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.