THE MYTH OF SOCIAL COST.pdf - Institute of Economic Affairs

SOCIAL COST
factory owner's self-employed efforts. The total gain reaches a
maximum of £56 at 8 units of input, where the value of
private marginal product equals the marginal private cost
(^12=^12). The postulated motive of maximisation (subject
to constraints) dictates that the factory owner will operate at
this quantity of output. The explicit constraints here include
the cost of inputs, the diminishing returns, and the state of
technology. Other relevant constraints are only implicit: that
the prices of input and output are determined costlessly in the
markets; that the producer has no difficulty in finding and
negotiating with his customers; that the workers, once contracted,
will work exactly as agreed; and the list may go on to
include the weather, health, and the like.
The values of economic 'waste' are listed in Column 5. These
values represent the losses in total gains at different amounts of
production. 1 Thus, if input is zero and therefore output is also
zero, the maximum total gain of £56 which could be obtained
by employing 8 units of inputs will now be lost and hence
wasted; at 3 units of inputs, the total gain of £36 is less than
the maximum gain of £56 by a waste of £20. What is a gain
from one view is a waste from another view: these are two
sides of the same coin. Thus constrained maximisation by the
factory owner produces a situation where economic waste is
zero. The efficiency of using 8 units of input may be interpreted
in another way. Column 2 represents the maximum values the
customers are willing to pay for the marginal shoe outputs
generated by the use of marginal inputs; Column 3 represents
the maximum values of alternative production forgone in employing
the marginal inputs for shoe production. When these
two values are equated at the margin, it becomes impossible to
re-allocate any input resource in shoe production so as to
benefit both the customer and the factory owner. The Pareto
condition is thus satisfied.
Pigou's central thesis: the polluting factory
We now introduce the central thesis of Pigou's argument.
Suppose that the factory emits smoke which pollutes the environment,
thereby inflicting damage on the neighbourhood
which is not subject to contracting; thus no transaction takes
1 There are other measures of economic waste if the analysis is broadened to
include other sectors of the economy, but this expansion is not yet important in
this Paper.
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