by purposeful interest groups encounter the untamed forces of the market where contracts and property rights dictate outcomes. New institutions for protecting environmental assets that emerge from the market encounter the raw forces of politics and an entrenched bureaucracy. Each day, a new world emerges from these encounters. Part of the outcome we observe is Coasean; another part is Pigovian. Underlying it all is a system of property rights that continues to evolve. Both Coase and Pigou help us to understand this process.
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