Thoughts on economics and liberty

Category: Economics

The core disagreement between Pigou, the profession, and Coase in the analyses of the externality question – Demsetz

By Harold Demsetz (1996). My annotated study, below. My main finding is that by 1996, Demsetz had NOT ACHIEVED CLARITY on this issue, and many of his arguments make no sense. He still thinks that social costs might be real under certain circumstances. That changed by 2011.


The source of disagreement between Pigou, the profession, and Coase in regard to the externalities is thought to be transaction cost. Coase shows that the traditional prescription for remedying externality problems can be wrong if transaction cost is positive. But Pigou did recognize that positive transaction cost played a role in creating externality problems even though the profession later failed to do so. The present paper documents this, and it suggests instead that the core disagreement was in Pigou’s willingness to rely on an omnicient State to implement policy and Coase’s refusal to do so. In a comparison of these two views, Coase’s zero transaction cost model plays a more important role than that commonly assigned it.

  1. Introduction

‘The Problem of Social Cost’ (Coase, 1960) is R.H. Coase’s most cited and most influential work. It is noted for, among other things, demonstrating the importance of incorporating transaction cost into the analysis of externalities and into the analysis of markets more generally. This theme, that markets are not free, is also found in the classic ‘The Nature of the Firm’ (Coase, 1937), so that, taking the perspective offered by both works, transaction cost turns out to be important whether one is analyzing allocation through the price system or through the firm. Coase in fact views his emphasis on transaction cost as an important part of his work. Noting the unrealism of the zero transaction cost model that precedes his discussion of the positive transaction cost model, he interprets the former as only a device by which to lead the reader, as it were by the hand, to the more complicated analysis of the latter. The profession joins him in this evaluation, but I do not. Instead, I argue the following here:

  1. Pigou was not neglectful of transaction cost although he definitely failed to perceive its general analytical significance.
  2. It was not Coase’s observations on the importance of transaction cost but his ‘privatization’ of the externality problem that constitutes the main methodological advance in his work.
  3. Coase was guided toward privatization of the interaction between parties by his refusal to accept Pigou’s and the profession’s idealized State as a solver of the externality question.

The result of the above conclusions is to make Coase’s zero transaction cost model much more important in the debate about externalities than is suggested by the purely pedagogical role assigned to it by Coase. In this reassessment of Coase’s contribution, I take the validity of his demonstrations as a given.

  1. Privatization and the responsibility issue

Prior to Coase’s article there was an unquestioning presumption as to where responsibility for externality costs (and benefits) should rest. This is true of Pigou’s initial discussion of externalities and also of the profession’s doctrine toward externalities at the time Coase wrote. The owner of the factory from which soot-filled smoke rises is held responsible, without question or analysis, for the increased cost of washing cloths in the neighboring laundry on which the soot falls. The owners of the ranch from which cattle stray to surrounding corn fields and of the railroad from which sparks fly are similarly held responsible for damage done to crops. This presumptive judgment made it difficult to recognize that the social value of the activities of the interacting parties might, in sum, be greater if the harmed party is left to bear the damages. If this possibility is not recognized, the inclination to take an analytical view toward the transaction cost variable is repressed, for the importance to be attached to transaction cost becomes apparent only on a genuine comparison of alternative assignments of responsibility.

The rationale for this asymmetrical approach is not in the neglect of transaction cost, but, rather, in a second implicit presumption made by Pigou and the profession — an omniscient and omnipotent government. The tax policy of an all-knowing, well-motivated state results in corrective adjustments for externalities that accord with the economist’s prescription; this obviates the need for considering alternative assignments of responsibility. The problem is analyzed as if the state is a perfect agent through which the blackboard plans of economists can be brought to fruition. Ignoring State-associated costs of errors, implementation, and improper motivation, rather than ignoring the cost of using of markets, is the root cause of the asymmetrical approach brought to the assignment of responsibility. As we shall see, Pigou’s analysis does recognize a positive transaction cost barrier to a market resolution of externality problems, but because he presumes an ideal state his analysis is nonetheless deficient. Coase does not adopt a state-devised solution in his analysis, and he is compelled to recognize a need for comparing alternative assignments of responsibility to private parties. He thus privatizes the externality problem. The comparison of private alternatives enters the analysis of externalities in a substantive way for the first time with the appearance of Coase’s article. [Sanjeev: No, Knight clearly showed that first, and ruled out any inefficiency]

However, it is not the privatized responsibility approach but positive transaction cost that is now judged as Coase’s primary theoretical innovation. This is because Coase’s analysis shows that resource allocation is unaffected by a policy toward private responsibility if transaction cost is zero. Positive transaction cost defines the context in which the responsibility issue is important if this is to be judged by impact on resource allocation. I shall argue below for another standard of importance, but the theoretical point involved here, that positive transaction cost is needed before the assignment of private responsibility makes a difference, cannot be deduced by a mind that has conjured an idealized state and obviated the need for considering alternative private responsibility solutions. Moreover, the more important quantitatively is transaction cost, the easier it is to argue against consideration of a privatized solution and for a Pigou-prescribed intervention by the state.

  1. Responsibility in a positive transaction cost setting

If Pigou did not grasp the analytical importance of transaction cost, he did recognize that transaction-like obstacles to market solutions gave rise to the externality problem. 2 [FN 2: I discovered after completing this paper that Victor P. Goldberg (1981) had already uncovered the fact that Pigou’s did take note of the need for markets to be unworkable if private cost were to deviate from social cost. In his discussion of this, Goldberg even selected some of the same quotations from The Economics of Welfare (Pigou, 1960) that I favored for the present paper.] He writes:

“[T]he 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“. 3 [FN3: Pigou (1960, p. 183). (Note: References made to Pigou’s The Economics of Welfare are to the 1960 printing. This printing contains revisions adopted by Pigou in 1934.) It is not entirely clear from his discussion whether he rules out a market solution because of what we would now call transaction cost or because of the absence of property rights in some scarce resources. The absence of ownership in ‘common pool’ problems may be what he had in mind. Since the absence of property rights exacerbates the transaction cost problem, and would not be a source of inefficiency if transaction (plus information) costs were zero, we may interpret Pigou as recognizing, at least implicitly, that markets do not function without cost. As we shall see, his recognition of this is not incidental.] (Italics added.)

Pigou describes three sources of the externality problem. These are distinguished by the positions of the person(s) who suffer the consequences of an externality and those who, according to Pigou, cause it. One case refers to a theme of Marshall’s that discusses the advantages of subsidizing increasing returns industries and taxing decreasing returns industries. Marshall’s ideas about this no doubt motivated Pigou’s own thinking about externalities, but Marshall’s theme, which confuses pecuniary and non-pecuniary effects, is not of interest to the present paper. A second case involves non-pecuniary externalities in which the interacting parties are already engaged in exchange. Here Pigou raises a question as to how land use is affected by differences in the time horizons of renters and landowners. He discusses this question in a context where both parties are already involved in contractual negotiations involving the renting of the land. This context distinguishes the second case from the third. The third involves non-pecuniary externalities in situations in which persons are not already involved in contractual negotiations. Pigou, as an example of this third case, refers to the quantity of resources allocated to parks. Here the private provider of a park for his own use in the midst of a city is viewed as overlooking the benefits, such as freshening the air, that others derive from its existence.

In his discussion of the second case, involving land owner and renter, Pigou finds a potential externality in the discrepancy between the tenant’s interest in making improvements and the owner’s and society’s interest in having these improvements made. The tenant’s interest is affected by the period of his tenancy, but the owner’s and society’s interest extends over the full life of the assets to which improvements are or can be made. The tenant’s private return, because of this limited time horizon, is less than the social return, and results in too few or too short-lived investments. Pigou calls for legislation bearing on both owner and tenant to create better incentives for the making of these investments. His treatment explicitly recognizes that the divergence between the tenant’s and owner’s returns to improvements is “larger or smaller in extent according to the terms of the contract between lessor and lessee” (Pigou, 1960, p. 175), and in a footnote (Pigou, 1960, pp. 176-177) he mentions contractual arrangements that might mitigate the problem. He goes so far as to acknowledge that

“The deficiency of the private, as compared with the social, net product… can be mitigated in various degrees by compensation schemes… In its simplest form [this] consists in monetary penalties for failure on the part of tenants to return their land to the owner in ‘tenantable repair”‘ (Pigou, 1960, p. 177).

Insofar as tenancy is concerned, Pigou is clear that agreements struck between the interacting parties can reduce the difference between private and social cost. These agreements belong to the realm of the possible because owners and tenants are already involved in negotiating a contract, and this contract might be amended readily to take account of what we now call agency considerations. However, even in this case Pigou doubts the perfection of contractual resolution. He goes on to claim that imperfections of one sort or another in such contractual arrangements bar the complete reconciliation of principal and agent interests. His notion that government, though some law, can rectify the situation easily is naive in the extreme. Still, without using Coase’s terminology, Pigou writes of this situation as if it were one where positive transaction cost bars a satisfactory market-determined resolution of the agency problem. Pigou easily could have been brought to agree that market negotiations would completely eliminate the divergence in the absence of these contractual impediments, but he insists that these impediments are present in sufficient degree to cause a divergence between private and social cost. 4 [FN4: Surprisingly, after discounting without reservation the ability of private parties to negotiate an appropriate contractual solution, Pigou seems to have no doubt that the State can improve the situation without difficulty. What the State should and should not do depends not only on narrow economic doctrine, but also on the theory of political-bureaucratic behavior that is brought to the policy table. A demonstration of economic inefficiency is not sufficient to establish the necessity for political action. Sidgwick (1883) was aware of this distinction; although he was Pigou’s precursor insofar as he clearly recognized and described the externality problem, he explicitly rejected an automatic call for state intervention, noting that this might make matters worse.]

It is in regard to the third case of externalities that Pigou gives life to the traditional externality doctrine that was to evolve from his work. This is the source he has in mind in the first quotation given above, in which he refers to exchange between A and B that results in consequences for other parties. In this quotation, Pigou rejects the possibility of contractual arrangements by which to mitigate the divergence between private and social returns. Unlike the tenancy case, no contractual interactions between the externality-affected parties and A or B are already in place. For Pigou, this seems to rule out privately devised contractual improvements such as might seem plausible between the landlord and tenant who are already tied into a contract.

“It is plain that divergences between private and social net product…cannot, like divergences due to tenancy laws, be mitigated by a modification of the contractual relation between any two contracting parties, 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’ or `extraordinary restraints’… The most obvious form…are, of course, those of bounties and taxes” (Pigou, 1960, p. 192).

He refers to private parks that improve a city’s air quality, investment in lamps at the doors of households, the light from which also illuminates the street, smoke from factory chimneys, and resources devoted to fundamental problems of scientific research, the perfecting of inventions, and improvements in industrial processes, all of a sort that they can “neither be patented nor kept secret”. He also refers to Sidgwick’s observation that “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”. A clever person might be able to devise pragmatic methods for joining the interests of the such parties through the device of market negotiations, and Coase (1974) has made the case that even the services of lighthouses can be and have been paid for, but clearly these cases do suggest prohibitively high transaction cost.

However, since prohibitively high transaction cost does not accompany all cases that fit the type three group, Pigou’s classification of type three cases is incomplete. Farmer—rancher and the factory—laundry interactions, for example, involve persons not already linked into landlord—tenant types of contracts but do not obviously involve transacting cost so high as to bar negotiations between the parties. That third parties are not already involved in pertinent negotiations, as they are in landlord—tenant type situations, carries no implication that it would be very costly to bring them into relevant negotiations. Because cases such as these are not discussed by Pigou, we may surmise either that he overlooked real possibilities of using markets to resolve externality-type problems or that he meant to be theorizing specifically about situations in which transaction costs are prohibitively high.

The importance of transaction cost, even at the superficial level of the recognition given to this cost by Pigou, ceased to be noticed at all in the professional view that prevailed when Coase wrote. The Meade (1952) modeling of the interaction between a bee keeper and an apple grower may be a major reason the profession lost sight of positive transaction cost, for the model presumed the lack of a market without justifying the presumption. The bee—apple situation was not described in a manner that would seem to convert it into a public good fraught with free rider problems, yet Meade assumed the absence of a price linking the apple grower’s activities to the bee-keeper’s activities. Meade’s discussion offers a good example of the dangers inherent in what Coase has called ‘blackboard economics’. Had Meade investigated bee keeping and apple growing, he would have discovered not only that there could be a market link between these activities, but that the market actually existed. 5 [FN5: The factual resolution of the problem is discussed by Cheung (1973) and Johnson (1973).]

Pigou’s greater awareness of the significance of transaction cost makes it tempting to believe that his view, unlike the post-Meade profession’s view, is innocent of neglecting transaction cost. There is analytical significance to Pigou’s recognition of the difficulty in making payment [Sanjeev: i.e. transaction cost]. If nothing is done about an externality because the cost of market negotiations is too great, too much of the good that Pigou presumes to be the cause of the externality is produced and too little of the adversely affected good is produced. This is as compared to the efficient solution that Pigou believes the state can secure via its tax policy. One mix of outputs prevails in the absence of explicit corrective policy, and this is readily interpreted as the mix that results if the ‘offending’ party is not held responsible for the interaction. The second mix results if the offending party is held responsible and taxed accordingly.

But Pigou nonetheless fails to see the full significance of the responsibility issue in a positive transaction cost setting. His neglect is at least partly due to his extreme naivete in regard to the state’s ability to set the matter right. If he would have ruled out state action on grounds of impracticality or politics, or if he would have recognized that the common law offered potential corrective action even if the state did not act, he would more likely have been led, as Coase was, to consider the consequences of assigning responsibility to either party to the interaction. The possibility that the value of output is greater if responsibility is not assigned to the party producing the ‘offending’ good would have been more obvious. The hidden presumption of an omniscient, omnipotent state breaks this chain of investigation because it allows one to pretend that the ‘ideally efficient solution’ is easily obtained through state action. The conditions that must be satisfied by the state’s action, derived through pure blackboard manipulation of curves and symbols, was taken to be sufficient to demonstrate that policy could achieve an ideal solution. The costs of using the state were implicitly assumed to be zero.

Pigou thus fails to examine the analytical consequences of positive transaction cost even though he recognizes that barriers to negotiations blocked an efficient market solution from emerging. He does not deduce the best that might be achieved in the presence of high transactions cost, and he does not recognize that negotiations of some sort might be pursued by the parties after the state imposes its tax; these negotiations would undermine the ideally efficient solution that the tax was to have brought about (see footnote 8).

The profession’s 1960 view, of course, also exhibited this weakness, but, because it took no note at all of transaction cost, it failed to see that transaction cost is relevant to the existence of an externality. [Sanjeev:  No, it’s NOT! It is clear that Demsetz had erred at this stage of his career, and realised his mistake by 2011] The externality problem was viewed by the profession as a technological problem, not a market problem. Soot from a factory changes the productivity of the laundry’s operation. No question was raised about what the laundry owner might do about this.

  1. Responsibility in a zero transaction cost setting

The approach of the profession just before Coase wrote was to take note of the existence of efficiency-impairing interactions between production functions and to call for corrective action by the state. The possibility of a negotiated resolution simply was unrecognized. [Sanjeev: This is incorrect. Frank Knight had clearly privatised the two roads example, in which the price for the use of road woud be determined through the market process of tatonnment, which is basically a bargaining process] Stigler (1952, pp. 104-105), in the revised edition of his then influential text The Theory of Price, writes:

“[T]here can be real differences between the alternative product of a resource to society and to an industry or firm or, in Pigou’s terminology, between the marginal social product and the marginal private product. A bundle of productive services may add $10 to the receipts of the firm, this is its marginal private product. If in addition it causes a loss to others of $3 (perhaps by contaminating a stream), its marginal social product is only $7”.

“…Some of the disharmonies between private and social product are large and important, and they are dealt with by a variety of techniques such as taxes and subsidies, dissemination of information, and the police power (for example, zoning)”. [Sanjeev: this is seriously loose thinking!]

The article ‘Anatomy of Market Failure’ (Bator, 1958) is the only treatment I have uncovered that mentions costs that are the equivalent of transaction cost, but like Pigou, he shows no appreciation for how transaction cost can undermine the traditional externality doctrine. [Sanjeev: Not really – the “externality doctrine” was entirely false from day 1. You can’t undermine something that’s already blatantaly false]

“In its modern version, the notion of external economies…belongs to a more general doctrine of ‘direct interaction’… Such interaction…consists in interdependencies that are external to the price system, hence unaccounted for by market transactions” (Bator, 1958, p. 358).

“This is what I would call an ownership externality. [Sanjeev: one more empty box] It is essentially Meade’s ‘unpaid factor’ case. Non-appropriation, divorce of scarcity from effective ownership, is the binding consideration. Certain ‘goods’ (or ‘bads’) with determinate non-zero shadow-values are simply not attributed. It is irrelevant here whether this is because the lake where people fish happens to be in the public domain, or because ‘keeping book’ on who produces, and who gets what, may be impossible, clumsy, or costly in terms of resources. For whatever legal or feasibility reasons, certain variables, which have positive or negative shadow value are not ‘assigned’ axes” (Bator, 1958, p. 364).

“In the end, however,…it is not easy to think of many significant ‘ownership externalities’ pure and simple. Yet it turns out that only this type of externality is really due to nonappropriability” (Bator, 1958, p. 365).

Coase attributed the profession’s incorrect analysis of the externality problem to the strong tendency of economists to analyze allocation problems with a mind set that implicitly treated markets as free to use, but I think this is not quite an accurate depiction. If they had taken markets to be free, they might have seen that productivity interactions do not defeat an efficient resource allocation. What is true of the profession’s mind set is that it simply ignored the market interactions that would arise as a result of these productivity interactions, and it did so, like Pigou, because of the appeal to blackboard intervention by an idealized state. The wearing of this particular set of blinders is consistent with Pigou’s inability to translate the existence of barriers to negotiation, clearly perceived by him, into a correct analysis of the problem.

It is not surprising that Coase, who devoted much of his life to convincing the profession of the importance of positive transaction cost, should attach greater significance to his positive transaction cost analysis of the externality problem than he attaches to his zero transaction cost model. Indeed, from Coase’s perspective the zero transaction cost model seems to serve mainly the pedagogical purpose of bringing readers of his article to the point where they can face the responsibility issue in the context of the more complicated positive transaction cost world in which externality problems must be resolved. This, I believe, is Coase’s view of the role of the zero transaction cost model, and the model does perform this task. But the impact of this model goes well beyond pedagogy. More than does the positive transaction cost model, it challenges the political agenda of many of those who saw in the externality problem an important lever for an expanded government role in resource allocation.6 [FN6: Coase (1988, pp. 174-175) writes: “The world of zero transaction costs has often been described as a Coasian world. Nothing could be further from the truth. It is the world of modern economic theory, one which I was hoping to persuade economists to leave”.]

The externality question as viewed by Pigou and many of his followers did not stand apart from the question of the role to be played by the state in economic affairs. The rationale for limiting the economic role of the state is found in conclusions drawn from self-interested, competitive interactions of the ‘invisible hand’ variety. Smith’s debate with the mercantilists demonstrated the allocative power of the invisible hand. Monopoly offered one counter-argument to this demonstration, but monopoly rejects the applicability of competition, it does not refute logical deductions made from competition. The empirical significance of monopoly might be debated, but shortly after the turn of the century, and after Darwin’s writings, most economists believed competition could not be contained. [Sanjeev: This is the correct position, i.e. monopolies are created by governments and/or cannot exist in a free market] From this belief it followed, as a practical matter, that the justification for a larger role of the state must be based on grounds that logically could co-exist with competition. The search for such grounds seems to have been an important mission of Pigou. He devotes a prominent portion of The Economics of Welfare to the task of showing that competition does not automatically yield an efficient outcome. One short quotation follows:

“The source of the general divergences between the values of marginal social and marginal private net product that occur under simple competition (italics added) is the fact that, in some occupations, a part of the product of a unit of resources consists of something, which, instead of coming in the first instance to the person who invests the unit, comes instead, in the first instance (i.e., prior to sale if sale takes place), as a positive or negative item, to other people” (Pigou, 1960, p. 174).

The desire to reject the conclusions usually drawn from competition no doubt motivated many of Pigou’s followers also, and to Pigou and followers alike the externality issue must have seemed the ideal conceptual vehicle for accomplishing this mission. Externalities seem to be consistent with competition yet they undermine the efficiency conclusions drawn from competition. Markets for laundry services and for steel products can be competitive yet suffer from externality-caused inefficiencies.

Judged from this perspective, we may consider which of Coase’s two models —the positive and the zero transaction cost models — best approximates the notions economists held when judging the efficiency consequences of competition. Perfect competition requires that prices and technologies be known to all. [Sanjeev: No. I don’t see why such information is required. Hayek showed that all relevant information is captured in prices; individuals do not need the detailed information] This is reasonably interpreted to mean that buyers and sellers have access to information that would be unavailable to them if transaction costs were positive. [Sanjeev: Why!?]  The perfect competition model is used to see how the price system solves the allocation problem. Accordingly, the exercise proceeds by assuming that prices of all goods are known [Sanjeev: No! only for the traded goods]. Transaction cost may be interpreted as a barrier to the universal possession of such knowledge, and, if so, as violative of perfect competition’s assumptions. Transaction cost, like monopoly, simply violates a plausible version of the competitive condition presumed to exist when efficiency conclusions are drawn, and, in this respect, is more a rejection of the assumptions than of the logical deductions drawn from competition.

The zero transaction model avoids this problem. If one were to represent the competitive economy by something like perfect competition, the zero transaction cost model is the more appropriate model by which to determine whether externalities allow one to reject theoretical deductions from competition. With very little difficulty, one can make and document an argument that the profession in 1960 was using externalities to undermine conclusions drawn from perfect competition. There is difficulty in doing this for Pigou because perfect competition was not a well-defined concept at the time he wrote. Whether his concept of competition did or did not resemble perfect competition cannot be determined. This is unfortunate, because a determination of whether the externality concept undermines the conclusions drawn from competition depends in part on a clear specification of what is meant by competition.

Not being able to decipher Pigou’s notion of competition forces us to adopt the profession’s 1960 view. If this view did not explicitly couch externalities within the perfect competition model, it relied on something very much like perfect competition. Assuming that perfect competition is the standard to which we have reference when discussing competitive resource allocation, it behooves us to analyze the externality problem by applying the Coase model that is most in agreement with the assumptions of perfect competition. This model is the zero transaction cost model, not the positive transaction cost model. The analysis is therefore kept much more in the relevant context of the theoretical-political debate by the zero transaction cost model. In the present discussion, this context is not one of pure science; it is not one of providing a theory to explain externality-related phenomena. Neither is it one of providing a positive theory of government action. The positive transaction cost model would be more appropriate for these purely scientific tasks, as would public choice theory. In the present discussion, it is logic that is it at issue, logic contained in a history of thought perspective of the great debate about the role of government. Empirical phenomena are not at issue. Fortunately, today’s debate about the role of the state rests more heavily on a positive science perspective. This involves positive transaction cost, but also much more.

The debate about externalities between Coase and those who preceded him, although it sometimes touches on actual behavior, especially in Coase’s recitation of court cases and legislation, is nonetheless more accurately described, surprise of surprises, as an exercise in blackboard economics. Is the validity of deduction made from the perfect competition model undermined by the concept of externalities? The zero transaction cost model allows Coase’s analysis to refute the ‘yes’ answer that the profession had been giving to this question. Social and private cost are necessarily equal if competition is perfect; there are no externalities.

Coase’s critics focused on the zero transaction cost model. Perhaps they did so because it offers the simpler and clearer analysis. One can say precisely what the outcome from Coase’s reasoning is if transaction cost is zero. This is a luxury not available to an analysis based on positive transaction cost. But perhaps, without critics realizing it, the zero transaction cost model became their favorite target because it represents the perfectly competitive situation best. By concentrating on the zero transaction model and virtually ignoring the positive transaction cost model, they acted as if they were prepared to accept the latter but not the former. They raised questions about the indeterminacy of a negotiated solution when this is made between two isolated negotiators (Samuelson, 1963), about the necessity for the interacting parties to be receiving enough economic rent to cover whatever their liabilities might be as a result of the interaction (Wellisz, 1964), and about the model’s neglect of long-run profit consequences (Calabresi, 1965). Their criticism of Coase’s article was rather exclusively concerned with his zero transaction cost model. 7 [FN7: Responses to these criticisms may be found in Demsetz (1972a,b,Demsetz, 1979)). Only one question that was asked pertained to the positive transaction cost model. Coase had claimed that both parties to a costly interaction should bear a tax or a liability for an interaction (externality) cost if transaction cost is prohibitively high, but his lack of clarity about what measure of the tax he had in mind led to confusion about this. This last issue aside, the overwhelming reaction of critics was to ignore the positive transaction cost model and attack the zero transaction cost model. The desire to preserve a role for the State is not the only ‘larger issue’ involved in the attack on the zero transaction cost model. Criticism of what were perceived to be ethical implications of Coase’s reasoning were raised by a few Austrian—Libertarian economists who cannot be described as favoring State intervention. Rather, their intent was to protect a particular view of the ethics of property rights. This sees legitimate rights as emerging from the mixing of effort with as yet unowned resources, and proponents of this view interpreted the conclusion of the zero transaction cost model as an assertion that the assignment of rights is a matter of indifference. No weight can be given to efficiency considerations by Coase’s analysis of zero transaction cost. Some economists, such as myself, might give great weight to efficiency considerations in the assignment of rights, and a good argument for a particular assignment of rights on this basis could be made if transaction cost is positive. Wishing to avoid such argument, critics chose to focus on the zero transaction cost model. The expression, by economists such as myself, of indifference in regard to right assignment in this case from the perspective of economics, was attacked as unethical (Block, 1977). Criticism came from those who viewed the factory’s issuance of smoke as an invasion of the legitimate property rights of the laundry’s owner. Of course, considerations other than externalities may influence how society does or should define rights, and in a broad inquiry into ownership these considerations should be taken into account. But the externality issue as raised by Pigou and followers was an efficiency issue, not an ethical one, and not one concerned with the legitimate origin of rights. To presume the existence of rights according to a not well-worked out theory of original mixing of effort with unowned resources is to presume away one of the central questions regarding policy toward externalities and, presumably, one of the central considerations of a grander theory of the ethics of ownership. How should the rights of the interacting parties be defined if the answer is to be determined solely on the basis of obtaining an efficient solution to a technical externality problem?]

The profession simply did not, and, I think, does not yet regard Coase’s positive transaction cost model as a serious attack on the state’s involvement in the resolution of externality problems. The recognition that transaction cost is positive might aid the state in its formulation of policy, as might recognition of the imperfection of the state as a tool for allocating resources. But in truth, the positive transaction model is not an attack on the principle of state involvement. Transaction cost blocks interacting parties from privately negotiating a solution that takes full account of the externality. Coase’s analysis of positive transaction cost made it clear that error can result from a policy that treated the choice of the responsible party in ad-hoc fashion, but this error can be avoided if the state’s policy is modified so as to take the responsibility issue and transaction cost seriously. One consequence of this would be to move analyses away from blackboard economics toward an examination of fact. Investigation of fact, however, is a time-honored activity of the State. Those who wished the State to become more involved in the economy could see no serious threat emanating from Coase’s positive transaction cost analysis, for Coase’s analysis, as distinct from expressions of his belief in this regard, was not an attack on the state as a problem solving institution. His analysis calls for more careful comparison of alternatives, but it does not demonstrate the superiority of the market over the state in making this comparison. Analyses impugning the state’s motivation and ability spring from different literatures, but mainly those emanating from Buchanan, Tullock, and Stigler.

The zero transaction cost model, on the other hand, leaves no room for special State intervention. The function of the State is reduced to and remains that of defining and enforcing property rights, tasks that are already endorsed by laissez faire policy. The zero transaction cost model allows the perfect competition model to resolve would-be externality problems in the same way that it resolves resource allocation problems generally — through markets. Efficiency results from a clear definition of ownership rights. Moreover, as Coase shows, serious consideration of the responsibility issue reveals, if transaction cost is zero, that efficiency results no matter which party is held responsible for a costly interaction. No opportunity for government action beyond that of defining property rights is created, as the same output mix results from either assignment of responsibility by the legal system. The case for laissez-faire in the blackboard economics debate that characterizes the history of thought on this topic is not weakened by the costly interactions between activities; there is no barrier to a market accounting of all costs and benefits. The state cannot be brought to the externality question not by a logic that shows it can improve resource allocation. The logic that progresses from competition to efficiency remains intact and becomes much more clear in the externality problem because of Coase’s zero transaction cost model. This forces a comparison between the solutions offered by Pigou and the profession, implicitly relying as they do on an idealized state, and the solutions offered by a market that is comparably idealized. The mythical state must not be compared to actual markets in which negotiations and information are costly; nor should the mythical perfect market be compared to actual political institutions. In a comparison between idealized market and idealized state, there is no intervention by the state that results in an efficiency improvement over what the market achieves in the zero transaction cost case. If both idealized market and the idealized state are analyzed correctly, this is the only conclusion that can be reached. The choice between market and state then rests on considerations of freedom and wealth distribution. 8 [FN8: Policy proposals put forward to guide state intervention sometimes analyzed these idealized alternatives incorrectly. This is particularly true for tax policy. The idealized market achieves an efficient allocation of resources, so the correct policy for the state is to refrain from levying a tax. But, since the efficient allocation generally involves some positive amount of soot, of sparks, or of cattle, and some damage to neighboring activities, it is easy to slip into the mistake of prescribing a tax to be levied on ‘the responsible party’, such tax seeking to force this party to take the damage to neighboring activities into account when deciding how much of its own good to produce. This leads to inefficiently small output of its own good and too much output of goods from neighboring activities.]

The comparison of actual market and actual state is, of course to be preferred, but this is not the way the externality problem has been put historically. Moreover, such a comparison is difficult to achieve because we have only begun to treat public choice and positive transaction problems seriously. I attempt no such a comparison here. My intent is only that of setting before the reader a somewhat different interpretation of history of thought aspects of this great debate. If we are to judge the importance of a contribution by how much it impacts this debate, a higher mark than is usually awarded is merited by Coase’s zero transaction cost model. 9 [FN9: Adopting this history of thought perspective, we may conclude with an observation about the appropriateness of the three assumptions that underlie the zero transaction cost model. Transaction cost, or at least its information cost component, should be zero if we are debating the perfect competition model. Income or wealth effects should be ignored; these have nothing to do with allocative efficiency. And, of course, the markets in which parties negotiate externalities should be competitive.]


Bator, F., 1958, The anatomy of market failure, Quarterly Journal of Economics, 351.

Block, W., 1977, Coase and Demsetz on private property rights, Journal of Libertarian Studies, Spring,

Calabresi, G., 1965, The decision for accidents: An approach to nonfault allocation of costs, Harvard Law Review, 713.

Cheung, Steve N.S., 1973, The fable of the bees: An economic investigation, Journal of Law and Economics, April, 11.

Coase, R.H., 1937, The nature of the firm, Economica, 4.

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Transcription of externality-related content from a Demsetz interview

With reference to this [see details here]

The relevant transcript

Demsetz (at around 22 minutes):

If the market can’t easily handle a problem like air pollution…

Why can’t it easily handle the problem?

Well, it’s difficult to have somebody own the quality of the air. There’s a big free-rider problem. If I drive a car and I say I’m going to put a small controlling device (for pollution) on my car at my cost and everybody benefits freely from that because they get to breathe the cleaner air. Well, hardly anybody’s going to want to put a device on their car. They want to wait for other people to do it. So it’s a difficult problem for the market to wrestle to the ground.

But you can have the authorities, presumably with high quality research behind them – which is not necessarily true – say what the total amount of air pollutants are we want to allow into the air, and then you could specify the number of tonnes of air pollutants. And you could issue coupons or certificates that give permission to put a ton of pollutant in the air. And you could distribute these to the industry with the total number of coupons equaling and sum the total amount of pollution you want to put into the air. And then you let these guys buy and sell these coupons back and forth.

The nice thing about that is that a firm that finds it very costly to get rid of pollution – and that means costly for customers of its product also – would buy the coupons from a firm that finds it very easy to get rid of pollution. And you’d get the total desired amount the pollution obtained at the lowest possible cost, whereas if you go around with detailed regulation of “you could put this out, you could put that out” you get a mess.

So that’s a good was a good idea and it shows what private property rights can do. The coupons are a form of property rights.

Interviewer Mark Grady: It’s a successful idea, they use that idea. The EPA uses that idea. That would be an example of how your ideas on property rights have led to a major policy change. The environmentalists support it. Before you wrote this piece I don’t think people understood clearly how property rights solve social problems, and what that article led to was really a more aggressive use of property rights in order to solve some very thorny problems that couldn’t be solved [otherwise]


Interviewer at around 35 minutes: Who was AC Pigou?

Demsetz: A.C. Pigou who was a famous British economist who inherited the chair of the more famous economist at that time, Alfred Marshall, at Cambridge, I believe. He pointed out something that economics was ignoring. He wasn’t the first one, by the way. Alfred Marshall pointed it out in his textbook, but he did it in an entirely different context in a very different way and it didn’t make many waves.

Pigou picked up the idea and he wrote a book called the Economics of Welfare in which this was the centerpiece. This idea came to be known as externalities in the profession. What it was about was the following:

Well, in the marketplace if you want something you pay for it, and if you want to supply it you pay the cost of supplying it, and if you can’t find somebody who wants to buy it, well you go out of business. You get what you pay for. And whoever buys what they purchase from me gets what they purchase from me. Whoever doesn’t buy it from me, doesn’t get it.

Pigou said, “Just a minute!” You run this steel plant, a steel mill. You use coal and you produce steel. You sell the steel to people. They get the steel, just like the market says – they pay for it. They don’t get it unless they’re willing to pay enough to cover the cost of producing it. So that’s the way resources get allocated nice and efficiently. They only go where people are willing to pay to have them.

But, when you burn that coal soot comes out of the smokestack. And that soot descends on, let’s say, a neighboring laundry. It makes it more expensive to launder the clothes. Well, this launderer didn’t buy that soot. He doesn’t want it. That’s an externality. It’s something that’s an external cost. There could be external benefits. External benefit is if I put to put a nice garden in my front yard and all the neighbors enjoy it as they walk by they don’t pay for it. So it breaks the nexus between getting what you pay for and what you ain’t getting. Sometimes you get a bad externality, sometimes you get a good externality. So he pointed this out and said: “Ah, because of this you’re not really getting the efficient allocation of resources that the exponents of neoclassical economics claimed, came from the market, because there was no market transaction here”.

Interviewer Mark Grady: So you’re getting too many bad externalities like soot, and too few …

Demsetz: It’s not just the soot, but what you said is true. What it really is, you raise the cost of laundering, so you so the price of laundering goes up. You get less clean clothes than you otherwise would get. And since the steel mill owner doesn’t pay the launderer for the damages, he produces more steel than he would if he had to pay the damages, so you get too much steel and too little cleansing of clothes, as a result of these externalities, as compared to what you would get if everybody paid for everything they got and didn’t get anything they didn’t pay for.

Interviewer Mark Grady: Now, what was his solution to that problem, because he had some solutions, I think.

Demsetz: Well, his solution was – I call it a Nirvana solution. Somehow the government knows exactly how much the steel mill ought to pay for putting out that soot, so it would levy a tax on the steel mill in proportion to the amount of soot that’s put out, or the amount of soft coal that it uses. And that tax raises the cost to the steel mill of using the soft coal, so it’ll use less soft coal, and you’ll get a lesser steel, and if the government sets the tax at exactly the right place, you’ll get the efficient amount of steel out of there and the efficient amount of cleansed clothes.

Interviewer Mark Grady: And why would that be a Nirvana for the government?

Demsetz: Well, the government doesn’t know what tax to levy and how to calculate these things at all.

Interviewer Mark Grady: Taxation was his solution, and he had to get the taxes exactly right in order to get efficiency.

Demsetz: Yes, he could overshoot and have too little coal and too little steel, and make the problem worse.

That’s Pigou’s claim to fame. He created this [externality] problem. And over the years he convinced almost the entire economics profession of the validity of his criticism.

Interviewer Mark Grady: Now that’s where your friend and colleague at Chicago ..

Demsetz: I’m coming to that.

He didn’t convince at least one person and that was Ronald Coase. Ronald Coase thought that Pigou was ignoring an important consideration, and that is he was ignoring the fact that it costs something to use the price system, it costs something to transact in the marketplace. And therefore, his reasoning went askance.

Well, yes and no.

Coase conjured up two cases. One, in which there’s no cost of transacting. You can carry out any transaction as you like without having to pay somebody to be your agent or whatever the case may be. In that case there is no externality. Why, because let’s suppose the law says that the steel mill has the right to burn soft coal without paying a tax. In that case the soot comes out and descends on the laundry.

Now look at this whole thing prospectively. This hasn’t happened yet. The steel mill is about to open up business, so the launder says, “Oh wait a minute. you’re going to make my business worse because they’re imposing a cost on me”. Steel mill says, “Well, I’m sorry but I have the right to do this”. So in that case the guy who owns the laundry goes over and knocks at the CEO’s door of the steel mill and says: “I’ll pay you to use less soft coal or produce less steel”. And how much will he pay? He’ll pay an amount that’s up to the additional cost that’s imposed upon him by the soot (if he didn’t eliminate that soot).

Interviewer Mark Grady: The damage to his laundry.

Demsetz: The damage to his laundry, right. Well, in this way the owner of the steel mill does take into account the damage done to the laundry because if he continues to produce the same amount of steel, he forgoes receiving this payment from the launderer. So, this cost is not external.

Interviewer Mark Grady: There’s no externalities.

Demsetz: The cost is no longer external to the steel mill owners calculations.

Interviewer Mark Grady: Now, that depends upon the laundry owner being able actually to go over and to make this.

Demsetz:  That’s the zero transaction cost case. So let’s suppose that it costs a hundred dollars to install the smoke precipitator which takes the soot out of the smokestack. So the launderer comes over. If he’s willing to pay a hundred dollars or more the soot gets taken out of the air. If he’s not willing to pay that much, the precipitator does not get installed and the soot still comes out of the smokestack. So he had these alternatives depending on what the arithmetic is in the case.

Let’s suppose now that he doesn’t want to pay $100, so the soot comes out in the air. Now a law student or a law professor jumps up and says: “Oh well, the law should have said that this the owner of the laundry has a right to soot-free air”. So now the steel mill can’t put that soot out without breaking the law. These are all law-abiding citizens. And if he does put the soot out, he’ll have to pay damages. So now to CEO who owns the steel mill goes over to the laundry and says: “Gee my costs are higher as a result of this law. I’ll pay you for your permission to put soot up in the air”. And the laundry says: “Well, how much are you’re willing to pay?” And the steel mill says: “I’ll pay you more than $100 dollars, or a hundred dollars anyway”. And the launderer stops and says, “Well, the cost that’s imposing on me (as we reckoned in the last example) is less than a hundred dollars” so he says “OK it’s a deal”. So, you get soot in the air no matter which way the law assigns the right.

Interviewer Mark Grady: And that’s Coase theorem, I think.

Demsetz: That’s right, that’s the Coase theorem. George Stigler called it the Coase theorem, Coase never did. That no matter which way you define the law, you get the efficient amount of soot and the efficient amount of laundering.

Interviewer Mark Grady:  That’s why your work was so important in the Chicago tradition because you could have the Coase theorem but unless you have property rights as you demonstrated.

Demsetz: You’re right about that, and I don’t think I’ve ever really emphasized that. So I think that’s a good point – I’ll have to write an article. Well, I [have] this new book of essays about property rights being a prerequisite to transactions, so that’s true.

Interviewer Mark Grady: How about here in the Los Angeles basin where they’ve created these property rights to emit pollution.

Demsetz: They’re really property rights to these certificates which give you the right to put pollution in the air. If you don’t have any certificates you can’t put this soot in there.

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Alfred Marshall On Socialism by John E. Elliott

My annotated notes of this article, BELOW.

But first, this is a summary of the socialist economists who’ve destroyed the world. The main bias of the socialists is the belief that governments are miraculously competent and honest. I CAN CONFIRM FROM 38 YEARS OF EXPERIENCE THAT THEY ARE THOROUGHLY INCOMPETENT AND CORRUPT.


1. The Context Of Marshall’s Views On Socialism

Alfred Marshall’s views on socialism are interesting because they enhance our understanding of the subject, the author of these views, and social and ethical dimensions of economics generally.

As in so many other instances of interest to social economists, however, we should search for enlightenment not within the main analytical corpus of what Keynes once called “that rounded globe of knowledge which is Marshall’s Principles of Economics,” but in its “concealed crevices” — footnotes, appendices, digressions, unexpected elaborations — and in other out-of-the-way sources, including speeches and letters (1956, p. 48).

Marshall was very much a man of his time and place: late nineteenth/early twentieth century England. The “socialism” about which he occasionally wrote was visionary and programmatic — that is, was more concerned with the process of social amelioration in and reform of capitalism than with the operation of what today are sometimes called “actually existing socialist societies.” English socialism drew inspiration from such sources as Owen, J. S. Mill, and Marshall himself, more than from Marx. It focused more on the process of social change than it did on the ultimate end-state per se. This process was presupposed to be democratic, peaceful, constitutional, and gradual.

2. Marshall’s Approach To Socialism

Marshall’s approach to socialism represents one “pole” while Joseph Schumpeter’s perspective occupies another. Schumpeter greatly admired the brilliant analyses of Marx (and to some extent other socialists), but was, by social prejudice and personal temperament, deeply opposed to the aspirations and values of the socialist project. Marshall was the polar opposite. He was attracted to socialism’s hopes, values, and wisdom, but was unimpressed by its analytical credentials.

This might have been the end of the matter were it not for Marshall’s own views concerning the social and ethical implications of the economics discipline. Marshall tells us that he came “into economics out of ethics” (1956, p. 360). Pigou claims that, for Marshall, economic science is “chiefly valuable . . . as a handmaid of ethics and a servant of practice” and that the discipline’s purpose is to “forward social improvement” (1956, pp. 83-84). Marshall’s stated “cherished ambition” as a university professor was to send forth from Cambridge University “strong men . . . with cool heads but warm hearts,” willing to grapple with “social suffering” and prepared to bend every effort to discover “how far it is possible to open up to all the material means of a refined and noble life” (1956, p. 174).

Thus, Marshall’s basic response to socialism was rooted in his own social and ethical approach to economics. Socialists, in his view, had admirably “warm hearts.” However, they did not always exhibit “cool heads.” His task, accordingly, was to find an appropriate niche for socialist aspirations and values, guard against socialism’s “impetuous” (1956, p. 173) proclivities, and provide a wise blend of cool analysis and warm-hearted concern.

3. Socialism’s Wisdom

Marshall believed there was much that was both warm-hearted and wise in socialism — and the writings of socialists. In his farewell address as Principal of the University College at Bristol, in 1881, Marshall observes that, in reading, as a young man, the works of socialist writers, he “found much with which anyone who has a heart at all must sympathize” (1956, p. 16). “The world owes much to socialists,” he states in his Presidential Address to the Economic Science and Statistics Section of the British Association, in 1890, “and many a generous heart has been made more generous by reading their poetic aspirations” (1956, p. 284). The socialists, Marshall avers, “were men who had felt intensely, and who knew something about the hidden springs of human action of which the economists took no account. Buried among their wild rhapsodies there were shrewd observations and pregnant suggestions from which philosophers and economists had much to learn” (1956, p. 156; 1952, p. 763). Notably, Ricardo and his contemporaries “argued as though man’s character and efficiency were to be regarded as a fixed quantity . . .” However, “modern economists” such as J. S. Mill, influenced, inter alia, by socialist writers, understand that human nature is malleable, a “product of the circumstances under which [man] has lived” (1952, pp. 763-64).

Marshall has a loose and generous interpretation of the term “socialist” which permits many, including himself, to be encompassed under its umbrella. Thus, in his famous discussion of “economic chivalry,” in 1907, he writes that “much” of the work of social amelioration

can be better performed by the State than by individual effort . . . In this sense I was a Socialist before I knew anything of economics; and, indeed, it was my desire to know what was practicable in social reform by State and other agencies which led me to read Adam Smith and Mill, Marx and Lassalle, forty years ago. I have since then been steadily growing a more convinced Socialist in this sense of the word” (1956, p. 334).

In a letter, in 1909, in which he considers the “Residuum” (Marshall’s adopted term for those who are genuinely unemployable), he similarly writes:

My own notion of Socialism is that it is a movement for taking the responsibility for a man’s life and work, as far as possible, off his shoulders and putting it on to the State. In my opinion, Germany is beneficially `socialistic’ in its regimentation of those who are incapable of caring for themselves; and we ought to copy Germany’s methods in regard to our Residuum (1956, p. 462).

As long as the socialist movement proceeds gradually, and avoids rapid and thereby disruptive change, it may well serve as the banner for successful, widespread social transformation. Thus, as early as 1885, Marshall declares that in “one sense indeed I am a socialist for I believe that almost every existing institution must be changed” (1968, p.173). And, from the perspective of old age, he reflects:

It is probable that a future Social Order may greatly surpass the present in justice and generosity; in the subordination of material possessions to human well-being; and even in the promptness of its adjustments to changing technical and social conditions (1956, p. 367).

In the context of this broad understanding of socialism, it is easy to identify several “socialist” elements in Marshall’s own writings. Three stand out: (1) unwise expenditures; (2) inequitable distribution of wealth and income; (3) poverty.

A. Unwise Expenditures.

Marshall inveighs against wasteful and improper expenditure of money and leisure, notably though not exclusively by the rich: “[M]uch of the expenditure of the very rich tends to lower rather than to raise human character” (1956, p. 463). Indeed, the “well-to-do spend largely on things that do not make life really worth living; and the loss of which would involve no serious detriment to the progress of art and knowledge, or to general refinement” (1956, p. 444)

In general, Marshall believes that “every increase in the wealth of the working classes adds to the fullness and nobility of human life, because it is used chiefly in the satisfaction of real wants.” Among the upper strata of the working class — that is, skilled workers or artisans —signs exist of “that unwholesome desire for wealth as a means of display which has been the chief bane of the well-to-do classes in every civilized country” (1952, p. 136). Thus, the “working classes,” along with the “rest of the population of England,” spend substantial sums “in ways that do little or nothing towards making life nobler or truly happier” (1952, p. 720). The well-to-do squander their opportunities to a much greater extent than the poor, partly because their temptations are so much larger (and their marginal utilities from necessities are so much smaller), and partly because a wise ordering of basic priorities is easier to divine the closer one is to subsistence. Consequently, although education and social progress generally, by improving human character, are salutary, a substantial rationale remains for reallocating spending and leisure from socially lower-order to higher-order needs, and doing so in an egalitarian manner:

[A] vast increase of happiness and elevation of life might be attained if those forms of expenditure which serve no high purpose could be curtailed, and the resources thus set free could be applied for the welfare of the less prosperous members of the working classes; the whole change being so made as not considerably to slacken the springs of productive energy (1956, p. 329).

In this, representative, quotation, promotion of wiser patterns of expenditure is associated with an egalitarian social program. In principle, however, enhancement of nobility and wisdom in the social order through adoption of ethically superior modes of expenditure would be socially desirable even in instances in which inequalities are not reduced. For example, reallocating resources from the activities and provisions of English pubs to those of public parks and museums, financed by a proportional income tax, might increase human character even when wealth and income distribution remained essentially unchanged.

Marshall’s argument, it should be emphasized, is not derived merely from assumptions concerning diminishing marginal utility of income or comparability of utility functions. His position is rooted in social value judgments assessing the consequences of alternative modes of expenditure for “nobility” and “human character,” not individual utility. It is analogous to, although it contains a more explicitly ethical component than, John Kenneth Galbraith’s (1957) concept of “social balance” in an affluent society. In principle, Marshall could support a social reorganization which enhanced these “higher” qualities of human existence even at the price of a reduction in “ignobly” formed individual utilities.

Marshall expressly recognizes that this analysis is ethically based and presupposes assumptions about “social aims” and the “social good.” He posits “progress” as the overarching social aim, where progress encompasses not merely economic growth, but improvement in human character, notably expansion in various forms of economic “chivalry” or concern for welfare of others. “There are some doubts as to what social good really is,” Marshall admits,

but they do not reach far enough to impair the foundations of our fundamental principle. For there has always been a substratum of agreement that social good lies mainly in that healthful exercise and development of faculties which yields happiness without pall, because it sustains self respect by hope (1956, p. 310).

From these underlying ethical premises, Marshall contends, we may conclude that no mere technical economy in production can compare with the “triumph” of

stimulating men of all classes to great endeavors by other means than that evidence of power which manifests itself by lavish expenditure . . . we need to turn consumption into paths that strengthen the consumer and call forth the best qualities of those who provide for consumption (1956, p. 310).

B. Inequality.

Wealth inequalities (in a modern, western society such as England), Marshall writes.

are a serious flaw in our economic organization. Any diminution of them which can be attained by means that would not sap the springs of free initiative and strength of character, and would not therefore materially check the growth of the national dividend, would seem to be a clear social gain (1952, p. 714).

Marshall bases his conclusion on several arguments. First, he is deeply suspicious of defenses of inequality based on notions of the absolutivity of property rights, and is supportive, instead, of a social view of wealth and this contribution to progress. “So far as the rights of property have a ‘natural’ and ‘indefeasible’ basis, the first place is to be attached to that property which any one has made or honestly acquired by his own labour” (1956, p. 352). Thus, property rights are conditional upon their “place” in an ethical hierarchy, in which the activities of labor, including the labor of business leaders, are “first,” those of saving and capital accumulation are next (1952, p. 587), and those associated with landed and inherited wealth rank very low. “Wealth,” Marshall asserts, “exists only for the benefit of mankind . . . its true measure lies only in the contribution it makes to human well-being” (1956, p. 366). Economic progress, he believes, requires “free individual responsibility, but not the maintenance of those rights of property which lead to extreme inequalities of wealth” (1956, p. 282). If “progress” is our overarching social value, and if there is “no real necessity” for extreme poverty side by side with great wealth as a means to foster progress, then there is “no moral justification” for such extreme inequality (1952, p. 714).

Marshall’s next argument, as already stated earlier, is that a moderate reduction in inequality improves want satisfaction:

When wealth is very unevenly distributed, some have more of it than they can turn to any very great account in promoting their own well-being; while many others lack the material conditions of a healthy, clean, vigorous and effective family life. . [W]ealth is distributed in a manner less conducive to the well-being of mankind than it would be if the rich were somewhat less rich and the poor were somewhat less poor (1956, p. 366).

Marshall’s final argument is that if the resources freed by graduated income taxation of the rich are allocated to improved social provisioning of the poor, “real wealth will be greatly increased” (1956, p. 366) by the ensuing increase in the productivity and character of the poor. In short, excessive inequality does not only distort economic progress; it constrains it. Moreover, properly engineered reductions in inequality not only humanize progress; they enhance it.

Industrial progress, Marshall states, depends on “getting the right men into the right places” and giving them a “free hand” and sufficient incentive “to exert themselves to the utmost.” It does not follow, however, that the “enormous fortunes” of the late nineteenth century are necessary to this end. Indeed, Marshall claims, extreme inequalities of wealth thwart progress because they “tend in many ways to prevent human faculties from being turned to their best account.” For example, “a good and varied education” and abundant open-air recreation for working class children could be financed by taxes on the rich without serious constraint on capital accumulation and with increased production through the productivity-enhancing effects of fuller cultivation of human faculties and efficacious apportionment of such improved talents through the competitive process (1956, pp. 282-83).

In general, Marshall argues, when workers have “less than the necessaries for efficiency, an increase of income acts directly on their power of work.” Thus, reducing inequalities raises output, as long as the effects of increased labor productivity exceed those of any temporary reduction in capital accumulation. Once labor income is sufficiently high to provide for necessaries, additional income increases can still raise production through favorable effects on the workers’

will to exert themselves. And all history shows that a man will exert himself nearly as much to secure a small rise in income as a large one, provided he knows beforehand what he stands to gain . . (1956, p. 283).

C. Poverty.

Marshall’s indictment of poverty is uncompromising and sustained. An economic system must conduce to the social good if it is to be legitimated and maintained. Insofar as it promotes social evils, it should be reformed. Society must not shrink from social reconstruction merely because socialists believe that such changes bring their own aspirations closer to attainment.

Marshall bases his conceptualization of the social good in the fundamental nature of human beings. The essential quality of the distinctly human condition, he believes, is the “development and exercise of faculties,” as noted earlier. “Work is not a punishment for fault; it is a necessity for the formation of character and, therefore, for progress.” Even in heaven, Marshall speculates, there must be something that “we can accomplish, is worthy of accomplishment, and requires effort” (unless human nature is to be “fundamentally changed” after death) (1956, p. 387).

Poverty, understood as the extreme want of material means, thwarts the “development and exercise of human faculties.” Its effects encompass a “dwarfing of activities as well as . . . curtailing the satisfaction of wants” (1952, p. 720). It is, therefore, dehumanizing and degrading to those afflicted and both wasteful and hurtful for society. Poverty, Marshall claims, is the “chief cause” of “physical, mental, and moral ill-health” among the bottom quarter of the English population. In addition to the very poor, there are “vast numbers”

who are brought up with insufficient food, clothing, and house-room; whose education is broken off early in order that they may go to work for wages; who thenceforth are engaged for long hours in exhausting toil with imperfectly nourished bodies, and have therefore no chance of developing their higher mental faculties. . . Overworked and undertaught, weary and careworn, without quiet and without leisure, they have no chance of making the best of their mental faculties (1952, pp. 2-3).

Moreover, poverty in one generation, by blocking the cultivation and proper use of human faculties, results in family and social environments which recreate poverty in succeeding generations. Marshall thus concludes that the cause and “destruction of the poor is their poverty” (1952, p. 3).

Marshall’s philanthropic sympathies clearly lie with the poor. Along with the socialists, he insists that “none ought to be shut out by the want of material means from the opportunity of living a life that is worthy of man” (1956, p. 173). He had high hopes that much could be accomplished in the direction of poverty reduction by the extension of “economic chivalry.” In the absence of sufficient philanthropic activity by the rich, however, anti-poverty programs by the state are indispensable. Poverty reduction, by improving human talent and character, tends to increase economic progress. However, because the main beneficiary of progress, other than the poor themselves, is society-at-large, individual self-interest will ineluctably tend to under-invest in such programs. Moreover, because one of poverty’s lamentable effects (and causes) is the stultification of faculties, the poor (notably, parents) are themselves often uncooperative and require “parental” guidance by state authorities.

For these essential state anti-poverty programs, Marshall tells us, “public money must flow freely. . . . ” The state “seems to be required to contribute generously and even lavishly to that side of the wellbeing of the poorer working class which they cannot easily provide for themselves” (1956, p. 718). Such expenditures constitute an investment in people at least equal in importance to other forms of investment.[1]

Marshall’s special focus is on children: education, to remove children from premature entry into the labor force, to provide greater leisure for study and play, to cultivate “character, faculties, and activities” (1956, p. 718), and, especially, as a means to stimulate reduction of unskilled labor relative to skilled and professional labor; parks, recreation facilities, and regulation of building construction, to provide opportunities for “fresh-air joyous play of the young” (1956, p. 387); “public aid and control in medical and sanitary matters” (1952, p. 718); and reduction of working hours, inter alia, as a means to foster greater time for family life and better parental supervision (especially by mothers) of children.[2]

Such programs are indispensable if working class children are to become “able workers and good citizens” (1952, p. 721). The first priority should be on children because

it is the young whose faculties and activities are of the highest importance . . . The most imperative duty of this generation is to provide for the young such opportunities as will both develop their higher nature, and make them efficient producers (1952, p. 720).

4. Capitalism’s Warts

The social aims of reducing inequality and poverty are defended, in Marshall’s writings, by a warm-heartedness which he shares with socialists. A cool-headed commitment to the basic organon of economic theory as Marshall interprets it, however, evidently worked as a barrier against embracing a comprehensive socialist argument or agenda.

For example, Marshall believes that modern industrial economies are in practice sufficiently competitive (or, more precisely, sufficiently characterized by “economic freedom,” that is, “self-reliant habits, . . . forethought, [and] deliberate and free choice”) and that monopoly is the exception rather than the rule (1952, p. 10). On the other hand, in certain instances at least, monopoly may provide a superior economic performance. Lower expenses on advertising, coupled with greater availabilty of economies of scale and technical improvements, may yield a lower supply schedule under one large monopoly firm than “if the same aggregate production were distributed among a multitude of comparatively small rival producers.” In this event, it may well be true that the “equilibrium amount of the commodity produced under free competition would be less than that for which the demand price is equal to the monopoly supply price” (1952, pp. 484-85).

Marshall recognizes ecomonic fluctuations, inflation, depression, and unemployment as empirical phenomena and characterizes them as “evil” (1952, p. 711). In Money, Credit, and Commerce, published at the end of his life, he states that the causes affecting the discontinuity of employment “are the deepest concern to the students of the conditions of social well-being; and they are designed to have a prominent place in the final volume of the present series” (1923, p. 234). This promise, never fulfilled, goes back to a lifetime research and publications plan stated in its first formation as early as 1895 (Keynes, 1956, p. 60).

Marshall attributes these social evils significantly to institutional features of the capitalist market economy. He ascribes the “chief cause of all economic malaise,” in considering the inherent difficulties of adjusting money wages to prices in an expanding economy, to “reckless inflations of credit” by private financial institutions (1952, p. 710). In a money-using economy, “though men may have the power to purchase, they may not choose to use it” (1952, p. 710). In an environment made uncertain by the separate and independent actions of private firms, investment is subject to fragility and sudden contractions: “For when confidence has been shaken by failures, capital cannot be got to start new companies or to extend old ones” (1952, p. 710). Because of economic interdependence in demand relations among independent firms, a demand failure in the investment sector can cause a cumulative, mutually reinforcing contraction in the entire economy:

Those whose skill and capital is specialized in [fixed capital] trades are earning little, and therefore buying little of the produce of other trades. Other trades, finding a poor market for their goods, produce less; they earn less, and therefore they buy less: the diminution of the demand for their wares makes them demand less of other trades. Thus commercial disorganization spreads: the disorganization of one trade throws others out of gear, and they react on it and increase its disorganization. The chief cause of the evil is a want of confidence (1952, p. 711).

Under such circumstances of economic “disorganization,” price reductions, instead of eliciting restoration of equilibrium with its associated full employment, tend to stimulate speculative downward movements, in which credit contraction serves as both cause and effect:

When credit is shaken, and prices begin to fall, everyone wants to get rid of commodities and hold of money which is rising in value; this makes prices fall all the faster, and the further fall makes credit shrink even more, and thus for a long time prices fall because prices have fallen. At such a time employers cease their production because they fear that when they come to sell their finished product general prices will be even lower than when they buy their materials . . . (1956, p. 191).

In a slump, that which is prudent for an individual firm becomes folly for society as a whole. Each individual employer finds a “stoppage” or at least reduction in production his “easiest course,” hoping “to improve the market for his own goods.” However, “every stoppage of work in one trade diminishes the demand for the work of others; . . . if all trades tried to improve the market by stopping their work together, the only result would be that everyone would have less of everything to consume” (1956, pp. 191-92).

Marshall never developed these ideas into an integrated theory of income and employment as a whole. That was left to his students, Pigou and, especially, Keynes. Moreover, Marshall believed that macroeconomic disfunctionality was moderate, rather than disabling, in magnitude.[3] The basic elements for such a theory, however, as partially adumbrated above, are plainly found in Marshall’s writings.

For our purposes, the main point is that although Marshall did not include these ideas as part of his self-professed “socialist” perspective, they are consistent with it. They all postulate the view that capitalist market economy contains endemic and systemic proclivities toward macroeconomic instability and unemployment, that these problems, like poverty and inequality, damage the social well-being, and that, at least by implication, their resolution will require collective action by government acting on behalf of society as a whole.

In addition to monopoly and instability, Marshall identifies two other problematic features of capitalism, which imply or could be incorporated into a socialist critique and program. First, the industrial revolution of the late eighteenth and early nineteenth centuries brought a “new organization of industry” and an associated substitution of economy-wide labor markets for the custom and local bargaining characteristic of pre-industrial societies. Although these changes “added vastly to the efficiency of production,” they brought “great evils.” The goods “cheapened by the new inventions were chiefly manufactured commodities of which the working man was but a small consumer.” Workers could have benefitted indirectly if English manufacturers had been able to trade freely their goods for imported food. However, this was “prohibited by the landlords who ruled in parliament.” Thus, the worker was impelled to sell his labor in a market in which the “forces of supply and demand would have given him a poor pittance even if they worked freely” (1952, pp. 748-49). In fact, labor markets were not equally “free”; workers were often disadvantaged and unempowered relative to employers. The typical worker, Marshall states,

had not the full advantage of economic freedom; he had no efficient union with his fellows; he had neither the knowledge of the market, nor the power of holding out for a reserve price, which the seller of commodities has, and he was urged on to work and to let his family work during long hours, and under unhealthy conditions (1952, p. 749).

These phenomena, Marshall explains, reacted back negatively on workers’ efficiency and on the “net value of their work, and therefore it kept down their wages.” Child employment and excessive working hours were not new to the industrial revolution. “But the moral and physical misery and disease caused by excessive work under bad conditions reached their highest point among the factory population in the first quarter of the [nineteenth] century” (1952, p. 749).

Conceivably, society would have been able to absorb the changes of capitalist industrialization and market economy more easily had they evolved gradually over centuries of time. To a great extent, however, “the evils . . . arose from the suddenness of this increase of economic freedom” (1952, p. 750).

Similarly, capitalist market economy would have been less disruptive at its inception had the new captains of industry exercised greater “economic chivalry.” Unfortunately, the manufacturers were “chiefly strong self-made men, who saw only the good side of competition.” Attributing their success in amassing great fortunes to their own energies, they tended to assume that “the poor and the weak were to be blamed rather than to be pitied for their misfortunes.” Nothing more was needed, they believed, than to make competition “perfectly free and to let the strongest have their way. They glorified individuality of character, and were in no hurry to find a modern substitute for the social and industrial bonds” holding people together in earlier societies (1952, p. 749).

Because of the rapidity with which capitalist market economy was introduced and the short-sighted and mean-spirited perceptions of early capitalist manufacturers, the task of tempering and de facto socializing capitalism was left for later generations:

Now first are we getting to understand the extent to which the capitalist employer, untrained to his new duties, was tempted to subordinate the wellbeing of his work people to his own desire for gain; now first are we learning the importance of insisting that the rich have duties as well as rights in their individual and in their collective capacity; now first is the economic problem of the new age showing itself to us as it really is (1952, p. 750).[4]

Marshall identifies a second feature of capitalism wherein public and private interest diverge, the analysis and resolution of which contain elements consonant with a socialist argument and agenda. In Marshall’s classical view of the matter, land is fixed in supply and, unlike labor and capital, is by nature incapable of adjustment based on effort and sacrifice.

Consequently, a defense of private ownership of land grounded in incentives for growth and progress is problematic. Indeed, Marshall observes,

the term landowner does not exist in English law: and English public opinion has never admitted that the landholder has the same rights of usance, without reference to the public interest, in regard to his land, as he has in regard to his carriage or his yacht.[5] Morally, everyone is a trustee to the public — to the All — for his use of all that he has: but the trusteeship under which he “holds” land is of a specially binding nature (1956, p. 464).

Therefore, Marshall concludes, wise statescraft is bound by a “greater responsibility to future generations when legislating as to land than as to other forms of wealth,” and from both economic and ethical viewpoints, “land must always and everywhere be classed as a thing by itself’ (1952, pp. 802-03). Private ownership of labor and capital is integral to capitalist market economy because their associated incomes are “derived from property made by man.” In principle, however, public ownership of land could be a sensible element in what Marshall elsewhere calls a “socialist” program. “If from the first the State had retained true rents in its own hands, the vigour of industry and accumulation need not have been impaired . . .” (1952, p. 803).

Marshall does not recommend that the state “quietly resume the full ownership of land” (1956, p. 464), (at least not “suddenly”), but more on grounds of expediency than principle. A “sudden appropriation by the State,” he declares,

of any incomes from property, the private ownership of which had once been recognized by it, would destroy security and shake the foundations of society. Sudden and extreme measures would be inequitable; and partly, but not solely for that reason, they would be unbusinesslike and even foolish (1952, p. 803).

On the other hand, Marshall’s opposition here is not to a process of socialization of land, but to “sudden and extreme measures.” “Caution is necessary” (1952, p. 803). By implication, a gradual extension of public ownership of land and/or regulation of rents would be consonant with Marshall’s vision of wise social change.

Marshall is especially concerned with what he calls the “conflict between public and private interests” in construction on urban land sites. A “closely peopled district,” he argues, is “impoverished” by each new or higher building. The threat to “fresh air and light and playroom [is] so grievous as to lower the vigour and the joyousness of the rising generation.” For the sake “of a little material wealth” now for owners of land sites, we waste and exhaust the energies of the working population which are crucial for creation of future wealth. The underlying cause of high site values is the undue “concentration of population” associated with industrial development and the flow of workers seeking employment to industrial centers. Thus, “rich private gains” accrue through essentially “public” causes. “Large expenditure is needed to secure air and light and playroom” necessary for public wealth. Private owners have “no equitable right” to harm the public well-being by “congested building.” Therefore, the “most appropriate source” to defray the public expenses necessary to cope with these anti-social effects of private interests are these “extreme rights of private property in land” (all quotations from 1952, pp. 659, 803).

Marshall also identifies a special position for inherited wealth. Although the “earning of great wealth generally strengthens character,” he states, “the spending of it by those who have not earned it, whether men or women, is not nearly an unmixed good” (1956, pp. 462-63). Inherited wealth differs in two ways from wealth earned from labor or capital. First, whatever rights of property accrue from work or “waiting,” such rights do “not automatically pass to [one’s] heirs.” Thus, “steeply graduated duties on inheritance . . . has approved itself increasingly to the ethical conscience and to the practical counsels of administration: and this in spite of the fact that such taxes are paid out of capital, for the heir seldom sets apart a sinking fund out of his income.” Second, the disincentive effect of death duties is plausibly much lower than that from taxes imposed during one’s lifetime. “The annoyance which a man finds on reflecting that his heirs will inherit somewhat less than he has owned does not seem to affect conduct much,” and revenues needed for public expenditures “may be safely got by a moderate increase of these [death] duties” (1956, p. 352).

5. Collectivism’s Danger’s

Despite the attractiveness of socialism’s aims and values and the numerous indications of divergence between public and private interest under market capitalism, Marshall believes that socialism contains distinct perils. First among his fears was rapid social change. Natura non facit saltum (nature makes no leaps) is the motto inscribed on the title page of Marshall’s Principles. “Progress,” says Marshall, “must be slow.” Certainly, institutional change must be “very much too slow to keep pace with the rapid inflow of proposals of the prompt reorganization of society on a new basis.” If new institutions “are to endure they must be appropriate to man: they cannot retain their stability if they change very much faster than he does” (1956, pp. 248-49). We “cannot move safely,” Marshall declares, “if we go so fast that our new plans of life outrun our instincts.” Human nature changes, stimulated in part by socio-institutional innovations. Still, changes in human nature are a matter of growth and, therefore, are gradual. “[C]hanges of our social organization must wait on it, and therefore they must be gradual too” (1956, p. 752). The “socio-economic mechanism,” Marshall insists,” is more delicate and complex than at first sight appears; . . . large, ill-considered changes might result in grave disaster” (1956, p. 712). “Projects for great and sudden changes are now, as ever, foredoomed to fail, and to cause reaction . . . ” (1956, pp. 751-52). We may thus anticipate “little good and much evil from schemes for sudden and violent reorganization of the economic, social, and political conditions of life” (1956, p. 713).[6]

Strictly speaking, these claims pertain not to socialism but to the speed and character of movement toward it. In principle, therefore, if the process of transition to socialism were gradual and peaceful, as, for example, the founders of the Fabian Society propose (Crossman, 1952), this element of Marshall’s argument, based heavily on his conservative temperament, would be largely mooted. Plainly, Marshall believes that socialists, even moderate English social democrats, are “impetuous” and impatient to get on with social reconstruction at a fairly rapid pace. Moreover, the very moderateness of English socialism contains an element of danger:

And now that democratic economics are so much more popular than they were a generation ago; now that the benefits of socialistic and semi-socialistic action are so much more widely advertised, and its dangers so much underrated by the masses of the people, I think it is more important to dwell on the truths in Mill’s Liberty than on those in his Essays on Socialism (1956, p. 444).

Marshall’s second criticism of socialism pertains to relationship between leaders and non-leaders. As to leadership, Marshall observes, “all socialist schemes,” especially those “of German origin,” are “vitiated” by underrecognition of the strategic role in business played by owners and managers. Socialists focus too much on competition as “the exploiting of labour by capital, of the poor by the wealthy,” and too little on the “constant experiment” by “the ablest men” in resource allocation, organization of work and production, and invention (1956, p. 283). Such men are not mere capital-providers. Their work is as indispensable to successful business as Julius Caesar or Napoleon were to the conduct of successful military victories (1956, p. 284).

The corollary of socialism’s neglect of business leadership is its tendency to exaggerate workers’ powers and capabilities to organize and operate modern business and society. Marshall wonders whether workers are sufficiently prepared, in education, skill, character, and patience, to play the leading role in society proposed for them by (many) socialists. On the one hand, with

better house-room and better food, with less hard work and more leisure, the great mass of our people would have the power of leading a life quite unlike that which they must lead now, a life far higher and far more noble (1956, p. 172).

Moreover, Marshall believed that workers must come to play a greater role in their own improvement. For example, “the main evil” of late nineteenth century anti-poverty programs is their “failure to enlist the cooperation of the working classes themselves.” They “alone can rightly guide and discipline the weak and erring of their own number . . ” (1956, p. 373). To an increasing extent, aided by

the telegraph and the printing press, of representative government and trade associations, it is possible for the people to think out for themselves the solution of their own problems. The growth of knowledge and self-reliance has given them that true self-controlling freedom, which enables them to impose of their own free will restraints on their own actions . . . ” (1952, p. 751).

All these changes augur well for the potentialities of collective projects of and by, as well as for, the working class. On the other hand, growth of the workers, in education, character, and self-restraint, is a gradual process. In the meantime, because “human nature improves slowly” (1952, p. 720), “too great a risk would be involved by entrusting to a pure democracy the accumulation of the resources needed for acquiring yet further command over nature” (1952, pp. 712-13).

On the whole, trade unions have exercised a “liberating and elevating influence.” At the same time, unions can engage in “restrictive influences,” promoting the interests of entrenched minorities against the well-being of the majority. Under such circumstances, employers who combat unions’ restrictive practices “often do fight the battle of the masses against class selfishness” (1956, p. 384). In an 1897 letter, Marshall also indicates a mixed view of unions:

I have often said that T.U.’s are a greater glory to England than her wealth. But I thought then of T.U.’s in which the minority, who wanted to compel others to put as little work as possible into the hour, were overruled. Latterly, they have, I fear, completely dominated the Engineers’ Union. I want these people to be beaten at all costs: the complete destruction of unionism would be as heavy a price as it is possible to conceive: but I think not too high a price (1956, p. 400).

Although “chivalry” is a scarce quality among all social classes, its underdevelopment is a special problem for those trapped in poverty and misery. In the “common man,” that is, the man “who is not endowed with the qualities of leadership, . . . jealousy is a more potent force than chivalry” (1956, p. 341). Consequently, wise social change, not merely the conduct of business, rests on leadership provided by educated and sensitive men — that is, men with “warm hearts” and “cool heads.” Workers have great potential for the gradual evolution of self-reliance. They are also, however, capable of mean-spirited, selfish behavior — against other workers, business, and society at large. The “truths in Mill’s Liberty” are that liberties of individuals and minorities, although conducive to social well-being, may be as threatened by an uneducated majority, prematurely thrust into the arenas of power, as by a tyrant or oligarchy. The working class, especially its poorer components, is likely to be the main beneficiary of a movement toward socialism. “But in relation to other classes, I regard the Socialistic movement as not only a danger, but by far the greatest present danger to human well-being” (1956, p. 462). A “purely democratic” movement for social change thus carries within its own potential for conflict with the public good. It is essential to “escape,” he declares, not only from “the cruelty and waste of irresponsible competition and the licentious use of wealth,” but from “the tyranny and the spiritual death of an ironbound socialism as well” (1956, p. 291).

Third, it is not merely an “ironbound” socialism to which Marshall objects. A “watershed,” he states, “divides the great majority of economists from ‘Collectivists’ — i.e., those who would transfer to the State the ownership and management of land, machinery, and all other agents of production” (1956, pp. 333-34). Socialism in this sense, Marshall claims, “even if brought about gradually and slowly, as the more responsible ‘Collectivists’ propose, might cut deeper into the roots of social prosperity than appears at first sight” (1952, p. 712).

Marshall’s main complaint is that he sees “no principle of progressive improvement in socialism” (1956, p. 16). Economic growth depends substantially on inventions and capital accumulation. But “experience shows creative ideas and experiments in business technique, and in business organization, to be very rare in Governmental undertakings. . . . ” And most productive instruments acquired by government “have been bought with resources borrowed mainly from the savings of business men and other private individuals” (1952, pp. 304, 712). Until the “whole people” acquire “a power of unselfish devotion to the public good which is now relatively rare,” “every great step in the direction of collectivism” is a “grave menace” to even a “moderate rate of progress” (1952, p. 713; 1956, p. 342). Moreover, collective ownership of the means of production would not only “deaden the energies of mankind,” and thereby “arrest economic progress”; it “might probably destroy much that is most beautiful and joyful in the private and domestic relations of life” (1952, p. 713). Therefore, as soon as “collectivist control,” by its spread, had considerably narrowed the

field left for free enterprise, the pressure for bureaucratic methods would impair not only the springs of material wealth, but also many of those higher qualities of human nature, the strengthening of which should be the chief aim of social endeavor (1956, p. 334).

In effect, Marshall qualifies his indictment of government enterprise in two major ways. First, “creative ideas and experiments” are also “not very common in private enterprises which have drifted towards bureaucratic methods as a result of their great age and large size” (1952, p. 304). Second, private corporations have “one great source of weakness”: Shareholders, who “undertake its chief risks,”have no “adequate knowledge of the business.” Typically, they are “almost powerless” to rectify bad management and, in any event, “cannot always judge whether the business is well managed” (1952, p. 303). Thus, strictly speaking, Marshall’s critique of “collectivism” presupposes young, relatively small, competitive, proprietary enterprises as counterpoint. If this presupposition is rejected, the cohesion as well as the clarity of Marshall’s account becomes suspect. Concretely, his indictment of government enterprise does not imply advocacy of large-scale, private, corporate oligopoly as an alternative, and his prejudice against “collectivism” does not constitute a rejection of several important features of “socialism.”

6. Marshall’s Synthesis

So, Marshall tells us that competition is both creative and destructive; socialism is both attractive and repellent; workers are both impoverished and potentially noble; businesses are centers of both selfishness and potential chivalry; and large-scale enterprise, both public and private, can deaden human energies and thwart economic progress. Can these diverse elements be integrated into a cohesive synthesis? Evidently, Marshall’s view is affirmative, although, as noted at the outset, his readers are impelled to construct their own versions of such a synthesis from ideas found in the “crevices” of his writings. Three main synthesizing ideas are discussed herein.

A. Every Worker a Gentleman Be; Every Gentleman a Worker He — Or the Withering Away of the (Unskilled) Working Class.[7]

According to Marshall, work, in its generic sense, is a necessary means for material life. However, in its “best sense,” work as the “healthy energetic exercise of faculties, is the aim of life, is life itself.” If one’s work promotes “culture and refinement” of character, if it stimulates one’s mental faculties, if it fosters social intercourse, kindly habits, and broad sympathies, then that work is the occupation of a “gentleman.” If, by contrast, one’s work does not “elevate the character and educate the faculties,” but instead keeps one’s character “rude and coarse,” exhausts the body and stultifies the mind with “long hours of hard and unintellectual toil” or, even if physically light, crushes one’s “inner life,” then, by occupation at least, one “belongs to the working classes” (1956, pp. 103-08, 115).

Aristotle, among numerous other ancient writers, believed that a good life for the few was predicated on the existence of the slave labor of the many. Modern society, Marshall states, has “outgrown this belief” in a literal sense, and now rejects slavery as sapping “moral life in every state . . ” (1956, p. 109). It has substituted, though, a contemporary variant of Aristotle’s position, viz., that there must be vast multitudes of people — the “lower” or “working classes” —”doomed” from birth to “weary toil” to provide others —”gentlemen” — the “requisites of a refined and cultured life,” but “prevented by their poverty and toil from having any share or part in that life” and thus “scarce any opportunity of mental growth” (1956, p. 109; 1952, p. 3).

In an early article, in 1873, Marshall provides a vision of a future society — resembling “in many respects” those of “some socialists” and containing some of the flavor of the “wild deep poetry of their faiths” — in which the distinction between “gentleman” and “working man” has disappeared because everyone, by occupation, is a gentleman (1956, p. 109). In such a society, everyone’s

activities and energies will be fully developed . . [M]en will work not less than they do now but more; only . . . most of their work will be a work of love; . . . whether conducted for payment or not, [work] will exercise and nurture their faculties. Manual work, carried to such an excess that it leaves little opportunity for the free growth of his higher nature, that alone will be absent; . . . In so far as the working classes are men who have such excessive work to do, in so far will the working classes have been abolished (1956, p. 118).

In his Principles (1952, p. 4), Marshall makes the same point, albeit more prosaically, by posing a direct question: Is it “really impossible that all should start in the world with a fair chance of leading a cultured life, free from the pains of poverty and the stagnating influences of excessive mechanical toil”? The young Marshall of 1873 not only declares that it is possible, but predicts that it “will” happen.[8] In the Principles, Marshall coyly states it depends, not only on “economic facts and inferences,” but on the “moral and political capabilities of human nature” (1952, p. 4). In general, he is optimistic.

Marshall’s optimism stems from his joint expectations of the continuation of economic growth and the implementation of a vigorous program of public investment in people, especially in education. The nation, he states, “has grown in wealth, in health, in education and in morality. . .” The working class has also experienced “steady progress.” The steam-engine has eliminated

much exhausting and degrading toil; wages have risen; education has improved and become more general; . . . while the growing demand for intelligent work has caused the artisan classes to increase so rapidly that they now outnumber those whose labour is entirely unskilled. A great part of the artisans have ceased to belong to the ‘lower classes’ in the sense in which the term was originally used; and some of them already lead a life more refined and noble than did the majority of the upper classes even a century ago (1952, pp. 751, 3-4).[9]

In short, the movement toward a day in which the “working classes have been abolished” and every worker is a “gentleman” is already in process. If the “perils of collectivism” are avoided (and, by tacit presupposition, recessions and unemployment are moderate), capital accumulation and technical improvement should continue to generate growth in demand for labor in general and skilled labor in particular. Meanwhile, expanding education should enhance skills and labor productivity (and thus reinforce growth), thereby both reducing unskilled labor and ensuring high pay for that (smaller) amount of manual labor that still needs to be done (1952, pp. 712-19).

B. That Great Order of Modern Chivalry — Cooperation.

“Productive co-operation is a very difficult thing, but it is worth doing” (1956, p. 246). Collective decision-making is slow and, occasionally, rancorous; business management is difficult and not easily mastered; capital is vital, but not easily or inexpensively obtained; leaders who meet the joint qualifications of business accumen and commitment to the cooperative faith are few — and mortal.

On the other hand, cooperatives, notably those engaged in production as well as trade, have their own special advantages. Unlike government enterprises, their small scale and private ownership generally exempt them from the “social perils of bureaucratic methods.” Unlike shareholders in a large corporation, worker-owners are in a strategic position to judge the quality of business management and to detect any managerial “laxity or incompetence.” Unlike both government enterprises and private corporations, worker cooperatives incur low supervisoral costs because workers’ pride and own pecuniary interests makes them “averse to any shirking of work . . . ” (1952, pp. 304-05).

Marshall lauds cooperation for its contributions to social well-being which go well beyond industrial efficiency and business success. “The days of romantic chivalry,” he laments, “are past. [B]ut there is as loud a call as ever for courage and chivalric self-sacrifice for great and worthy ends.” Cooperation, he declares, is “the great order of modern chivalry.” Thus, in addition to the fact that cooperative enterprises avoid the major “evils” of both governmental and private corporative businesses, the cooperative movement deftly mediates between the “broad and strong business basis” of capitalism and the “high social aim[s]” of socialism by (“alone”) combining both qualities (1956, pp. 240, 251).

Marshall identifies several contributions of workers’ cooperatives to “high social aims.” First, workers are strong in number. Through association, they can exert great power, based on mutual knowledge and trust and pooling of their individually small savings. This can “go a long way towards getting a free scope for their activities, and towards emancipating them from a position of helpless dependence on the support, and the guidance, and the goverance of the more fortunate classes” (1956, p. 228).

Next, “The Waste Product” of contemporary business society is “the higher abilities of many of the working classes; the latent, the undeveloped, the choked-up and wasted faculties for higher work, that for lack of opportunity have come to nothing.” Cooperatives can diminish the “evils which result to the mass of the people from the want of capital of their own” — that is, both the “insufficiency of material income, and want of opportunity for developing many of their best faculties” (1956, pp. 228-29).

Third, the “great evil of our present system” is that the means to stimulate human exertion “have in them too much that is selfish and too little that is unselfish.” A “chief aim” of cooperation is to remove this evil. He “who lives and works only for himself, or even only for himself and his family, leads an incomplete life; to complete it he needs to work with others for some broad and high aim.” The “production of fine human beings, and not the production of rich goods, is the ultimate aim of all worthy endeavour.” Association fosters these higher social purposes (1956, pp. 228, 238).

Last, although the progress of the cooperative movement may be small, “it has in it the seeds of growth, because it will educate the working classes in business capacity, and in the moral strength of united and public action for public purposes” (1956, p. 228). Therefore, on the one hand, cooperatives should “attain a larger success in the future than in the past” (1952, p. 307). On the other, cooperative workers, nurtured by bonds of association, will plausibly grow in character and civic virtue, become better citizens, and thereby pose less of a threat to other social classes. In consequence, the scope for collective projects by and on behalf of the democratic majority will expand.

Thus gradually we attain to an order of social life, in which the common good overrules individual caprice, even more than it did in the early ages before the sway of individualism had begun. But unselfishness then will be the offspring of deliberate will; and, though aided by instinct, individual freedom will develop itself in collective freedom (1952, p. 752).

It is sometimes said that workers’ cooperatives have been tried, but found wanting. But this, Marshall observes, presupposes workers who are uneducated and unskilled. If we suppose, instead, a generous and effective education of working class children, then, over time, many should acquire the capabilities and skills of middle class managers.

With an expanding pool of such people to draw on to lead cooperatives, problems of both management and credit should subside.[10]

C. Social Possibilities of Economic Chivalry.

A society characterized by a modest dose of collective enterprise, a larger but still no doubt relatively small cooperative sector, a significant realm for government taxation and expenditure, and abolition of at least the lower, more unskilled, components of the working class based, in part, on cooperative and governmental institutions, would still contain a dominant sector characterized by private enterprise and market economy. How would this sector be integrated with the ethical values and social aspirations guiding the cooperative and government sectors?

To some extent, Marshall believes this dominate sector of the modern economy is self-regulating through processes of “free competition.” Private firms, when they can avoid the bureaucratic methods of old age and excessive size, are often “managed by business men quick of thought and quick of action, full of resource and inventive power, specially picked for their work and carefully trained” (1956, p. 244). “[F]ree exchange” turns to account the “combative and predatory energy of the present crude nature of man.” It is the “driving force” which has brought dramatic improvements in “material comforts and intellectual training” even to the “crowded districts” of urban workers. These benefits accrue through an “almost mechanical action” of an “intricate” market organization which in the main “works smoothly,” its “wastes through frictions and maladjustments . . . small in proportion to its achievements . . . ” (1956, p. 367).

As noted earlier, however, Marshall does not rely on assumptions of pure and/or perfect competition to bolster his argument; nor does he deny in fact the growth of large, monopoloid corporations, in addition to ordinary market imperfections and limitations. Consequently, “chivalry” by business leaders could be, in principle, an additional form of social control of business.

To some extent, business chivalry already exists. Because much of the “best ability” in Western societies is engaged in business, then, unless human nature is “irredeemably sordid,” there is “much nobility” in business. Indeed, the “chief motive” to the “highest constructive work” there is a “chivalrous desire to master difficulties and obtain recognized leadership.” Still, society under free enterprise falls “far short of the finest ideals . . .” It is essential, therefore, that a “much higher general level of economic chivalry” be developed (1956, pp. 331, 342).

Marshall believes that, guided by education (and educators),[11] economic chivalry, by both individuals and society as a whole, can be substantially expanded. Public opinion can serve potentially as an informal “Court of Honor,” dispensing social approbation or disapprobation so as to guide business enterprise. Business conduct which was “noble” in aim and method would be nurtured by “public admiration and gratitude.” Wealth obtained by chicanery, false advertising, fraud, or “malignant destruction of rivals” would be denied social legitimacy. Because idleness would be “despised,” the rich might “set themselves to public tasks which would prepare the way for progress in the future, but would not yield sufficient immediate fruit to secure liberal endowment from a democracy.” The “growing opinion” that leaving large bequests to relatives at one’s death is an “ignoble use of wealth” should increase private philanthropic support of public projects, both before and at death (1956, pp. 343-45).

Marshall expects that economic chivalry by individuals and the community as a whole will be mutually stimulative. “The two together” should provide the necessary tax resources for needed government expenditures for education and other anti-poverty measures. The “chivalrous rich man” will supplement government programs by generous private philanthropy and will “cooperate with the State” in relieving social suffering (1956, p. 345). Thus, a

devotion to public wellbeing on the part of the rich may do much, as enlightenment spreads, to help the tax-gatherer in turning the resources of the rich to high account in the service of the poor, and may remove the worst evils of poverty from the land (1952, p. 719).

Thus, Marshall believes that if “we can educate this chivalry, the country will flourish under private enterprise.”[12] He uses this argument primarily as a weapon against “sudden” and comprehensive “collectivism.” It in no way constitutes a rejection of any of his views on (his conception of) “socialism.” To the contrary, a robust private sector, informed by chivalry, and complemented by workers’ cooperatives and wise “socialist” programs by democratic governments, would constitute a “true Socialism, based on chivalry . . . full of individuality and elasticity,” in contrast to a crude “collectivism,” based on “iron bonds of mechanical symmetry” (1956, p. 346).

Thus, a study of Marshall’s views on socialism reveals him as deeply committed to both human improvement and integration of ethical and explanatory modes of thought. It provides insights on social reconstruction which, though heavily informed by his temperament and prejudices (and those of his time and place), ring clearly today.


Crossman, R.H.S., ed. New Fabian Essays, London: Turnstile, 1952.

Galbraith, John K. The Affluent Society, Boston: Houghton Mifflin, 1957:

Keynes, John M. “Alfred Marshall, 1842-1924,” in Memorials of Alfred Marshall, edited by A.C.

Pigou (New York: Kelley and Millman, 1956).

Marshall, Alfred. “How far do Remediable Causes Influence Prejudicially (a) the Continuity of

Employment, (b) the Rates of Wages?” In the Industrial Remuneration Conference, edited

by Sir Charles W. Dilke. New York: Augustus M. Kelley, 1968. pp. 173-99.

– Money, Credit, and Commerce, London: Macmillan, 1923.

– Principles of Economics, New York: Macmillan, 1952.

– Memorials of Alfred Marshall, edited by A.C. Pigou. New York: Kelley and Millman, 1956. Pigou, A.C. “In Memoriam: Alfred Marshall,” in Memorials of Alfred Marshall, New York: Kelley and Millman, 1956.

Webb, Sidney et al. Fabian Essays. London: Allen and Unwin, 1962.



[1] The notion that the investment of funds in the education of the workers, in sanitation, in providing open air play for all children etc. tends to diminish ‘capital’ is abhorrent to me: Dead capital exists for man: and live capital that adds to his efficiency is every way as good as dead capital. It is not more important to have cheap maize than cheap wheat, merely because maize is the raw material of pigs, and wheat of men” (1956, p. 464).

[2] “Able workers and good citizens are not likely to come from homes, from which the mother is absent during a greater part of the day; nor to homes to which the father seldom returns till his children are asleep . . .” (1952, p. 721).

[3] Inconstancy of employment is a great evil, and rightly attracts public attention. But [it appears] to be greater than it really is.” Although several factors, including “the instability of credit, do certainly introduce disturbing elements into modern industry; yet . . . there seems to be no good reason for thinking that inconstancy of employment is increasing as a whole” (1956, pp. 687-88).

[4] What Marshall gave with his left hand, he often took away with his right. For example, at the end of the quotation cited in the text, he goes on to qualify his critique of early capitalist employers by observing that they were “huried along by urgent necessities and terrible disasters,” such as loss of the American colonies, a string of unusually bad harvests, and, most importantly, the phenomenally expensive Napoleonic Wars (1952, p. 750).

[5] A similar passage appears in (1952, p. 803), the implications of which for taxation of land sites is discussed below: “[E]xtreme rights of private property in land . . . have grown up almost imperceptibly from the time when the king, representing the State, was the sole landowner. Private persons were but landholders subject to the obligation to work for the public wellbeing: they have no equitable right to mar that wellbeing . .” (1952, p. 803).

[6] ”Competition is a monster now grown of overwhelming strength. If we were perfectly virtuous, he would now feel himself out of place and slink away. As it is, if we resist him by violence, his convulsions will reduce society to anarchy. But, if he can be guided so as to work on our side, then even the removal of poverty will not be too great a task” (1956, p. 361).

[7] This is a variant of the definition of a university, given in the “Tale of the Wandering Scholar,” in Chaucer’s Canterbury Tales, as a place where “every scholar a student be, every student a scholar he.”

[8] 1n 1923, commenting on his 1873 article, Marshall observes that it “bears marks of the over-sanguine temperament of youth” (p. 101n).

[9] Skilled artisans are quite conscious of the “superiority of their lot” over that of unskilled workers. And properly so, for many are “steadily becoming gentlemen,” that is, steadily acquiring greater education, valuing cultivated leisure, developing independence and greater respect for themselves and others, and “accepting the private and public duties of a citizen” (1952, p. 105).

[10] Strictly speaking, Marshall states, cooperative workers’ associations “have not been tried.” What “have been tried” are associations of “uneducated men,” unable to conduct “extensive and complicated business.” What now needs to be tried are associations “among men as highly educated as are managers now. Such associations could not but succeed; and the capital that belonged to them would run no risk of being separated from them” (1952, p. 114).

[11] “To distinguish that which is chivalrous and noble from that which is not, is a task that needs care and thought and labour; and to perform that task is a first duty for economists sitting at the feet of business men, and learning from them” (1956, p. 343).

[12] Of course, in principle, if chivalry could be educated, society could also flourish under a system of public enterprise. Thus, “should collectivists succeed in showing that human nature had at last been so firmly based in chivalry that their great venture might be tried without running violent risks, some other civilization than that which we can now conceive may take the place of that which now exists. It may, of course, be higher” (1952, p. 346). Such speculation, however, does not modify the basic logic of the argument. In light of Marshall’s conservative temperament, it is crucial to accept the fact that society “is where it is” in historical time. Given capitalist market economy, with its array of advantages and disadvantages, the task is to keep the best elements of the private enterprise/free competition baby while throwing out the super-individualist, laissez-faire bathwater, incorporating such “socialist” elements as are needed to accomplish this efficaciously.

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Some fallacies in the interpretation of social cost – Frank Knight 1924

I’m undertaking an annotated study of Knight’s article, below.


Arguments for social interference developed by Pigou and Graham illustrate common misinterpretations of the meaning of cost and its variation with output, 582. — I. The private owner of a natural opportunity secures maximum return from it by charging that rent which halts the application of investment at the point which is socially most advantageous, 584. — II. The notion of decreasing cost is a fallacy; competitive price fixation under decreasing cost or increasing returns an impossible situation, 592. — III. The law of comparative advantage in international trade is fundamentally sound, 599. — Importation a method of using resources to produce the imported good, and will be employed under competitive conditions only when more efficient than a direct method, 603. — The competitive system has important defects, but they lie outside the mechanical theory of exchange relations, 605.

IN two recent articles in this Journal,[1] Professor F. D. Graham of Princeton University has developed an ingenious argument to prove that the classical theory of comparative cost as a demonstration of the economic advantage of trade between nations is “all wrong.” He contends that a protective tariff may, after all, be a wise national policy in that it may enable the nation which adopts it to secure a larger product from its resources than would be secured if free trade were permitted. It is the opinion of the present writer, and the contention of this paper, that it is Professor Graham’s argument which is fallacious, tho the way in which the classical theory has been formulated in many instances leaves much to be desired. The matter is of the greater importance because the most important argument, from the standpoint of general theory, in Professor A. C. Pigou’s monumental work on The Economics of Welfare[2] is, as I shall also try to show, marred by the same, or a very similar, fallacy.

If economic theory is interpreted as a critique of the competitive system of organization, its first and most general problem is that of determining whether the fundamental tendencies of free contractual relations under competitive control lead to the maximum production of value as measured in price terms. The problems of the validity of the price measure of “real value,” and of the distribution of the value produced, are larger but subsequent problems, and belong to ethics as much as to economics; while the detailed comparison of the theoretical tendencies of perfect competition with the facts of any actual competitive society lie in the field of applied economics rather than that of theory. The theory of international or inter-regional trade is a special case under the more general problem, whether “society” can increase the production of exchange value by interfering with free bargaining relations: the case, namely, of bargains between its own members and members of some other society possessing a distinct body of productive resources. The peculiarity of international trade as compared with domestic lies in the immobility of population viewed as labor power. Natural resources are immobile even within a country, and capital goods enter into international commerce in the same way as goods ready for consumption.

Both Professor Graham and Professor Pigou reason to the conclusion that freedom of trade between regions may reduce the production of wealth in one or even both; and Professor Pigou extends essentially the same logic to cover the relations between different industries, irrespective of regional separation. The contention is that individual profit-seeking leads to an excessive investment of resources in industries of increasing cost (decreasing returns), part of which would yield more product if transferred by social action in some form to industries of constant or decreasing cost. The fallacy to be exposed is a misinterpretation of the relation between social cost and entrepreneur’s cost. It will be convenient to take up first Professor Pigou’s argument, which presents the more general problem.

In Professor Pigou’s study the argument that free enterprise leads to excessive investment in industries having relatively upward-sloping cost curves is developed with the aid of a concrete example, the case of two roads.[3] Suppose that between two points there are two highways, one of which is broad enough to accommodate without crowding all the traffic which may care to use it, but is poorly graded and surfaced, while the other is a much better road but narrow and quite limited in capacity.[4] If a large number of trucks operate between the two termini and are free to chose either of the two routes, they will tend to distribute themselves between the roads in such proportions that the cost per unit of transportation, or effective result per unit of investment, will be the same for every truck on both routes. As more trucks use the narrower and better road, congestion develops, until at a certain point it becomes equally profitable to use the broader but poorer highway. The congestion and interference resulting from the addition of any particular truck to the stream of traffic on the narrow but good road affects in the same way the cost and output of all the trucks using that road. It is evident that if, after equilibrium is established, a few trucks should be arbitrarily transferred to the broad road, the reduction in cost, or increase in output, to those remaining on the narrow road would be a clear gain to the traffic as a whole. The trucks so transferred would incur no loss, for any one of them on the narrow road is a marginal truck, subject to the same relation between cost and output as any truck using the broad road. Yet whenever there is a difference in the cost, to an additional truck, of using the two roads, the driver of any truck has an incentive to use the narrow road, until the advantage is reduced to zero for all the trucks. Thus, as the author contends, individual freedom results in a bad distribution of investment between industries of constant and industries of increasing cost.

In such a case social interference seems to be clearly justified. If the government should levy a small tax on each truck using the narrow road, the tax would be considered by the trucker as an element in his cost, and would cause the number of trucks on the narrow road to be reduced to the point where the ordinary cost, plus the tax, became equal to the cost on the broad road, assumed to be left tax free. The tax could be so adjusted that the number of trucks on the narrow road would be such as to secure the maximum efficiency in the use of the two roads taken together. The revenue obtained from such a tax would be a clear gain to the society, since no individual truck would incur higher costs than if no tax had been levied.

It is implied that the same argument holds good over the whole field of investment wherever investment is free to choose between uses subject to cost curves of different slope. Take, for example, two farms, one of superior quality, the other marginal or free land. Would not labor and capital go to the better farm, until the product per man became equal to the product to be obtained from the marginal land? If so, it is clear that the total product of all the labor and capital could be increased, as in the case of the roads, by transferring some of it from the superior to the inferior farm. This application of the reasoning will probably suggest the fallacy to any one familiar with conventional economic theory. The statement does in fact indicate what would happen if no one owned the superior farm. But under private appropriation and self-seeking exploitation of the land the course of events is very different. It is in fact the social function of ownership to prevent this excessive investment in superior situations.

Professor Pigou’s logic in regard to the roads is, as logic, quite unexceptionable. Its weakness is one frequently met with in economic theorizing, namely that the assumptions diverge in essential respects from the facts of real economic situations.[5] The most essential feature of competitive conditions is reversed, the feature namely, of the private ownership of the factors practically significant for production. If the roads are assumed to be subject to private appropriation and exploitation, precisely the ideal situation which would be established by the imaginary tax will be brought about through the operation of ordinary economic motives. The owner of the broad road could not under effective competition charge anything for its use. If an agency of production is not subject to diminishing returns, and cannot be monopolized, there is, in fact, no incentive to its appropriation, and it will remain a free good. But the owner of the narrow road can charge for its use a toll representing its “superiority” over the free road, in accordance with the theory of rent, which is as old as Ricardian economics. An application of the familiar reasoning to this case will show that the toll will exactly equal the ideal tax above considered, — tho the application may need to be more careful and complete than that made by many of the expositors of the classical theory.

The owner of a superior opportunity for investment can set the charge for its use at any amount not greater than the excess of the product of the first unit of investment above what that unit could produce on the free opportunity. Under this charge investment will flow into the superior road up to the point where congestion and diminishing returns set in. (It is better in such a simple case to use the notion of diminishing returns than to use that of diminishing costs, since in the large the practical objective is to maximize the product of given resources and not to minimize the expenditure of resources in producing a given product.) By reducing the charge, the owner will increase the amount of traffic using his road (or in general the amount of investment of labor and capital in any opportunity). But obviously the owner of the road will not set the charge so low that the last truck which uses the road secures a return in excess of the amount which it adds to the total product of the road (that is, of all the trucks which use it). This is clearer if we think of the owner of the road hiring the trucks instead of their hiring the use of the road. The effect is the same either way; it is still the same if some third party hires the use of both. The toll or rent will be so adjusted that added product of the last truck which uses the narrow road is just equal to what it could produce on the broad road. No truck will pay a higher charge, and it is not to the interest of the owner of the road to accept a lower fee. And this adjustment is exactly that which maximizes the total product of both roads.

The argument may be made clearer by the use of simple diagrams.[6]

Chart A and B represents the case of constant cost or constant returns, the cost of successive units of output or the return from successive units of investment on the broad road. In Chart C, the curve DD’Du is a cost curve for the narrow road, showing the cost of successive units of output. It starts at a lower level than the cost on the broad road, but at a certain point D’, congestion sets in and increasing cost appears. Curve DD’Dm is a curve of marginal costs on the narrow road, as Professor Pigou uses the term marginal cost; the marginal cost of the nth unit of product is the difference between the total cost of producing n units and the total cost of producing n+1 units. When costs begin to increase, the marginal cost will increase more rapidly than the cost of the added unit, since the production of each additional unit raises the cost of the earlier units to a level with that of the new unit. It must be observed that the cost of the additional unit is always the same as the cost per unit of the whole supply produced; much economic analysis is vitiated by a spurious separation of these two conceptions of cost.

Chart D represents the same facts as Chart C, but in terms of the product of successive units of investment instead of the cost of successive units of output, that is, as curves of “diminishing returns” instead of “increasing costs.” The output begins at a higher level than on the broad road, but at the point D’, which corresponds to the point of the same designation on Chart C, the return from investment begins to fall off. The curve D’Du shows the actual product of the added unit of investment, and the curve D’Dm its marginal product, its addition to the total. The latter decreases more rapidly, because the application of the additional unit reduces the yield of the earlier ones to equality with its own. The argument is the same, but stated in inverse or reciprocal form. As indicated, the viewpoint of Chart D is to be preferred, and it may be surmised that, if Professor Pigou had put his argument in this form, he would probably have avoided the error into which he was very likely misled by measuring efficiency in terms of cost of output instead of output of resources.[7]

The owner of the road will adjust his toll so that the traffic will take his road out to the point M in Chart C or D. It will not, under conditions of profit-seeking exploitation, be continued to M’, as argued by Professor Pigou. The actual output is the same as the “ideal” output, but it is the “ideal” output which is wrongly defined in Pigou’s treatment (p. 937). Evidently, the adjustment is correct when the marginal product of the last unit of investment on the superior road is equal to the product of a similar unit on the free road. Confusion arises in translating this condition into terms of cost and selling price of product. Selling price will be determined by cost on the free road, or at least these two will be equal, however the causal relation is conceived. That is, the money cost of any unit of product is the value of the investment which is necessary to produce it on the free opportunity, where cost is constant, or, in general, at an opportunity margin where rent does not enter. Comparison of the two viewpoints shown by our Charts C and D above shows that under competitive conditions the application of investment to the superior opportunity will be stopped at the point where marginal real cost (cost in terms of the transferable investment) is equal to real cost on the free opportunity. When equal additions to investment make equal additions to output, equal units of output have the same cost. But the condition of equilibrium cannot be stated in terms of money cost and money selling price of product on the superior opportunity, because these would be equal however the investment might be distributed, whatever rent were charged, or whether the opportunity were appropriated and exploited at all. The condition of equilibrium is that the rent on the superior opportunity is maximized as an aggregate. The rent per unit of output is a variable portion of a total unit cost which is fixed.

Extension of the foregoing argument to the general case of land rent involves no difficulties and will not be carried out in detail. The point is that any opportunity, whether or not it represents a previous investment of any sort, is a productive factor if there is sufficient demand for its use to carry into the stage of diminishing returns the application to it of transferable investment. The charge made by a private owner for the use of such an opportunity serves the socially useful purpose of limiting the application of investment to the point where marginal product instead of product per unit is equal to the product of investment in free (rentless) opportunities; and under competitive conditions this charge will be fixed at the level which does make marginal products equal, and thus maximizes productivity on the whole.[8]

It is pertinent to add that in real life, the original “appropriation” of such opportunities by private owners involves investment in exploration, in detailed investigation and appraisal by trial and error of the findings, in development work of many kinds necessary to secure and market a product — besides the cost of buying off or killing or driving off previous claimants.

The relation between “investment” and “opportunity” is an interesting question, by no means so simple as it is commonly assumed to be. In the writer’s view there is little basis for the common distinction in this regard between “natural resources” and labor or capital. The qualities of real significance for economic theory are the conditions of supply and the degree of fluidity or its opposite, specialization to a particular use. In a critical examination neither attribute forms a basis for erecting natural agents into a separate class.

Under competitive conditions, again, investment in such activities of “appropriation” would not yield a greater return than investment in any other field. These activities are indeed subject to a large “aleatory element”; they are much affected by luck. But there is no evidence proving either that the luck element is greater than in other activities relating to economic progress, or that in fact the average reward has been greater than that which might have been had from conservative investments.


While Professor Pigou constantly refers to industries of decreasing cost, or increasing returns, the principles at issue do not necessarily imply more than a difference in the way in which efficiency varies with size from one industry to another. Some of Professor Graham’s reasoning in regard to international trade and international value depends upon decreasing cost as such. It seems advisable, before taking up his argument concretely, to devote a few paragraphs to this conception, which the writer believes to involve serious fallacies, and to the meaning of cost and its variation.

Valuation is an aspect of conscious choice. Apart from a necessity of choosing, values have no meaning or existence. Valuation is a comparison of values. A single value, existing in isolation, can no more be imagined than can a single force without some other force opposed to it as a “reaction” to its “action.” Value is in fact the complete analogue of force in the interpretation of human activity, and in a behavioristic formulation is identical with force —which is to say, it is an instrumental idea, metaphysically non-existent. Fundamentally, then, the cost of any value is simply the value that is given up when it is chosen; it is just the reaction or resistance to choice which makes it choice. Ordinarily we speak of cost as a consumption of “resources” of some kind, but everyone recognizes that resources have no value in themselves; that they simply represent the products which could have been had by their use in some other direction than the one chosen. [Sanjeev: opportunity cost]

The notion of cost suffers greatly in logical clearness from confusion with the vague and ambiguous term “pain.” In the broad true sense every cost is a pain, and the two are identical. Little or nothing can be made of the distinction between pain and the sacrifice of pleasure, or between pleasure and escape from pain. The subject cannot be gone into here from the point of view of psychology; it is enough to point out that the way in which a particular person regards a particular sacrifice depends mainly upon the direction of change in the affective tone of his consciousness or upon the established level of expectations. The essential thing is that the pleasure-pain character of a value is irrelevant, that the universal meaning of cost is the sacrifice of a value-alternative. This is just as true of the “irksomeness” of labor, as of a payment of money. The irksomeness of digging a ditch reflects the value of the loafing or playing which might be done instead. And there is no significant difference between this irksomeness or pain and that of using the proceeds of the sale of a liberty bond to pay a doctor’s bill when it might have been used to procure a fortnight’s vacation.[9]

The natural and common rule in choice is necessarily that of increasing cost. In the exchange of one good for another at a fixed ratio, the further the exchange is carried, the more “ utility “ is given up and the less is secured. This is merely the law of diminishing utility. It is only when one commodity is given up in order that another may be produced by the use of the common and divertible productive energy that we ordinarily think of the variation of cost. If two commodities are produced by a single homogeneous productive factor, there is no variation of cost as successive portions of one are given up to procure more of the other by shifting that factor— except in the sense of increasing utility cost as met with in the case of exchange. Ordinarily, however, new considerations enter, as a matter of fact. If we wish to produce more wheat by producing less corn, we find that the further the shift of production is carried, the more bushels of corn (as well as corn value) have to be given up to produce a bushel of wheat (and still more for a given amount of wheat value). This is the economic principle of increasing cost (decreasing returns) as generally understood, reduced to its lowest terms and freed from ambiguity.

When costs are measured in value terms and product in physical units there are two sorts of reasons for increasing cost, one reflecting value changes and the other technological changes. The first would be operative if all productive resources were perfectly homogeneous and perfectly fluid. But this is not, in general, the case, and technological changes supervene which work in the same direction and add to the increase which would otherwise take place in the cost of a unit of the product which is being produced in larger volume. Principal among these technological changes is the fact that some of the resources used to produce the commodity being sacrificed are not useful in the production of that whose output is being increased, and in consequence the resources which are transferred are used in progressively larger proportions in the second industry and in smaller proportions in the first, in combination with certain other resources which are specialized to the two industries respectively. The consequent reduction in the physical productive effect of the transferred factors is what is meant by diminishing returns in one of the many narrower uses of that highly ambiguous expression. Another technological cause still further aggravating the tendency to increasing costs arises from the fact that productive factors are not really homogeneous or uniform in quality. As productive power is transferred from corn to wheat, it will be found that the concrete men, acres, and implements transferred are those progressively more suitable for corn-growing and less suitable for wheat. Thus each unit suffers a progressively greater reduction in its value in terms of units of either commodity, or it takes more units to represent in the wheat industry the value of a single unit in the corn industry, and value costs of wheat mount still higher for this third reason.

All three changes so far noted clearly involve increasing cost in the real sense, the amount of value[10] outlay or sacrifice necessary to produce an additional physical unit of the commodity whose production is increased. In addition to these we have to consider two further possible sources of increased cost. The first is that, when an additional unit of, say, wheat is produced, and the factors transferable from other industries to wheat are raised in price, the quantities of these factors already used to produce wheat will rise in price along with those added to the industry. Should all this increase in cost be charged up to the production of the last unit of wheat produced, which causes it to appear? In a sense, this is in truth a social cost of this last unit. Yet the transfer of productive energy will not take place unless there has been a shift in the market estimate of wheat in comparison with competing commodities such as to justify it. That is, as the exchange system measures values, making all units of the same good equal in value, the increase in the total value of the wheat must be greater than the decrease in the value of the output of competing commodities. (A discrepancy — in either direction — may result from considering the potential significances of infra-marginal units commonly designated as consumers’ surplus.) The second additional possible source of increased cost is the increased payments which will be made for the specialized factors used in producing wheat,[11] the cost elements which are of the nature of rent or surplus. These payments evidently do not represent social costs at all, but redistributions of product merely. Such redistributions may be “good,” or “bad,” depending on the moral position, according to some standard, of the owners of the two classes of factors respectively.

Decreasing cost (or increasing returns) is alleged to result in several ways, which can be dealt with but briefly. The most important is the technological economy of large-scale production. When the output of a commodity is increased, the cost of the productive services used to produce it will be higher; but this increase in their cost per unit may, it is held, be more than offset by economies in utilization, made possible by larger-scale operations, which increase the amount of product obtained from given quantities of materials and resources consumed.[12] But technological economies arise from increasing the size of the productive unit, not from increasing the total output of the industry as a whole. The possibility of realizing such economies — by the distribution of “overhead,” or more elaborate division of labor, or use of machinery — tends to bring about an increase in the scale of production, but this may happen independently of any change in the output of the industry. If competition is effective, the size of the productive unit will tend to grow until either no further economies are obtainable, or there is only one establishment left and the industry is a monopoly. When all establishments have been brought to the most efficient size, variation in total output is a matter of changing their number, in which no technical economies are involved.

The rejoinder to the above argument is the doctrine of “external economies,” which surely rests upon a misconception. Economies may be “external” to a particular establishment or technical production unit, but they are not external to the industry if they affect its efficiency. The portion of the productive process carried on in a particular unit is an accidental consideration. External economies in one business unit are internal economies in some other, within the industry. Any branch or stage in the creation of a product which offers continuously a chance for technical economies with increase in the scale of operations must eventuate either in monopoly or in leaving the tendency behind and establishing the normal relation of increasing cost with increasing size. If the organization unit is not small in comparison with the industry as a whole, a totally different law must be applied to the relation between output, cost, and price.

Two other alleged sources of decreasing cost are the stimulation of demand and the stimulation of invention. Neither can properly be regarded as an effect of increasing output, other things being equal. Producing a commodity and distributing it at a loss might result in developing a taste for it, but would be no different in principle from any other method of spending money to produce this result. Inventions tend to enlarge the scale of production rather than large-scale production to cause inventions. It is true that an increase in demand from some outside cause may stimulate invention, but the action takes place through first making the industry highly profitable. The result is not uniform or dependable, nor is it due to increased production as such.

These brief statements form a mere summary of the argument that, with reference to long-run tendencies under given general conditions, increasing the output of a commodity must increase its cost of production unless the industry is, or becomes, a monopoly. They also indicate the nature of the relation between social cost and entrepreneur’s money cost. Under competition, transferable resources are distributed among alternative uses in such a way as to yield equal marginal[13] value product everywhere, which is the arrangement that maximizes production, as measured by value, on the whole. Non-transferable resources secure “rents” which equalize money costs to all producers and for all units of product under the foregoing condition; or, better, the rents bring about that allocation of resources which maximizes production, under the condition that money costs are equalized.

A further major fallacy in value theory which suffuses Professor Graham’s argument will be pointed out in general terms before proceeding with detailed criticism. The reference is to the notorious “law of reciprocal demand.” This so-called law, that the prices of commodities exchanged internationally are so adjusted that a country’s exports pay for its imports, is at best a truism. To say that what one gives in exchange pays for what one gets is merely a statement of the fact that one is exchanged for the other. What calls for explanation in the case is the process which fixes how much of one thing will be parted with, and how much of the other received in return.


We are now ready to take up concretely the proposed refutation of the law of comparative advantage. Professor Graham begins by assuming two countries, which he calls A and B, but which it appears simpler to designate as England and America respectively. Suppose then that in England

10 days’ labor produces 40 units of wheat

10 days’ labor produces 40 watches;

in America

10 days’ labor produces 40 units of wheat

10 days’ labor produces 30 watches.

America has a comparative advantage in wheat, England in watches.[14] According to the accepted theory, trade at any ratio intermediate between the two cost ratios will be of advantage to both countries. Our author assumes it to begin at the ration of 35 watches for 40 units of wheat. Then, for each ten days’ labor devoted to producing wheat and exchanging for watches, America can get 35 watches instead of the 30 which could be produced by using the same labor in producing the watches. England, for each ten days’ labor devoted to producing watches and exchanging for wheat can secure 40/35 X 40 ( = 45 5/7) units of wheat, instead of the 40 units which could be directly produced with the same labor.

So far, well and good for the theory. But at this point Professor Graham’s blows begin to fall. Assuming that wheat-growing is an industry of increasing, and watchmaking one of decreasing costs, it will come to pass, as the two countries progressively specialize, that the cost of both commodities is decreased for England and increased for America. It clearly follows, first, that if the process goes on long enough, America will begin to lose, and just as clearly, from the assumptions of the article, that the process will go on forever! For the further it is carried, the greater becomes England’s comparative advantage in the production of watches and the greater becomes America’s comparative advantage in the production of wheat. Yet this conclusion must arouse a suspicion that there is something wrong in Denmark.

First, in accordance with the argument above, drop the assumption of decreasing cost as a permanent condition in the watch-making industry; then the two cost ratios in the two countries must come together instead of separating as the specialization of productive efforts progresses. Under any assumption whatever, either this must happen, or else one country must entirely cease to produce one of the commodities. In the first event, the exchange ratio will be the common cost ratio of the two countries (transportation costs being neglected, as usual in these discussions). If the second result ensues, — that one country abandons one of the industries, — the exchange ratio will be the cost ratio in the country which still produces both commodities (assuming, always, that monopoly is absent). Professor Graham “assumes” that the comparative advantage has become progressively greater as the result of specialization and then “assumes” (page 210) that, with the cost ratio in one country half what it is in the other, the market price may be established at any ratio between the two. In reality the only possible result under the cost conditions he states would be that America would stop producing watches at once and would exchange wheat for watches at the ratio of 40 for 40 (the cost ratio in England), thus making a gain of 20 watches on each ten days’ labor so employed as compared with using it to produce the watches in America.

Next, the author proposes to consider the effect of interpreting his cost figures as representing marginal cost instead of cost per unit. He gets no further, however, than to average up the marginal with assumed infra-marginal costs, which amounts merely to a slight change in the numbers assumed for cost per unit. He nowhere gives an explicit statement of what he means by cost, and must be suspected of not having clearly faced the difficulties and ambiguities in the notion, as brought out in the argument of the first and second parts of this paper. Certainly it will not do to recognize a possible permanent difference under competition in the money cost of different units of a supply, or in their marginal real cost. The money costs which represent real costs differ in different situations, but the rent element always equalizes them, or produces coincidence between equality of money cost, which would result in any case, and equality of marginal real cost, which is the social desideratum. Value and cost are like action and reaction, axiomatically equal, and as in an exchange system the value of all similar units must be equal, so must their costs.

In the writer’s opinion this also is socially and morally correct. We do not, and should not, value the first slice of bread more highly than the last, nor systematically value anything at more or less than its necessary cost. As between units of supply consumed by different persons, the case is different, because different persons do not come into the market with equal exchange power in the form of productive capacity. But the question is one of ethics, entirely outside the field of exchange as a mechanical problem. The famous surpluses have the same kind of significance as potential energy in physics. They relate to possible changes in fundamental conditions, but have nothing to do with the conditions of equilibrium in any particular situation. With reference to relations among actual magnitudes, cost curves and utility curves should always be interpreted to mean that, as supply varies, the cost, or utility, of every unit changes in the manner shown by the curve.

Marginal money cost, in the sense in which it is used by Professor Pigou, is meaningless with relation to competitive conditions. It is true that under monopoly the supply is so adjusted that the contribution of the last unit to total selling price (marginal demand price) is equal to the addition to total cost incurred in consequence of producing it (marginal supply price); but this is a mere equivalent of the statement that the difference between total cost and total selling price is made a maximum. Professor Graham seems to use the expression marginal cost to mean the particular money expense of producing the last unit of supply; but, as already stated, there cannot in the long run under competitive conditions be a difference between the cost of this unit and that of any other, or the cost per unit of producing the whole supply.

Professor Graham’s article makes use at several points of the effects of different elasticities of demand for different goods, especially as between agricultural products and manufactures. He fails to recognize that, with reference to large and inclusive groups of commodities, demand, which is an exchange ratio, is merely a different view of a production ratio, and hence of a cost ratio. In discussing the sale of a single commodity in a complicated economic society and with reference to small changes, it is permissible to treat money as an absolute; but in reducing all exchange to barter between two classes of goods, this procedure is quite inadmissible.

Moreover, consideration of the actual course of events when trade is opened up will show that elasticity of demand has little to do with the special theory of international trade or international value. Each country continues to specialize in the commodities in which it has a comparative advantage, until there is no gain to be secured from further specialization; that is, until it will cost as much to secure the next unit of the imported good by exchange as it will to produce it within the country. Now at a certain point, a country will obtain as much of the imported good as it would have produced for itself under an equilibrium adjustment within itself if foreign trade had been prohibited; and in consequence of the saving of productive power effected by the trade, a part of the resources which in its absence would be used to produce that commodity will be left to be disposed of. Beyond this point, that is, in the disposition of the saved productive power, elasticities of demand come into operation. This fund of saved productive power will not all be used to produce either of the commodifies concerned in the exchange with the foreign nation, but will be distributed over the whole field of production in accordance with the ordinary laws of supply and demand.

The foregoing paragraphs are believed to cover the main points in the writings criticized which involve fallacies in the interpretation of cost and so come under the title of this paper. The entire argument of Professor Graham’s second article falls to the ground, as he has stated it, as soon as the principles of cost are applied to the determination of international values instead of “assuming” the latter. Many further points in his first article are especially inviting to criticism, but fall outside the scope of the present paper. It suffices for the solution of the essential problem of international trade to recognize that the production of one good to exchange for another is an alternative method of producing the second commodity. Under competitive conditions, productive resources will not be used in this indirect process of production unless the yield is greater than that obtained by the use of the direct method. The task of economic analysis is to show why the profit-seeking motive impels the private producer to put resources to the use which brings the largest yield. Now to the entrepreneur producers of wheat and watches, in a case like that used in the illustration, the choice is not a question of comparative advantage, but of absolute profit or loss. If ten days’ labor will produce a quantity of wheat which can be exchanged for more than 40 watches, then that amount of labor will be worth more than 40 watches, and the business enterprise which uses it to produce the watches will simply lose money. It is an example of the common fallacy of thinking in terms of physical efficiency, whereas efficiency is in the nature of the case a relation between value magnitudes.

That free enterprise is not a perfectly ideal system of social organization is a proposition not to be gainsaid, and nothing is further from the aims of the present writer than to set up the contention that it is. But in his opinion the weaknesses and failures of the system lie outside the field of the mechanics of exchange under the theoretical conditions of perfect competition. It is probable that all efforts to prove a continued bias in the workings of competition as such, along the lines followed by Professors Pigou and Graham, are doomed to failure. Under certain theoretical conditions, more or less consciously and definitely assumed in general by economic theorists, the system would be ideal. The correct form of the problem of general criticism referred to at the outset of this paper is, therefore, that of bringing these lurking assumptions above the threshold into the realm of the explicit and of contrasting them with the facts of life — the conditions under which competitive dealings are actually carried on.[15]

When the problem is attacked from this point of view, the critic finds himself moving among considerations very different from the logical quantitative relations of such discussions as the foregoing. Human beings are not “individuals,” to begin with; a large majority of them are not even legally competent to contract. The values of life are not, in the main, reducible to satisfactions obtained from the consumption of exchangeable goods and services. Such desires as people have for goods and services are not their own in any original sense, but are the product of social influence of innumerable kinds and of every moral grade, largely manufactured by the competitive system itself. The productive capacities in their own persons and in owned external things which form the ultimate stock in trade of the human being are derived from an uncertain mixture of conscientious effort, inheritance, pure luck, and outright force and fraud. He cannot be well or truly informed regarding the markets for the productive power he possesses, and the information which he gets has a way of coming to him after the time when it would be of use. The business organizations which are the directing divinities of the system are but groups of ignorant and frail beings like the individuals with whom they deal. (In the perfectly ideal order of theory the problem of management would be non-existent !) The system as a whole is dependent upon an outside organization, an authoritarian state, made up also of ignorant and frail human beings, to provide a setting in which it can operate at all. Besides watching over the dependent and non-contracting, the state must define and protect property rights, enforce contract and prevent non-contractual (compulsory) transactions, maintain a circulating medium, and most especially prevent that collusion and monopoly, the antithesis of competition, into which competitive relations constantly tend to gravitate. It is in the field indicated by this summary list of postulates, rather than in that of the mechanics of exchange relations, that we must work out the ultimate critique of free enterprise.


[1] February 1923, November 1923.

[2] The Macmillan Co., 1918. This paper was written and submitted to the editor of the Quarterly Journal before the appearance of the March number of the Economic Journal. In that number, Professor D. R. Robertson has an article covering some of the same ground and treating it with his usual analytic penetration and stylistic brilliancy. Moreover, in a rejoinder appended to that article, Professor Pigou admits the particular error in his analysis and states that it is to be eradicated in a forthcoming revised edition of his book. It seems inadvisable to recast and enlarge the present paper so as to include a discussion of Professor Robertson’s argument, which is notably divergent from that presented herewith. I trust it will not be thought presumptuous to print without change the few pages which in some sense cover ground already covered by Professor Robertson.

[3] Economics of Welfare, p. 194.

[4] For simplicity, no account is taken of costs involved in constructing the two roads. The aim is to study the effects of the two types of “cost” — that which represents a consumption of productive power which might have been put to some other use, and pure rent or the payment for situation and opportunity. The assumption adopted is the simplest way of making the separation. The conclusion will not be changed if various types of cost are taken into account, so long as one of the roads has a definite situation advantage while the investment in the other can be repeated to any desirable extent with equivalent results in other locations.

[5] For the edification of the advocates of “inductive economics” it may be observed that the “facts” are not in dispute; that what is needed in the case is not more refined observation or the gathering of “statistics,” but simply correct theorizing. There is, of course, also a large field in which the crucial facts are not obvious.

[6] Cf. Pigou, op. cit., Appendix iii, pp. 931-938.

[7] It may be noted that Robertson makes the opposite contention, that the concepts of increasing and decreasing costs are to be preferred to those of decreasing and increasing returns. Loc. cit., p. 17. He gives no argument for this position. It seems to me that this is the entrepreneur’s point of view, while that of either the investor or society is the inverse one advocated in the text above, and is distinctly to be preferred for general analysis.

[8] It is a theoretically interesting fact that the rent on an opportunity which maximizes the return to its owner and brings about the socially correct investment in it is its “marginal product,” in the same sense as used to describe the competitive remuneration of other productive factors transferable from one use to another or ultimately derived from labor and waiting. It is exactly the amount by which the product of the whole competitive system would be reduced if the opportunity were held out of use or destroyed, and the investment which would be combined with it were put to the next best possible use. This point is brought out in Professor Young’s chapter on Rent in Ely’s Outlines of Economics (pp. 409, 410 in the fourth edition). Professor Young also pointed out the essential fallacy in Professor Pigou’s argument, in a review of the latter’s earlier work on Wealth and Welfare (Quarterly Journal of Economics, August 1913).

[9] Besides confusion with the notion of pain, which has at last obtained in psychology a definite meaning independent of unpleasantness, the notion of cost encounters in economics another source of obscurity. This is in the relation between those values which do not pass through the market and receive prices and those which do. The “loafing” which underlies the irksomeness of labor is such a value, and there is a tendency to associate the notion of cost with these non-pecuniary values. In this connection it should be noted that not merely labor but all types of productive service are subject to the competition of uses which yield their satisfactions directly and not through the channel of a marketable product. Thus land is used for lawns as well as for fields, and examples could be multiplied at will.

[10] Value as used in this discussion means “real” value, relative significance or utility. No assertion as to exchange value or price is implied.

[11] The fallacy of identifying specialized factors with natural agents and transferable factors with labor and capital has been referred to above. It will not be elaborated in this paper.

[12] Professor Graham says (p. 203, note) that decreasing cost is an “aspect of the law of proportionality.” This is a form of statement frequently met with, but rests on a misconception sufficiently refuted in the text. It is true only accidentally, if it is true in any general sense at all, that a more elaborate technology is associated with a change in the proportions of the factors.

[13] “Differential” is the term in use in other sciences for the idea commonly referred to as a marginal unit in economics.

[14] The use of labor as equivalent to productive power, or the treatment of labor as the only factor which may be transferred from one industry to the other, is a simplification likely to mislead the unwary, but it will not be criticized here. It is of interest to note, however, that historically the whole doctrine of comparative cost was a prop for a labor cost theory of value.

[15] The great bulk of the critical material in Professor Pigou’s Wealth and Welfare is of this character.

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