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Pigovian Welfare Economics

 Pigovian Welfare Economics and Externalities

Meaning of Welfare Economics

            According to Pigou, welfare resides in a man’s state of mind or consciousness which is made up satisfactions or utilities. The basis of welfare hence is necessarily the extent to which an individual’s desires are met. Social welfare is regarded as the summation of all individual welfares of society. Since general welfare is a very wide complicated and impracticable notion, Pigou delimits the range of his study to economic welfare. He therefore, defines economic welfare as “that part of social welfare that can be brought directly or indirectly into relation with the measuring rod of money.” Thus economic welfare, in the Pigovian sense, implies the satisfaction of utility derived by an individual from the use of exchangeable goods and services.

Pigovian Welfare Conditions

  1. The first condition states that welfare is said to increase when national income increases. Given the same tastes and income distribution, an increase in the national income represents an increase in welfare. Pigou contends that in most cases the national income would increase even though the disutility of work also increases.
  1. Second, for welfare maximisation the distribution of the national income is equally important. It national income remains constant, transfers of income from the rich to the poor would improve welfare. According to Pigou such transfers mean less to the wealthy than to poor, as a result the economic position of the latter is raised. This welfare condition is based on the dual Pigovian postulates of ‘equal capacity for satisfaction and diminishing marginal utility of income.’

Pigou argues that different people derive the same satisfaction out the same real income and that “People now rich are different kinds from the people now poor having in their fundamental nature greater capacities for enjoyment.”

Causes of Divergences Between Private and Social Costs and Returns

According to Pigou, it is self-interest that leads to the equality between private and social costs and returns. But certain business practices tend to foster rigidities and create divergences between private and social costs and returns which can be widened by variations in demand, tastes, cyclical fluctuations, war and the rise of new industries.

The private product diverges from the social product due to the existence of external economies or diseconomies thereby leading to divergences between private and social costs and benefits.

  1. External Economies of Production – When some firm renders a benefit or cost of a service to other firm without appropriating to itself all the benefit or cost of the service, it is an external economy of production. External economies of production may arise when the expansion of a firm makes it possible for other firms in the industry to obtain their inputs like rained labour force, raw materials etc. at low rates. In all such cases, social marginal benefits exceed the private marginal benefits and the private costs exceed the social costs. For the expanding firm does not receive any remuneration for the costs incurred by it and the benefits which its has conferred on others.
  1. External Diseconomies of Production – External diseconomies of production also lead to divergences between private social costs and returns when the production of a commodity or service by a firm affects adversely other firms in the industry. Prof. Pigou’s example of air pollution explains these divergences. Suppose a factory is situated in a residential or populated area and it emits smoke. The smoke from the factory soils clothes, cleaning of house hold articles and rooms and cleaning and painting of buildings and enhanced medical expenses.
  1. External Economies of Consumption – External economies of consumption arise from non-market interdependences of the satisfactions enjoyed by different consumers. An increase in the consumption of a good or service which affects favourably the consumption patterns and desires of other consumers is an external economy in consumption. When an individual installs a TV set, the satisfaction of his neighbours increases when they and their children view the various programmes.
  1. External Diseconomies of Consumption – When the consumption of a good or service by one consumer confers a disadvantage or affects adversely the consumption patterns and desires of other consumers, it is an external diseconomy of consumption. Diseconomies of consumption especially arise in the case of dress fashions and articles of conspicuous consumption.
  1. The case of Public goods – Another cause of divergence between private and social benefits is the case of public goods which Pigou completely ignored. Prof. Baumol defines a public good as “one whose consumption by one individual does not reduce its utility to any other individual.” The consumption of public goods is joint and equal. Certain services provided by the government are public goods such as national defence, public safety, courts for the administration of justice, disease control etc. the benefits of public goods are indivisible.

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