Economics (McConnell) AP Edition, 19th Edition

"The price which a person pays for a thing can never exceed, and seldom comes up to that which he would be willing to pay rather than go without it: so that the satisfaction which he gets from its purchase generally exceeds that which he gives up in paying away its price; and he thus derives from the purchase a surplus of satisfaction. The excess of price which he would be willing to pay rather than go without the thing, over that which he actually does pay, is the economic measure of this surplus satisfaction. It may be called consumer’s surplus."⁽¹⁾

Alfred Marshall (1842-1924) was born in Clapham, England, the son of a cashier of the Bank of England. Despite his father’s wishes that he study for the ministry at Oxford, Marshall attended Cambridge University, where he studied mathematics, physics and economics. In 1877 he married one of his students, Mary Paley. They collaborated on his first book, The Economics of Industry, published in 1879.⁽²⁾

The leading economist of his time, Marshall belonged to what economists refer to as the Neoclassical school of economic thought. Much of what appears in your textbook comes from Neoclassical economics, and Marshall’s contributions have stood the test of time.

Although Marshall used mathematics extensively in his economic models, he emphasized that the math was merely a shorthand language, and not the foundation for economic inquiry and analysis. Marshall established his own set of rules for the use of mathematics in economic theorizing:

"(1) Use mathematics as a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in (4), burn (3). This last I [Marshall] did often."⁽³⁾

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.

The [Pigou] approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: How should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: Should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm.⁽¹⁾

To demonstrate what Stigler later termed "Coase Theorem," Coase used the example of a cattle rancher and a farmer. The cattle stray onto the farmer's land and destroy crops. If the property rights are structured such that the rancher is liable for the damages incurred by her cattle, she will have an incentive to offer payment to the farmer for the use of his land.

If the farmer's rights are protected, why would he negotiate? Because if the payment from the rancher exceeds what he would have earned growing crops, he will be better off allowing the cattle onto his land.If, conversely, the rancher holds the property right and can graze her cattle on the farmer's land, the farmer may offer payment for her to stop. If the farmer offers more than what the rancher loses by not grazing her cattle on that land, the rancher will accept payment and move her cattle elsewhere.

If property rights are clearly defined, the number of affected parties is small, and the costs of negotiating are low, then according to Coase, externalities can be eliminated through private bargaining, with no need for government intervention.