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Economics Pigovian Theorem Questions

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Politics, Policy, and the Pigovian Margins Author(s): James M. Buchanan Source: Economica , Feb., 1962, New Series, Vol. 29, No. 113 (Feb., 1962), pp. 17-28 Published by: Wiley on behalf of The London School of Economics and Political Science and The Suntory and Toyota International Centres for Economics and Related Disciplines Stable URL: JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at , Wiley and The London School of Economics and Political Science are collaborating with JSTOR to digitize, preserve and extend access to Economica This content downloaded from on Mon, 21 Feb 2022 16:06:08 976 12:34:56 UTC All use subject to 1962] Politics, Policy, and the Pigovian Margins’ By JAMES M. BUCHANAN Since Sidgwick and Marshall, and notably since Pigou’s The Economics of Welfare, economists have accepted the presence or absence of external effects in production and consumption as a primary criterion of market efficiency. When private decisions exert effects that are external to the decision-maker,” ideal ” output is not obtained through the competitive organisation of economic activity even if the remaining conditions necessary for efficiency are satisfied. The market ” fails ” to the extent that there exist divergencies between marginal private products and marginal social products and/or between marginal private costs and marginal social costs. This basic Pigovian theorem has been theoretically refined and elaborated in numerous works, but its conceptual validity has rarely been challenged.2 The purpose of this paper is to bring into question a fundamental implication of this aspect of theoretical welfare economics, namely, the implication that externalities are either reduced or eliminated by the shift of an activity from market to political organisation. I shall try to show that this implication will stand up to critical scrutiny only under certain highly restricted assumptions about human behaviour in modern political systems. When these restrictive assumptions are modified, the concept of divergence between marginal” social ” product (cost) and marginal private product (cost) loses most of its usefulness.3 1 Although independently developed, this note draws upon and extends certain ideas that have been developed in a larger work undertaken in collaboration with Gordon Tullock. See, The Calculus of Consent (forthcoming). I should acknowledge Tullock’s indirect as well as his direct influence on the general ideas presented in this paper. 2The current work of my colleague, Ronald Coase, should be mentioned as a notable exception. Coase’s criticism of the Pigovian analysis concerns the implications of externality for resource allocation. For a preliminary statement of Coase’s position see his ” The Federal Communications Commission “, Journal of Law and Economics, vol. ii (1959), especially pp. 26-7. A more complete stateme appears in ” The Problem of Social Cost “, Journal of Law and Economics, vol. III (1960). 3 It should be noted that I shall not be concerned with the conceptual ability of welfare economists to make specific policy prescriptions, a problem that has been central to much of the modern discussion. It is now widely acknowledged that welfare economics, as such, can provide few guides to positive policy-making in a specific sense. But the analysis continues to be employed for the purposes of demonstrating the existence of market failure. If, as J. de V. Graaff suggests, ” laissezfaire welfare theory ” was ” largely concerned with demonstrating the optimal properties of free competition and the unfettered price system “, it is surely equally accurate to suggest that modern welfare theory has been largely concemed with demonstrating that these conclusions are invalid: that is, that competitive markets do not satisfy the necessary conditions for optimality. Graaff’s own work is, perhaps, the most elegant example. See his Theoretical Welfare Economics, 1957. (Citation from page 170.) 17 This content downloaded from on Mon, 21 Feb 2022 16:06:08 UTC All use subject to B 18 ECONOMICA [FEBRUARY ” Imperfection” and ” failure ” are descriptive nouns that tell something about the operation of the organism, the activity, or the organisation that is under discussion. These words, and others like them, are meaningful only if the alternative states of” perfection” and ” success ” are either specifically described or are assumed to be tacitly recognised by participants in the discussion. In the analysis of market organisation, the ” perfectly-working” order has been quite carefully defined. The necessary conditions for Paretian optimality are now a part of the professiolnal economist’s stock-in-trade, and these conditions are known to be satisfied only when all of the relevant costs and benefits resulting from an action are incorporated into the calculus of the decision-maker that selects the action. By contrast with this state of perfection, almost all ordinary or real-world markets are ” imperfect “, in greater or lesser degree. Most private decisions exert external effects. So far, so good. If this were the end of it, however, there would be little point in all of the effort. Economists must imply or suggest that the imperfectly-working organisation is, in fact, ” perfectible”: that is, they must do so if they are to justify their own professional existence. The analysis of an existing social order must, almost by the nature of science itself, imply that some 4′ improvement ” in results can be produced by changes that can be imposed on the variables subject to social control. Such improvements in the organisation of economic activity have, almost without exception, involved the placing of restrictions on the private behaviour of individuals through the implementation of some political action. The various proposals that have been advanced by economists are sufficiently familiar to make a listing at this point unnecessary. They run the gamut from the relatively straightforward tax-subsidy schemes of Marshall to the more sophisticated and highly intricate proposals for multi-part pricing, counter-speculation, collective simulation of ideal market processes, and many other intriguing methods designed to promote and to insure the attainment of economic efficiency. Indeed, economists tend to be so enmeshed with efficiency notions that it seems extremely difficult for them to resist the everpresent temptation to propose yet more complex gimmicks and gadgets for producing greater ” efficiency “. In almost every case, and often quite unconsciously, the suggested improvement is assumed to be within the realm of the genuinely attainable. And, if some sceptic dare raise a question on this point, the economist is likely to respond to the effect that his task is not that of the politician, that he does not appropriately concern himself with the political feasibility or workability of his proposals. But if political obstacles to realisation are not, in fact, discussed, the implication is clear that the proposals which are advanced are attainable as a result of some conceivable politicallyimposed modifications in the institutional framework within which decisions are made. It seems fully appropriate to charge welfare economists, generally, with an implicit acceptance of this implication This content downloaded from on Mon, 21 Feb 2022 16:06:08 UTC All use subject to 1962] POLITICS, POLICY, AND THE PIGOVIAN MARGINS 19 of their analyses. If this were not the case, it is difficult to see why, for example, William J. Baumol should have attempted to construct a theory of the state, of collective action, on the basis of the externality argument,’ why K. W. Kapp should have entitled his work, The Social Costs of Private Enterprise,2 and why Francis Bator should have called his recent summary analysis, ” The Anatomy of Market Failure “. 3 I shall not be concerned here with the analysis of market imperfection or failure, as such. The primary criticism of theoretical welfare economics (and economists) that is advanced in this note is that its failure to include analyses of similar imperfections in realistic and attainable alternative solutions causes the analysis itself to take on implications for institutional change that are, at best, highly misleading. To argue that an existing order is” imperfect ” in comparison with an alternative order of affairs that turns out, upon careful inspection, to be unattainable may not be different from arguing that the existing order is ” perfect “.4 The existence of demonstrated imperfection in terms of an unattainable state of affairs should imply nothing at all about the possibility of actual improvement to an existing state. To take this step considerably more is required than the preliminary analysis of” ideal output “. This is not to suggest, of course, that the preliminary analysis is not essential and important. In what follows I shall try to show that, with consistent assumptions about human behaviour in both market and political institutions, any attempt to replace or to modify an existing market situation, admitted to be characterised by serious externalities, will produce solutions that embody externalities which are different, but precisely analogous, to those previously existing. Indeed, the Pigovian analysis lends itself readily to the analysis of political imperfection. I In order to analyse political processes in a manner that is even remotely similar to the methods of economic theory, great simplification and abstraction are required. To the political scientist, accustomed as he is to working with more ” realistic” models of human behaviour, the simplified models with which the economist must analy political institutions can only seem to be grossly inadequate caricatures of the operation of complex organisational structures. This rather sharp methodological gap between the two social sciences incorporated in ” political economy ” provides an important reason why the 1 William J. Baumol, Welfare Economics and the Theory of the State, 1952. 2 K. W. Kapp, The Social Costs of Private Enterprise, 1950. Francis Bator, ” The Anatomy of Market Failure “, Quarterly Journal of Economics, vol. LXXII (1958), pp. 351-79. 4 Professor Frank Knight’s statement that ” to call a situation hopeless is equivalent to calling it ideal ” may be reversed. To call a situation ideal is merely another means of calling it hopeless: that is, not perfectible. This content downloaded from on Mon, 21 Feb 2022 16:06:08 UTC All use subject to 20 ECONOMICA [FEBRUARY political scientist has not filled, and could hardly be expected to fill, the analytical void left open by the incompleteness of welfare economics. I shall assume the existence of a community composed of separate individuals in which all collective decisions are reached by a voting rule of simple majority with universal suffrage. More complex, and realistic, models introducing representation, political parties, leadership, etc., could be employed but without significantly altering the conclusions reached. Almost any political order described by the term, ” democratic “, in the modern Western usage of this term may, for present purposes, be simplified into this extreme model of’” pure ” democracy. Characteristics of the political structure may modify the majority equivalent in the simple model That is to say, a model of two-thirds or three-fourths majority may be more appropriate to the analysis of some political structures? under certain conditions than the simple majority model. However, this quantitative variation in the voting rule equivalent does not affect the conclusions of this paper. Each particular rule, save that of unanimity, leads to conclusions that are identical to those reached in the simple majority model. The magnitude of the distortions produced is, of course, affected by the voting rule. The analysis here is concerned solely with indicating the direction of these effects, not with their magnitude. A distinction among the various” majority equivalents ” is not, therefore, necessary. In the first model, the orthodox assumptions of positive economics will be retained in so far as these concern individual motivation and action. Private individuals are assumed to be sufficiently informed and rational to conduct the required calculus and to reach decisions on the basis of a comparison of private costs and benefits at the relevant margins. No considerations of the” public ” or the” social ” interest are assumed to enter into this individual calculus within the relationship in question except in so far as this should coincide with individual interest. In determining his voting behaviour on each issue confronted by the group, the individual is assumed, quite simply, to act in that manner which he considers to advance his own interest. The model embodies, therefore, a rather straightforward extension of the be- havioural assumptions of orthodox economic theory, as a predictive, explanatory theory, to political choice-making. If no institutional restrictions are placed on this majority-rule model of the collective choice process, the characteristics of the ” solution” should be intuitively clear. The minimum-size effective or dominating coalition of individuals, as determined by the voting rule, will be able to secure net gains at the expense of the other members of the political group. These gains, secured through the political process, will tend to be shared symmetrically (equally) among all members of the dominant coalition. In the simple majority-rule model, this involves, in the limit, fifty plus per cent. of the total membership in the dominating coalition and fifty minus per cent. of the total membership in the losing or minority coalition. That such a solution will, in fact, tend to emerge This content downloaded from on Mon, 21 Feb 2022 16:06:08 UTC All use subject to 1962] POLITICS, POLICY, AND THE PIGOVIAN MARGINS 21 under the conditions of the model seems hardly subject to question. It is helpful, however, to note that such a solution, and only such, satisfies fully the Von Neumann-Morgenstern requirements for solutions to n-person games which, of course, all political” games ” must be.I It is useful to apply the familiar Pigovian calculus to this model of political behaviour. To the individual member of the effective majority, the political process provides a means through which he may secure private gain at the expense of other citizens. In determining the margins to which political activity shall be extended, the individual member of the dominant coalition will include in his calculus a share of the net benefits from public activity that will be larger than the offsetting individualised share or proportion of the net costs of the activity. In the calculus of the individuals effectively making the final collective decision, marginal private benefits will tend to exceed marginal social benefits and/or marginal private costs will tend to fall short of marginal social costs. The distortions produced are, therefore, precisely analogous, in opposing directions, to those present in the market solution characterised by the familiar Pigovian divergencies. In essence, the value of a political vote in this model lies in its potential power to impose external costs on other members of the group. Externalities must be present in any solution reached by the voting process under all less-than-unanimity rules. If the possible ” perfectibility” of market organisation is to be determined under these conditions, it is clearly necessary to compare two separate imperfections, in each of which significant divergencies of the Pigovian sort may exist at the individualised margins of decision-making. Since there will be nothing in the collective choice process that will tend to produce the” ideal” solution, as determined by the welfare economist, the presence or absence of a Pigovian marginal divergency in the market solution, even of sufficient seriousness to warrant concern, provides in itself no implication for the desirability of institutional change.2 II This conclusion holds so long as consistency in individual behaviour patterns over market and voting processes is retained, independently ‘J. Von Neumann and 0. Morgenstern, Theory of Games and Economic Be- havior, third ed., 1953, p. 264. 2 1 am not suggesting that deliberate exploitation of minority by majority need be the only purpose of collective activity, even in this polar model. The point is rather that, independently of the motivation for collective activity, majority-rule institutions of decision-making create opportunities within which Pigovian-like externalities may arise. There will, of course, arise situations in which the selfinterest of the individual dictates the collectivisation of an activity in order that the application of general rules to all members of the group can be effected. It is precisely in such cases that, conceptually, unanimity may replace majority rule as the decision device, and the propositions of modem welfare economics become fully appropriate. But so long as majority rule prevails, the ” political externalities ” are plesent, whether these be purposeful or ancillary to collective action designed to accomplish other ends. This content downloaded from on Mon, 21 Feb 2022 16:06:08 UTC All use subject to 22 ECONOMICA [FEBRUARY of the specific motivation The oversimplified model of Part I may be criticised on the grounds that individuals do not act in the way postulated: that is, they do not follow their own interests when they participate in the formation of social decisions for the community. Several responses might be advanced to such criticism, but it is not the purpose of this note to defend the validity, methodologically or otherwise, of the self-interest assumption about behaviour. The relevant response to the charge of unrealism at this point is surely the frank admission that, of course, individuals do not always act as the model of Part I postulates. A model is a construction that isolates one element of behaviour and, upon this, the analyst may erect conceptually refutable hypotheses. The model of majority rule in the simple pure democracy is not different in this respect from the competitive model of economic theory. Both models isolate that part of human behaviour that does reflect the rational pursuit of private gain by individuals in particular institutional relationships and both models fail to the extent that individuals do not, in fact, behave in this fashion in the relationships under consideration.’ Any number of models of individual behaviour can be constructed. The only real limitation lies, ultimately, in the testing of the predictions made. It will not be necessary, however, to develop any large number of additional and complex models to illustrate the central point of this note. One additional extremely simple model will suffice for this purpose. In this second model, I shall drop the assumption that individuals, in both their market and in their political behaviour, act in pursuit of their own narrowly defined self-interest. Instead, I now postulate that individuals act in the other extreme: I assume that each individual, in all aspects of his behaviour, tries to identify himself with the community of which he is a member and to act in accordance with his own view of the overall ” public ” or” social ” interest. Each member of the group tries to act in the genuine interest of the whole group as this is determined for him through the application of some appropriately-chosen Kantian-like rule of action. The results are again almost intuitively clear. Since each member of the group acts on the basis of identifying his own interest with that 1 Care must be taken to distinguish between the self-interest assumption, as the basis for a ” logic of choice” and the self-interest assumption as the basis of a predictive, explanatory theory of human action. In the first sense, all action of individuals must be based on self-interest, and it becomes meaningless to discuss alternative models of behaviour. The pure logic of individual choice is not without value, but it should be emphasised that the argument of this paper employs the second version of the self-interest assumption. If conceptually refutable hypotheses are to be developed, the behaviour of choice-making individuals must be externally observable in terms of measurable criteria of choice. In the market relationship, this degree of operational validity is often introduced by stating that the minimal requirement is that individuals, when confronted with choice, choose ” more ” rather than” less “. But” more” or ” less” take on full operational meaning only when they become measurable in something other than subjective utility of the choosers. The” measuring rod of money” must be allowed to enter before the generalised logic of choice can produce even so much as the first law of demand. This content downloaded from on Mon, 21 Feb 2022 16:06:08 UTC All use subject to 1962] POLITICS, POLICY, AND THE PIGOVIAN MARGINS 23 of the larger group, no deliberate exploitation of minority by majority can take place through the political process regardless of the voting rule that is applied. Differences that may arise, and which must be resolved by voting, stem solely from differences in individual conceptions of what the group interest on particular issues is. The Pigoviantype marginal divergencies between private and social costs or benefits disappear from the individual calculus in this model of behaviour. It is in application to market, rather than to political, behaviour that this model seems somewhat unorthodox. Under the assumptions of the model, the individual in his market behaviour will also try to identify himself with the group as a whole and to act in accordance with what he considers to be the ” public” interest. If his chimney pours out smoke that soils his neighbours’ laundry, he will assess these costs as if they were his own in reaching a decision concerning the possible introduction of a smoke-abatement device. The familiar analysis of welfare economics simply does not apply. Each individual decision-maker does, in fact, attempt to balance off” social ” benefits against ” social” costs at the margin. While, as in the collective sector, differences may arise among members of the group concerning the proper definition of social benefits and social costs, these differenc cannot be interpreted in the standard way. The Pigovian divergence between marginal private product and marginal social product disappears in both the market and the political organisation of activity in this universal benevolence model. The policy conclusions are, however, identical with those reached from the use of the extreme self interest model. If chimneys smoke, or if the majority is observed to impose discriminatory taxes on the minority, these facts carry with them no implications for institutional changes. In this case, they must represent the decision-makers’ estimates of genuine community interest. Neither ” real” nor ” apparent” externalities can, in themselves, provide grounds for suggesting organisational changes. III From the analysis of these two extreme and contrasting models of human behaviour, the inference is clear that so long as individuals are assumed to be similarly motivated under market and under political institutions there can be no direct implications drawn about the organisational structure of an activity on the basis of a Pigovian-like analysis of observed externalities. The orthodox implication of Pigovian welfare economics follows only on the assumption that individuals respond to different motives when they participate in market and in political activity. The only behavioural model appropriate to the Pigovian analysis is that which has been called” the bifurcated man “. Man must be assumed to shift his psychological and moral gears when he moves from the realm of organised market activity to that of organised political activity and vice-versa. Only if there can be demonstrated 
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