Term Paper on "Pigou's Contributions to Microeconomics"

Term Paper 8 pages (2113 words) Sources: 5 Style: Chicago

[EXCERPT] . . . .

Pigou's Contributions To Microeconomics

Although his following was somewhat lest robust than that of economists such as Marshall or Keynes, several ideas proposed by Pigou form the basis for various economic and finance theories in practice today. Pigou is regarded as the creator of modern notions of welfare economics, which encapsulates the study of how the smooth running of economies can be facilitated, and the relationship between equity and efficiency (Pressman 1999). He also founded the basis for modern public finance, which enabled analysts to assess the impact that taxes have on the economy and the reasoning and justification for government to intervene in the economy (Pressman 1999). These contributions alone demonstrate the relevance and importance of Pigou's theoretical proposals in the scope of microeconomics.

According to Pressman (1999), the major economic contributions offered by Pigou could be categorized into two distinct groups. In one category is Pigou's analysis of externalities. This analysis provides the basic foundational theory behind modern public finance, welfare economics, and environmental economics. The second group contains Pigou's oppositions to the macroeconomic revolution instigated by Keynes. Pigou was essentially the first major opponent of this influential economist.

The first major works offered by Pigou in the field of economics, including Protective and Preferential Import Duties (1906) and Wealth and Welfare (1912), were concerning the topic of industrial relations and import duties, which further increased Pigou's interest in how government policy has the profound ability and potential to increase the well-being of the entire nation. This interest further spawned Pigou's work toward the ultimate invention of modern public finance, including compelling arguments for economic intervention by government, which were originally propagated by Pigou through works such as 1912's Wealth and Welfare (Pressman 1999).

Pressman describes how Pigou introduced the concept of social costs of production through his work entitled Stabilizing the Dollar (1920). This work demonstrated that production costs incurred by private firms generally do not accurately reflect the social costs of the production involved (Pressman 1999). In particular, Pigou focused in on the detrimental effects that production can have on the environment, and how these costs are not paid by the producers themselves but by society as a whole. Moreover, the market outcomes are exceeded by the social costs under these conditions.

Pigou's theory on social cost has profound effects on modern day environmental taxation. The issue is addressed by Morgenstern (1996), who explains how the overgrazing of common lands occurs due to the divergence of private and social costs, and there is essentially no way to effectively force herders into considering the grand-scale effects that their practices have on others. Furthermore, profit-maximizing decisions made by private firms result in detrimental outcomes for society, and pollution is a direct result of the market's failure to adequately incorporate all costs of economic activities in order to avoid these externalities (Morgenstern, 1996). The presence of these externalities further necessitates and justifies government intervention, often in the form of taxes and regulation (Collard 1983). These interventions are expected to result in outcomes that are more beneficial to society. Morgenstern (1983) explained how taxation is often the best employed policy in the case of externalities since the revenue provided can offset any financial imbalances caused by the tax. Regarding whether capital or labor should be taxed in these situations, Morgenstern (1996, p.3) concludes:

Other than the case where one is simply substituting a revenue-neutral environmental tax for an existing regulation, such tax swaps do not yield cost-less environmental gains (although the may substantially reduce the cost compared to other policy mechanisms

Pigou concentrated much of his efforts addressing externalities, which are the divergences between private costs and social costs associated with production. It was maintained by Pigou that when there was a divergence between marginal private costs and marginal social costs, there was inefficiency in the market system, and that government intervention into the market system may be justified (Pressman 1999). Pigou takes issue with externalities because of the problems that can stem from them. One such problem is a type of free-riding, in which there are large positive externalities, and people are able to gain regardless of whether they paid anything. Pigou sees this situation as one instance where the government should intervene in order to improve on market based outcomes (Pressman 1999). These interventions include taxes, subsidies and legal interventions. Pigou proposed that cost-benefit analyses should be applied to problems of externalities because sometimes the cost of remedying externalities are greater than the societal costs imposed by them I the first place (Pressman 1999).

In regards to remedying social costs through government intervention, such as taxation, Pigou stated in The Economics of Welfare (1920):

if the value of the marginal social net product is less than the value of the marginal private net product this implies that the output obtained is greater than the ideal output. It follows that, under conditions of perfect competition, for every industry in which the value of the marginal social net product is greater than that of the marginal private net product, there will be certain rates of bounty the granting of which by the state will modify output in such a way as to make the value of the marginal social net product there more nearly equal to the marginal social net product of resources in general, thus provided that the funds for the bounty can be raised by a transfer that does not inflict any direct injury on production - increasing the size of the national dividend and the sum of economic welfare; and there will be one rate of bounty, the granting of which would have the optimum effect in this respect. In like manner, for every industry in which the value of the marginal social net product is less than that of the marginal private net product, there will be certain rates of tax, the imposition of which by the State would increase the size of the national dividend and increase economic welfare; and one rate of tax, which would have the optimum effect in this respect.

An interpretation of this statement offered by Lebedur (1960) contends that the meaning intended by Pigou was that the remedies offered to eliminate externalities were to be applied unconditionally and unequivocally. Furthermore, governmental intervention in the form of taxation and regulation should be inflexibly applied according to the beliefs of Pigou.

According to Pigou, identifying and remedying externalities is a moral responsibility of the economist, which can be achieved through the demonstration of when and the manner in which government should intervene in market affairs in order to improve upon market outcomes (Pressman 1999). This is addressed in Pigou's work entitled Stabilizing the Dollar (1920). The ultimate goal Pigou had in mind when dealing with externalities was increasing the overall National well-being, and Pigou recognized that this was dependent on the size and distribution of economic prosperity (Pressman 1999). Furthermore, Pigou believed strongly that redistributive economic policies are an effective way of increasing welfare among the general population, since, as purported by Pigou, the satisfaction obtained from money is reduced as one acquires more money (Pressman 1999). In order for this economic redistribution to function effectively, the loss of welfare from taxing the rich must be less than the gain in economic welfare from giving that money to the poor. Progressive taxation and transfer programs to aid the poor could thus be justified as improving the overall well-being of the nation (Pressman 1999, pp. 97-8).

The possibility of a trade-off between growth and equity was recognized by Pigou (Pressman 1999). He maintained that national welfare was improved by anything that increased the output of a nation but did not worsen the situation of its poor, and likewise, well-being was also improved by anything increased the amount of national output being directed at the poor but did not decrease the total size of the national output (Pressman 1999). Pigou also recognized that transfers to the poor sometimes reduced national output, but that sometimes these small sacrifices were worth the resultant gains from increased equity (Pressman 1999).

Pigou was the first major opponent to Keynes macroeconomic revolution, which had its beginnings in England in the 1930s, and Keynes was also at odds with Pigou on many of his views, including Pigou's take on unemployment. Pigou never advocated wage reductions for workers, but it seemed like this was part of the solutions to employment that were proposed by Pigou. It was because of Pigou's inconsistency on this issue that Keynes extended criticism toward him (Pressman 1999). Pigou criticized Keyne's General Theory because it lacked any consistent, proper theoretical interpretation of the effect that expectation has in the marketplace (Collard 1983). In regard to rational expectations and the function that 'surprise' supply has, Pigou argued two points, as outlined by Collard (1983, p.411):

equilibrium and rationality implied the absence of systematic forecasting errors, monetary factors could independently affect output only by means of unanticipated inflation (deflation).

A asymmetrical errors due to 'psychological causes' could be a… READ MORE

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