Welfare Economics and Imperfect Competition

Among Marshall’s pupils, two emerged above the others: John Maynard Keynes, to whom the next chapter is devoted, and Arthur Cecil Pigou (1877-1959). Six years older than Keynes, Pigou was chosen by Marshall in 1908 as his successor to the economics chair in Cambridge. He supported an orthodox version of the Marshallian theory and was known for the stimulus given to welfare economics through recourse to the notion of external economies and diseconomies illustrated by Marshall in the Principles.[1]

Let us recall that we have external economies (or diseconomies) whenever an economic activity - be it production or consumption - generates indirect effects on third parties, from which they reap a benefit (or suffer a loss), without having participated in the decision of the economic agent directly concerned. When the (assumedly rational, actually selfish) economic agent decides how much to produce and consume, s/he considers the effects of her/his action that directly concern her/him but not the effects on others; this implies that too little is consumed and produced of what generates external economies and too much of what generates external diseconomies. Hence the desirability of public intervention in the economic field, aiming at stimulating with subsidies the former kind and deterring with taxes the latter kind of activity. Welfare economics is precisely the field of analysis that studies the nature and measure of such interventions, designed to drive the economy towards optimal situations for the community as a whole. Pigou (1912) used the analytical tool of consumer’s surplus, designating the gain of total utility obtained by the buyer from exchange thanks to the fact that, while for the last (infinitesimal) dose purchased the price paid corresponds to the additional utility obtained (marginal utility), the utility of the preceding doses was greater than the price paid. The difference between these two magnitudes (measured in terms of money, under the assumption of constant marginal utility of money), added up for all units purchased, gives the consumer’s surplus. The choice between different situations is derived by comparing the consumer’s surplus realised within the economy in different cases: this is in fact the road taken by welfare economics.[2]

In comparison to the traditional marginalist notion of perfect competition, in which the firm is too small to be able to influence with its behaviour the determination of the price, Marshall appeared to assume a margin of freedom of firms in determining their behaviour. This idea was developed in Joan Robinson’s (1933) theory of imperfect competition, according to which the consumers do not consider as identical the products of different firms; as a consequence each firm faces a decreasing, and not a horizontal, demand curve, so that within a certain range it is able to increase the price of its own product without losing all its clientele. In a situation of this kind, the equilibrium of the firm is possible even under conditions of constant or slowly decreasing costs when the quantity produced increases.

Joan Robinson’s book remained within the traditional Marshallian framework, relying on the notions of the firm and the industry. The work by Edward Chamberlin (1899-1967) on monopolistic competition, published in the same year (1933), in stressing the margins of freedom enjoyed by each firm because of the widespread presence of market imperfections, remarked that in this way the very notion of industry loses meaning, since its boundaries had been established artificially on the basis of the assumption of homogeneity of the product of firms included in the same industry. In the place of group of firms (the industry) producing an identical commodity, we now have a continuum of qualitative variations among products of different firms. In this respect, Chamberlin’s contribution represented a shift in the direction of the modern axiomatic theory of general economic equilibrium, in which each economic agent represents a case in itself.

  • [1] Pigou was also known for his defence, against Keynes’s criticisms, of the idea ofa tendency to full employment equilibrium under perfect competition, through thePigou effect, later embodied in Modigliani’s (1944,1963) neoclassical synthesis discussedlater. This adjustment mechanism is set in motion by the positive impact that the pricereduction caused by increasing unemployment via the fall in money wages has on the realvalue of money balances held by families. Thus, the increase in the real value of thewealth offamilies brings out an increase in consumption and hence in aggregate demand,leading to a fall in unemployment. Cf. Pigou 1933, 1950.
  • [2] Because of the assumption of constant marginal utility of money and of the assumptionthat the demand curve does not shift when the quantity produced or consumed changes,the notion of consumer’s surplus is exclusively applicable in the context ofpartial analysis(in which it had been originally formulated by Marshall). Another dubious aspect ofwelfare economics concerned the issue of interpersonal comparability of utilities, whichwas essential for determining the compensation to be offered to render a change acceptable to the agents who bear a loss while others obtain an advantage.
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