Originally, I had intended to move on from Sidgwick's analysis of the negative and positive aspects of combination to Chapman's theory of the hours of labor. The later theory turns the old prejudice that union regulations are organized shirking on its head to reveal a compelling case of common pool resource management. I was going to anchor my discussion with reference to Chapman's historical research on the Lancashire cotton industry, which was very much in the Marshallian tradition of the study of industrial localization.
It so happens, though, that a more famous economist – John Maynard Keynes, in fact – became interested, in the late 1920s, in the decline of the Lancashire cotton industry. Keynes's involvement in trying to engineer a solution to the industry's crisis has been described by Roberto Marchionatti as suggestive of the "microfoundations" for the subsequent macroeconomic General Theory of Employment, Interest and Money.
It's beyond the scope of this series on the problem of social cost to establish the links between Keynes's writing on the Lancashire cotton industry and his general theory, as is elaborating on the connections and differences between Keynes's discussion of the Lancashire cotton industry and Chapman's. But the salient feature is the key – that is to say, not peripheral – role played by "external economies" in both analyses of the industry.
In Marshall's view – faithfully represented by Chapman – localization enabled small and medium-sized firms to take advantage of proximity and evolve a mixture of competition and co-operation that was sometimes explicit and sometimes tacit. By contrast, Keynes viewed the unorganized collection of firms as preventing rationalization in the face of a profound change in international competitiveness. He termed the situation "a cumulative progress towards perdition only limited by the rate at which other countries can erect new spindles." His prescribed remedy for this hodgepodge was cartelization, enforced by pressure from the banks. In it's inability to adjust to the new circumstance, the Lancashire cotton industry resembled Sidgwick's fishery, in that it was clearly in the general interest that excess capacity be phased out and goods not be sold for under a certain price but it would be rash to rely on voluntary cooperation to bring about such a result.
The point I want to emphasize is that the notion of "externalities" is not something to do with nuisance side effects of economic production -- rabbits running amuck on a neighbor's estate or sparks from a locomotive causing a brush fire. It was a key element of Alfred Marshall's view of industrial development and of John Maynard Keynes's analysis of industrial decline. It may even be considered the unheralded microfoundation of Keynes's macroeconomic analysis.
Postscript: The Lancashire cotton industry was cartelized, as per Keynes's recommendations but continued its historical decline.
Next: Lancashire, Labor and the Lump of Transaction Costs
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