My annotated study of Pigou’s observations re: externalities

The HUGE ERROR OF ECONOMIC ANALYSIS of positive externalities (there are plenty of them in negative externalities as well, cf. Demsetz) started with a **REALLY STUPID BOOK** BY PIGOU, in which he cites meaningless examples to prove the “problem of social benefit”.

Pigou says that the State can “fix” things with a “bounty” – subsidy. From where does this bounty magically appear? It comes from dollars that would have been otherwise put to valuable use by private individuals.

Worse, his ONLY example of bounty is protectionism. MERCANTALIST!

In brief, Pigou was the Keynes/Malthus of micro-economics. He was not quite a Marx but pushed (stupid) arguments for a big state.

On negative externalities, we need to follow Demsetz. On positive, we need to abandon Pigou altogether.

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From The Economics of Welfare, 1932 (4th edition; original edition 1920)

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10. I now turn to the second class of divergence between social and private net product which was distinguished in § 3. Here the essence of the matter is that one person A, in the course of rendering some service, for which payment is made, to a second person B, incidentally also renders services or disservices to other persons (not producers of like services), of such a sort that payment cannot be exacted from the benefited parties or compensation enforced on behalf of the injured parties. [Sanjeev: There is no intention to exact payment, so that can’t be assumed in the definition]. If we were to be pedantically loyal to the definition of the national dividend given in Chapter III. of Part I., it would be necessary to distinguish further between industries in which the uncompensated benefit or burden respectively is and is not one that can be readily brought into relation with the measuring rod of money. This dis­tinction, however, would be of formal rather than of real importance, and would obscure rather than illuminate the main issues. I shall, therefore, in the examples I am about to give, deliberately pass it over.

Among these examples we may set out first a number of instances in which marginal private net product falls short of marginal social net product, because incidental services are performed [Sanjeev: this makes it clear that SERVICES ARE PERFORMED CONSCIOUSLY AND DELIBERATELY] to third parties from whom it is technically difficult to exact payment. Thus, as Sidgwick observes, ” it may easily happen that the benefits of a well-placed light­house must be largely enjoyed by ships on which no toll could be conveniently levied.” [Sanjeev: This has been proven to be a wrong example] Again, uncompensated services are rendered when resources are invested in private parks in cities; for these, even though the public is not admitted to them, improve the air of the neighbourhood. [Sanjeev: here Pigou mixes up things. There is NO INTENTION in these private parks to provide a service to anyone other than the private owner.] The same thing is true—though here allowance should be made for a detriment elsewhere—of resources invested in roads and tramways that increase the value of the adjoining land—except, indeed, where a special betterment rate, corresponding to the improvements they enjoy, is levied on the owners of this land. It is true, in like manner, of resources devoted to afforestation, since the beneficial effect on climate often extends beyond the borders of the estates owned by the person responsible for the forest. [Sanjeev: the fact that these activites are undertaken is because they are profitable. We can’t have any quarrel with them.] It is true also of resources invested in lamps erected at the doors of private houses, for these necessarily throw light also on the streets. It is true of resources devoted to the prevention of smoke from factory chimneys: for this smoke in large towns inflicts a heavy uncharged loss on the community, in injury to buildings and vegetables, expenses for washing clothes and cleaning rooms, expenses for the provision of extra artificial light, and in many other ways.  [Sanjeev: the smoke is already being reduced: what’s the problem here?] Lastly and most important of all, it is true of resources devoted alike to the fundamental problems of scientific research, out of which, in unexpected ways, discoveries of high practical utility often grow, and also to the perfecting of inventions and improvements in industrial processes. [Sanjeev: Terrence Kealey has demolished this nonsense] These latter are often of such a nature that they can neither be patented nor kept secret, and, therefore, the whole of the extra reward, which they at first bring to their inventor, is very quickly transferred from him to the general public in the form of reduced prices. The patent laws aim, in effect, at bringing marginal private net product and marginal social net product more closely together. By offering the prospect of reward for certain types of invention they do not, indeed, appreciably stimu­late inventive activity, which is, for the most part, spontaneous [Sanjeev: Here Pigou admits he is on a pointless fishing expedition], but they do direct it into channels of general usefulness. [Sanjeev: No!]

[Sanjeev: I’m skipping this – about negative externalities, which has links with the harm principle] Corresponding to the above investments in which marginal private net product falls short of marginal social net product, there are a number of others, in which, owing to the technical difficulty of enforcing compensation for incidental disservices, marginal private net product is greater than marginal social net product. Thus, incidental uncharged disservices are rendered to third parties when the game-preserving activities of one occupier involve the overrunning of a neighbouring occupier’s land by rabbits—unless, indeed, the two occupiers stand in the relation of landlord and tenant, so that com­pensation is given in an adjustment of the rent. They are rendered, again, when the owner of a site in a residential quarter of a city builds a factory there and so destroys a great part of the amenities of the neighbouring sites; or, in a less degree, when he uses his site in such a way as to spoil the lighting of the houses opposite: or when he invests resources in erecting buildings in a crowded centre, which, by contracting the air space and the playing-room of the neighbourhood, tend to injure the health and efficiency of the families living there. Yet again, third parties—this time the public in general—suffer incidental uncharged disservices from resources invested in the running of motor cars that wear out the surface of the roads. The case is similar—the conditions of public taste being assumed—with resources devoted to the production and sale of intoxicants. To enable the social net product to be inferred from the private net product of the marginal pound invested in this form of production, the investment should, as Mr. Bernard Shaw observes, be debited with the extra costs in policemen and prisons which it indirectly makes necessary. Exactly similar considerations hold good in some measure of foreign invest­ment in general. For, if foreigners can obtain some of the exports they need from us by selling promises, they will not have to send so many goods; which implies that the ratio of interchange between our exports and our imports will become slightly less favourable to us. For certain sorts of foreign investments more serious reactions come into account. Thus, when the indirect effect of an increment of investment made abroad, or of the diplomatic manoeuvres employed in securing the concession for it, is an actual war or preparations to guard against war, the cost of these things ought to be deducted from any interest that the increment yields before its net contribution to the national dividend is calculated. When this is done, the marginal social net product even of investments, which, as may often happen in countries where highly profitable openings are still unworked and hard bargains can be driven with corrupt officials, yield a very high return to the investors, may easily turn out to be negative. Yet again, when the investment consists in a loan to a foreign government and makes it possible for that government to engage in a war which otherwise would not have taken place, the indirect loss which Englishmen in general suffer, in con­sequence of the world impoverishment caused by the war, should be debited against the interest which English financiers receive. [Sanjeev: this is a good point, about fungibility – later elaborated by Peter Bauer]. Here, too, the marginal social net product may well be negative. Perhaps, however, the crowning illustration of this order of excess of private over social net product is afforded by the work done by women in factories, particularly during the periods immediately preceding and succeeding confinement; for there can be no doubt that this work often carries with it, besides the earnings of the women themselves, grave injury to the health of their children. The reality of this evil is not disproved by the low, even negative, correlation which sometimes is found to exist between the factory work of mothers and the rate of infantile mortality. For in districts where women’s work of this kind prevails there is presumably—and this is the cause of the women’s work—great poverty. This poverty, which is obviously injurious to children’s health, is likely, other things being equal, to be greater than elsewhere in families where the mother declines factory work, and it may be that the evil of the extra poverty is greater than that of the factory work. [Sanjeev: trying to “fix” the problem would be worse than the cure] This consideration explains the statistical facts that are known. They, therefore, militate in no way against the view that, other things equal, the factory work of mothers is injurious. All that they tend to show is that prohibition of such work should be accompanied by relief to those families whom the prohibition renders necessitous. [Sanjeev: here Pigou is using his SENSIBILITY to pretend that he’s talking economics. He should have joined politics.]

11. At this point it is desirable to call attention to a somewhat specious fallacy. Some writers unaccustomed to mathematical analysis have imagined that, when improved methods of producing some commodities are introduced, the value of the marginal social net product of the resources invested in developing these methods is less than the value of the marginal private net product, because there is not included in the latter any allowance for the depreciation which the improvement causes in the value of existing plant; and, as they hold, in order to arrive at the value of the marginal social net product, such allowance ought to be included.’ If this view were correct, reason would be shown for attempts to make the authorisation of railways dependent on the railway companies compensating existing canals, for refusals to license motor omnibuses in the interests of municipal tramways, and for the placing of hindrances in the way of electric lighting enter­prises in order to conserve the contribution made to the rates by municipal gas companies. But in fact the view is not correct. The marginal social net product of resources devoted to improved methods of producing a given commodity is not, in general, different from the marginal private net product; for whatever loss the old producers suffer through a reduction in the price of their products is balanced by the gain which the re­duction confers upon the purchasers of these products. This is obvious if, after the new investment has been made, the old machines continue to produce the same output as before at reduced prices. If the production of the old machines is diminished on account of the change, it seems at first sight doubtful. Reflection, however, makes it plain that no unit formerly produced by the old machinery will be supplanted by one produced by the new machinery, except when the new machinery can produce it at a total cost smaller than the prime cost that would have been involved in its production with the old machinery: except, that is to say, when it can produce it at a price so low that the old machinery would have earned nothing by producing it at that price. This implies that every unit taken over by the new machinery from the old is sold to the public at a price reduced by as much as the whole of the net receipts, after discharging prime costs, which the old machinery would have obtained from it if it had produced that unit. It is thus proved that there is no loss to the owners of the old machines, in respect of any unit of their former output, that is not offset by an equivalent gain to consumers. It follows that to count the loss to these owners, in respect of any unit taken over from them by the new machinery, as a part of the social cost of producing that unit would be incorrect.

An attempt to avoid this conclusion may, indeed, still be made. It may be granted that, so far as direct effects are concerned, ordinary commercial policy, under which investment in improved processes is not restrained by consideration for the earnings of other people’s established plant, stands vindi­cated. There remain, however, indirect effects. If expensive plant is liable to have its earnings reduced at short notice by new inventions, will not the building of such plant be hindered ? Would not the introduction of improved processes on the whole be stimulated, if they were in some way guaranteed against too rapid obsolescence through the competition of processes yet further improved ? The direct answer to this question is, undoubtedly, yes. On the other side, however, has to be set the fact that the policy proposed would retain inferior methods in use when superior methods were available. Whether gain or loss on the whole would result from these two influences in combination, is a question to which it seems difficult to give any confident answer. But this impotent conclusion is not the last word. The argument so far has assumed that the rapidity with which improvements are invented is independent of the rapidity of their practical adoption; and it is on the basis of that assumption that our comparison of rival policies fails to attain a definite result. As a matter of fact, however, improvements are much more likely, to be made at any time, if the best methods previously discovered are being employed and, therefore, watched in actual operation, than if they are being held up in the interest of established plant. Hence the holding-up policy indirectly delays, not merely the adoption of improvements that have been invented, but also the invention of new improvements. This circumstance almost certainly turns the balance. The policy proper to ordinary competitive industry is, therefore, in general and on the whole, of greater social advantage than the rival policy. It is not to the interest of the community that business’ men, contemplating the in­troduction of improved methods, should take account of the loss which forward action on their part threatens to other business men. The example of some municipalities in post­poning the erection of electric-lighting plant till their gas plant is worn out is not one that should be imitated, nor one that can be successfully defended by reference to the distinction between social and private net products. The danger that beneficial advances may be checked by unwise resistance on the part of interested municipal councils is recognised in this country in the rules empowering the central authority to override attempts at local vetoes against private electrical enter­prise. The policy followed by the Board of Trade is illustrated by the following extract from their report on the Ardrossan, Saltcoats and District Electric Lighting Order of 1910: ” As the policy of the Board has been to hold that objection on the grounds of competition with a gas undertaking, even when belonging to a local authority, is not sufficient reason to justify them in refusing to grant an Electric Lighting Order, the Board decided to dispense with the consent of the Corporation of Ardrossan.”¹

12. So far we have considered only those divergences between private and social net products that come about through the existence of uncompensated services and uncharged dis­services, the general conditions of popular taste being tacitly assumed to remain unchanged. This is in accordance with the definition of social net product given in Chapter II. § 5. As was there indicated, however, it is, for some purposes, desirable to adopt a wider definition. When this is done, we observe that a further element of divergence between social and private net products, important to economic welfare though not to the actual substance of the national dividend, may emerge in the form of uncompensated or uncharged effects upon the satisfaction that consumers derive from the consumption of things other than the one directly affected.[Sanjeev: this sounds to me like the futile “arms race” arguments that are sometimes used by psuedo-economists to justify government intervention.] For the fact that some people are now able to consume the new commodity may set up a psychological reaction in other people, directly changing the amount of satisfaction that they get from their consumption of the old commodity. It is conceivable that the reaction may lead to an increase in the satisfaction they obtain from this commodity, since it may please them to make use of a thing just because it is superseded and more or less archaic. [Sanjeev: correct, collectors of old, junk cars]  But, in general, the reaction will be in the other direction. For, in some measure, people’s affection for the best quality of anything is due simply to the fact that it is the best quality; and, when a new best, superior to the old best, is created, that element of value in the old best is destroyed. Thus, if an improved form of motor car is invented, an enthusiast who desires above all “the very latest thing ” will, for the future, derive scarcely any satisfac­tion from a car, the possession of which, before this new in­vention, afforded him intense pleasure. In these circumstances the marginal social net product of resources invested in pro­ducing the improved type is somewhat smaller than the marginal private net product. It is possible that the introduc­tion of electric lighting into a town may, in some very slight degree, bring about this sort of psychological reaction in regard to gas: and this possibility may provide a real defence, supplementary to the fallacious defence described in the preceding section, for the policy of municipalities in delaying the introduction of electricity. This valid defence, however, is almost certainly inadequate. The arguments actually employed in support of the view that municipalities should not permit competition with their gas plant are those described in the preceding section. They are, in general, independent of any reference to psychological reactions, and are, therefore, like the arguments which persons interested in canals brought against the authorisation of the early railways, wholly fallacious.

13. It is plain that divergences between private and social net product of the kinds we have so far been con­sidering cannot, like divergences due to tenancy laws, be mitigated by a modification of the contractual relation between any two contracting parties, [Sanjeev: here he directly violates the contracting that widely occurs, e.g. bee keeper and apple orchard]  because the divergence arises out of a service or disservice rendered to persons other than the contracting parties. It is, however, possible for the State, if it so chooses, to remove the divergence in any field by “extraordinary encouragements” [Sanjeev: subsidies] or “extraordinary restraints” [Sanjeev: taxes] upon investments in that field. The most obvious forms which these encouragements and restraints may assume are, of course, those of bounties and taxes. Broad illustrations of the policy of intervention in both its negative and positive aspects are easily provided.

The private net product of any unit of investment is unduly large relatively to the social net product in the businesses of producing and distributing alcoholic drinks. Consequently, in nearly all countries, special taxes are placed upon these businesses. Marshall was in favour of treating in the same way resources devoted to the erection of buildings in crowded areas. He suggested, to a witness before the Royal Commission on Labour, ” that every person putting up a house in a district that has got as closely populated as is good should be compelled to contribute towards providing free playgrounds.” The principle is susceptible of general application. It is employed, though in a very incomplete and partial manner, in the British levy of a petrol duty and a motor-car licence tax upon the users of motor cars, the proceeds of which are devoted to the service of the roads. It is employed again in an ingenious way in the National Insurance Act. When the sickness rate in any district is exceptionally high, provision is made for throwing the consequent abnormal expenses upon employers, local authorities or water companies, if the high rate can be shown to be due to neglect or carelessness on the part of any of these bodies. Some writers have thought that it might be employed in the form of a discriminating tax upon income derived from foreign investments. But, since the element of disadvantage described in § 10 only belongs to some of these investments and not to others, this arrange­ment would not be a satisfactory one. Moreover, foreign investment is already penalised to a considerable extent both by general ignorance of foreign conditions and by the fact that income earned abroad is frequently subjected to foreign income tax as well as to British income tax.

The private net product of any unit of investment is unduly small in industries, such as agriculture, which are supposed to yield the indirect service of developing citizens suitable for military training. Partly for this reason agriculture in Germany was accorded the indirect bounty of protection. A more extreme form of bounty, in which a governmental authority provides all the funds required, is given upon such services as the planning of towns, police administration, and, sometimes, the clearing of slum areas. This type of bounty is also not infrequently given upon the work of spreading information about improved processes of production in occupations where, owing to lack of appreciation on the part of potential beneficiaries, it would be difficult to collect a fee for under­taking that task. Thus the Canadian Government has established a system, “by means of which any farmer can make inquiry, without even the cost of postage, about any matter relating to his business”; and the Department of the Interior also sometimes provides, for a time, actual instruction in farming. Many Governments adopt the same principle in respect of information about Labour, by providing the services of Exchanges free of charge. In the United Kingdom the various Agricultural Organisation Societies are voluntary organisations, providing a kindred type of bounty at their subscribers’ expense. An important part of their purpose is, in Sir Horace. Plunkett’s words, to bring freely ” to the help of those whose life is passed in the quiet of the field the experience, which belongs to wider opportunities of observation and a larger acquaintance with commercial and industrial affairs.” The Development Act of 1909, with its provision for grants towards scientific research, instruction, and experiment in agricultural science, follows the same lines.

It should be added that sometimes, when the inter­relations of the various private persons affected are highly complex, the Government may find it necessary to exercise some means of authoritative control in addition to providing a bounty. Thus it is coming to be recognised as an axiom of government that, in every town, power must be held by some authority to limit the quantity of building permitted to a given area, to restrict the height to which houses may be carried, — for the erection of barrack dwellings may cause great overcrowding of area even though there is no overcrowding of rooms,—and generally to control the building activities of individuals. It is as idle to expect a well-planned town to result from the independent activities of isolated speculators as it would be to expect a satisfactory picture to result if each separate square inch were painted by an independent artist. No “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 and should tackle the collective problems of beauty, of air and of light, as those other collective problems of gas and water have been tackled. Hence, shortly before the war, there came into being, on the pattern of long previous German practice, Mr. Burns’s extremely important town-planning Act. In this Act, for the first time, control over individual buildings, from the standpoint, not of individual structure, but of the structure of the town as a whole, was definitely conferred upon those town councils that are willing to accept the powers offered to them. Part II. of the Act begins: “A town-planning scheme may be made in accord­ance with the provisions of this Part of the Act as respects any land which is in course of development, or appears likely to be used for building purposes, with the general object of securing proper sanitary conditions, amenity, and con­venience in connection with the laying out and use of the land, and of any neighbouring lands.” The scheme may be worked out, as is the custom in Germany, many years in advance of actual building, thus laying down beforehand the lines of future development. Furthermore, it may, if desired, be extended to include land on which buildings have already been put up, and may provide “for the demolition or alteration of any buildings thereon, so far as may be necessary for carrying the scheme into effect.” Finally, where local authorities are remiss in preparing a plan on their own initiative, power is given to the appropriate depart­ment of the central Government to order them to take action. There is ground for hope, however, that, so soon as people become thoroughly familiarised with town-planning, local patriotism and inter-local emulation will make resort to pressure from above less and less necessary.

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