Arthur Pigou and the Invisible Hand

Thom Lambert writes (19 April) in the Truth on the Market Blog http://www.truthonthemarket.com/2010/04/19/some-warnings-for-modern-pigovians-from-pigou-himself/:


“Some Warnings for Modern Pigovians (from Pigou Himself)”

“These various interventions to correct for externalities are the brainchild of Cambridge economist Arthur Cecil Pigou. Writing in the 1920s, Pigou recognized that negative externalities would result in “too much” of an activity and that positive externalities would result in “too little.” He thus concluded that when externalities exist “[n]o ‘invisible hand’ can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts. It is therefore necessary that an authority of wider reach should intervene.”

Specifically, he asserted, [i]t is … possible for the State, if it so chooses, to remove the divergence in any field by ‘extraordinary encouragements’ or ‘extraordinary restraints’ upon investments in that field. The most obvious forms which these encouragements and restraints may assume are, of course, those of bounties and taxes.

In other words, the government should tax activities that create negative externalities and subsidize those that create positive externalities, thereby ensuring that the actors at issue bear the full costs and benefits of their conduct. If they do, they’ll act optimally, taking all actions that create benefits in excess of cost and none that don’t. Thus was born the idea of “Pigovian” taxes and subsidies — the notion underlying the proposed climate change legislation, President Obama’s bank tax, the various subsidies for electric vehicles, and scads of other government interventions into private affairs.”

Comment
This is a relevant point by Arthur Cecil Pigou (1877-1959), author of The Economics of Welfare, 1920 because it illustrates what his generation of economists were thinking of the phrase, the invisible hand, in those decade before Keynes’ General Theory. Pigou developed an economic rationale for welfare intervention in the externalities evident in a complex capitalist economy, and it sparked a massive interest in what became known as welfare economics that peaked in the post-war years up the 1960s (Kaldor, Hicks, Coase) and led to several spin-offs, including public choice theory. (‘Welfare economics’ was not just about social welfare re-distributive policies of modern states.)

The sentence: ‘“[n]o ‘invisible hand’ can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts’ recognizes a conventional and mistaken treatment of the ‘invisible hand’, later popularized by such as Paul Samuelson, and comments on its practical validity.

This created the divergence between those of saw the need for a theory justifying intervention and those who preferred to rely on markets to act out what they claimed for them, using the ‘invisible hand’ as the ‘miraculous’ power of markets to create the ‘best of all possible worlds’.

The Hesitant Hand by Steven Medema (Princeton University Press): Part 6: ‘Coase’s Challenge’.

Steve Medema’s account of Ronald Coase’s major contributions to economics is strengthened by his knowledge of the circumstances in which he addressed and defended his seminal article, ‘The Problem of Social Cost’ (1960).

Coase worked on practical proposals, and the theory behind them, of how to use a market to allocate broadcast frequencies to privately-owned radio stations regulated by the US Federal Communications Commission, assuming that the pricing mechanism and property rights worked well enough to allow broadcasting rights to flow ‘towards their highest valued uses’ and users.

Surprisingly, perhaps, economists from the University of Chicago, led by Milton Friendman, George Stigler and Aaron Director, and 17 others, disagreed with Coase’s approach at first, but changed their minds after hours of debate. This became the seminal article in Journal of Law and Economics in 1960, and the rest is history.

The party causing harm to another was no longer the obvious candidate for a tax related to the damages it caused. If A harms B, how should A be restrained, because when A causes harm to B, avoiding harm to B inflicts harm on A, and the question is now should A be allowed to harm B, or should B be allowed to inflict harm on A?

Economists know harms inflicted on others as externalities and Coase realised that the rights assigned to A simultaneously may expose B to the consequences of A exercising her rights. Among the consequences may be the infliction of losses from costs to B arising from A’s rights. But this has deeper significance: whose rights prevail, A’s or B’s? Merely restraining the polluter damages the polluter and does not include the costs of that restraint.

Here Pigou’s taxation of the polluter does not necessarily maximise national welfare when the costs of one, and not the costs of both parties, are considered. This reduced to the existing legal system and how rights are distributed among the affected parties.

Most econ students become familiar with Coase’s Rancher/Farmer problem. Cattle wandering into the farmer’s fields to graze impose costs on the farmer (lost crops) and add to the rancher’s gross income. To fence off his fields costs the farmer the expence of erecting and maintaining a fence; to add cattle to his herds adds to the rancher’s profits. A exercising his rights imposes costs of B; B exercising his rights imposes costs on A.

Coase showed there was a level of compensation payable by A or B that would be acceptable to both parties that would leave them both better off than an imposed choice of winner or loser. The amount of compensation offered and accepted could be determined by voluntary negotiation by A and B that reflected their respective valuations of harm, and thereby achieve the efficient bargained outcome through the price mechanism.

Coase solutions were consistent with Adam Smith’s expectation that resources gravitate towards their highest-value uses (p111). At a stroke, legal-rule determined Pigouvian taxation/subsidies theories were discarded (in theory). No wonder Friedman and Stigler bowed to Coase’s contentions in their 1959 debate.

Of course there are transaction costs in determining who compensates who, whether by administrative fiat, legal judgment, or private bargaining (which is where Coase first made his mark in his seminal "Nature of the Firm”, 1937), and Steve leads the reader through the practical consequences of this field with impressive clarity.

Anybody who has spent time bargaining for something that matters to the parties (assuming you have found the right people to bargain with) will know of the real costs of such activity, even before a contract is formalised and agreed, plus the après-contract work of monitoring performance of the other party during implementation, with the ever present possibility of contract breakdown and resort to legal sanctions.

In my experience, judges often hear (or read) the submissions of the parties and then tell them to go away and sort out a solution upon which she will rule, rather than sit and listen to disputatious parties though long hours (days, weeks) of expensive adversarial confrontations.

However, Steve explores how Pigovian state remedies also take up expensive time and resources, though neatly stepped over as costless transactions by assumption. Yet corporate resistance to social costs judgements face major political pressures, lobbyists, media influences, and civil service mind-sets, all of which add to decision costs. Public enquires can take years too. For certain, transaction costs are not zero.

It’s not that Coase claimed that markets are universally less costly than applying Pigovian solutions because either can be the most expensive; they both face costs in dealing with externalities. It is the case that market solutions, partial or total, in many cases are more efficient that sole use of public-based solutions and regulatory monitoring. These options are worth exploring, argued Coase. Just assuming that public measures are least expensive is based on ignoring transaction costs and assuming “that government interference will improve matters” (p. 117).

The problem, says Steve, lies in the formulation of the divergence between “marginal private net product and marginal social net product” rather than comparing total social product yielded by the different arrangements. It is easier, Steve concludes, reporting on Coase, to conceive of “better worlds” than to “devise practical arrangements which will correct defects in one part of the system without causing more serious harm in other parts” (p 121).

Steve’s presentation of what is known as the Coase theorem is the best I have seen over many years since the 1960s (when I was an undergraduate).