Early Twentieth Century

The first point to recognize is that twentieth-century developments in the Cambridge approach to welfare built upon the foundations that were laid in the nineteenth century by Sidgwick, Foxwell, Marshall, and Neville Keynes. The influence of Sidgwick and Marshall is common knowledge, but Foxwell’s interest in fluctuations in employment and prices as well as Neville Keynes’s distinction between ‘truth’ and ‘light’ and his associated articulation of the difference between the science and art of economics are all too evident in twentieth-century developments.

Pigouvian Market Failure and Welfare Analysis

Arthur Cecil Pigou first addressed welfare issues related to the notion of utility with reference to Marshall’s concept of surplus, discussed in his ‘Some Remarks on Utility’ (Pigou 1903), where it is argued that an individual’s scale of utilities could only be assumed as constant if all other consumers keep unaltered their spending on the same commodity, and in ‘Producers’ and Consumers’ Surplus’ (Pigou 1910 [2002]), in which the technical apparatus for the analysis of public and social costs and benefits is for the first time clearly articulated. These ideas, and others that emerged under the influence of Sidgwick (see O’Donnell 1979), found their way into Pigou’s first major contribution to welfare economics, Wealth and Welfare, originally published in 1912 and later transformed and extended as The Economics of Welfare (Pigou 1932), which went through four editions in his lifetime (Collard 2014; McLure 2012). Like Marshall, Pigou was mainly concerned with the narrower and material part of welfare where money was the measuring rod of utility, as this provided a clear basis for careful deliberation about the role of public agents in correcting market failures. According to this approach, Pigou advanced three fundamental criteria to further economic welfare: (1) an increase in the national dividend without reducing the absolute share of each group; (2) a reduction in income inequality, everything else remaining unaltered; and (3) a decrease in the variability of the national dividend, especially in that part accruing to poorer families (Pigou 1912: 20-32).^[1]

As regards the first criterion, Pigou’s focus was on the national dividend, a notion that derived from Marshall but was clarified by Pigou after reflecting on Irving Fisher’s views on the issue. However, it is sometimes seen as indicative of a certain distance between Pigou and Marshall emerging because the focus on variation in national dividend allowed Pigou to largely set aside Marshall’s surplus analysis.

In Pigou’s view, an increase in the national dividend would not, a priori, have a detrimental effect on the share accruing to labour compared to non-labour categories of income, so that total utility would most likely increase as a consequence of an expansion in the national dividend. The reasons he presented in support of this belief were threefold. First, an increase in the capital stock (‘waiting’), requisite for the growth in wealth, under the constancy of technical conditions, would diminish the reward of capital with respect to labour. Second, in the presence of a gain in productivity due to some innovation, the most unfavourable scenario would be the one of labour-saving devices. Even in this case, in spite of its negative short-run effect on wages, the parallel increase in non-labour income would occasion a faster accumulation of capital in the long run, bringing down profits and restoring the distributive balance in the economy. Lastly, Pigou held that since most innovations affect goods consumed by working families, this continuous process would end up increasing their real earnings (Pigou 1912: 78-95).

As a general rule, Pigou indicated that the pursuit of self-interest would lead to the highest possible national dividend when net private returns attained a common level across economic sectors. This general conclusion, however, is significantly altered when the marginal social net product resulting from the action of private agents, rather than the marginal private net product, is given its due weight in a world dealing with welfare propositions. This fundamental concept within Pigou’s theory of welfare concerns the aggregate contribution to the national dividend by the addition of a unit of capital in some line of production, account being taken of all the effects of the expanded activity on other members of the community besides the owners of the invested resources. These resulting effects comprise what the literature has designated as externalities, which is considered to be the ‘single most enduring contribution’ of Wealth and Welfare to the analysis of the deficiencies affecting a competitive economy (McLure 2012: 103). Pigou’s own definition, formulated in The Economics of Welfare, reads as follows:

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, as will be explained more fully in a later chapter, that costs are thrown upon people not directly concerned, through, say, uncompensated damage done to surrounding woods by sparks from railway engines (Pigou 1932: 134-135).

In some instances, as Pigou explained, a discrepancy between these two economic measures might demand some kind of state intervention to constrain or stop the unchecked action of self-interest in order to advance society’s material welfare. Situations like these could arise in certain types of long-term contracts as, for instance, when the farmer, before returning land to its owner, takes out from it more capital than he actually invested. Also, discrepancies between private and social net returns involving third parties would require some form of public action, generally by favouring or punishing particular forms of investment. Taxes also might be used to discourage building in crowded areas or bounties granted to agriculture in order to keep families in the countryside. Auctioning licences to conduct public services could be a convenient way, advised Pigou, of handling natural monopolies once periodic revision of regulations were specified in order to adjust them to changing market conditions (Pigou 1912: 246—289). Aslanbeigui and Oakes (2012), though, underline the point that care must be taken when generalizing Pigou’s position on the application of his welfare theory, including the notion of externalities derived from the distinction between private and social costs, to public policy problems. The various editions of The Economics of Welfare raise many complications with regard to policy options, including the possibility of entering into private contract arrangements and, as a result, the appropriate welfare-enhancing policy responses should be arrived at on a case-by-case basis.

Moving to the second criterion of welfare, Pigou drew on the law of diminishing utility, predicated on interpersonal comparisons of utilities, and the declining propensity to consume, to assert that income redistribution favouring the poor would in fact increase the well-being of society. In the presence of these conditions, as he stated, ‘it is evident that any transference of income from a relatively rich man to a relatively poor man of similar temperament, since it enables more intense wants to be satisfied at the expense of less intense wants, must increase the aggregate sum of satisfaction’ (Pigou 1932: 89). In terms of practical policies, Pigou investigated the pros and cons of a system of mutual insurance against sickness, unemployment and other hazards, redistribution of the national dividend from the rich to the poor via wage adjustments and taxation, and, lastly, the establishment of a national minimum that provides for accommodation, food, sanitary convenience, health, and even some leisure (Pigou 1912: 346-398).

In the 1930s, Pigou’s approach to welfare economics endured a serious assault on its very foundations by Lionel Robbins (1932) and John Hicks (1939), who deemed unscientific and meaningless efforts at comparing the utility of different individuals (see also Aslanbeigui 1990).^[2] Impervious to these criticisms, Pigou held to his convictions. In his later years, he replied that such a procedure was crucial to economics, since this assumption made it possible to devise concerted actions designed to improve the welfare of nations: ‘In all practical affairs we act on that supposition. We cannot prove that it is true. But we do not need to do so ... The burden is the other way. To deny this is to wreck, not merely Welfare Economics, but the whole apparatus of practical thought’ (Pigou 1951: 292).

After the Second World War, Pigou’s welfare theory was the target of another serious, and largely successful, challenge by Ronald Coase (1960), who argued that instead of taxing the causative agent in situations of harmful collateral effects from private actions, the parties involved would be able to settle their differences in monetary terms when property rights were well defined and transactions costs low (see also Medema 2009: 101-124).

• [1] Pigou’s third criterion of welfare was dropped in subsequent editions of the book but received a comprehensive treatment in Industrial Fluctuations (Pigou 1927), where businessmen’s errors of forecast due toalternating waves of optimism and pessimism were posited as the main cause of industrial cycles.
• [2] When reassessing the status of welfare economics in the 1970s, Hicks (1975) retracted his former position, accepting that useful theory must be normative, as Pigou had always maintained.