Before you read on: a factory's smoke harms people living nearby. What did Arthur Pigou propose?
Pigou argued that a tax equal to the harm makes the polluter count the damage it does to others.
- Lived
- Born 18 November 1877 in Ryde, Isle of Wight; died 7 March 1959 in Cambridge
- Nationality
- British
- Work
- Fellow of King's College, Cambridge, from 1902; professor of political economy at Cambridge, 1908 to 1943, succeeding Alfred Marshall
- Key works
- Wealth and Welfare (1912), The Economics of Welfare (1920), The Theory of Unemployment (1933), Employment and Equilibrium (1941)
- School
- Neoclassical economics, in the Cambridge tradition Marshall founded
What Pigou was reacting to
Pigou was one of Alfred Marshall's best students, and in 1908 took over his chair at Cambridge. Marshall had described costs and benefits that land on people outside a deal, now called externalities.
Pigou built that point into a study of welfare, meaning how well off a society is. He asked when a free market leaves a society worse off than it could be. A firm weighs only its own costs, so the harm it does to others never enters its sums.
Pigou's key ideas
Can you name Pigou's four key ideas?
Private cost is what the decision maker pays. Social cost adds costs that fall on others, called an externality. Pigou argued that, left alone, markets make too much of goods that harm outsiders and too little of goods that help them.
Can you think of an example?
A haulage firm pays for diesel and drivers, but not for the fumes its lorries add to a town.
A tax on a harmful activity, set at about the harm each unit does, so the person causing it bears the full cost. A subsidy rewards a helpful activity by about the benefit others get.
Can you think of an example?
If each tonne of a plant's smoke does £40 of harm, a £40 tax per tonne makes the plant count it. Vaccination can be subsidised, since each person vaccinated also protects others.
Charging different prices for the same good. First degree: each unit sells at the most the buyer would pay. Second: the price depends on quantity bought. Third: each group of buyers the seller can tell apart pays its own price.
Can you think of an example?
A railway sells the same seat more cheaply to holders of a student or senior railcard. That is the third degree, the kind Pigou thought mattered most in practice.
If prices fall in a slump, the money people hold buys more, so they feel richer and spend more. Pigou argued in the 1940s that, through this real balance effect, a fully flexible economy returns to full employment unaided.
Can you think of an example?
Prices fall by 10 per cent, so a household's £5,000 of savings buys about 11 per cent more, and it may spend some.