Case for Improving upon the Market System
Unlike the "optimistic followers" of the "classical school" who believed that markets would "natural!yn or "automatically" produce a socially optimal result "if only Government refrains from interference,'' Pigou pointed out that "even Adam Smith himself" recognised the need for "an organised system of civilised government and contract law." So, the invisible hand, the spontaneous order and the self-organised, emergent patterns that are touted as . congruent with a socially optimal configuration are not a routine outcome of every decentralised system. On the contrary, human institutions and rules have evolved "to the end of directing self-interest into benejcial channels." There is no reason to reject out of hand "Government interference" because Government is already intimately involved in the system.
For Pigou, Government sets the rules to which the agents respond. He advocated State action in selective and studied ways and did not propose direct government control of individual agents; instead, he saw government providing the necessary incentives, carrots or sticks that would improve upon the current allocation of resources. This implies Pigou's continued reliance on Approach individual ownership and control of resources by self-interested agents.
Returning to his framework of deviations from an ideal, global optimum being caused by obstacles to movement and divergences of private from social product, he argued that decreases in either of these factors would improve economic welfare. In successive chapters in The Economics of Weyare, he described how decreases in obstacles to movement due to improved information or lower costs of movement could be effected by manipulating the rules of the market game. For example, Pigou sees the development of stock exchanges as an ingenious way to make capital more finely divisible. This lowers the costs of movement of capital because it can flow more perfectly, in Pigou's metaphor, 'into ever-smaller streams and tributaries'. But with regard to inefficiency caused by imperfect knowledge, Pigou cites securities regulations as an appropriate means of combating fraud and the associated misallocation of resources because they check the fraudulent ! exploitation of incompetent investors by dishonest professionals and thus tend to diminish the range of error to which the general mass of operative forecasts made in the community is liable. His view of a stock exchange and the government regulatory apparatus surrounding it shows how Pigou saw the market system as a decentralised group of self-interested resource owners making decisions about the use of their factors of production under a set of rules designed to channel those resources to their highest valued uses.
When Pigou turns his attention to the second main category that leaves a socially inefficient allocation, the divergence of private and social returns, he simply applies the same set of ideas. Subject to costs of movement, self-interest will tend to bring about equality in the values of marginal private net products of resources invested in different ways. But it will not tend to bring about equality in the values of the marginal social net products except when marginal private net product and marginal social netprgduct are identical. When there is a divergence between these two sorts of marginal net products, self-interest will not, therefore, tend to make the national dividend a maximum; and, consequently, certain specific acts of interference with normal economic processes may be expected, not to diminish, but to increase the dividend.
Uncompensated services or disservices cause divergences between private and social product that are "bound to lead to maladjustments." In such cases, it is always possible, on the assumption that no administrative costs are involved, to correct them by imposing appropriate rates of tax on resources employed in '. uses that tend to be pushed too far and employing the proceeds to provide bounties, at appropriate rates, on uses of the opposite class.
There is no need to go into further detail because in the discussion on 'externality' in coming units, we shall explore the conditions under which "appropriate" tadsubsidy schemes will correct the "maladjustment." The point here, however, continues to be that Pigou saw tadsubsidy manipulations as one way to improve the incentive structure of the system. Agents maintain control of their resources and follow their self-interest in generating a configuration of resource uses. For this reason, taxes and subsidies are merely one of a myriad of incentive-altering options available. Pigou cites penalties in contracts or threat of lawsuit, for situations in which the parties are in dirqct contact, as other ways of closing the gap between private and social product.
When it is difficult to extract payment for services or damages to other parties, Pigou sees the Government as the means by which the rules can be rewritten to better align private and social marginal net products. In the case of patents, Pigou pointed out that, "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, but they do direct it into channels of general usefulness."
In some cases, the divergence of private and social product may be so pathological, e.g., fraudulent advertising or adulterated products, because from the first dose the MSNP is negative, that absolute prohibition is required. And, finally, when other remedies have been exhausted, there may be certain cases in which direct government intervention, "either by the exercise of control over concerns left in private hands or by direct public management" may be necessary in order to maximise the national dividend. In these extreme cases, Pigou warns that we should not proceed, until we have considered the qualifications which governmental agencies may be expected to possess for intervening advantageously. It is not sufficient to contrast the imperfect adjustments of unfettered private enterprise with the best adjustment that economists in their studies can imagine. For, we cannot expect that any public authority will attain, or will even whole-heartedly seek, that ideal. Such authorities are liable to ignorance, to sectional pressure and to personal corruption by private interest.
Consistent with his focus on maximising the national dividend, Pigou warned against blind application of every conceivable rule that could lower the obstacles to movement or close the gap between private and social marginal net product. The gains from the proposed incentive must be weighed against the costs of implementation: "Of course, in real, life considerable administrative costs would be incurred in operating [tadsubsidyl schemes of this kind. These might prove so large as to outweigh the benefit even of the optimum scheme, and, a fortiori, of the others". Pigou's view of the economic world has self-interested individuals operating within a given system of institutions and rules of which the Government is a major part. The system works fairly well, according to Pigou, "in the main body of industries," but can be improved upon by decreasing obstacles to movement and divergences between private and social cost. Government is responsible, not for the direct control of resources, but for providing an environment, which ensures that the free play of self-interest will yield the maximum total value of output. Seen in this context, Pigovian tadsubsidy , proposals are merely one of many devices that Government might use, in addition to many already in effect, in order to maximise economic welfare by improving the incentive mechanisms operating in a completely unfettered market. Thus, Pigovian analysis constitutes the foundation of welfare ' economics, which inspired the modem economists to comprehensively elaborate on the subject in succeeding periods.