Oxford University Press

External Economies of Scale and Competitive Equilibrium
Author(s): John S. Chipman

Source: The Quarterly Journal of Economics, Vol. 84, No. 3 (Aug., 1970), pp. 347-385
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THE
QUARTERLYJOURNAL
OF ECONOMICS
Vol. LXXXIV August 1970 No. 3
EXTERNAL ECONOMIES OF SCALE AND

COMPETITIVE EQUILIBRIUM *
JOHN S. CHIPMAN
I. Introduction,347.-Il. Productionfunctionsand producerequilibrium,

352.- III. Demand functions and supply of labor, 356.-IV. Equilibrium
under laissez-faire,358.-V. Ideal output, 362.- VI. Taxes, bounties, and
optimalityrules,366.-VII. Analysisin terms of consumers'surplus,373.-
VIII. Dynamicstability of the adjustmentprocess,381.
I. INTRODUCTION
Are increasing returns to scale compatible with perfectly com-

petitive equilibrium? This was once a lively subject of debate. The
debate appears to have petered out in the 1930's, with nobody the
apparent winner. That this was the outcome seems evident from
later writings of some of the participants. Thus, Sir Dennis Robert-
son presented in 19571 an account which was substantially unaltered
from his contribution to the 1930 Symposium on Increasing Re-
turns,2 supporting the compatibility of increasing returns with per-
fect competition. On the other hand, Sir Roy Harrod in 1967 was
able to state flatly, without any qualification as to whether econ-
omies were internal or external, that: "Increasing returns can, of
course, only occur if competition is less than perfect." 3 In the
* I am much indebted to Kenneth Arrow and Frank Hahn, whose inci-
sive criticisms have contributed much to the crystallization of the ideas pre-
sented in this paper; I am grateful as well to Gottfried Haberler for many
penetrating comments. Thanks are due also to Martin Bronfenbrenner, Abba
Lerner, Edwin Mills, Peter Newman, and Paul Samuelson for suggestions,
and to K. S. Kim for eliminating numerous typographical errors in the orig-
inal typescript.
This work was supported in part by NSF Grant No. G-24027.
1. Sir Dennis H. Robertson, Lectures on Economic Principles (London:
Staples Press, 1957), Vol. I, Ch. IX, pp. 114-23.
2. "The Trees of the Fcrest," Economic Journal, Vol. 40 (March 1930),
pp. 80-89.
3. Roy F. Harrod, "Increasing Returns," in Monopolistic Competition
Theory: Studies in Impact; Essays in Honor of Edward H. Chamberlin, ed.

348 QUARTERLY JOURNAL OF ECONOMICS
contemporary international trade literature, some authors maintain

that perfect competition can prevail under conditions of increas-
ing returns, provided the economies of scale are external to in-
dividual firms; 4 whereas others deny the compatibility of economies
of scale with perfect competition under any circumstances, and with
equal confidence.5
A history of the debate was covered in my survey of interna-
tional trade theory,6 and need not be repeated. However, it is in-
structive to ask why the debate petered out so inconclusively. Most
likely, the reason is that the weight of opinion was on the side of the
skeptics, led by Piero Sraffa, and consequently the Marshallian
theory gave way to the new theories of imperfect and monopolistic
competition. Since these new theories could handle internal as well
as external economies of scale, the old issue no longer seemed rele-
vant. Unfortunately, however, to this day the theory of monopolis-
tic competition remains logically incomplete, since it has yet to be
formulated within a consistent general equilibrium framework.
The purpose of the present paper is to formulate, under some
very simplified assumptions, a general equilibrium model of perfect
competition in which firms may operate under increasing, constant,
or decreasing returns to scale. While the assumptions are very
stringent - a single factor of production (labor), production func-
tions homogeneous of constant degree, uniform expenditure pro-
portionality in consumption, no intermediate products - they per-
mit the mathematical analysis to be carried out on an elementary
level throughout, so that the logic of the argument is not obscured
by inessential details of a technical nature; they also make possible
a direct comparison with Marshall's original treatment, and it will
Robert E. Kuenne (New York: John Wiley & Sons, Inc., 1967), pp. 63-76.
The passage quoted occurs on p. 74.
4. E.g., James Edward Meade, A Geometry of International Trade
(London: George Allen & Unwin Ltd., 1952), p. 33.
5. Cf. R. G. Lipsey, "The Theory of Customs Unions: A General Survey,"
Economic Journal, Vol. 70 (Sept. 1960), 496-513 (reprinted in A. E. A.,
Readings in International Economics, Homewood, Ill: Richard D. Irwin,
Inc., 1968, pp. 261-78). He states on pp. 511-12 (p. 277 of the reprinted ver-
sion): "It is, of course, well known that unexhausted economies of scale are
incompatible with the existence of perfect competition, but it is equally
well known that unexhausted economies of scale are compatible with the
existence of imperfect competition as long as long-run marginal cost is de-
clining faster [sic] than marginal revenue."
6. J. S. Chipman, "A Survey of the Theory of International Trade:
Part 2, The Neo-Classical Theory," Econometrica, Vol. 33 (Oct. 1965), pp.
685-760. The section on external economies occurs on pp. 736-49.
7. Some of the difficulties encountered in attempts to do so have been
pointed out by Jacob Marschak in "The Rationale of the Demand for Money
and of 'Money Illusion,'" Metroeconomica, Vol. 2 (Aug. 1950), pp. 71-100
(esp. pp. 92-93).

ECONOMIES OF SCALE AND EQUILIBRIUM 349
be argued in Section VII that these are precisely the assumptions

underwhich Marshall'sanalysis in terms of consumers'surpluscan
be given a valid interpretation. Besides, the assumptions can be
and have been relaxed,8without essential changesin the conclusions.
The crucial concept introducedin my survey article and de-
velopedhere is that of parametric external economies of scale. Each
entrepreneuris assumedto believe that his firm is operatingunder
constant returns to scale, and any departures from this assumed
output-factorrelationshipare interpretedby him as broughtabout
by a perturbation in his unit-homogeneousproduction function,
even if such departuresare caused in part by changes in his own
level of output. Such shifts are, in turn, assumed to be governed
by the level of output in the industry.
The concept may be illustrated in terms of Adam Smith's pin
factory.9 If a particular firm expands, some of the work can be
divided and specialties will develop. Such specialized labor be-
comes available, at least part-time, to other firms in the industry.
However,only a substantial expansionin the industry will provide
enough openings for a pool of labor to develop with a specialized
skill, and the contributionof a single firm to this processwill be so
imperceptiblethat it will be neglected by the entrepreneur. The
change in the characterof the labor force will be regardedas exog-
enous by all firms, even though each firm (by the laws of arith-
metic) necessarily contributes to the process. One could try to
formalizethis, followingRobert Aumann,lin terms of the idealiza-
tion of a continuumof firms,so that no single firm would carry any
positive weight though any continuum of firms would. However,
this is not necessary; there is no logical contradictioninvolved in
the notion that economicagents do not perceive things as they ac-
tually are, and while the idea of treating production functions
parametricallymay be more subtle and unusual than that of treat-
ing market prices in this way, both ideas are of the same logical
order.
One possible confusionthat should be guarded against is ter-
minological:the economicsof scale in each of Smith's pin factories
are, of course,in fact partly internal; that is, they benefit the ex-
pandingfirms as well as the remainingfirms in the industry. How-
ever, the effect is spreadso thinly that the economiesare conceived
8. By Masahiko Aoki, "Increasing Returns to Scale and Market Mech-
anisms," Ph.D. thesis, University of Minnesota, 1967.
9. Wealth of Nations, Ch. I.
1. Robert J. Aumann, "Markets with a Continuum of Traders," Eco-
nometrica, Vol. 32 (Jan.-April 1964), pp. 39-50.

to be completely external in the minds of the individual entrepre-

neurs. Thus, "parametriceconomiesof scale" might better describe
the conceptbeing developedhere, with the term "external"dropped
altogether;I adhereto "external"out of deferenceto the Marshal-
lian tradition,2 and because it describes the preponderanteffect,
even though the term has since been extended by J. E. Meade and
others to cover a much wider assortment of diverse phenomena.3
A great advantage of the concept of parametriceconomies is that
it dispensesaltogetherwith the need for introducingsuch artificial
assumptionsas that of A. C. Pigou 4 that each firm's expansion is
offset by an exactly equal contraction on the part of the other
firms of the industry, or that of Jacob Viner5 that expansionin the
industry takes place as a result of an increase in the number of
firms.
The types of economiesanalyzed in this paper are those attrib-
utable to scale alone, and are therefore fully reversible. Conse-
2. Alfred Marshall, Principles of Economics (London: Macmillan and

Co., 1890); 8th ed., 1920, esp. pp. 266, 277-83.
3. J. E. Meade, The Theory of International Economic Policy, Vol. II,
Trade and Welfare (London: Oxford University Press, 1955), esp. pp. 18-21.
An examination of Meade's examples reveals that most of them involve some
form of joint production, and moreover the by-product is usually a non-
marketable public good (or more frequently still, a "public bad" such as
smoke or noise). In the present paper, joint production is excluded altogether,
as are public commodities or discommodities. While terminology may be
similar, it must be stressed that many phenomena that are lumped together
as "externalities" have only a superficial resemblance and must be analyzed
by quite different methods.
4. A. C. Pigou, "An Analysis of Supply," Economic Journal, Vol. 38
(June 1928), pp. 238-257 (p. 242), and The Economics of Welfare, 3rd and 4th
editions (London: Macmillan and Co., Ltd., 1929, p. 791, and 1932, p. 793).
5. Jacob Viner, "Cost Curves and Supply Curves," Zeitschrift fulr Na-
tionalokonomie, Vol. 3 (1931), pp. 23-46 (p. 40). Since Viner used this as an
illustration, I may be misinterpreting him in regarding the assumption as nec-
essary. Viner's definition was as follows (p. 38): "External economies are
those which accrue to particular concerns as the result of the expansion of
output by their industry as a whole, and which are independent of their own
individual outputs." I would modify this by replacing the last phrase by "and
which are considered by the concerns to be independent of their own indi-
vidual outputs." I might add that in the formulation of this paper, all para-
metric external economies of scale are "technological" rather than "pecuniary"
in Viner's sense (op. cit., pp. 38-39), though I do not regard the distinction as
at all crucial; a more general formulation could take care of both kinds, and
indeed a mere redefinition of factor quantities in terms of "efficiency units"
would transform technological economies into pecuniary ones. Cf. Joan Rob-
inson, The Economics of Imperfect Competition (London: Macmillan and
Co., Ltd., 1933), pp. 34344.
As discussed in my "Trade Survey," loc. cit., the idea of firms' cost
curves shifting downward as the industry expands can be traced back to
Henry Cunynghame and F. Y. Edgeworth; it is also present quite explicitly in
the treatment of Murray C. Kemp, "The Efficiency of Competition as an
Allocator of Resources: I. External Economies of Production," Canadian
Journal of Economics and Political Science, Vol. 21 (Feb. 1955), pp. 30-42.

quently, there are none of the ratchet phenomenadiscussedand em-

phasized by Alfred Marshall in AppendixH of the Principles, and
which may to some extent be regarded as formalized in K. J.
Arrow's"learningby doing"model.6 The exclusionof such irrevers-
ibilities does not imply a belief on my part that they are unimpor-
tant, but results simply from a desireto concentrateattention on the
economiesthat are purely attributableto scale and not to time as
well.
The main results may be summarizedas follows: There exists
a unique full-employment equilibrium with positive wages (zero
wage equilibria with less than full employment exist as well, but
these are excludedas not being of interestin the presentdiscussion).
If productionfunctionsare homogeneousof the same degreein each
industry,7this equilibriumis also Pareto optimal. On the other
hand, if there are differencesamongdegreesof homogeneitypj in the
n industries,competitive laissez-faire equilibriumwill no longer be
Pareto optimal, "ideal" output being greater or smaller than lais-
sez-faire output according as pi is greater or smaller than the
weightedaveragep'= X Ojpj,wherethe weights Ojare the proportions
j=1
of consumers'budgets devoted to the respective commodities.
This formulationmakes possible a rehabilitationof the doctrine
evolved by Marshall,8Pigou,9 and R. F. Kahn,1to the effect that
industrieswith greaterthan average returnsto scale should be sub-
sidized and those with less than average returnsto scale should be
taxed. The optimal ad valorem tax rates are given by T =1-pip',
resulting in prices equal to p' times marginal costs in accordance
6. Kenneth J. Arrow, "The Economic Implications of Learning by Do-

ing," Review of Economic Studies, Vol. 29 (June 1962), pp. 155-73. While
this model has undergone considerable development in the literature, as far
as I know it has not yet been extended beyond the case of a single commod-
ity.
7. This qualification should have been added in my "Trade Survey"
(op. cit., pp. 746-48). The treatment of optimality given on those pages is
off the mark, and superseded by that of the present paper. In particular,I now
accept in toto the analysis of R. C. 0. Matthews, "Reciprocal Demand and In-
creasing Returns," Review of Economic Studies, Vol. 17 (1949-50), pp. 149-
58, and hope that the present contribution may serve as a rigorous foundation
for his.
8. Principles, 1st ed., pp. 44649; 8th ed., pp. 467-70.
9. A. C. Pigou, Wealth and Welfare (London: Macmillan and Co., Ltd.,
1912), Ch. VIII (pp. 172-79). The Economics of Welfare (London: Macmillan
and Co., Ltd.); 1st ed., 1920, Ch. VIII (pp. 189-96) and App. III (pp. 931-53,
esp. pp. 939-41); 2nd ed., 1924, Ch. X (pp. 191-200); 3rd ed., 1929, Part II,
Ch. XI (pp. 218-23) and App. III (pp. 787-800); 4th ed., 1932, Part II, Ch.
XI (pp. 213-28) and App. III (pp. 789-802).
1. R. F. Kahn, "Some Notes on Ideal Output," Economic Journal, Vol.
45 (March 1935), pp. 1-3.

with Kahn's proportionalityrule. (Income taxes allowing for mar-

ginal cost pricing are also discussed- see eqs. (6.30) and (6.31).)
Conditions under which Marshall's original treatment in terms
of consumers'surplus can be given a valid interpretationare de-
rived in Section VII. The followingresults are proved: (a) if some
industriesoperate under increasingand some under decreasingre-
turns to scale, there exists a tax-and-bounty scheme satisfying the
condition that the total of revenues collected equals the total of
subsidiespaid, such that in each decreasingreturnindustry,the tax
revenueexceedsthe loss in consumers'surplus,and in each increas-
ing returnindustry, the gain in consumers'surplusexceedsthe sub-
sidy payment; (b) if p'= 1, the optimal tax-and-bountyscheme also
satisfies this property,but need not if p'71.
A dynamic (non-tatonnement)adjustmentprocessis postulated
in Section VIII, and the full-employmentequilibrium,with or with-
out a tax-and-bounty scheme, is shown to be stable under this
process.
FUNCTIONS
II. PRODUCTION EQUILIBRIUM
ANDPRODUCER
Let there be n industries, each producing a single distinct ho-

mogenous product with the aid of a single factor, labor. The produc-
tion function facing each firm in the ith industry will assume the
simple form
(2.1) yiv= kizv; ki ,0 (v=l 2, . . ., Nj)
where yes is the amount of the ith commodityproducedby the Ath
firm in industry i, zi, the amount of labor employed by the firm,
and N4 the numberof firms in the ith industry. Defining aggregate
industrialoutput and input by
N. N.
(2.2) yi= Xyp z= ZiV
gives the industry productionfunctions
(2.3) yi=kizi (i=l, 2, . . . , n).
Parametric external economies are introduced in the following
way: the term ki, which will be treated as a constant by each firm,
will actually be related to the aggregate quantity of employment in
the ith industry as follows: 2
(2.4) ki= ciziet- ; Pi> 0; < pi < .
2. It is, of course, quite arbitrary to assume that k, depends on total em-

ployment in the ith industry alone, and not on employment in other indus-
tries. The assumption is traditional and therefore adhered to, but could be
relaxed.

The reason for requiring pi>O will be discussed presently. If, now,
(2.4) is substituted into (2.3), we obtain
(2.5) yj=KiZiPt (i=1, 2, . . . , n).
This will be called the objective production function in the ith in-
dustry, whereas (2.3) will be called the subjective production func-
tion. (In the dynamic analysis of Section VIII, (2.5) will be identi-
fied with the long-run production function, and (2.3) with the short-
run production function.) In analyzing the criteria for economic
welfare, it is of course the objective production function (2.5) that
must be used; on the other hand, in order to explain the behavior of
the firms in the industry, it is the subjective production function
that is relevant. Both are relevant to the analysis of the determi-
nateness of competitive equilibrium. The essential feature of the
model is that ki will be treated as a parameter by each firm, and
consequently the collective behavior of the firms in industry i will
not take the relation (2.4) into account.
As an alternative to expressing the scale effect ki in terms of
the amount of employment as in (2.4), we may equally well - and
more in the tradition of Pigou 3- express it in terms of industrial
output as follows: 4
(2.6) k, = caky.; -oo < ni<l
(the restriction on vi will be discussed presently). This formulation
is also more appropriate for extending the analysis to more than one
factor. Substitution of (2.6) in (2.3) gives
1 1
(2.7) 1-? o Zi
Y'=/Xi 1-Z a,
which is the same as (2.4) if we set pi=1/(1-pi) and Ki=/Le i. The
reason for imposing the condition - oo <i <1 is now evident: if
v= 1, output would be unbounded, and at the other extreme, vi=
-00, it would be a constant, independent of the quantity of labor.
Likewise, the equivalent condition O<pi< oo in (2.4) expresses the
assumption that the objective marginal product of labor
(2.8) dy-= pJKJZ4
dzi
3. "An Analysis of Supply," op. cit., and the 3rd and 4th editions of
The Economics of Welfare, Ch. XI and App. III.
4. Professor Herbert A. Simon has kindly brought my attention to the
fact that he introduced a similar formulation in his unpublished paper, "Some
Models for the Study of the Economic Effects of Technological Change,"
Cowles Commission Discussion Papers, Economics No. 213, University of
Chicago, Dec. 16, 1947, pp. 12-13. He further noted (p. 13): "We see that
stability from the standpoint of the individual entrepreneur . . . is entirely
compatible with increasing returns from the standpoint of the entire econ-
omy. . . ." (The word "stability" was used here in the sense of a stationary
maximum point, rather than of dynamic stability.)

(computedfrom (2.5)) is positive and finite.

From assumptionsto be spelled out in the next section it will
follow that there will be a uniform wage rate w among industries.
Let q1, q2, . . . , q. be the prices received by the firms for their
outputs of commodities 1, 2, . . . , n (and assumed by them to be
beyond their control, along with the wage rate as well). To de-
termine equilibriumconditionsfor the firms, one computesthe sub-
jective marginalproductof labor6
(2.9) =k=KiN
azi
from (2.3), holding ki constant, which differs from the objective
marginalproduct (2.8) by a factor of pi. Equilibriumunder profit
maximizationrequiresqjk_ w, with inequality holding only if ye=
z=O; hence the condition for producerequilibriumwhen zi>O is
qdk,=w,or
(2.10) qjyjwzi(i = 1, 2, . . . , n), qy= wzi if z> 0.
Unit and total cost of productionbeing definedby
(2.11) C,= wzjc,Cj=-
Yi
it follows that qi=ci. The total cost functions (subjective and ob-
jective) are obtained by substituting the subjective and objective
production functions, (2.3) and (2.5), respectively, in the cost
equation (2.11), to get
wz=
(2.12a) Cur= 8i
ki
(2.12b) ( )
where (2.12b) is obtainedfrom (2.4) and (2.5) since
(2.13) ki= ICZiP4= Ki) (P 1)/PI = KS1/P4y.(Pi 1)/P4.
From the viewpoint of the economist analyzing the situation,

5. These two concepts of subjective and objective marginal produc-
tivity are roughly comparable to Pigou's private and social marginal net
products: "By the 'social net product' is meant the aggregate contribution
made to the national dividend; by the 'private net product,' the contribution
made to the earnings of those responsible for the industry under review"
(Wealth and Welfare, p. 149). The formal definitions of "private" and "sub-
jective" definitely conflict, but the concepts nevertheless play similar roles.
In the first edition of The Economics of Welfare, Pigou changed "private
net product" to "trade net product" and altered the definition to "the con-
tribution . . . that is capable of being sold and the proceeds added to the
earnings . . ." (p. 149). He reverted to "private" in the second edition, with
the definition left unchanged (p. 151). In the third and fourth editions (pp.
136-37 and pp. 134-35, respectively), the terminology was retained but the
definitions were considerably qualified and elaborated.

(2.12a) and (2.12b) necessarily coincide,on account of the relation

(2.4), which is assumedto be unknownto the entrepreneurs.On the
other hand,the subjectiveand objectivemarginalcosts must in gen-
eral differ, since the subjective marginal cost is obtained by differ-
entiating (2.12a) partially with respect to yi, holding ki (and also
w) constant,to get (using (2.13)):
(2.14) _ k = _ /Psy,( -P4)/pi
whereas the objective marginal cost is obtained by differentiating

(2.12b) totally with respectto yj (still holdingw constant) to get:
dCi 1
W 1/PjY,(1-P4)/Pj_ wM(y.
dy= pi
This definesthe functionM (yj), which will be called the objective
real marginal cost curve. Thus the objective marginal cost differs
from the subjective marginal cost by a factor of l/pi, and the sub-
jective marginal cost coincides with the objective and subjective
average costs, i.e.,
(2.16) -
Dye Yi - dC,=p iy
Equation (2.14) definesthe supply price in the ith industry, and in
terms of the real supply price qi/w we definethe supply curve, pro-
vided w > 0, by
(2.17)
w wdy l, =
_= 1y Kc'/Pjyi(lp4)/p=S4(y )
which is rising, constant, or falling accordingas p <1,=1, or >1.

By virtue of (2.16), Sj(y) and Mi(yi) stand in the same relation-
ship as any averageand marginalcurves,i.e., when the supply (sub-
jective real marginalcost) curve Si(yi) is rising, it is always below
the objective real marginalcost curveMi(yj), and when it is falling,
always above it. These two cases are illustrated in Figure I (the
superimposeddemandcurves will be discussedin the following sec-
tions); with appropriate reinterpretations,the diagrams can be
broughtinto exact correspondencewith those of Pigou.6
6. Wealth and Welfare, pp. 172-75; The Economics of Welfare, 1st ed.,
pp. 931-38. Pigou's earliest treatment was in his paper "Producers'and Con-
sumers' Surplus," Economic Journal, Vol. 20 (Sept. 1910), pp. 358-70. His
supply curve and curve of marginal supply prices may be thought of as cor-
responding, respectively, to the above supply curve S&(y) and objective real
marginal cost curve Mi(y,). However, Pigou fell into the error in Wealth
and Welfare of applying this analysis to the case of diminishing returns to a
variable factor operating with a fixed factor, rather than limiting it to de-
creasing returns to scale, as was pointed out by Allyn A. Young in "Pigou's
Wealth and Welfare," this Journal, Vol. 27 (Aug. 1913), pp. 672-86 (esp. pp.
676-78, 683-84). Simultaneously with the further criticisms to this effect by

III. DEMAND FUNCTIONS AND SUPPLY OF LABOR
It is well known that utility functions can be aggregated if

they are identical, positively homogeneous, and strictly quasi-
concave, in the sense that aggregate market demand can under
these circumstancesbe conceived of as obtained by maximization
of an aggregateutility function.7 In conformitywith our objective
of keepingthe analysis on an elementarylevel, this assumptionwill
be adopted, making possible a rudimentaryproof of existence of
equilibriumthat requiresno advancedtopologicalmethods.
Thus, supposethere are mnindividuals,each with a utility func-
tion of the form
(3.1) uVj=f(yi, Yi2, . . . , Yin) (i-i 2 . . ., m)
where f is positively homogeneousand strictly quasi-concave,8and
whereyU denotesthe ith person'sconsumptionof the jth commodity.
If all consumersface the same set of market prices Pi, P2, . . . IN
for the n commodities,then regardlessof their income (owing to the
homogeneity)they will consumethe commoditiesin the same unique
Frank H. Knight in "Some Fallacies in the Interpretation of Social Cost,"
this Journal Vol. 38 (Aug. 1924), pp. 582-606, who even brought into question
"the doctrine of 'external economies,' which surely rests upon a misconcep-
tion," Pigou withdrew the entire sections B-D of Appendix III (pp. 931-38)
of the first edition of the Economics of Welfare (1920) from the corresponding
appendix (p. 743) of the second edition (1942). The apparatus was, however,
essentially revived in Pigou's 1928 paper, "An Analysis of Supply," cited above,
and in the third and fourth editions of The Economics of Welfare, where the
previous "supply price" corresponding to the above S&(yt) became "supply
price simpliciter" or "supply price per unit from the standpoint of the indus-
try producing the commodity" ("Analysis of Supply," pp. 254-56; Economics
of Welfare, 3rd ed., p. 219; 4th ed., pp. 217-18), while the previous "marginal
supply price" correspondingto the above MW(y,)became the unwieldy "supply
price, as conceived when correction has been made for transfer elements"
("Analysis of Supply," p. 252) and later, "supply price from the standpoint
of the community" (3rd ed., p. 220; 4th ed., p. 217). Other terms which ap-
pear to be substantially equivalent to these are "marginal substitute cost"
for St(yi) and "marginal additive cost" for MW(Y,)(3rd ed., p. 790; 4th ed.,
p. 792), always making allowance for Pigou's awkward device of assuming, in
the definition of "marginal substitute cost," that an increase in the ith firm's
output is exactly balanced by an equal decrease in the other firm's outputs-
a contrivance which is dispensed with in the present parametric formulation.
7. In fact, it need not be assumed that they are identical; as will be
clear from the ensuing explanation, it is sufficient to assume that they yield
demand functions which, for each set of prices, are linear in income with the
same slope (propensity to consume) for each individual. This result goes
back to G. B. Antonelli (Sulla teoria matematica delta economia politica,
Pisa: nella Tipografia del Folchetto, 1886,pp. 12-13) and has been rediscovered
by Gorman and Nataf. Cf. W. M. Gorman, "Community Preference Fields,"
Econometrica, Vol. 21 (Jan. 1953), pp. 63-80 (p. 70) and Andre Nataf, "Sur des
questions d'agregation en econometrie," Publications de l'lnstitut de Statis-
tique de l'Universite de Paris, 2 (Fasc. 4, 1953), 5-61 (p. 32).
8. That is, f(Xyl, Xyt2, . . . ,Xyvn)- Xf(y41, Y42, . . , Yin) for X>0; and
for all ut, the set of (yi,l,2 . . . Y in) for which f(y4i, y, . . . X Ynn)?Ut
is strictly convex.

proportion(since utility functions are identical, homogeneous,and

strictly quasi-concave). If the aggregate amount of the jth com-
modity consumedis
(3.2) 2 j ~=yj (j= 1,2, . n)
s=1
then correspondingto these amountsthere must exist
m
(3.3) Sk_? YXi= I
s=1
where each depends on P1, P2, . ..
Xi , pn, such that
(3.4) yij =xiyj for all j = 1, 2, . . ., n.
Using (3.1)-(3.4) and the propertiesof f, we have
m m
A=
u=-: U1
,=1 9=1
f (Yi1YWi2, ..Xyin)
m
= Ef(XiY1,XY2,
.X.. , XiYn)
i=1
m
(3.5) = Ei f(Yi, Y2, * . . , yn) =f(yi, Y2, * * * , yn).*
Thus, Samuelson's "utility possibility curves"9 (for m = 2) are

straightlines, and any point of consumerequilibriumis one at which
the aggregateutility function (3.5) is at a maximum.
More particularly,we shall choosef to be of the form
n
(3.6) U-i= Yilol Yi262. . . Yino (Oj> OEy = 1)
j-1
and we verify that the correspondingaggregateutility function is

n
(3.7) ff = Nilel 'Yi282...Ynnt = 1) .
(aj > 02> #9j
j-1
Finally, it is assumedthat there is a fixed aggregatequantity

of homogeneouslabor, Z, and that labor is perfectly mobile and in-
differentas to occupation. Consequentlythe allocation of labor is
constrainedby
n
(3.8) E Zi.<Z.
i-I
It is assumed that the acquisition of specialized skills is gained

simply by practice, and requiresno investmentof labor. However,
in conformitywith the dynamic analysis to be introducedin Sec-
tion VIII, I shall assumethat it does requirean investmentof time.
Accordingly, I shall make the rather special assumption-with
considerablereluctance-that workers have a zero rate of time
9. P. A. Samuelson, "Evaluation of Real National Income," Oxford

Economic Papers, N.S., Vol. 1 (Jan. 1950), pp. 1-29.

preference. It follows that in long-run equilibrium there cannot be

any discrepancies in wage rates corresponding to different special-
izations. This yields the conclusion, used in the previous section,
that there will be a uniform wage rate w among as well as within
industries.
Consumer demand functions are now obtained by maximizing
(3.7) subject to the budget constraint
n
(3.9) piY4 ?wZ
i=1
where the pi are the market prices. Since prices and quantities are
intrinsically nonnegative, in view of the utility function (3.7), ob-
viously equality must hold in (3.9). Setting marginal utilities pro-
portional to prices, we arrive at the well-known rule that the pro-
portion of each consumer's income that is devoted to the ith com-
modity is equal to Gi:
(3.10) piyi=iwZ (i=1, 2, . . ., n).
The demand curve for the ith product is defined (for positive w)
by
(3.11) Pi (yi)
w yi
These are shown below in the two diagrams of Figure I (for w=
Z=1).
IV. EQUILIBRIUM UNDER LAISSEZ-FAIRE
Our model has been reduced to three systems of relationships,

consisting of n objective production functions:
(2.5) yi= KiZiPt (i= 1, 2, . . . , n),
n conditions for equilibrium of firms:
(2.10) wzi-zqiyi (i=1, 2, . . . , n), wzi=qiyi if zi>O,
and n conditions for equilibrium of households:
(3.10) piyi= OiwZ (i=l1, 2, . . . , n) ,
where pi is the price paid by consumers for the ith product, and qi
the price received by firms. The model may be closed by the addi-
tion of the further conditions
(4.1) pj=qi (i=1, 2, . . . ,n),
which characterize laissez-faire, or perfect competition in the ab-
sence of taxes and subsidies. The latter will be introduced in Sec-
tion VI.
First it may be noted that the assumptions so far made do not
guarantee full employment. For suppose w =0. This entails piyi= 0

from (3.10), so that no commodities with positive prices will be

produced, and all produced commodities will be free. Not all prices
can be zero, for then maximization of (3.7) subject to (3.9) would
require the yi's, and consequently the zip'son account of (2.5), to be
unbounded, in violation of (3.8). Hence some prices, say the first
m, must be positive; consequently yj =0 for i = 1, 2, . . . , m and
O_ y<oo for i=m-)+-1, . . . , n. An infinity of solutions are there-
n
fore possible in which zi=0 for i= 1, 2, .. .,m and0 z<?Z.1
m+1
To rule out unemployment I shall arbitrarily assume
(4.2) w>0.
In Section VIII, this will turn out to be a property of the assumed
dynamic adjustment process.
An immediate consequence of (4.2), (4.1), and utility maximi-
zation is that equality must hold in (2.10), and thus (2.10) and
(3.10) together imply
(4.3) zit - OV7 (i=J) 2, . . . , n),
where the dagger indicates an equilibrium solution, which in this
case is unique. Defining for convenience
(4-4) Cj=zj1Z (i-1, 2. . . ., n),
we may write (4.3) in the form
(4.5) tit = 6 (i= 1, 2, . . ., n),
stating that the proportion of the labor force employed in the ith in-
dustry is equal to the proportion of consumers' budgets devoted to
the ith commodity. tit will be called the laissez-faire allocation of
labor.
Now from (4.3) one immediately obtains (bearing in mind
(3.7))
n
(4.6) Ezit=ZY
i=1
i.e., full employment.
To obtain the complete solution, substitute (4.3) into the pro-
duction function (2.5):
(4.7) it = K (OiZ)Pi (i- 1, 2, . . . , n) .
1. These difficulties would still not be completely alleviated if a utility
function were chosen with the monotonicity property, i.e., such that y>y'
implies u(y)>u(y'), where y>y' means that yi?y4' for all i and y4>yi' for
some i. (This is violated by the utility function (3.7) whenever some yg=0.)
For in that case, if w=0 and p,=0, utility maximization would require in-
finite yi, which would be incompatible with (3.8) and (2.5); thus from (2.10),
if w=O then all pi>0, hence all y,=0 and from (2.5) all zi=O. Therefore this
still allows the single solution with zero wage rate and total unemployment.
To rule out such a solution, one must add more assumptions; the most natural
procedure is to postulate a dynamic adjustment process that renders it un-
stable. Thereby hangs a tale concerning classical and Keynesian economics.

91i.5; PIr.8
2~~~~~~W1
, IsZ -
PI Zi\
\ t ' .304 or
\ \ Xo",ro.13, rl..., 2
* I
.S*II
Ct _+ _
_._..i I I~~~~~~~1
FIGUIM
The prices are then obtained by substituting (4.7) in the demand

equation (3.10):
(4.8) -p-it~ , Z) -p2. (= 1, n) .
xt
Only the ratios pi/w are determinate.

I interesting
w (4.7)~ reveals the
Equation I f act that pi is the elas-
ticity of laissez-faire output with respect to the supply of labor; a
proportionate expansion in labor supply then leads to more or less
than proportionate expansion in output according as the industry is
(2.17) -Lit-(@Zlty"-Pd (Pi=1=~,) 2, . . 2.
one of increasing or diminishing returns. Then).)
effect on prices is the
Onyterto s/Waedtriae
opposite.
The solutions (4.7) and (4.8) may be arrived at in more classi-
cal fashion. Combining (2.5), (2.10), (4.1), and (4.2) we obtain
as in Section l1the supply curves

e~-.5 e2 -1.5
-y T -. 304 or
P2+<T2e' os3
S2
P2*
I
~~~~~~M2
yi . . XI
0 Y2' Y2 Y2
P~~~~~~~~~~~~~~~~~2
FIGURE lb N
and from (3.10) and (4.2) we obtain as in Section III the demand
curves
OZZ
These Pi- =_ (y.Di ) 1(i=1 , 2, . . . n)
Theseareshown superimposed in Figure I. The supply curve has

constant elasticity pI1( -pI), and the demand curve has constant
elasticity - 1. Since (1 - pi) /pi > - 1, it follows that the supply
curve necessarily cuts the demand curve from below, and exactly
once. Thus, Marshall's criterion for stability is always met.2
The system (2.17) and (3.11) is completely decomposable, and
solvable industry by industry. Thus, the classical Marshallian and
Pigovian diagrams (Figure I) may be used to depict the solution
for each i. It is to be emphasized that these are not "partial equilib-
2. Alfred Marshall, The Pure Theory of Domestic Values, 1879 (London:
The London School of Economics and Political Science, 1949), p. 10, Prop.
XIX. See also Marshall's Principles, 8th ed., pp. 346n, 466n, 806n, and P. A.
Samuelson, Foundations of Economic Analysis (Cambridge, Mass.: Harvard
University Press, 1947), p. 18. The question of dynamic stability is taken up
in Section VIII below.

rium"solutionsin the sensethat they are valid only for given values
of the remainingvariables;on the contrary,for each i, the two equa-
tions (2.17) and (3.11) fully determine the equilibriumquantity
yMtproduced and consumedof the ith commodity, as well as its
equilibriumreal price pit/wt, independentlyof the remainingquan-
tities and prices. These of course are the same solutions as given
by (4.7) and (4.8).
OUTPUT
V. IDEAL
In view of the assumptionthat all consumershave the same
homogeneousutility function (3.6), the correspondingaggregate
function (3.7) coincides (assumingthat the appropriatelump sum
transferscan be made without cost) with the social utility function
in Samuelson'ssense-3 whatever the particularform of the social
welfare function may be. A situation will thereforebe Pareto opti-
mal if and only if (3.7) is maximized. It is to be maximizedsubject
to the productionpossibility set which, from (2.5) and (3.8), is
given by
(5.1) Y= { (Yl, Y2, . .. , Yn) Zi y_);ps !t
yoyo.
i=1 KjX
The set Y is closed and bounded,and the function (3.7) is con-

tinuous,so by a well-knowntheorema maximumof (3.7) subjectto
(5.1) exists. Since Y contains interior points of the n-dimensional
positive orthant, and the utility function (3.7) vanishes on its
boundary,it follows that an optimal solution
y* = (y1*, Y2*, ... * , *)
must have all its componentspositive. (An asterisk will be used
to denote optimal values.) In fact we shall show that the optimal
solution is unique.
Define
(5.2) U= log u; Ye=logyi.
Then (3.7) is linear in the logarithms:
n n
(5.3) U OXY (0,> 0; 0 = 1).
s=1 s~~=1
It will now be shown that the logarithmicconstraintset
(5.4) log Y=(Yi, Y2, .. ., Y).5 (,< {)
is strictly convex (see Figure II).

Given
(5.5) Y = (YI) Y2, . Yn), I"= (Yily Y21 y n )
3. P. A. Samuelson, "Social Indifference Curves," this Journal, Vol. 70

(Feb. 1956), pp. 1-22.

both in log Y, we must show that for any A, O<X<1, the convex
combination XY+ (1 - x)Y' is in the interior of log Y. From (5.2)
and (5.4), if Y, Y'Elog Y, then
Y2
Y2'>Xu
0 Y,*
FIGURE Ha
(5.6)
i-l Kj i-1 Ki )i Ki i= Ki
We are to show that

(5.7) Nl/p6 (Yi/wi(l-x) )fpi Z
i=1 Kj ==1 Ki
equality holding if and only if Y= Y'. Now the fact that (5.7) fol-
lows from (5.6) is a simple consequence of the well-known inequal-
ity between the geometric and arithmetic mean: 4
(5.8) (Yl/p,)X\(y."/Pt) I-X.< xyil/pt+(-)8t/i
4. Cf., e.g., G. H. Hardy, J. E. Littlewood, and G. P61ya, Inequalities
(Cambridge: at the University Press, 1934), p. 17,

log Y2
log y1Is
T
logy1
<---w?9Y2~~~- -- *0Y2
for, dividing both sides of (5.8) by Kj11P' and summingover i we ob-

tain, using (5.6),
(5.9)
1 (< ) CA _- + (1 A ( ) _Z.
i=1 j=
i1 Ki = Ki
As equality holds in (5.8) if and only if ye= yi', the set log Y defined
by (5.4) is strictly convex.
The "ideal output"5 may now be found by maximizing (3.7)
subject to (5.1). Define the Lagrangeanfunction
(5.10) L (i, Y2, , Yn; A) = i1 Yi KX j= 1 I/Pi-Z'
5. A. C. Pigou, Wealth and Welfare, p. 173. The Economics of Welfare:

1st ed., p. 937; 2nd ed., p. 196; 3rd and 4th eds., pp. 800 and 802, respectively.

Then
(5.11) =-u-- / =0,
D~yi yi Pi i
whence
Y
(5.12) =ipi AX ) =Azi
using (2.5). Summingover i and makinguse of (5.1) with equality

holding,we obtain after dividingthroughby Z
(5.13) A= u n
which, when substitutedback in (5.12), yields for the optimal allo-

cation
(5.14) z*= PZ (i=1, 2, . . ., n)
j-1
or, from (4.4),
(5.15) o*= (i=1, 2, n),
j=p1
which may be contrastedwith the laissez-faire solutions (4.3) and
(4.5).
The optimal outputs, or ideal outputs in Pigou's terminology,
are now determinedfrom (5.14) and the objective function (2.5):
pi
(5.16) yi* = Kj(OZ)P'.
Comparisonof (5.16) and (4.7) shows that the optimal and laissez-
faire outputs differ by a factor of (pi/ I Ojpj)Pi. Thus we arrive at
j. 1
the simple rule:
(5.17) yi* = yit according as pi =p'
where
n
(5.18) P., X Aps.
j=1
That is, optimal output of the ith product is greater than, equal to,
or less than laissez-faire output according as the degree of homogene-
ity of the production function for the ith commodityis greater than,
equal to, or less than the weighted average of degrees of homogeneity

of all productionfunctions, where the weights are the proportions

of consumers'budgets devoted to the respective commodities.
n
The weighted average, p'= Ojpj,may be identified with the
X
j=1
''average amount of external economy" as stipulated by Kahn:
On the assumption that every industry competes for its factors with a group
of industries which is uncorrelated with it in nature and extent . . . it is de-
sirable to divert factors of production from those industries which are as-
sociated with less than average amount of external economy (per unit in-
crease of employment) to those which are associated with more than the
average. . . We may arrange all industries in descending order of magnitude
in respect to the external economies associated with them (diseconomies being
regarded as negative economies). At a certain point, represented by the
"average" industry, a line may be drawn. Then all industries above the line
have to expand to reach their ideal outputs and all those below the line have
to contract, the extent of the socially desirable expansion or contraction
varying directly with the distance from the line.
VI. TAXES, BOUNTIES, AND OPTIMALITY RULES

There remains the problem of finding a way to implement the
Pigovian program of ideal output while remaining within the com-
petitive framework. One approach is to retain the producer and
consumer equilibrium equations
(2.10') qiyi= tiwZ (i=1, 2, . . . , n)
(3.10) pjy,,=OwZ (i=1, 2, . . . , n)
(where (2.10') makes use of (2.10) and (4.4)) along with the (ob-
jective) production functions
(2.5) y =.Ki(CZ) P0 (i= 1, 2, . . . , n),
and replace equations (4.1) either by
(6.1) p,-qi=ti (i=11 2, . . .,. n)
where the ti are suitably chosen per-unit excise taxes, or by
(6.2) pi-qj=ripj (i=1, 2, ...,n)
6. R. F. Kahn, "Some Notes on Ideal Output," Economic Journal, Vol.
45 (March 1935), pp. 1-35 (p. 6). Thus, Kahn's conclusions appear to be
vindicated despite Leontief's harsh criticisms of his methodology; cf. Wassily
Leontief, "Implicit Theorizing: A Methodological Criticism of the Neo-Cam-
bridge School," this Journal, Vol. 50 (Feb. 1937), pp. 337-51. Criticizing both
his concept of the marginal utility of money, which Kahn assumed to be equal
among consumers (the concept is of course Marshall's, and its use in this
analysis is discussed in Section VII below), as well as the concept of the
"average consumer," Leontief stated (pp. 341-42): "Very likely the concept
[apparently the "marginal utility of money"] can be shown to be funda-
mentally irrational. Mr. Kahn's implicit assumption would become in this
case not only methodologically useless, but also logically false, and the entire
structure of his theory of ideal output would have to be razed from top to
bottom." Regardless of the merits of Kahn's methodology, I think the lesson
to be learned is that bad methodology can sometimes be transcended by good
insight.

where the Ts are suitably chosen ad valorem excise taxes. First I

take up the case of per-unit excise taxes.
From (6.1), (2.10'), and (3.10), excise taxes per unit of product
must satisfy
(6.3) tjys= (pi-qj) yi = (j- t) wZ;
clearly Y"i tiy = 0, i.e., the total of subsidies paid is balanced by
the total of taxes collected. For yj>0, (6.3) yields together with
(2.5)
(6.4) ti= (i- ,_)WWxK _p'Z1-P4.
Setting j = t* and substituting (5.15) in (6.4), we obtain
(6.5) ti*= (i- (Z)
Y j=1ljpj i =1 jpj
(i=1, 2, . . . , n).
This is positive when pj<Y7=
1i0jpjand negative (a subsidy) when
pi>, fe=pf When Y. = tjp =1 this reduces to Marshall's rule7
adheredto by Pigou in the early editionsof his work.8
While the tax rates given by (6.5) allow the ideal output to be
producedand consumed within a competitive market framework,
we are not entitled to concludethat their mere impositionwill auto-
matically bring the desired situation about; for it is conceivable
that in this new model of modified competition, equilibriumwill
no longer be unique. That is, once the optimal excise tax rates tj*
have been fixed, the possibility cannot be excludedthat there might
be anotherlabor allocationC1, 2, . . . X g satisfying
,
( (adsGu)=*
i
yi
= (0Zgi yi
* ,,
i.e., satisfying
(6.6) gt(W) = ($-It) tps( -It)CO*pt O
togetherwith the condition
(6.7) i=
Ethe I
For pi?C>iY9Ojpj it is easily verified from (6.6) that gi(gt) has ex-
actly one positive root, but it could have several for pi> Y, lmjpj. .
As long as at least two industrieshad greater than average pi, one

could doubtless concoct an example with multiple roots also satis-
7. Principles, 8th ed., pp. 467-70.

8. Wealth and Welfare, p. 178. The Economics of Welfare, 1st ed., p. 193.

fying (6.7). Nevertheless the example would have to be totally

artificial, and we can safely rule out such cases as pathological.
If taxes are imposed ad valorem, the difficulties just encountered
can be avoided altogether. For piyi > 0, equations (2.10') and (3.10)
yield
(6.8) == (i=1, 2, . . . , n)
Pi Oi
and the corresponding ad valorem tax rates must satisfy
(6.9) 1= 1- q =1- ti (i= 1, 2, . . . , n) .

Pi 0i
This implies
(6.10) Y, i9 r0j=; -oo<Ti<1 (i=1, 2, . . ., n).
Conversely, for any system of ad valorem tax rates T1,T2y . . . , Tn
satisfying (6.10), the allocation of labor is uniquely determined by
(6.11) go= (1 - T) i (i= 1, 2, . . . , n)
and moreover it is verified from (6.10) and (3.10) that
(6.12) =
i. lipyi 1TirAWZ = 0,
i.e., subsidies paid are balanced by taxes collected. The optimal ad
valorem tax rates are obtained by substituting (5.15) in (6.9):
(6.13) ri* = 1- = 1- P Pi
di n P
j= ioPj
Let us turn to the optimality criteria developed by Pigou and
Kahn. Denoting the objective marginal cost by
(6-14) x, __dC= Wp Ki- /p, (1-P)
dy W
and the market value of the objective marginal product by
(6.15) =
d= iPypiKiZi -
(see eqs. (2.15) and (2.8), respectively), and substituting the pro-
duction function (2.5) in (6.14), we find upon making use of (2.5)
again, as well as (3.10), (4.4), and (6.8), that
Pi As dsps Pi
(6.16) -=-= Pi.
7ri IV
qW
Under a regime of laissez-faire this becomes, for any fixed w >0,
(6.17) Pit =t
Wit w
in view of (4.5), whereas optimality requires
(6.18) * = w -=e=1JPJ=P'

on account of (5.15). This is the proportionality rule: for all com-

modities, prices must stand in the same relation to marginal costs,
and the wage rate to the value of the marginalproduct,the factor
of proportionality being the average returns to scale p'= 71.0jptj.
If p'= 1, we have the special case in which prices should be set
equal to marginal costs, and the wage rate to marginal products.
This assumption is perhaps implicitly behind the tax-and-bounty
scheme as originally proposed by Marshall (see Section VII). It
seems also to be implicit in the early editions of Pigou's work,9and
in the later editionsit was admittedthat: "Whenit was urged above
that in certain industriesa wrong amount of resourcesis being in-
vested because the value of the marginal social net product there
differs from the value of the marginal private net product, it was
tacitly assumed that in the main body of industries these two
values are equal. . . . If in all industries the values of marginal
social and marginalprivate net productdifferedto exactly the same
extent, the optimumdistributionof resourceswould always be at-
tained, and there would be . . . no case for fiscal interference." 1
In terms of the present model, if P1= P2 = . . . = pnio the ratios
pi of subjective to objective marginal cost (see eq. (2.16)) are all
equal and the optimal ad valoremtax rates Tj* are all zero.
If p'l, not only would it not be optimal in the model (2.10'),
(3.10), (2.5), and (6.2) to equate pricesto marginalcosts- it would
not even be possible. For if pi=7ri for i=1, 2, . . . , n, it follows
from (6.16) that go=Hopi,hence hi Oipi=Hi=lti=l. This con-
clusion follows upon replacing the producerequilibriumequations
(2.10') by the assumptionthat prices equal marginalcosts.
The conclusionjust reached,based on the model describedby
eqs. (2.10'), (3.10), (2.5), and (6.2), does not necessarily apply to
differentor moreelaboratemodels. This simple but importantpoint
must be borne in mind in judgingthe debate betweenthe adherents
of the proportionalitythesis and the proponentsof marginal cost
pricing.2 The latter have based their criticism of the formeron the
neglect of certain structural relationshipswhich further constrain
the system, once account is taken of phenomenasuch as interindus-
try relationshipsand variability of factor supplies-both of which
have been excludedfrom the present model by assumption. On the
9. See the very complete discussion of this by Kahn, op. cit., pp. 7-9.
1. 3rd ed., p. 226; 4th ed., p. 225.
2. The debate has been surveyed by Nancy Ruggles in "The Welfare
Basis of the Marginal Cost Pricing Principle" and "Recent Developments in
the Theory of Marginal Cost Pricing," Review of Economic Studies, Vol. 17
(1949-50), pp. 29-46 and 107-26.

other hand, they have failed to provide much in the way of precise
fiscal proposals for the implementation of marginal cost pricing,
leaving some doubt as to where the issue rests.3
The case against the proportionality rule when interindustrial
relationships are taken into account was argued extensively by
L. W. McKenzie.4 A succinct argument was presented by J. de V.
Graaff,5 which may be summarized as follows. Let the objective
production functions (2.5) be replaced by
(6.19) Xi = hi (xl, XQ2, . X. ., Gino ZO; YJ = Xi -:4 i= 1
where xij is the amount of the jth input used to produce the ith out-
put, and xi is the gross output of the ith product. When one assumes
ft to be continuously differentiable, minimization of cost
(6.20) Ci = P1Xi1+P2Xi2+. . . +PnXin+WZi
subject to the production function entails (for an interior solution)

(6.21) P1/Ai= x= dCj/dxj
where x is a Lagrangean multiplier (equal to marginal cost) and
f iafi/axq.
i If one sets pi=k dCG/dxj for i=1, 2, , n+1
(where Xiyn+i zi, Pn+l-W) it follows that
(6.22) ftef,=k2
But efficiency requires that the marginal productivity of the jth in-
put for the ith output be the reciprocal of the marginal productivity
of the ith input for the jth output, i.e., k= 1.6
Since the restrictions imposed by interindustry trade require
3. This point was made by Nancy Ruggles, op. cit., p. 119.
4. L. W. McKenzie, "Ideal Output and the Interdependence of Firms,"
Economic Journal, Vol. 61 (Dec. 1951), pp. 785-803.
5. J. de V. Graaff, Theoretical Welfare Economics (Cambridge: at the
University Press, 1957), pp. 151-52.
6. An argument that appears to resemble this one was presented in
Melvin W. Reder, Studies in the Theory of Welfare Economics (New York:
Columbia University Press, 1947), p. 42n. However, it appears intended to
apply to the use of factors as direct services rather than to intermediate
products. Reder stated: "If the ratio of the price of every product (includ-
ing direct services [of factors]) to its marginal cost is the same, then the
marginal cost of producing each product must be equal to its price. For
the ratio of price to marginal cost of any product, X, in terms of any other
product, Y, is the reciprocal of that ratio for Y in terms of X. The only value
of the two ratios which makes them equal is unity; i.e., the only possible ratio
of price to marginal cost which could hold for all products simultaneously is
unity." However, if for example two barbers hire each others' services, and
both transactions are subject to a proportional ad valorem tax, there is no
contradiction involved in the assertion that the price of each barber's services,
as product, exceeds the price of his services, as factor (which is the marginal
cost). The taxes collected from both barbers can be used to subsidize the manu-
facture of industrial products which they both consume. Reder's argument
appears to assume implicitly that prices paid and received for direct services
(i.e., their prices and marginal costs from the standpoint of the commodity
market, or alternatively their marginal value products and wages from the
standpoint of the factor market) are the same, but this violates rather than
invalidates the proportionality rule (unless the factor of proportionality

prices in general to be equal to marginal costs, a system of ad

valorem excise taxes is obviously inadequate to give effect to the
welfare objectives except in the special case p'= 1. Let us therefore
introducea proportional income tax To7 which constrainsconsum-
ers' budgets by
(6.23) Y.i IN= (1-To)WZ; -00 <ro<1
Maximizationof the utility function (3.6) subject to (6.23) results
in the consumerequilibriumequations (3.10) being replacedby
(6.24) pAyS=(1-ro)90wZ (i= 1, 2, . . . , n).
(Alternatively, one could make use of an expendituretax to=Tro/
(1 - To) where -1 < to< oo.) The remainingequationsof the system
will be retained, namely eqs. (2.10') of producerequilibrium,eqs.
(2.5) of integratedproduction(thus no accountis taken in a formal
sense of the interindustrialrelationships (6.19)), and eqs. (6.2) for
the excise taxes. Then (6.9) is replacedby
C,
(6.25) T1=1- q=1- (i=-1 2, . ., n)
Pi (1 -'ro6
and (6.10) by
(6.26)
(1-To)(1->4~ti) =; - X<T< (i=0) )
(For an expenditure tax the correspondingequation is simply
to+Y.. 1Tj = 0.) Further, equations (6.16) become
(6.27) Pi=-= (l-To)p7-=p-- (i=1, 2, . . . , n).
Setting gi equal to the optimal allocation (5.15), the excise taxes
(6.25) become
1 pi
(6.28) Ti*1 iop (i=1, 2, . . ., n),
1-T'o p
and the optimalprices in (6.27) become
*P '2.
(6.29) = = (l -To) p' (i = 1 2, . . . , in).
happens to be unity). On the other hand a problem does arise in the case of
self-service or leisure (to be discussed presently) since these are activities that
take place outside the market. Similar difficulties beset the arguments pre-
sented by I. M. D. Little, A Critique of Welfare Economics (Oxford: at the
Clarendon Press, 1950), pp. 135-36; 2nd ed., 1957, pp. 143-45.
7. The necessity of introducing such a tax was perceived by Aoki, op.
cit., in his extension of the present model to allow for interindustrial relation-
ships and variable supply of factors of production. The discussion presented
in the following paragraphshas been influenced by his work, in which the tax
rates given by (6.30) and (6.31) below are shown to apply to the general case,
provided to 2 p.*y,* is levied in lump sum fashion as in (6.35).

An infinity of tax systems is now available, one for each choice

of the income tax To. Exactly one of these allows prices to be equal
to marginal costs, namely,
(6.30) rO*= 1- llp (to* = p - 1)
(This becomes negative (a subsidy) if p' < 1.) The corresponding
excise taxes are
(6.31) ri**=1-pi (i=l, 2, . . . , n),
from (6.28). Conversely, setting prices equal to marginal costs,
(6.25) becomes
(6.32) 1- 1 -Pi-= 1 -P
Pi pi
since q =p 7ri from (2.16) and (6.14), and this then determines the
income tax from (6.28) as in (6.30).
The case of interindustrial relationships is thus handled by in-
troducing an income tax to finance the net deficits of firms, or a pro-
portional social dividend if marginal cost pricing results in a net
industrial surplus, which will be the case when the average re-
turns to scale are less than unity. This is all under the assumption
that labor is in perfectly inelastic supply and indifferent as between
alternative occupations.
The last remark leads to the remaining major objection that has
been lodged against the proportionality rule. As stated by A. P.
Lerner, "labor always has the alternative of not working but pro-
viding leisure for the individual who is the owner of his own labor." 8
Considering leisure to be the nth commodity in our model, we find
that the corresponding "production function" will naturally be
Yn=Zn, with Pn=1. In the absence of income or expenditure taxes,
the proportionality rule requires - when p' > 1 - that leisure be
taxed and industry subsidized. From the condition (3.10) for equi-
libriumnof households, and the optimal allocation formula (5.15),
this would require
(6.33) Pa= * = WI >
i.e., the price of leisure would have to exceed the wage rate. To the
extent that leisure is a private activity, this obviously cannot be
8. Abba P. Lerner, The Economics of Control (New York: The Mac-

millan Company, 1944), p. 102. See also his booklet Everybody's Business
(East Lansing: Michigan State University Press, 1961, and New York: Harper
& Row, Publishers, Inc., 1964), pp. 30-31. The point was also made by Abram
Bergson in The Structure of Soviet Wages (Cambridge, Mass.: Harvard Uni-
versity Press, 1944), p. 20, and by Paul Samuelson in the Foundations, p. 240.
Bergson also discussed the question of occupational choice.

achieved. If an income tax To were introduced, eq. (6.33) would be

altered to (using (6.24) and (5.15))
On
(6.34) Pn = (1 -TO) W- (-TO) wp
(where "income" and "expenditure" include the imputed value of
the leisure time); hence imposing pn =w leads to (6.30) again. But
since it is not practicable to levy taxes on imputed income, it is
necessary instead to impose a lump sum tax
(6.35) T* =Tro*wZ= (1-1/p') wZ,
leaving a disposable income of wZ/p'.
Although the price of leisure is now equal to the wage rate, the
effect of the tax system (6.31) and (6.35) will be to bring about re-
duced disposable income, hence reduced demand for leisure (in-
creased supply of labor), relative to the laissez-faire level. This re-
sult cannot be produced in Kahn's system; nevertheless Kahn did
perceive the need for some such device in observing: "if external
economies are at all appreciable over the field of industry in general,
it is socially desirable to stimulate the supply of factors of produc-
tion." 9 An intriguing speculation is that this type of consideration
may be what is behind some old and popular arguments for adver-
tising: people must be persuaded to buy more and work longer than
they would do on their own accord, so that they may reap the ad-
vantages of mass production.
VII. ANALYSISIN TERMS OF CONSUMERS'SURPLUS
Marshall's original treatment of the criteria for taxing increas-

ing-return industries and subsidizing decreasing-return industries
was carried out in terms of the now generally discredited concept
of consumers' surplus.' As Samuelson has shown,2 the concept can
be given a meaningful interpretation in terms of modern welfare
economics only in certain limited circumstances, which include the
case of the log-linear utility function U of (5.3). Marshall's use
of the concept in his tax-and-bounty analysis has never won com-
plete acceptance; 3 in this section, I shall therefore present an anal-
9. Op. cit., p. 19.
1. Principles, 8th ed., pp. 128n, 467n-70n.
2. Paul A. Samuelson, "Constancy of the Marginal Utility of Income,"
in Studies in Mathematical Economics and Econometrics, In Memory of
Henry Schultz, ed. Oscar Lange, Francis McIntyre, and Theodore 0. Yntema
(Chicago: University of Chicago Press, 1942), pp. 75-91. Also the Foundations,
pp. 192-93.
3. Samuelson has stated: "Historically the important propositions con-
cerning increasing and decreasing cost industries, which are attributed to

ysis which shows that Marshall's original method of reasoning

can, in limited circumstances and subject to certain qualifications,
be given an interpretation which makes his treatment logically
correct.
Marshall assumed independent utilities as a matter of course.4
Thus, if the utility function has the form
(7.1)
U(Yy, Y2Y... ., Yn)=E=18 i~ii(N) (bet(ye) >O01 0,

> E:=1Z0l,
and if it is maximized subject to the constraint
(7.2) Y =lPiy$?I= (1 -To)WZ
where I is disposable money income and To is the proportional in-
come tax rate, then equality will hold in (7.2) and the conditions
(7.3) U= 01 (N) =,UP,
will be satisfied, where p is a Lagrangean multiplier representing the

marginal utility of income dU/dI (Marshall's "marginal utility of
money"). Multiplying (7.3) by ys and summing, we have
1OkYkPk'(Yk)
(7.4) Su=
I
In order for the demand price pi = Gipj'(yj) /u to be independent of
yj for j=/=iand each fixed I, as assumed by Marshall,5 obviously u
must be independent of yj, so 0jycjp'(yj) =constant.6 Integrating
Marshall's consumer's surplus notions, may be said at best to have been in-
complete derivations, and at worst may be said to be absolutely incorrect
statements which, by a pun or play on words, seem to resemble the Pigouvian
doctrine concerning industries with external economies and diseconomies. In
its earlier form the Pigouvian doctrine is close to that of Marshall, but from
the writings of Knight and Pigou himself, we know that earlier form to be
quite wrong." (Foundations, p. 196.) See also the skeptical remarks by Milton
Friedman in "The 'Welfare' Effects of an Income Tax and an Excise Tax,"
Journal of Political Economy, Vol. 60 (Feb. 1952), pp. 25-33 (p. 33), reprinted
in Milton Friedman's Essays in Positive Economics (Chicago: University of
Chicago Press, 1953), pp. 100-13 (p. 113).
4. Principles, Mathematical Appendix, Note XII bis, p. 845.
5. In the Principles, p. 100, he recognizes that, for instance, the demand
price for tea will be a function of the quantity of coffee, but observes in a
footnote that it is convenient to group commodities together so as to eliminate
such cross-elasticities.
6. If the social welfare function U=F(U1, U2, . . . , Ur) is symmetric,
then from the assumption that all people are identical in their capacities and
tastes, their incomes will be equal in equilibrium, and consequently so will
their marginal utility of income dUt/dI,=mu; further, no lump-sum transfers
would be needed to bring this about. More generally, however, it can only
be said that dU/dIi is the same for all individuals, since the dU4/dI can be
different; that is, it is only the "marginal social significance of every dollar"
in Samuelson's terminology ("Social Indifference Curves," op. cit., p. 11) that

yields 0j (yi) = coj+ cli log yj where coi and cl0>0 are constants.
Sincethe same argumentappliesto each j, (7.1) must be an increas-
ing linear transformationof
(7.5) U(y1, Y2, Y,y) =E- l6 log y, (6>0, Es 1j= 1),
for which = 1/I. The inverse demand function correspondingto
(7.3) is then
(7.6) Pi
I Yi
A natural definition for the consumers'surplus obtained from
the ith commoditywould be the contribution8,q,(yi) = oi log yj of
this commodityto total utility, which could be written as
(7.7) st(y,)=f Pdyi =Otf' =G log Yt.
Marshall'sdefinitionwas, instead,7
(7.8) L'dy,
0
Unfortunately,the integral in (7.8) diverges;however,a close scru-
tiny of Marshall'suse of the concept reveals that only increments
in consumers'surplus enter in any essential way into his analysis,
and since the secondterm of (7.8) is the constant O,,we may just as
well choose the definition (7.7). Equivalently we may define con-
sumers'surplusas
(7.9) s (y,) =- f/
yid(Pj) = J P4/' d(pi/I)
= log PI-log es)=o log y,
is equalized. To the extent that maximization of social welfare required a
system of lump-sum interpersonal transfers, this of course would be quite
apart from and supplementary to the taxes and subsidies being discussed in
this paper.
7. In his "The Rehabilitation of Consumers' Surplus," Review of Eco-
nomic Studies, Vol. 8 (Feb. 1941), pp. 108-16, J. R. Hicks made much of the
distinction between Marshall'sverbal and mathematical definitions (Principles,
pp. 124 and 128n); according to his interpretation, they coincide when the
marginal utility of income is constant. As Samuelson showed in the Schultz
memorial volume (op. cit.), 1A cannot be invariant with respect to all changes,
and in the present case it is invariant with respect to quantities consumed, for
fixed income and utility scale, so presumably Hicks's distinction does not
apply. A related distinction has been emphasized by Milton Friedman, "The
Marshallian Demand Curve," Journal of Political Economy, Vol. 57 (Dec.
1949), reprinted in his Essays in Positive Economics, op. cit., pp. 47-99.
Friedman's interpretation is that Marshall's demand curve is drawn on the
assumption that other prices adjust so as to keep "real income" (a euphemism
for utility or welfare) constant. However, it is hard to believe that in analyz-
ing the effects of taxation on welfare, Marshall would have employed a concept
that assumed welfare to be held constant throughout.

The geometric equivalence of the two definitions (7.7) and (7.9)

is obvious, since the demand curve is a rectangular hyperbola.
From these definitions, the utility function U of (7.5) is simply
the sum of consumers' surplus in all n industries. Since labor is
assumed to be perfectly inelastic in supply, and indifferent as be-
tween alternative occupations, no question of "producers' surplus"
arises.
Marshall's analysis proceeded by comparing the change in
consumers' surplus in each industry with the revenue collected (or
subsidy paid) in that industry. Let us assume that a system of
taxes ro, ri, . . . , n is determined as in eqs. (6.25) and (6.26),
with ro chosen arbitrarily and the remaining ri depending on ro in
accordance with (6.25). From (6.25) it follows that
(7.10) go= (1-t-o) (1 - 7) 0j,
whence substitution of this into the production function (2.5) gives
(7.11) yji= Ki (0jZ) Pi [ (1 -70) (1 -ri) IPi.
Consumers' surplus is therefore
(7.12) Si=09 log [Ki(GiZ)Pi]+0ipi [log (1-ro)+ log (1-ri)].
The first term is the consumers' surplus in the pre-tax situation; so
the second term gives the change following the tax, which will be
denoted Asi. To make the revenue collected commensurable with the
consumers' surplus, it must be expressed as a proportion of total
income wZ. In the case of excise taxes, this proportion is rjpjyj/wZ=
(1 -Tro) Tj0j from eq. (6.24). Income taxes have to be prorated, say
accordingto topiyi/wZ = TO0j(also by (6.24)), where to= ro/ (1- To).
Thus the revenue collected in the ith industry is, as a percentage of
national income,
(7.13) ri=9i[To+(l-ro)Ti]=Gi[1-(1-To)(1-as)].
It is easy to verify from eq. (6.25) that these expressions (7.12) and
(7.13) give the same result for any To as for To=O; so given the
above prorating convention there is no loss of generality in assuming
TO= 0 for the remainder of this analysis.8 A distinction will now be
8. The situation is illustrated in Figure I. The curves labeled Di, St, Mt

correspond to the functions D4y0), Sdy4), M(yt) defined in eqs. (3.11),
(2.17), and (2.15), respectively, except that the prices are to be expressed rela-
tive to wZ rather than w to make the definitions commensurate with that of
consumers'surplus in (7.6) and (7.7) (or alternatively, units may be chosen so
that Z=1). Two other curves are shown. N, is defined by N(y,)=
[ri/(1-T)]Si(y4), which gives the supply price inclusive of the tax; under
the proportionality rule this is higher than the marginal cost for both indus-
tries when p'>l, i.e., N(y0=p`M,(y) when Tr=1-pi/p'. Es is defined by
Ej(y)=((1-ro)Di(y) and represents effective demand following the impo-
sition of an income tax To; under marginal cost pricing, 1-7o*=-l/p'; con-
sequently the intersection of Et with Mt occurs at the same output but a
lower market price. The gross excise tax and gross subsidy under the pro-

made betweenincipient taxes, which permit a gain in total welfare,

and optimal taxes, which yield maximumwelfare.
Marshall's criterion for gain is as follows (for To = 0):
(7.14) Asi+ri= i[pi log (1 -Ti) +Ti] > 0
for each industry i. That is, the loss in consumers'surplusmust be
exceededby the revenue collected, and the gain in consumers'sur-
plus must exceed the subsidy paid. Marshall neglected to specify
the additionalrestrictionthat
(7.15) Yni~i-ri = ; - oo <Otis<1 (i = 1, 2, . .. , n)
(eq. (6.10) above), i.e., that taxes collected must equal subsidies
paid. Without implying that Marshall would have formulatedthe
matter quite so precisely, I shall for conveniencedescribe as Mar-
shall's conjecture concerning incipient taxes and subsidies the fol-
lowing proposition: if there exist two industries, say 1 and 2, such
that pi<1 and p2> , then there exists a tax T1>O and a subsidy
T2<0, satisfying (7.14) and (7.15) for i=1, 2, where Ti=O for i:Q1,
#42, such that in each industry the algebraic sum of the gain in
consumers' surplus and the tax revenue is positive (eq. (7.14)), and
the tax collected equals the subsidy paid (eq. (7.15)).
The propositionis proved as follows. The inequality (7.14) is
satisfied if either
(7.16a) Ti > 0 and log ( -T) >
or
(7.16b) Tri<O0 and lo lTj <Pi.
l og (11-Ti)
Define the function
I -T
(7.17) g(T)= log (1-T)i
li if T0.
g is continuousand differentiable,and is strictly decreasingin the

intervals - oo <T <O and 0 <T < 1 9 (see Figure III). Moreover,
portionality rule are decomposed into a net excise tax (or net subsidy) plus
income tax under marginal cost pricing. Note that even though the income
tax displaces the demand curves to the left, consumers'surplus is still measured
by the area under the demand curve Di, and not the area under E.. The
numerical magnitudes chosen for the figure are KL=K2=l, p1=O8, P2=15, and
01=02 = 0.5, leading to optimal excise taxes of r1*=-T2* = 30.4% under the
proportionality rule, and optimal excise taxes of T1*= 20%o,72* =-50% to-
gether with an income tax of To*=13% under marginal cost pricing.
9. Differentiate g(r); the result is negative if and only if
log (1-r)>-r/(1-T).
To prove this inequality for r<O, integrate both sides of the inequality

g (T) increases without limit as r-* - oo, and also g (1) = 0. Therefore
there exist unique T +>0 and T4 <0 such that g(Th)=pi and
9 (T 2) = p2 with the properties
~~ ~ ~~~~~l 1.5 ' t2
t - -1.145 0 Tl * 371 l
FIGUREIII
pl<g(T1) <1 for 0<T1<4r1

(7.18)
l<9(T2) <p2 for T 2 <T2 <0
Consequently,the inequalities (7.16a) and (7.16b) are satisfied for

all T1, 72 in the above respectiveintervals. This defines a rectangle
in the southeastquadrantof the (TI, T2) plane, which is certainly in-
tersectedin its interiorby the line 611+ 02T2= 0, proving the propo-
sition.' Moreover,for any tax-subsidy pair (T1, T2) satisfying the
proposition,so does (AT1, XT2) for 0<A< 1.
In his analysis, Marshall was careful to say that the tax col-
lected would exceed the loss of consumers'surplus only if "the law
1/t>1/(1-'r) from 1 to 1-r; similarly, for r>O integrate both sides of the
inequality 1/t<l/(l-T) from 1-T to 1.
1. The line 91T1+82T2=0 will intersect the right side of the rectangle
0?r1:Ti4, T27_T2O, if 61r1 +o2T7 ?O, and the bottom side if 61T14+02r:?0;
in either case it intersects the interior. It is clear that the proposition can be
extended in such a way that if I is the set of indices such that p<l for i el,
and J the set of indices for which p,>1 for j eJ, then there exists a set of taxes
r,>O for i e I, and subsidies TJ<0 for j e J, satisfying 21t=Oktk=0.

of diminishing returns acts so sharply that a small diminution of

consumption causes a great falling-off in the expenses of production
other than the tax," and likewise in the increasing return industry,
"the increase of consumers' surplus may [sic] exceed the total pay-
ments made by the State to the producers; and certainly will do
so in case the law of diminishing returns acts at all sharply." 2
However, the above analysis shows that under the present assump-
tions these qualifications are unnecessary; the inequalities p,<l
and P2> 1 are sharp enough provided Ti and T2 are sufficiently
small.3
To prove that it is desirable to tax the decreasing-return in-
dustry and subsidize the increasing-return industry, all that is
needed is to establish that the gain in consumers' surplus in the
latter exceeds the loss of consumers' surplus in the former, i.e., that
(7.19) 02P2 log (1-T2) > -OipI log (1-Ti);
whereas Marshall's criterion requires the following string of in-
equalities to be established:
(7.20) 02P2 log (1-T2) > -922=OTJ> - O1p1 log (1 -TI).
On the face of it, Marshall requires too much, but as we have just
seen, it turns out that (7.20) will always hold, at least for sufficiently
small TJ'S (satisfying (7.18)).
The above analysis only proves that, industry by industry,
some tax-and-bounty scheme is better than none. Do optimal
taxes and bounties satisfy Marshall's criterion? In general the
answer is No, but it turns out to be Yes in the special case pi'= 1.
This will now be shown.
From eqs. (7.5) and (7.11) it follows that utility may be ex-
pressed as a function of the tax rates:
(7.21) V(T) V(Toy l

Tj, * * Tn) =n1t4pi log [(1-To) (1-Tr)].
This differs from U by a constant, and coincides with Asn (see

2. Principles, pp. 468-69.
3. Such a point was, in fact, perceived by C. F. Bickerdike in his seminal
paper, "The Theory of Incipient Taxes," Economic Journal, Vol. 16 (Dec.
1906), pp. 529-35. Bickerdike's reasoning consisted of comparing the triangle
and rectangle obtained after subtracting the common intersection of the tax
revenue and the loss of consumers' surplus (shown by the cross-hatched area
in Figure Ia), as follows (p. 533): "If we imagine the tax to be made very
small, [the rectangle] becomes a line, and [the triangle] becomes a point, and
there is, therefore, necessarily some advantage, provided that the supply
curve . . . is not an absolutely horizontal line." The looseness of this argument
was commented upon indulgently by F. Y. Edgeworth in "Appreciations of
Mathematical Theories. III," Economic Journal, Vol. 18 (Sept. 1908), pp.
392403 (p. 398), reprinted as "Mr. Bickerdike'sTheory of Incipient Taxes and
Customs Duties" in his Papers Relating to Political Economy, Vol. II (Lon-
don: Macmillan and Co., Ltd., 1925), pp. 340-66 (p. 347).

eqs. (7.12) and (7.14)). Maximizationof V subjectto the restriction

(6.26) that taxes collected be equal to subsidies paid leads to the
first-orderconditions
(7.22) (1-To*) (1-TJ*) =pi/p (i= 1, 2, . . . , n),
which are, of course, the same as the conditions (6.28) previously
derived. Thus,
(7.23) V (T*) =lipJ log (Pi/p').
In the special case p'= 1, V(T*) can be decomposedas follows:
(7.24) V(T*) =>'3e8[pf log pi+1-pl] >'=i94(PJ)X
which defines the function
(7.25) +(p)=p log p+1-p.
Now when To*=0, each ith term in (7.24) is simply the sum of the
change in consumers'surplus and the tax revenue in the ith in-
dustry:
(7.26) Oi,&(pi) =-i[Pt log pi+l-pi] =O[pi log (1-T4*) +T T]
= &sj+ri
(see eq. (7.14)). Now it is easily verifiedby differentiationthat the
function q of (7.25) is strictly decreasingfor p<1 and strictly in-
creasing for p > 1, and that 0 (1) = 0. Therefore,
(7.27) +(p) >0 for p7?1.
This proves that if the average degree of returns to scale p'= tpi
is equal to unity, the optimal tax-and-bountyscheme will satisfy
Marshall's criterion that, in each industry for which peedkl,the
algebraicsum of the change in consumers'surplus and the tax rev-
enue is positive.
That the conditionp'= 1 is indispensable4 can be seen by con-
sideringthe following examplewith n= 2. Let pi = 0.8, P2 = 1.5, 61 =
0.25, 02=0.75; then p'= 1.325 and the optimal tax rates (in the ab-
sence of income taxes) are r1* = 0.396 and T2* =-0.132. The alge-
braic sum of the gain in consumers'surplus and the tax revenue is
(7.28) As,+ri=6j[pj log (1-T4*) +T* ]
= Ot[pi log (Pi/p) + 1-Pi/p],
in accordancewith (7.14) and (7.22). For industry 1 this gives the
value -0.007, and for industry 2 the value 0.039; thus Marshall's
criterion fails to hold in industry 1. The roots of the equation
4. It is certainly not necessary, however. In the example illustrated by
Figure I, which is identical with the one now being described except that
consumers' tastes are such that 01=02=0.5, the optimal tax-subsidy pair
(T1*, T2*) = (0.304, -0.304) falls inside the required rectangle 0<r1<0.371,
- 1.45<r2<0; hence the Marshallian comparisons hold good in each in-
dustry.

9(7) = pi are, respectively, T+=9-g1(0.8) =0.371 and T2 = 1(1l5)=

- 1.145, where g is defined by (7.17), and thus the optimal tax-
subsidy pair (T1*, 72*) = (0.396, -0.132) falls outside the required
rectangle defined by (7.18). The situation is illustrated in Figure
IV.
In the general case when p' need not be equal to unity, the
function V (T*) of (7.23) can be decomposed in the following way:
I~~~~~~
(l2 -t).P,~~~~~~~~~
(1-,r2)GA#
01 .25 -.75
1-Ti- _P -
*.8 P2- 1.5
-Tj '1j 1 1 tlj

FIGURE IV
(7.29) V(*) =I='1=i(pi log pi+1-pi) - (p` log p'+1-p').

The terms t (pt) = pi log pi+l - pi, while strictly positive for pj#1,
no longer correspondto the sum of the gain in consumers'surplus
and the tax revenue; and since the last term q'(p')=p' log p'+l-p'
is also positive for p'#l1, one can no longerconcludethat
V (t*) > V (O) = 0
simply by addingup positive terms, industry by industry. However

we may note that q"(p) = 1/p >0, so the function q is strictly con-
vex; thereforeby Jensen'sinequality,5
( 7.30) V (T ) =17 = 101t( pi) -0 (1 _10ip) > ?A
with equality holding if and only if PI= P2 = * =pn
VIII. DYNAMIC STABILITYOF THE ADJUSTMENTPROCESS

No discussion of competitive equilibrium under increasing re-
turns would be completewithout a discussionof dynamic stability.
5. Cf. Hardy, Littlewood, and P6lya, op. cit., pp. 74-75.

382 QUARTERLYJOURNALOF ECONOMICS
It has already been shown that the Marshallian criterion for sta-
bility is met, that the supply curve always cuts the demand curve
from below. This will now be shown to carry over to dynamic sta-
bility in a general equilibriumframework.
The distinctionmade in Section II between subjective and ob-
jective productionfunctions actually becomesmore plausible when
put in a dynamic context. Instead of assuming that the objective
productionfunction (2.5) holds for both variables simultaneously,
let us replace (2.4) by
(8.1) dt) =a4[k'(t)-k4(t)]; aj>O (i=l, 2, . . ., n)
where k (t) is defined by
(8.2) ki (t) =KJZ,(t)'P,-1 (i= 11 2, . . . , n).

Let the subjectiveproductionfunction (2.3) hold simultaneouslyin
the two variables, accordingto
(8.3) y,(t)=ki(t)zj(t) (i=1, 2, . . . , n).
It may be interpretedas the (objective) short-runproductionfunc-
tion, and the equation
(8.4) d'(t) =k d(t) = Zi(t) = KiZi( t),o. 1i~ 2, . . . , n),
which is the dynamic version of (2.5) and defines the quantity
yd (t), may be identifiedwith the long-runproductionfunction. The

short-run and long-run cost functions may be defined similarly.
Note that y (t) =y d (t) holds only in long-runequilibrium.
To completethe dynamic model, we must make some assump-
tions concerningdynamic adjustment in product and factor mar-
kets. Let a system To, Ti, . . . , Tn of income and excise taxes be
fixed accordingto any formulasatisfying (6.26), and set
(8.5) q (t) = (1 - r) pi(t) (i=ly 2, . . . , n).
Let us postulate instantaneousadjustmentin the markets for con-
sumers'goods,and sticky wages:
(8.6) Pi(t) y (t) = (1-T0) 4W(t)Z; w (t) = w > O
(i= ly 2, . . . , n).
It shouldbe noted that wages are still assumedto be uniformamong
industries-no longer an innocent assumption in a dynamic con-
text.6 Summing (8.6) over i, one obtains Walras' law-also a
6. As mentioned in Section III, it can be justified by assuming a zero

rate of time preference-an assumption that is also needed to justify maxi-
mization of the static social utility function u of (3.7). This follows because

strong assumption, since workers are assumed to spend the amount

they would earn at current wages if they were fully employed.7
Analogously to (2.10), the desired demand for labor zi(t) is
defined to satisfy
(8.7) qi(t)yi(t) =wz4 (t) (i= 1, 2, . . . , n),

and the dynamic adjustment equations determining labor alloca-
tion will be assumed to have the form
(8.8) dt =/3[zi(t)-zd(t)]; 8>0 (i=1, 2, . . . , n)

where zi(t) is actual supply of labor to the ith industry at time t.
On account of the instantaneous adjustment in commodity markets
given by (8.6), as well as the relations (8.5), the relation (8.7) im-
plies that the desired demand for labor in the ith industry takes
the constant form of Mill's "wages fund":
(8.9) wz (t) = (1-To) (1-r)Oiwz=WZ i
(thus the time dependence is dropped). Canceling w>0 from both
sides and summing over i, and making use of (6.26), we obtain
(8.10) E ~z = Z.
Now we naturally assume
(8.11) Y.".izi(t) -<Z,
so that (8.8) in conjunction with these two conditions forces equality
in the second, i.e.,8
{s.12 nr izi (t =Z.
if an "optimal" tax scheme (ts*, T1* . . . , rn*) were suddenly imposed on an

economy in laissez-faire equilibrium, the momentary utility
ut=U(?Jl(t), YAOt . . . , vnM))
would at first fall, since the laissez-faire equilibrium would be optimal in
terms of the short-run production functions prevailing at that time, in the
00
sense of maximizing the momentary Ut. If a Ramsey utility integral f e-5tutdt

were chosen as a social objective, the optimal path would converge to the
"golden rule" solution with maximum ut as t-> o0 only when 5-40.
7. This aspect of Walras' law, which appears to be generally overlooked,
has been discussed in my paper, "The Nature and Meaning of Equilibrium
in Economic Theory," in Functionalism in the Social Sciences, ed. Don
Martindale (Philadelphia: American Academy of Political and Social Sci-
ence, Monograph 5, Feb. 1965), pp. 35-64.
8. As a behavior equation for firms, (8.8) is admittedly artificial in that
the same coefficient p is assumed to hold for all industries. I must frankly
apologize for the makeshift nature of this artifice; my only defense is that the
question of the stability of full employment equilibrium is not peculiar to the
present study, nor is it the question at issue in this study.

Profits in the ith industry will be given by
(8.13) P(t) = qi(t) yi(t) -wzi(t) = w[zi-zi (t) ]

so that eq. (8.8) may be interpreted as stating that employment will
be expanded in industries earning profits, and contracted in indus-
tries suffering losses. Total profits in the economy are zero from
(8.13), (8.10), and (8.12); we may imagine that the temporary
losses are covered by bank loans financed out of debt repayment on
the part of firms earning temporary profits.
We may now proceed to solve the dynamic system, as follows.
Given any initial allocations zi (0+) satisfying :4t jzi (0+) =Z
the solution of the differential equation (8.8) is
(8.14) zi(t) = z- [zt-zi(0+) ]e
where z is given by (8.9) ; we verify that >,4=1z (t) =Z. Moreover,

(8.15) lim Zi(t) =z?.
t->eo
The solution (8.14) is now substituted in (8.2), and the function
kd (t) entering into eq. (8.1) is determined by
(8.16) kV(t) =Ki[z- (z4-zi(0+) )e-fi]P-

Given any initial condition ki(O+), the solution of (8.1) is then
given by 9
(8.17) ki(t) =ki(0+)e-ast+hj(t)
where
td
(8.18) hi(t)== f aie a4(t T)k (T)dr.
0
We shall now prove that
(8.19) lim ki (t) = Ki (Z ) Pi'
tF-a
where ZdiS given by (8.9).

The first term on the right of (8.17) approaches zero, and from
(8.15) and (8.2) it is clear that
(8.20) lim kd (t) =K(z")Pt'.
ton3
It remains therefore to show that (8.20) and (8.18) imply that

(8.21) lim hi(t) =Ki(Zi)Pi'1.
tB-ox
9. Cf., e.g., Gustav Doetsch, Guide to the Applications of Laplace

Transforms (Princeton, N.J.: D. Van Nostrand Company, Inc., 1961), p. 45.

This follows immediately from a summability theorem due to

Knopp 1 upon verifying that the kernel G(t, T) =ae-a(1-T) of the
integral equation (8.18) (where the subscript i has been dropped for
convenience) satisfies the following three properties:
t
(A) f | G(t, T) dT=1-e-aI<H(=1) for all t>O;
0
T
(B) lim f | G(t, T) I dT= lim e-at(eaT-1) =0 for all
t- 00o 0 t-G
T < oo;
t
(C) lim f G(t, T)dT= lim (1-e-at)=l.
t->0o 0 t -> o
Thus, (8.21) follows and the equilibrium of the system is dynami-
cally stable.
UNIVERSITY OF MINNESOTA
1. Cf. G. H. Hardy, Divergent Series (Oxford: at the Clarendon Press,

1949), Theorem 6, pp. 50-51. The theorem assumes that the function kt4(t)
is bounded, and this is satisfied in the present case on account of (8.2) and
the monotonicity of the solution (8.14).


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External Economies of Scale and Competitive Equilibrium

Author(s): John S. Chipman

This content downloaded from 91.229.229.203 on Wed, 18 Jun 2014 23:29:57 PM

EXTERNAL ECONOMIES OF SCALE AND

I. Introduction,347.-Il. Productionfunctionsand producerequilibrium,

Are increasing returns to scale compatible with perfectly com-

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contemporary international trade literature, some authors maintain

This content downloaded from 91.229.229.203 on Wed, 18 Jun 2014 23:29:57 PM

be argued in Section VII that these are precisely the assumptions

This content downloaded from 91.229.229.203 on Wed, 18 Jun 2014 23:29:57 PM

to be completely external in the minds of the individual entrepre-

2. Alfred Marshall, Principles of Economics (London: Macmillan and

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quently, there are none of the ratchet phenomenadiscussedand em-

6. Kenneth J. Arrow, "The Economic Implications of Learning by Do-

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with Kahn's proportionalityrule. (Income taxes allowing for mar-

Let there be n industries, each producing a single distinct ho-

2. It is, of course, quite arbitrary to assume that k, depends on total em-

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This content downloaded from 91.229.229.203 on Wed, 18 Jun 2014 23:29:57 PM

(computedfrom (2.5)) is positive and finite.

From the viewpoint of the economist analyzing the situation,

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(2.12a) and (2.12b) necessarily coincide,on account of the relation

whereas the objective marginal cost is obtained by differentiating

which is rising, constant, or falling accordingas p <1,=1, or >1.

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III. DEMAND FUNCTIONS AND SUPPLY OF LABOR

It is well known that utility functions can be aggregated if

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proportion(since utility functions are identical, homogeneous,and

Thus, Samuelson's "utility possibility curves"9 (for m = 2) are

and we verify that the correspondingaggregateutility function is

Finally, it is assumedthat there is a fixed aggregatequantity

It is assumed that the acquisition of specialized skills is gained

9. P. A. Samuelson, "Evaluation of Real National Income," Oxford

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preference. It follows that in long-run equilibrium there cannot be

IV. EQUILIBRIUM UNDER LAISSEZ-FAIRE

Our model has been reduced to three systems of relationships,

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from (3.10), so that no commodities with positive prices will be

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The prices are then obtained by substituting (4.7) in the demand

Only the ratios pi/w are determinate.

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Theseareshown superimposed in Figure I. The supply curve has

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The set Y is closed and bounded,and the function (3.7) is con-

is strictly convex (see Figure II).

3. P. A. Samuelson, "Social Indifference Curves," this Journal, Vol. 70

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We are to show that

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for, dividing both sides of (5.8) by Kj11P' and summingover i we ob-

5. A. C. Pigou, Wealth and Welfare, p. 173. The Economics of Welfare:

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using (2.5). Summingover i and makinguse of (5.1) with equality

which, when substitutedback in (5.12), yields for the optimal allo-

(5.17) yi* = yit according as pi =p'

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if an "optimal" tax scheme (ts, T1 . . . , rn*) were suddenly imposed on an