The Efficiency of Competition as an Allocator of Resources: I. External Economies of Production

Abstract

Marshall and, later, Pigou were the first to question the competitive allocation of resources, arguing that “increasing-cost” industries produce beyond the optimal point and that the outputs of “decreasing-cost” industries fall short of the optimum. They proposed, on this basis, a system of taxes on the former group of industries, subsidies on the latter group. The criticism of Young, Robertson, and Knight almost completely destroyed the argument. At present, only when “external economies” (and “diseconomies”) play a part in determining the competitive supply function is it admitted that interference with the competitive allocation of resources may be justified.Our purpose is to present diagrammatically the case for interference with the competitive allocation of resources when external economies of production are present. With the aid of three significant cross-classifications of economies we are able to arrive at several conclusions with policy implications of some importance. In particular, we seek to show that only under very special conditions will the incentive provided by subsidies restore the optimal allocation of resources. Section I is concerned with the definition of terms. Sections II to V provide the diagrammatic analysis, section VI states the policy implications of our results. Section VII briefly summarizes our earlier conclusions.Throughout the discussion abstraction is made from any special disadvantages of government intervention. No consideration is given to the danger of bureaucratic corruption nor to the possibility that sectional interests will be advanced at the expense of the “general welfare.” Further, all problems of incentive attendant upon government intervention are neglected. Finally, the cost of collecting the revenue from which any net subsidies are to be paid is ignored.