Pigovian Analysis

The starting point of the Pigovian welfare analysis is the notion that there is a
resource allocation problem that can be optimally solved. Through his work, Pigou
made clear that society was faced with the choice of how to allocate scarce
productive resources to competing ends and was to maximize total social welfare.
In practical terms, this reduced to maximizing economic welfare, "that part of total
welfare which can be brought directly or indirectly into relation with a money
measure". Pigou was concerned about the channeling of "real" factors of
production to their best uses. He saw particular configurations of factors of
production as yielding a measurable worth of total output and sought that
arrangement generating a maximum value.
After setting the main problem of inquiry as 'the allocation of real factors of
production to maximize the total value of output', Pigou tried to describe some
characteristics indicative of an optimal configuration and define deviations from
this optimal solution as inefficient. A crucial part of the analysis was the concept of
changes in output resulting from a movement of resources from one use to another.
Pigou defined marginal net product as 'the ' difference between the aggregate flow
of product for which flow of resources, when appropriately organized, is
responsible and the aggregate flow of product for which a flow of resources
differing from that flow by a small. (marginal) increment, when appropriately
organized, would be responsible'.
Pigou then drew a distinction between social and private marginal net product. The
marginal social net product is the 'total net product of physical things or objective
services due to the marginal increment of resources in any given use or place, no
matter to whom any part of this product may accrue'. It might happen, for example,
that costs are thrown upon people not directly concerned, though, say,
uncompensated damage done to surrounding woods by sparks from railway
engines. All such effects must be included-some of them positive, others negative
elements in reckoning up the social net product of the marginal increment of any
volume of resources turned into any use or place. The marginal private net product
is that 'part of the total net product of physical things or objective services due to
the marginal increment of Pigovian vs Paretian resources in any given use or place
which accrues in the first instance i.e., Approach prior to sale to the person
responsible for investing resources there'. In some conditions this is equal to, in
some it is greater than, in others it is less than the marginal social net product. '
In a first pass through the problem, assuming no costs of resource movement,
Pigou noted that a necessary condition for a maximum is that the marginal social
net product (MSNP) of each resource employed in any use or place be exactly
equal. Were resources to be distributed so that the MSNP of each factor of
production was unequal, the total value of output could be increased by moving
resources from uses with lower MSNP to those with higher MSNP. This
straightforward application of the equimarginal principle is the key to Pigou's
analysis.
The natural extension to the notion of an ideal, global optimum is consideration of
impediments that block the realization of the best possible result. Starting from a
decentralized system in which self-interested resource owners make decisions
concerning the employment of their labor and capital, Pigou presented a
framework that paired "obstacles to free movement" and divergence of private
from social marginal net product as two fundamental I elements that prevent
resources from flowing to their best uses.
Obstacles to free movement are composed of 'costs of movement and imperfect
knowledge'. For Pigou, costs of movement include 'not only the payments to the
agents who transport factors of production from one place to another ("promoters,
financing syndicates, investment trusts, solicitors, i bankers and others", but also
the imperfect divisibility of productive i resources'. De Serpa points out that
Pigou's costs of movement can be broadly interpreted to include 'transactions costs'
of every type (principal-agent, holdout and similar problems). In other words, it
would seem more correct, to consider Pigou's overarching category, "obstacles to
free movement," which encompasses both costs of movement and imperfect
knowledge, as the appropriate counterpart to today's "transactions costs."
When the assumption of no costs of movement is relaxed, Pigou modifies the
optimal solution to be one in which the MSNP of each resource diverges by less
than the cost of movement. Obviously, if the gain from driving two MSNPs to
equality is outweighed by the cost of the movement, then such a move is
inefficient. Thus, in the presence of costs of movement, a given configuration
might show some inequalities in MSNP yet may be the best arrangement, not
indeed absolutely, since if there were no costs, a better arrangement would be
possible, but relatively to the fact of the initial distribution and the existing costs of
movement.
Pigou also discussed second order conditions and considered the implications of
several local maxima. He offered the possibility that State action might be
"justfled" if it could 'yerk the industrial system out of its present poise at a position
of relative maximum, and induce it to settle down again at the position of absolute
maximum-the highest hill-top of all. Later, however, he adds that worries about
relative versus global maxima are a "secondary matter" (see Hla Myint, "Theories
of Welfare Economics", Harvard University Press, 1948, p. 128).
After discussing how imperfect knowledge can, like costs of movement, prevent
the attainment of an optimal resource allocation, Pigou turned to the welfare
Economics issue of divergence between private and social marginal net products. It
is important to note that Pigou sees obstacles to movement and divergence of
private and social net product as separate, but possibly concurrently operating
factors, either of which may be manipulated by the State in order to effect an
improved allocation of resources.
For Pigou, the problem facing society is one of allocating resources so that the total
value of output is maximized. He makes extensive use of the "$owing resources"
metaphor: A flowing stream of resources is continually coming into being and
struggling, so far as unavoidable costs of movement allow of this, to distribute
itself away from points of relatively low returns towards points of relatively high
returns. A clear signal of the performance of any observed configuration of
resources is the marginal social net product of each resource. There is an answer to
society's resource allocation problem and, thus, deviation from optimality cannot
only be judged inadequate, it can be improved.