External economies of production, Murray Kemp, Competitive allocation of resources, Pigovian subsidies, Diseconomies tax
Econometrics | Industrial Organization | Macroeconomics
In an article published in 1955, Murray Kemp analyzed the case for interference with the competitive allocation of resources when external economies of production are present. In the specific model we are interested in—where the costs of any one producer's operations are affected by the total output of all producers of the same product—Kemp attempted to show that where entry into the industry is closed (although the industry is otherwise perfectly competitive), "there can always be found a subsidy, either on the product or on a particular factor, which will be a sufficient incentive to firms to produce an optimal output or to use an optimal quantity of each factor."
However Kemp argues that where there is open entry, "subsidies are rarely a sufficient remedy for the misallocation of resources resulting from external economies; in many cases found in reality, fiscal controls are impotent to restore an optimal allocation of resources. In the absence of far-reaching changes in the laws safeguarding property rights, the only possible solution [emphasis added] in those cases involves recourse to direct controls." We disagree with this conclusion and intend to show that for the kind of external economy discussed by Kemp, even in the case of open entry a simple Pigovian subsidy is sufficient to restore the economy to a Pareto-optimal position. (A similar conclusion applies to external diseconomies where a tax is the policy variable.)
Hay, George A. and McGowan, John J., "External Economies and Competitive Equilibrium" (1972). Cornell Law Faculty Publications. Paper 1164.
Published in: Canadian Journal of Economics, vol. 5, no. 4 (November 1972).