A.C. Pigou and Welfare Economics

A.C. Pigou and Welfare Economics

A. C. Pigou is known as the father of modern welfare economics, which studies how to make economies operate more efficiently as well as the trade-offs between efficiency and equity. Pigou is also one of the founders of modern public finance. This work developed the means to analyze how taxes impact the economy and the justification for government intervention in economic affairs.


He began studying history at Cambridge; but in his third year he came under the influence of Alfred Marshall and Henry Sidgwick, who convinced him to study political economy. Like Marshall, Pigou was attracted to economics for its practical value. When Marshall retired from Cambridge in 1908, Pigou succeeded him in the Chair of Political Economy. From then until his retirement in 1943, Pigou was the main expositor of Marshallian economics at Cambridge.

Basic Issues relating to Wealth and Welfare:

   Wealth and Welfare was the first major book on economics that A. C. Pigou wrote after succeeding Alfred Marshall to the Chair of Political Economy in the University of Cambridge.  In the first place Pigou explained the differences between social and private marginal net products arising from imperfect divisibility, to elements of monopoly and similar factors, and to the methods of controlling monopoly and otherwise correcting these divergences; second, it considered methods of remunerating labor and the practicability and desirability of interference to raise the wages of poorer workers. Wealth and Welfare treated rather scantily the whole question of taxation as it involves transfers from the relatively rich to the relatively poor, which later editions of Economics of Welfare treated more fully and systematically.


Much of Pigou’s work, as far as it relates to monopoly, to pricing policies of public activities, and to wage bargaining, for example, has been so thoroughly absorbed into the present corpus of economic doctrine that it has long ceased to be identified consciously with his name. Antipathy to his conclusions has been much keener and much more continued with regard to his argument that measures to equalize incomes would increase economic welfare.


In later editions Pigou slightly modified his actual presentation of the argument for increased welfare with less inequality of income, but the essentials remained the same. He began by assuming that individuals are of similar temperament and anticipating the potential criticism that at present rich and poor are temperamentally different, argued that there is evidence that with greater income equality and with time any differences of temperament and taste would disappear. He satisfied himself, by appeal to evidence based on social inquiries, that the assumption he proposed was a plausible one.

A Framework towards Wealth in relation to Welfare:

Wealth and Welfare is not simply a treatise on the neoclassical approach to welfare economics.  Rather, it is a work prepared by a scholar schooled in the moral sciences, with Henry Sidgwick, the Cambridge philosopher and ethicist (and economist), coming to influence Pigou in significant ways as did the British idealism associated with T. E. Green.

Firstly Pigou discussed about welfare and the national dividend. He discusses the general relationship between wealth and welfare. Pigou argued that the same is true of welfare, though, notwithstanding this, he asserts that ethics has something to say about what things belong to welfare and writes two general propositions about ‘welfare’ and the purpose of Wealth and Welfare. First, welfare includes states of consciousness only.  Second, welfare can be considered by categories such as ‘greater or lesser’.

Pigou then presents his taxonomy of what is ‘good’ by prescribing ‘economic welfare’ as just one part of ‘welfare’, the part that directly concerns the ‘national dividend’ and its allocation. ‘Welfare’ and ‘economic welfare’ are broadly correlated, but they are not synchronized to the point where a change in ‘economic welfare’ necessarily yields an equal change in ‘welfare’.


Within that context, Pigou defines economic welfare with reference to social changes which, other things being equal, increase economic welfare in a probabilistic sense. The three social changes that he associates with an increase economic welfare are ‘an increase in the size of the national dividend’ an increase in the absolute share of the national dividend accruing to the poor and a ‘diminution in the variability of the national income, especially of the part accruing to the poor’.


The general introductory discussion of the relationship between wealth and welfare makes it clear that a fundamental issue in welfare economics concerns the respective ‘harmony’ and ‘disharmony’ between each of the three goals above.  Economic welfare is enhanced, at least in a probabilistic sense, when an outcome enhances one or more of these three goals and there is no disharmony with the other goals.  For example, economic welfare would be increased if an improvement in distributive fairness has no adverse impact on either wealth-efficiency or macroeconomic stability.  But, very significantly, Pigou does not rule out the possibility of an economic welfare improving even in the face of ‘disharmony’, such as when disharmony is only evident in the short run, all of which complicates the assessment of economic welfare significantly.

Market Failures:

Having noted the potential for disharmony between the various goals of welfare economics, Pigou mainly considers the wealth-efficiency issue in isolation.  The analysis is predicated on ‘money’ being a cardinal indicator of economic welfare.  In that context, Pigou relates the greatest magnitude of the national dividend to equality of marginal net products, with his most significant analysis directed towards the investigation of ‘hindrances’ to that equality.  Pigou’s notion of ‘hindrances’ suggests that there will be ‘maladjustments’ in the movement towards efficient market equilibrium, which have the same general meaning as the modern phrase ‘market failures’.

The most enduring contribution of Wealth and Welfare to the study of market failure within a competitive environment concerns Pigou’s investigation of ‘hindrances’ to investment, which introduces the distinction between ‘marginal private net product’ and ‘marginal social net product’.  The resulting analysis provided the basis for subsequent analysis in welfare economics concerning the relationship between investment and what became known as ‘externalities’, which Pigou effectively “made a centerpiece of his Wealth and Welfare”. Nevertheless, the theoretical foundation for that analysis derives from his Economic Journal article ‘Producers’ and Consumers’ Surplus’, which treats the issue in a more general framework.


Specifically, the prominence of the ‘net’ products from investment in Wealth and Welfare is replaced by a more general emphasis on the market, with the supply price considered with reference to a distinction between ‘private marginal supply price’ and ‘collective marginal supply price’, and, the demand price considered with reference to a distinction between ‘private marginal demand prices’ and ‘collective marginal demand price’.  In terms of Pigou’s more enduring influence on welfare economics, however, it is the specific focus on investment presented in Wealth and Welfare that proved to be the most influential, perhaps because the concept of externalities is more typically considered with reference to supply side market failures – and the associated consequence for over, or under, investment.  His prior discussion of externalities caused by demand side market failures was to prove less influential.


The next most discussed ‘hindrance’ that Pigou addressed in Wealth and Welfare concerns the topic of competition and increasing returns.  As in the case of ‘hindrance’ due to the potential inequality between ‘marginal private net products’ and ‘marginal social net products’, Pigou’s analysis of ‘hindrance’ to investment due to competition and increasing returns also derives from his article, ‘Producers’ and Consumers’ Surplus’. Indeed, both these ‘hindrances’ are analyzed using common tools: Pigou framed supply decisions within a static context to contrast the decisions of an individual supplier with the aggregate industry supply of a good.  While this proved effective in isolating ‘externalities’, in modern parlance, it proved problematic in dealing with goods produced in industries that do not exhibit constant returns to scale.


Pigou gave most attention to the case of industries that exhibit increasing returns but his analysis also extended to diminishing returns.  When calculating the supply price, he examines changes in the total supply of the industry, which, as Allyn Young (1913) has demonstrated, had the effect of attributing rents that firms realize from increasing returns to the marginal net product of resource.  On that basis, Pigou concluded that taxes and bounties could be considered for industries that do not exhibit constant returns to scale, but the appropriateness of such a policy prescription has not been widely accepted among economist.


Other ‘hindrances’ to equality between marginal net products under simple competition are also discussed. These include imperfections in the mobility of labour, and differences in the relative variability of labour and ‘waiting’ in different industries.  In addition to the earlier mentioned ‘hindrances’ to the promotion of wealth-efficiency in a competitive context, Pigou’s discussion of the potential to diminish the net national dividend extends to other cases of goods being produced ‘by one set of people and sold to another set’ such as ‘simple monopoly’, ‘discriminating monopoly’, ‘monopolistic competition’ and ‘purchasers’ associations’.


It should perhaps be stressed, however, that Pigou’s discussion of ‘monopolistic competition’ is not a strict precursor of the seminal work of Edward Chamberlin.  Pigou’s notion of ‘monopolistic competition’ concerns predatory pricing.  Specifically, in the case of two or more firms, with substantial shares of the market, Pigou reflects on whether or not each of the firms will consider engaging in ‘cut-throat’ price warfare with a view to eliminating the competition from the market. Specific chapters on special cases are also included, such as public operation of railways and ‘purchaser organizations’. He concluded that delimit the potential for public intervention to enhance the wealth-efficiency goal.        

 Distributive Fairness and Macro-economic Fluctuations:

Pigou’s treatment of the distribution of the national dividend analyzes the goal of improving distributive fairness is considered from two general perspectives. First, and most indirectly, the potential to alter income distribution through variations in the wage rate is reviewed. Second, the potential to ‘directly’ alter income distribution through the transfer of funds, from the rich to the poor, is discussed.


The analysis on the ‘national minimum’ which brings together the earlier analysis of both wealth-efficiency and distributional fairness based on a late utilitarian view of collective wellbeing.  Specifically, the national minimum provides for redistribution in cash and services to the point where the poor’s marginal benefit from the last dollar of redistribution received is equal to the marginal cost from the last dollar of the national income given up to fund the national minimum.


The treatment of the variability in the national dividend is largely concerned with the effects of macroeconomic fluctuations on wages and wage rates.  It is not, in large part, a macroeconomic study, although it includes discussion of some elements of macroeconomics.  Rather, it presents a study of the welfare effects of macro-economic fluctuation on the poor, partly achieved by direct consideration of wages income in aggregate.


It also includes consideration of the interdependence between variability in the consumption of the poor, which declines during down turns, variability in the employment of labor, with reduced hours of work or complete loss of employment increasing during downturns, and the increases in insecurity and uncertainty that fluctuations engender. But before systematically investigating the above relations, Pigou raised two contextual issues in separate chapters: one being a practical matter – working person’s insurance and consideration of whether it should be voluntary or compulsory, the other being a theoretical matter, monetary theory in relation to the ‘variability of general prices’.


This discussion of monetary theory focuses on the quantity theory of money and price adjustments rather than variations in economic output.  General prices are considered in the light of issues like of the supply of ‘money’, the supply of ‘money proper’, the elasticity of money supply and the demand for money.


Pigou analyzed how economic fluctuations may alter resources available for the purchase of labor.  He also outlined his proposition that variability in the income of the working class is magnified beyond that of the rest of the community because goods consumed by the working class tend to be especially variable in supply. This is complemented by an investigation of economic fluctuations and the effects on the movement of aggregate wages relative to the movement in the wage of the representative working person when the mobility of labor between different locations is limited.  Pigou stated about the variability of error in business forecasts’, which focuses on forecasting errors that are related to financial activities.


Such variations were important to Pigou because they altered expectations and influence investment decisions.  “Experience suggests that, apart altogether from the financial ties, by which different business men are bound together, there exists among them a certain measure of psychological interdependence.  A change of tone in one part of the business world diffuses itself, in a quite unreasoning manner, over the other and wholly disconnected parts. There comes into play a quasi-hypnotic system of mutual suggestion”. To better understand these influences, Pigou reflected on the character of modern industry, the personal qualities of forecasters, the reaction to different forecasts from different forecasters and the ‘reproductive power’ of errors.


Wages and Wage Policy:

The theory of wages and employment is treated extensively across a number of chapters.  His objectives and analysis of labor economics here draws significantly from the Principles and Methods of Industrial Peace (Pigou 1905), both of which consider whether an ‘artificial’ rise in the wage rate beyond its natural level can result in a transfer of resources from the rich to the poor.  After reflecting on issues related to the elasticity of demand for labor and the presence, or absence, of differentiated wages for heterogeneous labor within an industry, Pigou’s general probabilistic conclusion is that it is unlikely that distributive fairness will be enhanced by altering wage rates, mainly because of the importance of exchange to the economic process.


Nevertheless, he does not rule it out altogether.  On a related issue, Pigou considers whether high ‘artificial’ wages are likely to act against the wealth-efficiency goal.  Again, in general, he finds this to be the case, especially in the long run, but nevertheless he insists that it is still possible to defend increases in the wage rate for the lowest classes of labor.  Having pointed to the significant limits of using wages policy to effect income redistribution, Pigou then considered the possibility of achieving the same end by using direct transfer measures, either by philanthropists or the State.  One chapter is devoted to introducing the problem, mainly to remind readers of the interdependence between the goals of wealth-efficiency and distributive fairness.  The chapters that follow consider the effects of direct transfer measures on the rich (i.e. the incentive effects of taxation) and the poor.


Despite his many contributions to welfare economics and to public finance, Pigou has probably attained greatest notoriety as an opponent of the Keynesian Revolution that began at Cambridge during the 1930s. Pigou published a popular work entitled. Unemployment which argued that in the long run unemployment was due to inflexible and high wages.


Many years later, he argued that reduced demand by businesses for workers would lead to higher unemployment, but that this problem could be remedied if workers let their real wages fall.  In the Theory   of Unemployment Pigou argued that, if wage levels were greater than the marginal productivity of workers, businesses would not hire anyone since the cost of doing so would exceed the benefits of hiring that worker. Although Pigou never actively advocated wage cuts, in all these cases the solution to the unemployment problem seemed to be a reduction in wages. And it was for this reason that Keynes criticized Pigou.

Real Balance –Pigou Effect:

Pigou was  deeply offended by the  General Theory, both  for  its attacks on  himself and its attacks on  the  Marshallian tradition  at Cambridge. Reviewing  the  General Theory, Pigou accused Keynes of misrepresenting his views, and claimed there was nothing at all of merit in the book. He argued that in his previous work he recognized that expansionary policies could increase prices, thereby reducing real wages and increasing employment in the  short run. Pigou later developed his own criticisms of Keynesian economics.


He  formulated the  real  balance  or  Pigou Effect, which described one way that the problem of high unemployment would tend to be self-correcting and not require Keynesian economic policies. Pigou pointed out that prices generally fall during periods of high unemployment because firms cannot sell goods otherwise. As a result, real wealth, or the purchasing power of prior savings, increases during a recession. Being wealthier, people tend to spend more. This additional spending will then spur production,  and businesses  will hire more workers. Unemployment would thus end automatically and macroeconomic policy was unnecessary.