Sanjeev Sabhlok's blog

Thoughts on economics and liberty

Murray Rothbard’s critique of the concept of externalities

From Man, Economy, and State with Power and Market. My annotations in blue.


Two favorite, seemingly scientific, justifications for govern­ment activity and enterprise are (a) what we might call the argu­ment of “external benefits” and (b) the argument of “collective goods” or “collective wants.” Stripped of seemingly scientific or quasi-mathematical trappings, the first argument reduces to the contention that A, B, and C do not seem to be able to do cer­tain things without benefiting D, who may try to evade his “just share” of the payment. This and other “external benefit” argu­ments will be discussed shortly. The “collective goods” argu­ment is, on its face, even more scientific; the economist simply asserts that some goods or services, by their very nature, must be supplied “collectively,” and “therefore” government must supply them out of tax revenue.

This seemingly simple, existential statement, however, cloaks a good many unanalyzed politico-ethical assumptions. In the first place, even if there were “collective goods,” it by no means follows either (1) that one agency must supply them or (2) that everyone in the collectivity must be forced to pay for them. In short, if X is a collective good, needed by most people in a certain community, and which can be supplied only to all, it by no means follows that every beneficiary must be forced to pay for the good, which, incidentally, he may not even want. In short, we are back squarely in the moral problem of external benefits, which we shall discuss below. The “collective goods” argument turns out, upon analysis, to reduce to the “external benefit” argument. Furthermore, even if only one agency must supply the good, it has not been proved that the government, rather than some voluntary agency, or even some private cor­poration, cannot supply that good.

Secondly, the very concept of “collective goods” is a highly dubious one. How, first of all, can a “collective” want, think, or act? Only an individual exists, and can do these things. There is no existential referent of the “collective” that supposedly wants and then receives goods. [Sanjeev: this point is self-evident, in that something which might be a bothersome negative externality to some, e.g., soot from a factory, would hardly bother a poor worker who depends on the factory for the survival of his family]. Many attempts have been made, nev­ertheless, to salvage the concept of the “collective” good, to provide a seemingly ironclad, scientific justification for govern­ment operations. Molinari, for example, trying to establish defense as a collective good, asserted: “A police force serves every inhabitant of the district in which it acts, but the mere establishment of a bakery does not appease their hunger.” But, on the contrary, there is no absolute necessity for a police force to defend every inhabitant of an area or, still more, to give each one the same degree of protection. Furthermore, an absolute pacifist, a believer in total nonviolence, living in the area, would not consider himself protected by, or receiving defense service from, the police. On the contrary, he would consider any police in his area a detriment to him. Hence, defense cannot be con­sidered a “collective good” or “collective want.” Similarly for such projects as dams, which cannot be simply assumed to ben­efit everyone in the area.

Antonio De Viti De Marco defined “collective wants” as con­sisting of two categories: wants arising when an individual is not in isolation and wants connected with a conflict of interest. The first category, however, is so broad as to encompass most market products. There would be no point, for example, in putting on plays unless a certain number went to see them or in publishing newspapers without a certain wide market. Must all these indus­tries therefore be nationalized and monopolized by the govern­ment? The second category is presumably meant to apply to defense. This, however, is incorrect. Defense, itself, does not reflect a conflict of interest, but a threat of invasion, against which defense is needed. Furthermore, it is hardly sensible to call “collective” that want which is precisely the least likely to be unanimous, since robbers will hardly desire it! Other econo­mists write as if defense is necessarily collective because it is an immaterial service, whereas bread, autos, etc., are materially divisible and salable to individuals. But “immaterial” services to individuals abound in the market. Must concert-giving be monopolized by the State because its services are immaterial?

In recent years, Professor Samuelson has offered his own def­inition of “collective consumption goods,” in a so-called “pure” theory of government expenditures. Collective consumption goods, according to Samuelson, are those “which all enjoy in common in the sense that each individual’s consumption of such a good leads to no subtraction from any other individual’s con­sumption of that good.” For some reason, these are supposed to be the proper goods (or at least these) for government, rather than the free market, to provide. Samuelson’s category has been attacked with due severity. Professor Enke, for example, pointed out that most governmental services simply do not fit Samuelson’s classification—including highways, libraries, judi­cial services, police, fire, hospitals, and military protection. In fact, we may go further and state that no goods would ever fit into Samuelson’s category of “collective consumption goods.” Margolis, for example, while critical of Samuelson, concedes the inclusion of national defense and lighthouses in this category. But “national defense” is surely not an absolute good with only one unit of supply. It consists of specific resources committed in certain definite and concrete ways—and these resources are necessarily scarce. A ring of defense bases around New York, for example, cuts down the amount possibly available around San Francisco. Furthermore, a lighthouse shines over a certain fixed area only. Not only does a ship within the area prevent others from entering the area at the same time, but also the construc­tion of a lighthouse in one place limits its construction else­where. In fact, if a good is really technologically “collective” in Samuelson’s sense, it is not a good at all, but a natural condition of human welfare, like air—superabundant to all, and therefore unowned by anyone. Indeed, it is not the lighthouse, but the ocean itself—when the lanes are not crowded—which is the “collective consumption good,” and which therefore remains unowned. Obviously, neither government nor anyone else is normally needed to produce or allocate the ocean.

Tiebout, conceding that there is no “pure” way to establish an optimum level for government expenditures, tries to salvage such a theory specifically for local government. Realizing that the taxing, and even voting, process precludes voluntary demonstra­tion of consumer choice in the governmental field, he argues that decentralization and freedom of internal migration renders local government expenditures more or less optimal—as we can say that free market expenditures by firms are “optimal”—since the residents can move in and out as they please. Certainly, it is true that the consumer will be better off if he can move readily out of a high-tax, and into a low tax, community. But this helps the consumer only to a degree; it does not solve the problem of government expenditures, which remains otherwise the same. There are, indeed, other factors than government entering into a man’s choice of residence, and enough people may be attached to a certain geographical area, for one reason or another, to per­mit a great deal of government depredation before they move. Furthermore, a major problem is that the world’s total land area is fixed, and that governments have universally pre-empted all the land and thus universally burden consumers.

We come now to the problem of external benefits—the major justification for government activities expounded by economists. [Footnote: The problem of “external costs,” usually treated as symmetrical with external benefits, is not really related: it is a consequence of failure to enforce fully the rights of property. If A’s actions injure B’s property, and the government refuses to stop the act and enforce damages, prop­erty rights and hence the free market are not being fully defended and maintained. Hence, external costs (e.g., smoke damage) are failures to maintain a fully free market, rather than defects of that market. See Mises, Human Action, pp. 650–53; and de Jouvenel, “Political Economy of Gra­tuity,” pp. 522–26.] Where individuals simply benefit themselves by their actions, many writers concede that the free market may be safely left unhampered. But men’s actions may often, even inad­vertently, benefit others. While one might think this a cause for rejoicing, critics charge that from this fact flow evils in abun­dance. A free exchange, where A and B mutually benefit, may be all very well, say these economists; but what if A does something voluntarily which benefits B as well as himself, but for which B pays nothing in exchange?

There are two general lines of attack on the free market, using external benefits as the point of criticism. Taken together, these arguments against the market and for governmental inter­vention or enterprise cancel each other out, but each must, in all fairness, be examined separately. The first type of criticism is to attack A for not doing enough for B. The benefactor is, in effect, denounced for taking his own selfish interests exclusively into account, and thereby neglecting the potential indirect recipient waiting silently in the wings. [Sanjeev: this is the argument that A doesn’t build enough schools, or produce enough inventions] [Footnte: For some unexplained reason, the benefits worried over are only the indirect ones, where B benefits inadvertently from A’s action. Direct gifts, or charity, where A simply donates money to B, are not attacked under the category of external benefit.]  The second line of attack is to denounce B for accepting a benefit without paying A in return. [Sanjeev: this is the alleged free rider] The recipient is denounced as an ingrate and a virtual thief for accepting the free gift. The free market, then, is accused of injustice and distortion by both groups of attackers: the first believes that the selfishness of man is such that A will not act enough in ways to benefit B; the second that B will receive too much “unearned increment” without paying for it. Either way, the call is for remedial State action; on the one hand, to use vio­lence in order to force or induce A to act more in ways which will aid B; on the other, to force B to pay A for his gift.

Generally, these ethical views are clothed in the “scientific” opinion that, in these cases, free-market action is no longer optimal, but should be brought back into optimality by correc­tive State action. Such a view completely misconceives the way in which economic science asserts that free-market action is ever optimal. It is optimal, not from the standpoint of the personal ethical views of an economist, but from the standpoint of the free, voluntary actions of all participants and in satisfying the freely expressed needs of the consumers. Government interfer­ence, therefore, will necessarily and always move away from such an optimum.


It is amusing that while each line of attack is quite wide­spread, each can be rather successfully rebutted by using the essence of the other attack! Take, for example, the first—the attack on the benefactor. To denounce the benefactor and implic­itly call for State punishment for insufficient good deeds is to advance a moral claim by the recipient upon the benefactor. We do not intend to argue ultimate values in this book. But it should be clearly understood that to adopt this position is to say that B is entitled peremptorily to call on A to do something to benefit him, and for which B does not pay anything in return. We do not have to go all the way with the second line of attack (on the “free rider”), but we can say perhaps that it is presump­tuous of the free rider to assert his right to a post of majesty and command. For what the first line of attack asserts is the moral right of B to exact gifts from A, by force if necessary.

Compulsory thrift, or attacks on potential savers for not sav­ing and investing enough, are examples of this line of attack. Another is an attack on the user of a natural resource that is being depleted. Anyone who uses such a resource at all, what­ever the extent, “deprives” some future descendant of the use. “Conservationists,” therefore, call for lower present use of such resources in favor of greater future use. Not only is this com­pulsory benefaction an example of the first line of attack, but, if this argument is adopted, logically no resource subject to deple­tion could ever be used at all. For when the future generation comes of age, it too faces a future generation. This entire line of argument is therefore a peculiarly absurd one.


The second line of attack is of the opposite form—a denun­ciation of the recipient of the “gift.” The recipient is denounced as a “free rider,” as a man who wickedly enjoys the “unearned increment” of the productive actions of others. This, too, is a curious line of attack. It is an argument which has cogency only when directed against the first line of attack, i.e., against the free rider who wants compulsory free rides. But here we have a situation where A’s actions, taken purely because they benefit himself, also have the happy effect of benefiting someone else. Are we to be indignant because happiness is being diffused throughout soci­ety? Are we to be critical because more than one person bene­fits from someone’s actions? After all, the free rider did not ask for his ride. He received it, unasked, as a boon because A bene­fits from his own action. To adopt the second line of attack is to call in the gendarmes to apply punishment because too many people in the society are happy. In short, am I to be taxed for enjoying the view of my neighbor’s well-kept garden? [Footnote: “If my neighbors hire private watchmen they benefit me indirectly and incidentally. If my neighbors build fine houses or cultivate gardens, they indirectly minister to my leisure. Are they entitled to tax me for these benefits because I cannot ‘surrender’ them?” (S.R., “Spencer As His Own Critic”).

One striking instance of this second line of attack is the nub of the Henry Georgist position: an attack on the “unearned increment” derived from a rise in the capital values of ground land. We have seen above that as the economy progresses, real land rents will rise with real wage rates [Sanjeev: which rise because of productivity], and the result will be increases in the real capital values of land. Growing capital structure, division of labor, and population tend to make site land relatively more scarce and hence cause the increase. The argument of the Georgists is that the landowner is not morally responsible for this rise, which comes about from events exter­nal to his landholding; yet he reaps the benefit. The landowner is therefore a free rider, and his “unearned increment” rightfully belongs to “society.” Setting aside the problem of the reality of society and whether “it” can own anything, we have here a moral attack on a free-rider situation.

The difficulty with this argument is that it proves far too much. For which one of us would earn anything like our pres­ent real income were it not for external benefits that we derive from the actions of others? Specifically, the great modern accu­mulation of capital goods is an inheritance from all the net sav­ings of our ancestors. Without them, we would, regardless of the quality of our own moral character, be living in a primitive jungle. The inheritance of money capital from our ancestors is, of course, simply inheritance of shares in this capital structure. We are all, therefore, free riders on the past. We are also free riders on the present, because we benefit from the continuing investment of our fellow men and from their specialized skills on the market. Certainly the vast bulk of our wages, if they could be so imputed, would be due to this heritage on which we are free riders. The landowner has no more of an unearned increment than any one of us. Are all of us to suffer confisca­tion, therefore, and to be taxed for our happiness? And who then is to receive the loot? Our dead ancestors, who were our bene­factors in investing the capital?

An important case of external benefits is “external economies,” which could be reaped by investment in certain industries, but which would not accrue as profit to the entre­preneurs. There is no need to dwell on the lengthy discussion in the literature on the actual range of such external economies, although they are apparently negligible. The suggestion has been persistently advanced that the government subsidize these investments so that “society” can reap the external economies. Such is the Pigou argument for subsidizing external economies, as well as the old and still dominant “infant industries” argu­ment for a protective tariff. [Sanjeev: Pigou made an argument for protection of agriculture]

The call for state subsidization of external economy invest­ments amounts to a third line of attack on the free market, i.e., that B, the potential beneficiaries, be forced to subsidize the benefactors A, so that the latter will produce the former’s benefits. This third line is the favorite argument of economists for such proposals as government-aided dams or reclamations (recipients taxed to pay for their benefits) or compulsory schooling (the taxpayers will eventually benefit from others’ education), etc. The recipi­ents are again bearing the onus of the policy; but here they are not criticized for free riding. They are now being “saved” from a situation in which they would not have obtained certain ben­efits. Since they would not have paid for them, it is difficult to understand exactly what they are being saved from. The third line of attack therefore agrees with the first that the free market does not, because of human selfishness, produce enough exter­nal-economy actions; but it joins the second line of attack in placing the cost of remedying the situation on the strangely unwilling recipients. [Sanjeev: this is not correct. Even A is asked to pay – as a taxpayer: double expenditure!] If this subsidy takes place, it is obvious that the recipients are no longer free riders: indeed, they are simply being coerced into buying benefits for which, acting by free choice, they would not have paid.

The absurdity of the third approach may be revealed by pon­dering the question: Who benefits from the suggested policy? The benefactor A receives a subsidy, it is true. But it is often doubtful if he benefits, since he would otherwise have acted and invested profitably in some other direction. The State has sim­ply compensated him for losses which he would have received and has adjusted the proceeds so that he receives the equivalent of an opportunity forgone. Therefore A, if a business firm, does not benefit. As for the recipients, they are being forced by the State to pay for benefits that they otherwise would not have purchased. How can we say that they “benefit”?

A standard reply is that the recipients “could not” have obtained the benefit even if they had wanted to buy it voluntar­ily. The first problem here is by what mysterious process the critics know that the recipients would have liked to purchase the “benefit.” Our only way of knowing the content of preference scales is to see them revealed in concrete choices. Since the choice concretely was not to buy the benefit, there is no justifi­cation for outsiders to assert that B’s preference scale was “really” different from what was revealed in his actions. [Sanjeev: economists are not God, omniscient]

Secondly, there is no reason why the prospective recipients could not have bought the benefit. In all cases a benefit produced can be sold on the market and earn its value product to con­sumers. The fact that producing the benefit would not be prof­itable to the investor signifies that the consumers do not value it as much as they value the uses of nonspecific factors in alter­native lines of production. For costs to be higher than prospec­tive selling price means that the nonspecific factors earn more in other channels of production. Furthermore, in possible cases where some consumers are not satisfied with the extent of the market production of some benefit, they are at perfect liberty to subsidize the investors themselves. Such a voluntary subsidy would be equivalent to paying a higher market price for the benefit and would reveal their willingness to pay that price. The fact that, in any case, such a subsidy has not emerged eliminates any justification for a coerced subsidy by the government. Rather than providing a benefit to the taxed “beneficiaries,” in fact, the coerced subsidy inflicts a loss upon them, for they could have spent their funds themselves on goods and services of greater utility.






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The Problem of Social Cost: What Problem? – My annotated study of Demsetz’s 2011 piece

My annotations in blue.


The Problem of Social Cost: What Problem? A Critique of the Reasoning of A.C. Pigou and R.H. Coase

HAROLD DEMSETZ University of California, Los Angeles

This essay discusses and refutes allegations by A.C. Pigou and R.H. Coase that a competitive, private-ownership economic system that conforms to the neoclassical model fails to allocate resources efficiently. [Sanjeev: I was not aware till earlier today how badly Pigou had deviated from standard classical economics. I’m glad Demsetz directly pinged Pigou.] The essay then suggests a source of inefficiency that differs from and is much more limited in application than are those offered by Pigou and Coase; and the suggested source, moreover, is compatible with the neoclassical model.


The 18th century debate between mercantilists and Scottish philosophers came to an important juncture in 1776 when Adam Smith published his remarkable work The Wealth of Nations. Smith’s contributions to the emerging new discipline of economics were multifaceted and far-reaching, but most relevant to this debate was his claim that a competitive, private-ownership economy in which persons act freely to serve their own interests could, and would, serve the public’s interest also. This was a rejoinder to the view held by mercantilists, who saw the well-being of a nation as dependent on its stocks of gold and other precious metals, and who called for the State to control trade in ways that enhanced these stocks.

Smith’s work set before future economist-philosophers the task of proving or disproving the generality of this claim. Essential to this task was the development of a model of a decentralized, private-ownership economic system, one in which individuals freely act on behalf of their own personal interests, have no control over each other’s actions, and inform their decisions by way of market-determined prices. Mainline economists writing during the neoclassical period of economics completed this task (and others) early in the 20th century. The core of their modeling effort became known as the perfect competition model, a label that seems misleading to me. The model really says little about competitive activities except insofar as entry and exit into a market is thought of as a competitive activity; that is, the model says nothing about altering price, improving technology, investing in advertising and so on. Its real contribution is to offer an analytically coherent view of the workings of a highly decentralized, unplanned economic system, and it should have been labeled, and in this essay is labeled, ‘perfect decentralization.’

The model sets forth minimal conditions that, if met, were thought by mainstream economists to sustain Smith’s belief that pursuit of private interests serves public interests. Most of these conditions are well known. They include extreme decentralization of resource ownership, full information of prices and of one’s personal preferences, knowledge of available (but fixed in nature) production technologies, and rational personal behavior in pursuit of self-interest. Not explicitly specified, but nonetheless clearly implicit, are presumptions that all scarce resources are privately owned and that private ownership is both understood and respected. The conclusion drawn (rightly or wrongly) from this model was that self-seeking private behavior will result in an efficient allocation of resources. Such an efficient allocation of resources became the implied marker of public interests. The claim of efficiency presumably was stronger for real economic systems that came closer to meeting the assumptions that defined the model.[1] Serious monopoly problems or serious disrespect of legal ownership, for example, would cast doubt on a claim that an economy allocates resources efficiently. Later work by Schumpeter and others raised objections to the perfect decentralization model because of its neglect of innovative activities.

Two sorts of objections might be raised to perfect decentralization’s claim of efficient resource allocation. One is to find logical error in deductions made from the model, and the other is to declare the model inadequate to deal with the problem whose resolution is its goal. The first type of error is unlikely. The task was to find a set of conditions that, if met, implied efficient resource allocation. The production of these conditions was one of the achievements of the neoclassical effort, and it is doubtful that the conditions that were set in place are insufficient, or even overly-sufficient, to deduce an efficient allocation of resources. The second type of objection offers more fertile ground for debate about this deduction. Objections of the second type can be of two sorts, one of which comes as no surprise. These are claims that the economy is rife with problems of monopoly, scale economies, decision errors and so on. They dismiss the assumptions of the perfect decentralization model for reasons of unrealism. Whether the model is or is not sufficiently realistic may be examined and debated, but not here. The more interesting sort of claim is that the model omits conditions  that should be present in a decentralized, private-ownership economic system. That is, the minimal set of conditions set in place by neoclassical economists may be sufficient to deduce an efficient allocation of resources, but they are not sufficient to describe a decentralized, private-ownership economy. R.H. Coase, in his important 1960 article ‘The Problem of Social Cost,’ makes this claim. It is that no decentralized economic system functions without price guidance and exchange. These require resources, but the neoclassical model treats price guidance and exchange as if they are free. The model, therefore, presents an inadequate description of the very economy it seeks to model. The objections offered by A.C. Pigou in his important work The Economics of Welfare (1920) are not clearly of this sort. Instead, they seem to be based on observation of an economic system that is quite different from what we would think describes that which Smith and the neoclassical economists sought to examine. So, let us now turn to the claims of these two formidable doubters.


Pigou offers constructed examples in which private costs (or benefits) are not equal to social costs (or benefits). His examples differ circumstantially, but in their essences are very similar. A favorite example involves the allocation of traffic between two roads, both of which connect the same terminal points. One road is subject to considerable congestion because it is narrow; the other road is wide and escapes much of this congestion but, lacking the directness of the narrow road, its users require a longer time to travel between the terminal points. Pigou claims that traffic will be inefficiently distributed to these two roads because drivers who choose the quicker road will have done so without regard to the cost their action will put on other users of this road by way of increasing the degree of congestion they face. Hence, the narrow road is over-used and the broad road is under-used. The claimed difference between private cost to a driver (which does not include the added congestion cost borne by others) and social cost (which does include the added congestion cost) is a marker for inefficient resource allocation.

So far, so good. But Pigou fails to show that his example is properly placed in the context of a decentralized, private economy. Can a situation that fits this example also fit the conditions that define a (perfect decentralized) private economy? Pigou’s failing in this respect was noted long ago by Frank H. Knight (1924) in a brilliant article on social cost. He notes that Pigou’s discussion of the two roads treats these roads as if entry is free to all. Presumably, then, they are publicly provided and managed open access roads. As such, the example cannot illustrate the inefficiency of an economic system that rests exclusively on private resource allocation. Knight argues that the use of these roads, had they been privately owned (in a competitive setting), would have been priced by their owners so as to achieve an efficient allocation of traffic; the price to use the narrow road would have been raised to levels higher than the price asked to use the broad road. Properly interpreted, Pigou’s example reveals the opposite of what he intended. It shows inefficiency arising from a flaw in public or collective management of scarce resources. Public administrators have failed to price the use of these roads so as to achieve an efficient allocation of traffic. I remind the reader that congestion itself is not evidence of inefficiency. Knight’s private roads and Pigou’s recommended tax-subsidy remedy would result in an optimal amount of congestion and not necessarily its complete absence.

Pigou’s other examples are of the same sort. They depict conditions that seem quite removed from how we would describe a decentralized, private-ownership economic system (populated by rational persons). A private person (or the Dept. of Recreation) constructs a park but does not control its use by others; the park is over-crowded as a result. But it must be that the owner of the property takes pleasure from the overcrowding or that he neglects his own interest. In the first case there is no inefficiency, since the pleasure he derives from large crowds must be taken into account; in the second case, this person cannot be a resident of the model being examined by Smith or neoclassical economists. A third type of example involves what we now call an agency problem. An owner of land rents the land to an occupant. Pigou asserts that the occupant will not take proper care of the land because he cannot be monitored closely by the owner of the land. Hence, Pigou calls for legislation to reduce the severity of misuse of property. But there is no reason to suppose the State can monitor the renter more effectively than can the land’s owner. It must be then, if the owner is rational, that the cost of monitoring the tenant’s behavior exceeds the added value that doing so would bring to the owner’s property. Hence, there is no inefficiency. All Pigou’s examples that I have examined suffer from this type of failure: they assume faulty behavior or a non-private organizational arrangement (State ownership or the complete absence of ownership) that is precluded by the neoclassical model. Special attention should be given to the last example discussed above, the land-owner/land-renter example, for the assumed positive cost of monitoring comes very close to costs that Coase would classify as transaction costs or as being necessary to a price system.

In response to the inefficiencies that he sees, Pigou turns to the State to levy taxes or confer subsidies that result in equality between private and social cost. His manner of doing this idealizes the State, which somehow knows the facts and is able to employ them at less cost than could private parties. He writes of idealized State-directed solutions to the problems that, as illustrated above, are likely to have been caused by the State itself. A Nirvana State is a dangerous tool, for it diverts attention from the real underlying problem. Why is ownership lacking or why is an owner not tending to his self-interest? In The Economics of Welfare and the doctrine that it spawned, the State is but a magic wand that Pigou waves with no effort to make private and social cost equal – the same State that, through its mismanagement, has caused many of the inequalities between private and social cost that Pigou discusses.

Notwithstanding the weaknesses in Pigou’s demonstration, his view commanded attention from economists and succeeded in replacing or becoming an appendage to the neoclassical model. Then, in 1960, came Coase’s ‘The Problem of Social Cost.’ Coase noted, as had Knight, that Pigou’s examples were offered without rationalizing their emergence from or within a private ownership, decentralized, competitive economy. Coase then goes on to modify the conditions that describe the decentralized, private-ownership economic system. Since perfect decentralization assumes that all persons know all prices that are relevant to their decisions, the model implicitly assumes that the cost of acquiring knowledge about various opportunities for employing resources is zero. Coase identifies this implicit assumption as a presumption that the price system is free to all to use, and he argues effectively for rejecting this assumption and replacing it with one that recognizes that resources are needed to create and maintain a price system. (Following contemporary discussion, I henceforth denote the cost of creating and maintaining the price system as the cost of transacting.) I concur with Coase in his claim that the perfect decentralization model treats the price system as if it were free. Where Pigou simply conjures unowned resources and failures of contracts, Coase essentially proposes a modified model of a decentralized, private-ownership economic system in which positive transaction cost is embedded. However, had Coase remembered Knight’s work, he might have found an equally good or, in my judgment, a better way to enrich the neoclassical model. The model assumes that private ownership attaches to all resources and that rights of ownership are fully respected. In effect, in addition to a free price system, it assumes a free private ownership system. And we know this cannot be the case. Rather than rely on positive transaction cost, Coase could have insisted on positive cost of ownership, or on both.[2]

Allow me a moment to defend the way neoclassical economists modeled the economic system. They sought to deduce the consequences of price-informed private decisions. This goal cannot be reached if transaction or ownership costs are positive. Take the extreme case of infinitely high levels of these costs. Infinitely high transaction cost completely blocks exposure to price-guidance; infinitely high privatization cost completely blocks privatization of assets. These costs, then, defeat accomplishment of the desired task – discovering the consequences of  price-guided privately made decisions. Positive, but less than infinite, transaction and ownership costs allow for some price guidance and private ownership, but this only reduces the degree of inadequacy with which the assumed task is fulfilled. Treating these costs as positive is more realistic but not more useful in coming to an understanding of the functional roles played by prices and ownership in a highly decentralized economic system. However, if the neoclassical goal was not to examine price-informed private decisions but, instead, to describe the essentials of a decentralized, private-ownership economic system, it would seem that positive costs of creating and maintaining a price system and a private ownership system should be acknowledged. After all, the model devised by neoclassical economists assumes that the production of all goods and services requires the use of scarce resources.

Interestingly enough, Coase’s emphasis on transaction cost in his social cost article marks a change from the position he took a year earlier in his 1959 article on ‘The Federal Communications Commission.’ Most economists and legal scholars see Coase’s FCC article as the point of departure for his 1960 social cost paper, but in at least one important respect the two papers stand in contrast. The FCC paper is much more in the spirit of Knight’s 1924 article than in that of Coase’s 1960 social cost paper. It was written for a conference whose task was to examine and evaluate the Federal Communications Commission. The dominant rationale used then to justify the existence of the FCC was that the Commission was needed to prevent users of the frequency spectrum from interfering with each other’s broadcast signals. The FCC’s task, and its accomplishment, was to eliminate or reduce the severity of this interference. The Commission achieved this through limits it imposed on the power of broadcast signals, on the proximity in spectrum space of assigned broadcast frequencies, and on the closeness in geographic space of broadcast stations. Coase’s major contribution to the conference undermined this rationale. He argued convincingly that private ownership of the right to broadcast on a specifically defined frequency would suffice to eliminate interference problems or to reduce their severity significantly, doing so by way of legal methods like those used by landowners to prevent trespassing. Coase’s understanding – that private ownership resolves conflicts in the use of a scarce resource – seems to have come as a surprise to many economists, but it was much like Knight’s understanding. In his discussion of the role of ownership, Coase mentions an exception. The resolution of such conflicts through negotiations between private parties might, on occasion, become so complex that something like the FCC might be of help. This exception appears in the FCC paper as just that, an exception. The generally applicable proposition in the article is that market negotiations between broadcasters who are private owners of broadcast rights will effectively resolve interference problems. In Coase’s social cost article, published a year later, this exception becomes the dominating consideration in his criticisms of Pigou and neoclassical economics; complexity of negotiations as discussed in the FCC paper easily becomes cost of using the price system in the social cost paper.[3]

Using this notion of transaction cost, Coase demonstrates brilliantly that externality-type inefficiencies cannot exist in a world such as is described by the neoclassical model of perfect decentralization, one in which markets and price information are freely accessed and used. [Sanjeev: this proposition holds] Coase then goes on to declare that a world without transaction cost is irrelevant. When turning to the more realistic world in which transaction costs are positive, Coase deceives himself into arguing that the decentralized economic system, after all, may not equate private and social cost. After having pointed to Pigou’s failure to provide a link between an inequality between these costs and the perfect decentralization model, Coase provides a link (or so he thought) in the form of an amendment to the model – simply add transaction cost to the neoclassical model. And, here, more caution than Coase exercised is needed. We know that, if transaction cost is assumed to be zero, the perfect decentralization model yields an efficient allocation of resources, but the model embraces positive costs of producing all other types of goods and services. If these costs do not block the deduction of efficiency, why should the deduction be blocked by including one more type of service – the provision of a price system? [Sanjeev: This is Demsetz’s main insight] Imagine a railroad capable of shipping goods between two firms. The railroad incurs cost if it does this, and the cost may be so high that the shipment does not occur (and, instead, as Coase wrote in ‘The Nature of the Firm’ (1937), the would-be receiving firm chooses to rely on in-house production of the good that would have been shipped were there no transport cost). No inefficiency has been created if the shipment does not take place under these circumstances, for the implied gain from making the shipment is less than the cost of doing so. But, pray tell, we reach the same conclusion if we change ‘shipment cost’ to transaction cost. So, we had better re-examine Coase’s reasoning about positive transaction cost.


He begins this demonstration with an element of ambiguity about ownership.[4] Two parties contend for control of a resource that, apparently, is not yet owned (contrary to the assumption of the perfect decentralization model). They take their dispute to a common-law court. The court identifies one claimant as the legal owner, but it does not prescribe the use to which the chosen person may put the resource; this person might, if he or she chooses, sell control of the resource to someone else. It might well be that there are differences between the two contenders in their capabilities for using the contested resource productively. Assume the court awards the right of ownership to the party whose capability to generate wealth from the use of the resource is the more limited. Realization of the higher value use would nonetheless obtain if the two parties can negotiate after the court has made its decision, since the losing party, by assumption of superior capability, can and will pay more to purchase the resource from the selected party than this party can obtain by directly employing the resource. No inefficiency here. However, the cost of transacting might be so high as to block the negotiation; in this case it appears, as it did to Coase, that the economic system has failed to put the resource to its highest value use. Should this situation be realized, Coase claims that the economic system fails to allocate resources efficiently. However, the appearance of inefficiency is but an illusion.

Coase has treated the legal system and its courts as if they are parts of the economic system, when they are not. The situation pictured by Coase is no different from a government levying taxes and offering subsidies in order to achieve a redistribution of wealth. We do not consider the government as a part of the economic system that was of interest to Smith and the neoclassical economists. Since a court’s assignment of a right of ownership of a scarce asset to person ‘A’ creates a different distribution of wealth than would have come about had the court assigned the right to person ‘B,’ the courtroom drama differs hardly at all from a government’s choice of wealth distribution. We would not accuse the market of inefficiency if the government assigned a right to parties that put it to less valuable uses than would others. Why accuse the market of inefficiency if the court does the same? Moreover, enriching the perfect decentralization model with positive transaction cost is quite different from treating the court system as part of the economic system.[5] [Sanjeev: This is the core of Demsetz’s criticism. Yes, there are positive transaction costs, but these are just costs. Second, the court system is not part of the economic system] Should the reader favor realism, please note that real social systems in fact design their courts so as to insulate them from the influence of the marketplace. Offers and acceptances of payments to the court for desired decisions are illegal, and a court’s survival is not made to depend on profit earned from the decisions it renders. The neoclassical model of an economy and the conclusions drawn from it are confined to economic institutions, to firms, buyers, sellers, markets and so on. It deduces no conclusions about the resource allocation that results from actions taken by non-market institutions such as courts and legislatures.

The implication Coase draws from this case is that the economic system, functioning in the presence of positive transaction cost, can inefficiently allocate resources, but this cannot be deduced from the case he has imagined. [Sanjeev: Correct. Demsetz has pointed out very clearly how Coase deceived himself.]  The court may have made its choice of owner for reasons different from maximization of market value, since it serves broad social principles, or it simply may have made a mistake because it is not guided in its decisions by a market-based calculus. The proper role of courts in a society is a complex issue, one I do not propose to discuss here. Suffice to note that courts as presently constituted do not function as part of the economic system and do not (explicitly) behave as if they were owners of the resource whose control is being resolved. They are therefore irrelevant to an evaluation of the efficiency of the market-based economic system. The proper domicile of the efficiency calculus, as this was discussed by Pigou and the economics profession (before recent innovations in political economics), is wholly within the economic system. Although there may be very good reasons for not creating a market-like legal system, we may note that if we suppose that courts are remade into market institutions whose survival depends on revenues secured from petitioners who purchase their services and decisions, ownership of a disputed resource would never go to the petitioner who is less capable of maximizing value from its use. Coase’s imagined court decision would never have been made. As courts are presently constituted, the economic system simply takes court decisions (which, in a small way, affect the distribution of wealth) as exogenously imposed constraints on what can and cannot be done, just as the economic system accepts decisions by the State to use taxes and subsidies to redistribute wealth. An efficient economic system is one that makes the most of scarce resources within whatever constraints are handed down to it by courts and legislatures. [Sanjeev: this is a good definition of efficiency]. This means that efficiency is served if the market blocks post-court negotiations between the two claimants discussed, simply because the cost of negotiations between them is expected to exceed the increase in the value derived from realigning ownership of the contested resource.

Transaction cost does prohibit owners of resources from knowing all values that might be realized from various uses of their resources, especially for uses imagined by others. The cost of transacting may prevent some of these opportunities from being brought to a resource owner’s attention by way of negotiated offers. However, those values that are not known will be only those for which the cost of acquiring price information is expected to exceed the value of the knowledge that is expected to be obtained from this information. All other prices are known because they are worth knowing. Put differently, there exists an efficient amount of ignorance in an economic system if the cost of acquiring information is positive. [Sanjeev: well said] The amount of ignorance that is efficient increases as does the cost of transacting (viewed as the cost of conveying information). Ignorance not only may be bliss, it also may be efficient. One cannot claim that resources are wrongly allocated simply because information is not possessed or negotiation is absent; nor can one claim that resources are misplaced because a specific market does not exist. None of these is free, and the costs of acquiring information and creating and maintaining markets may be so high as to make it efficient to forego some information and some markets. A decision that something is not worth taking into account is not, because of this, a source of inefficiency. That this something is not taken into account is a reckoning if it follows from a thoughtful anticipation that it is not worth taking into account. An explicit accounting for every ‘something’ would be inefficient indeed in a world in which knowledge is not free.[6]

There is no difference between transaction cost and other costs in this respect. The amount of soot from the production of steel may remain positive even if its presence results in an increase in the cost of laundering to a nearby laundry owner. If it remains positive because the cost of transacting between laundry and mill owners is too great to make a transaction worth undertaking or because the launderer and steel mill owner believe that the cost of substituting hard coal for soft is too great to make a transaction worth undertaking, then this positive amount of soot is efficient. In both cases, more soot descends on the laundry than if the cost of reducing soot were smaller, but if we do not think resources are wrongly allocated in the case in which hard coal is too costly to use, why should we think resources are wrongly allocated in the case in which transaction cost is too great to bear? Both situations are compatible with efficient resource allocation, and, after all, it is efficiency that is claimed by the neoclassical model, not the complete absence of interaction costs; neither negotiation nor hard coal is sought in and of itself. Indeed, one can rewrite the neoclassical model with transaction cost embedded in it and still deduce from it an efficient allocation of resources. Transaction cost just shifts supply curves upward (or demand curves downward, or some combination of both) as would an increase in any cost, and it carries no special implication of inefficiency at equilibrium values of price and output. [Sanjeev: this is the sum and essence]

The above discussion also applies to positive costs of ownership. Private ownership cannot be created and maintained without the bearing of costs to do so, even if the neoclassical model simplifies things by presuming that all resources are effectively privately owned. There exists an efficient degree of ownership that generally is smaller than ‘100 percent.’ While the neoclassical model eases the pathway to understanding of the roles of prices and ownership, it could, with a bit more difficulty, reach the same conclusion about efficiency while incorporating positive costs of ownership and transactions. Ownership, as a result, would be less than perfect, but perfect would be inefficient if the cost of ownership is positive. (However, see the final section of this essay.)

I emphasize that none of what is written above denies the possibility of inefficiency in a competitive, private-ownership economy. My message is that this possibility is not a result of competitively determined positive transaction or ownership cost. Our reliance on a transaction cost rationale has caused us to exaggerate the scope of externality problems in a reasonably described decentralized economic system that puts control of resources into private hands. Yet, there remains a problem.


To avoid problems of scale economies, and the ability to influence price that comes with it, the neoclassical model assumes divisible inputs. However, it places no restrictions on the characteristics of goods and services produced with these inputs. Samuelson in his article ‘The Pure Theory of Public Expenditure’ (1954) notes that some goods are not divisible and, once produced, are available at no additional cost. A national defense policy is available to all citizens at a cost that (theoretically) need not be any larger than is required to make it available to only a few citizens. Similarly, a change in air quality or climate is consumed by all, whether or not they have contributed to the costs of producing this change. This puts these goods and services in a somewhat different category than those considered by neoclassical economists when they settled on the set of conditions sufficient to allow the deduction of efficiency from a decentralized, private-ownership economic system. The model of perfect decentralization implicitly assumes that goods and services are divisible to a degree that allows some to consume them without automatically making them available to all. Hence, the price system is able to reflect individual demands for these goods and to extract individual payments for them. Non-excludable goods, such as these might be, create the ability for people to behave strategically. An inability to establish partitioned ownership rights for goods of this nature creates advantages in the collective provision of them. Such provision would be forthcoming without difficulty if all persons would willingly reveal the true values they attach to different levels of improvement in air quality or different degrees of change in climate, but such honesty is not to be expected. Persons who under-reveal personal true value will be able to argue for reducing the amounts they contribute to pay for these changes while still enjoying these improvements as much as do others. Deceit becomes potentially remunerative in a way not possible if dealing with divisible goods.

The potential for deceit is not due to positive transaction cost. If everyone who would benefit from improved climate could transact freely (that is, could be gathered at no cost, could speak to each other at no cost, could write and enforce contracts at no cost), the problem of biased demand revelation would still remain. Under-revelation of demand is not, in its essence, a result of cost imposed by some on others (like soot from a steel mill descending on a laundry). It is a result of psychological propensities to secure a larger share of whatever rent is created through collective action. And this possibility would exist even if a single producer of climate change were given rights of ownership to what he created, for what would be the value of such rights if no one can be excluded from enjoying climate change once the change is produced? Surely, the strategic game imposes costs of delay and of practicing deception, but the game would be played even if these costs were zero, simply because some persons believe they are more skilled at, or enjoy more, deceiving others. Here we have human behavior that is consistent with a decentralized, private-ownership economic system, since a private owner can offer to produce a climate change and face competition from other potential producers, but, because of the indivisibility of the product, the owner is unlikely to yield a product that meets true underlying demands for it. [Sanjeev: undersupply]

Supply and demand in the neoclassical model express true intensity of desire for goods. The neoclassical model, by way of its assumptions, faces buyers and sellers with given non-negotiable equilibrium market prices, prices that cannot be influenced by individual bargaining. [Sanjeev: this ignores the point of tatonnement] It is not designed for and does not treat strategic action. The possibility of misrepresenting one’s position does not depend for its existence on positive cost of transacting; it requires only a prospective favorable distribution of gains from cooperative action. Close reading of Pigou and Coase does not reveal concerns about strategic misrepresentation. The distribution of traffic between Pigou’s two roads is inefficient because no price is charged for using them, not because drivers deceive each other. The failure to realize maximum value from available resources in Coase’s courtroom drama is a problem of legal decision, not one of false testimony.

The production of divisible goods, it may be assumed, is less costly if done by competing private parties than by central planners, but this assumption seems less plausible for the production of indivisible goods. The State offers legitimate power to coerce people into what it perceives to be a (tax paid) solution to the collective good problem. This power is not found in the decentralized economic system; that it is not is what makes markets so attractive to lovers of freedom. Yet, coercion can be especially useful in cases in which strategic behavior has impaired agreement on production. Just as we find the State’s ability to coerce legitimately helpful in the maintenance of law and order, so we may find it useful in helping to finance production of goods and services that are important to society but are subject to serious strategic bargaining problems. It is possible in some instances to remedy the problem through a proper set of private rights – that is, to substitute a tollway for a freeway in order to reduce the collective ‘bad’ we call congestion. [Sanjeev: this is when we convert a public good into a club good] In other instances this sort of solution is too costly. Resort to State coercion appears more appealing when this is the case. When this is the case, we may claim that the decentralized, private-ownership economy allocates resources inefficiently. People will react to this claim differently, depending on the confidence they attach to proper use of coercion by the State and the value they attach to retaining personal freedom of choice. The rationale for declaring inefficiency for a decentralized, private-ownership economic system in the production of indivisible goods is a willingness to accept a higher degree of coercion than can be secured from the economic system itself when faced with the inadequacy of voluntary arrangements. Strategic behavior problems associated with indivisible goods may be the only category of problems calling for State action in the cause of efficient resource allocation. I do not view strategic behavior as an externality problem, but the name of the category of problems in which we place it is not very important. The important point is that the category of problems that we call externality problems now includes a great many that are not strategic in nature. The preceding parts of this essay were meant to convince readers that these other ‘problems’ should not be associated with inefficient allocation of resources. The literature of externality problems, from Pigou to Coase, makes it seem as if they are associated with inefficiencies, but they are not. The strategic behavior problem, however, seems to me to associate properly with claims of inefficiency if State coercion (unavailable to private dealings) is thought to cost less (socially) than is the gain to be realized from applying coercion to resolve indivisible goods problems.


Coase, R.H. 1937. “The Nature of the Firm,” 4(16) Economica 386-405.

_______. 1959. “The Federal Communications Commission,” 2 Journal of Law and Economics 1-40.

_______. 1960. “The Problem of Social Cost,” 3 Journal of Law and Economics 1-44. Demsetz, H. 2008. From Economic Man to Economic System. Cambridge, MA: Cambridge University Press.

_______. 1964. “The Exchange and Enforcement of Property Rights,” 7 Journal of Law and Economics 11-26.

_______. 1969. “Information and Efficiency: Another Viewpoint,” 12(1) Journal of Law and Economics 1-22.

_______. 1970. “The Private Production of Public Goods,” 13(2) Journal of Law and Economics 293-306.

Knight, Frank H. 1924. “Some Fallacies in the Interpretation of Social Cost,” 38 Quarterly Journal of Economics 582-606.

Pigou, A.C. 1920. The Economics of Welfare. MacMillan & Co. Ltd.

Samuelson, P.A. 1954. “The Pure Theory of Public Expenditure,” 36(4) Review of Economics and Statistics 387-389.


[1] These sufficient conditions, however, are not also claimed to be necessary. An economy planned centrally or one whose processes are more dynamic than those embodied in the perfect decentralization model, such as would be an economy dominated by Schumpeterian ‘creative destruction,’ does not satisfy these conditions but, nonetheless, may allocate resources efficiently.

[2] Aside from the issues raised in the present essay, I want to recognize Coase’s important demonstration that it makes no more sense to speak of A harming B than of B harming A when A and B seek to put the same scarce resource to competing uses. The history of prior discussion of the externality problem is replete with mistaken attributions of causation when the real source of the problem simply is resource scarcity.


[3] If we are to understand Coase’s argument in his social cost article, it is useful first to understand

what he means by the cost of using the price system. He describes what he intends as follows: In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal with action needed to make sure that the terms of the contract are being observed, and so on. (Coase, 1960:15).

[4] Ironically, Coase’s demonstration has circled round and come back to the source of Pigou’s difficulty – the presumption of the existence of an as yet unowned resource.


[5] The neoclassical model, we may note, assumes that all resources are privately owned and that ownership is fully respected; there is no place in its deductions for the courtroom drama imagined by Coase.

[6] Early statements of the importance of this principle in regard to transaction costs are found in Demsetz (1964, 1969).

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Arthur Cecil Pigou was effectively a Fabian socialist

I smelled a lot of (albeit rather refined) socialist thinking in Pigou’s Economics of Welfare, and suspected he might be linked with the Fabians.

Keynes was DEFINITELY a socialist (I’ve written a lot about it), but Pigou was merely “progressive”. [see my notes at:]

Nevertheless, he pushed for far greater government intervention than had been acceptable to standard economists till before his time. I find his work on positive externalities particularly poor.

==In 1948, he wrote what would surely qualify as a Fabian Socialist Manifesto. (extract from his book, Socalism vs Capitalism). I recognise in this extract EVERYTHING THAT NEHRU DID TO DESTROY INDIA. Nehru was a Fabian. I thought only India was destroyed by them, but I find that they are active globally, even today: Positive externalities as a way to increase government power! VERY CLEVER!

* * *
If, then, it were in the writer’s power to direct his country’s destiny, he would accept, for the time being, the general structure of capitalism; but he would modify it gradually. He would use the weapon of graduated death duties and graduated income tax, not merely as instruments of revenue, but with the deliberate purpose of diminishing the glaring inequalities of fortune and opportunity which deface our present civilisation. He would take a leaf from the book of Soviet Russia and remember that the most important investment of all is investment in the health, intelligence and character of the people. To advocate “economy” in this field would, under his government, be a crimical offence. All industries affected with a public interest, or capable of wielding monopoly power, he would subject at least to public supervision and control. Some of them, certainly the manu4 facture of armaments, probably the coal industry, possibly the railways, he would nationalise, not, of course, on the pattern of the Pogt Office, but through public boards or commissions. The Bank of England he would make in name—what it is already in effect—a public institution; with instructions to use its power to mitigate, so far as may be, violent fluctuations in industry and employment. If all went well, further steps towards nationalisation of important industries would be taken by degrees. In controlling and developing these nationalised industries, the central government would inevitably need to “plan” an appropriate allocation If, then, it were in the writer’s power to direct his country’s destiny, he would accept, for the time being, the general structure of capitalism; but he would modify it gradually. He would use fortune and opportunity which deface our present civilisation. He would take a leaf from the book of Soviet Russia and remember that the most important investment of all is investment in the health, intelligence and character of the people. To advocate “economy” in this field would, under his government, be a crimical offence. All industries affected with a public interest, or capable of wielding monopoly power, he would subject at least to public supervision and control. Some of them, certainly the manufacture of armaments, probably the coal industry, possibly the railways, he would nationalise, not, of course, on the pattern of the Pogt Office, but through public boards or commissions. The Bank of England he would make in name—what it is already in effect—a public institution; with instructions to use its power to mitigate, so far as may be, violent fluctuations in industry and employment. If all went well, further steps towards nationalisation of important industries would be taken by degrees. In controlling and developing these nationalised industries, the central government would inevitably need to “plan” an appropriate allocation for a large part of the country’s annual investment in new capital.

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My annotated study of Pigou’s observations re: externalities

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

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

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

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

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


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


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

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

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

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

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

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

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

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

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

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



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