Origin of the Idea

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4.1 Principal-Agent Problem

Although not referring to it as such Smith offered one of the first articulations of what is now known as the principal-agent problem. For Smith, the principals are the owners of the corporation (what Smith referred to as joint-stock companies). The agents are the managers, hired by the ownership but not owners themselves. Smith believed that since managers were not motivated by profit, they would be negligent in their tasks and tend to spend excessively.

Adam Smith (1723-1790) is perhaps the most famous of all economists. At the very least he is the best-known classical economist and his contributions have played a significant role in shaping modern economic thought. Born in Kirkcaldy, Scotland, Smith attended Glasgow College at age 14, and later studied moral and political science and languages at Balliol College, Oxford. After serving as a lecturer on rhetoric and literature in Edinburgh, Glasgow College, in 1751, elected Smith to be professor of logic and, a year later, the chair of moral philosophy. Smith left Glasgow College 12 years later to serve as a private tutor. In the course of his travels as a tutor, Smith spent time in France, where he befriended Francois Quesnay and Anne Turgot. The two physiocrate economists helped shape Smith's thinking, as evidenced by his use of the French term, laissez-faire.

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Before focusing his attention on political economy (the old term for economics), Smith published The Theory of Moral Sentiments in 1759. This work concentrated primarily on philosophy and ethics, and in particular the moral forces which guide behavior. Smith's best known work, the work that clearly defines Smith as an economist, was An Inquiry into the Nature and Causes of the Wealth of Nations (often referred to simply as Wealth of Nations), published in 1776. The 900 pages of Wealth of Nations contain not only the articulation of many time-tested concepts in economics, but also a refutation of the economic philosophy known as mercantilism. Mercantilists believed that nations should enact trade barriers with other countries so as to reduce imports and achieve a trade surplus. Their belief was that the wealth of a nation was in the gold and silver (bullion) it possessed, and that trade surpluses were a primary means to accumulating bullion. Smith argued that the wealth of a nation was the real goods it produced, not the money it possessed.

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4.2 Externalities

Although Henry Sidgwick (1838-1900) first articulated the idea of spillover costs and benefits (externalities), Arthur C. Pigou (1877-1959) receives most of the credit for formalizing the concept. Pigou, a British welfare economist (meaning that his economic theories focuses on maximizing the well-being of society), studied at King's College in Cambridge and later served as the chair of political economy at Cambridge from 1908 to 1943. The previous chair, Alfred Marshall, significantly influenced Pigou's thinking, as both were concerned about how to use economic theory to promote social well-being.

To illustrate the concept of spillover effects, Pigou used the example of sparks from railway engines. These sparks would ignite surrounding woodlands or farmland, destroying timber or crops. Because the owners of the land were not compensated for the damage, those directly involved in the railway transaction (for example, the railway company and passengers) were not bearing the full cost of their exchange. Pigou illustrated the idea of spillover benefits through an example of someone planting a forest. The reforestation benefited surrounding property owners through natural seeding of their vacant land, yet no compensation was paid for the benefit. As a result, said Pigou, less tree planting occurred than was optimal from society's perspective.

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Pigou is also known for his contributions to the aggregate demand-aggregate supply model (the "real balances effect"), and to theories of price discrimination. He also argued that a more equal distribution of income would increase social welfare. "Any transference of income from a relatively rich man to a relatively poor man of similar temperament, since it enables more intense wants to be satisfied at the expense of less intense wants, must increase the aggregate sum of satisfaction."⁽¹⁾ Pigou's reasoning was that the marginal utility of a dollar for a poor man was greater than for a rich man, and so by transferring dollars from the rich to the poor, the net gain in social welfare would be positive.

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