Welfare Economics
Pigou’s venture into welfare economics represents an innovative extension of the economics of Marshall, possibly inspired by Henry Sidgwick’s contribution to ethics. In his definition, Pigou identifies social welfare, the subject of his inquiry, with economic welfare, the “limited group of satisfactions and dissatisfactions” that “can be brought directly or indirectly into relation with the measuring-rod of money” (1920 [1932]: 14, 11) - to be distinguished from noneconomic welfare.
The indicator used for economic welfare is the “national dividend”, a measure rather similar to present-day’s net national product: other things being equal, increases in the size of the national dividend as well as increases in the share of the poor are to be considered improvements in economic welfare, so that there is in effect a double criterion; furthermore a decrease in the variability over time of the national dividend is also considered an improvement thus providing a rationale for dealing with the business cycle (Pigou 1912: 66). Against this background Pigou’s most innovative idea, still alive and well today, is the distinctionbetween social and private costs, or in his own terminology between “marginal social” and “marginal private net product”. The social net product indicates the contribution to the national dividend while the private net product the contribution to profit or loss from the individual’s point of view. Thus when these two products diverge it becomes possible to reallocate the resources of the economy so as to increase the national dividend, that is, economic welfare. In his writings Pigou lists many examples of such distortions, ranging from land tenancy and the diminished incentive for tenants to invest with a fixed contract length, to air pollution, and finally to the alleged discrepancy between actual and ideal output in industries not subject to long-run constant costs (see below).
From the latter emerged Pigou’s famous tax-bounty solution, that is, to levy a tax on activities where actual output lies above ideal output and vice versa. It is this general argument of a Pigou tax on which many well-known proposals of modern environmental policy are based, for example, the recommendation of a carbon tax for addressing the danger of global warming.In the ensuing theoretical debate Pigou’s specific type of “old” welfare economics and its proposed solution to divergences between social and private cost encountered two main criticisms. The first criticism is based on the rejection of interpersonal comparisons of utility (and also of the cardinal measurability of individual utilities) as put forward by Robbins’s methodological essay (1932) and implied by Hicks’s revision of the foundations of demand theory (1934). Ultimately this attack resulted in a “new” welfare economics, with its criterion of Pareto efficiency, an approach almost purged from any considerations of distributional equity. The source of the second criticism is Coases’s famous questioning of the problem of social costs (1960). Accordingly, discrepancies between social and private cost originate from the lack of well-defined property rights or, on the other side of the same coin, from excessive transaction costs. Rather than imposing taxes (or granting subsidies) that might in effect aggravate existing distortions, the direct remedy lies in the establishment of property rights to realign private incentives with social benefits. Although both types of criticism appear incontrovertible as far as abstract theory goes, their impetus derived possibly as much from their quest to remedy logical shortcomings as from the scepticism towards the belief in the prevalence of “market failures” and in the neglect of government failure. Yet for practical purposes of economic policy debate, the tool-kit of Pigovian welfare economics appears still to provide an important benchmark.