Microeconomics
Central and most typical of Pigou’s contribution to microeconomics, or the economics of industry, is his participation in the so-called cost controversy. The starting point of the controversy lies in Marshall’s enigmatic presentation of the “laws of returns”, distinguishing diminishing, increasing and constant returns, and deriving therefrom industries characterized by rising, falling and constant (long-run) supply price.
In the quest for practical relevance, for example, with regard to falling supply price, Marshall’s analysis made use of internal as well as external economies, of technological as well as pecuniary effects, of technical improvements giving rise to an increase of output as well as of output growth giving rise to such improvements, and finally, of a “representative firm” situated in an industry composed of firms of different sizes and in different phases of their individual life cycles. Furthermore, Marshall introduced, and Pigou in the early editions of Economics of Welfare elaborated, the idea that with non-constant returns an industry’s actual would as a rule deviate from its ideal output, and thus taxes on increasing-costs-industries might be justified as well as bounties for industries with decreasing costs. When in this situation the economic historian Clapham (1922) doubted that this classification might contain only “empty economic boxes”, the ensuing debate soon transgressed the realm of history and turned into a fundamental critique of the whole Marshallian (and Pigovian) edifice.The controversy, in which Piero Sraffa, Allyn Young and Joseph Schumpeter stood out as critics (against the British, Dennis Robertson, Gerald Shove and Pigou), dragged on well through the 1920s and exposed the inevitable tension between the phenomena to be analysed and - as Schumpeter (1928: 379) put it - “the cracking frame” of an approach of static and partial equilibrium.
First, turning to the problem of pecuniary effects, these are owing to the feedback from an industry’s output to the demand for its factors of production and to factor prices, and thereby back to its production costs. Yet these effects cannot justify a discrepancy between actual and ideal output, nor can they be legitimately analysed within a partial equilibrium framework as the change in factor prices may work back both on the distribution of income and on the prices of substitutes in demand. Second, it became clear that in a modern setting, with profit-maximizing firms choosing in the long-run the optimum firm size, economies internal to the firm generating a downward sloping marginal cost curve are incompatible with equilibrium of perfect competition - in this regard Sraffa’s critique (1926) coincided with the development of the “imperfect competition revolution” of Chamberlin and Robinson. The only way to salvage the coexistence of decreasing-costs industries and perfect competition is by the artifice of economies external to the firm but internal to the industry; yet although this solution is logically consistent, its realism soon appeared doubtful. Third, the defenders of the Marshallian (and Pigovian) framework also realized the necessity to distinguish between historical and analytical cost curves, that is, those to be traced out in historical investigations and those derived in static conditions, with a given state of knowledge. The concentration on analytical cost curves, however, eliminated aspects from the analysis that some economists believed to be crucial for the dynamics of the capitalist system, for example, innovations as shifts of production functions (Schumpeter) or increasing returns deriving from the division of labour (Young).Pigou’s contributions to the cost controversy were manifold (1922, 1927b, 1928): he suggested replacing Marshall’s “representative firm” with the “equilibrium firm”; he emphasized external (instead of internal) economies for making both increasing returns compatible with perfect competition and actually diverge from ideal output; to keep the analysis within the bounds of partial equilibrium he discarded pecuniary effects as a cause of rising (or falling) supply prices and was thus compelled to restrict this explanation to “unimportant” goods; he integrated profit maximizing firms and the optimal choice of firm size into the analysis of industry supply price; and finally, he was among those participants who clearly identified supply price with the aggregate of marginal (and not, as others did, average) costs.
However, in Pigou’s writings imperfect competition is notable by its absence. In sum, what Pigou did to the Marshallian edifice was to reshape or “purify” it, sacrificing Marshall’s vent for descriptive realism for the logical consistency of a static model of perfect competition. He thus paved the way for the codification of this type of analysis, which in the geometrical presentation introduced by Viner (1931) is still enshrined in present-day elementary textbooks.