Krugman: Review of 'Knowledge and the Wealth of Nations,' by David Warsh

Paul Krugman with an interesting review of David Warsh's book Knowledge and the Wealth of Nations about the role of increasing returns to scale in theories of economic growth:

The Pin Factory Mystery, Review of 'Knowledge and the Wealth of Nations,' by David Warsh, Review by Paul Krugman, Sunday Book Review, NY Times: Economic ideas play a large role in shaping the world. "Practical men, who believe themselves to be quite exempt from any intellectual influences," John Maynard Keynes said, "are usually the slaves of some defunct economist." So it's odd how few popular books have been written describing the social and personal matrix from which economic ideas actually emerge. There have been no economics equivalents of, say, James Watson's book "The Double Helix," or James Gleick's biography of Richard Feynman.

David Warsh has now made a major effort to fill that gap. "Knowledge and the Wealth of Nations" is the story of an intellectual revolution, largely invisible to the general public, that swept through the economics profession between the late 1970's and the late 1980's. I'll come back to the question of how important that revolution really was. But whatever one thinks of the destination, Warsh, ... takes us on a fascinating journey through the world of economic thought — and the lives of economists — from Adam Smith to the present day. ... But let me focus on the book's virtues before I talk about its minor flaws.

Warsh tells the tale of a great contradiction that has lain at the heart of economic theory ever since 1776, the year in which Adam Smith published "The Wealth of Nations." Warsh calls it the struggle between the Pin Factory and the Invisible Hand. On one side, Smith emphasized the huge increases in productivity that could be achieved through the division of labor, as illustrated by his famous example of a pin factory whose employees, by specializing on narrow tasks, produce far more than they could if each worked independently. On the other side, he was the first to recognize how a market economy can harness self-interest to the common good, leading each individual as though "by an invisible hand to promote an end which was no part of his intention."

What may not be obvious is the way these two concepts stand in opposition to each other. The parable of the pin factory says that there are increasing returns to scale — the bigger the pin factory, the more specialized its workers can be, and therefore the more pins the factory can produce per worker. But increasing returns create a natural tendency toward monopoly, because a large business can achieve larger scale and hence lower costs than a small business. So in a world of increasing returns, bigger firms tend to drive smaller firms out of business, until each industry is dominated by just a few players.

But for the invisible hand to work properly, there must be many competitors in each industry, so that nobody is in a position to exert monopoly power. Therefore, the idea that free markets always get it right depends on the assumption that returns to scale are diminishing, not increasing.

For almost two centuries, economic thinking was dominated by the assumption of diminishing returns, with the Pin Factory pushed into the background. Why?

As Warsh explains, it wasn't about ideology; it was about following the line of least mathematical resistance. Economics has always ... sought the rigor and clarity that comes from using numbers and equations to represent their ideas. And the economics of diminishing returns lend themselves readily to elegant formalism, while those of increasing returns — the Pin Factory — are notoriously hard to represent in the form of a mathematical model.

Yet the fact of increasing returns was always a conspicuous part of reality, and became more so as the decades went by. Railroads, for example, were obviously characterized by increasing returns. And so economists tried, again and again, to bring the Pin Factory into the mainstream of economic thought. Yet again and again they failed, defeated by their inability to state their ideas with sufficient rigor. Warsh quotes Kenneth Arrow, who received a Nobel in economic science for work that is firmly in the Invisible Hand tradition: increasing returns were an "underground river" in economic thought, always there, yet rarely seeing the light of day.

The first half of "Knowledge and the Wealth of Nations" is a history of economic thought from the vantage point of that underground river. It describes how great economists chose to exclude increasing returns from their analyses, even though many of them understood quite well that they were leaving out an important part of the story. It also tells the tale of economists, most notably Joseph Schumpeter, who decided that if increasing returns couldn't be modeled rigorously, so much the worse for rigor — and who found their literary, nonmathematical versions of economics simply ignored. ... The second half of the book describes how the underground river finally fountained to the surface.

I've never seen anyone write as well as Warsh about the social world of economic research, a world of brilliant, often eccentric people who bear no resemblance to the dreary suits you see discussing the economy on CNBC. It's a world of informal manners yet intense status competition, in which a single seminar presentation can suddenly transform a young man or woman into an academic star.

For about a decade, starting in the late 1970's, many of those star turns involved increasing returns. Economists had finally found ways to talk about the Pin Factory with the rigor needed to make it respectable. One after another, fields from industrial organization to international trade to economic development and urban economics were transformed.

Warsh does a superb job of conveying the drama of it all. ... There are some flaws. The work of the economists who brought increasing returns to international trade, a group that included yours truly, receives flattering treatment, yet Warsh's account misrepresents that work in subtle but important ways.

Maybe that slight sloppiness reflects Warsh's relative lack of interest in applications of increasing returns other than the one he believes to be most crucial: as an explanation of economic growth. He portrays a famous 1990 paper about increasing returns and growth by Paul Romer of Stanford University as a sort of pivot around which the whole way economists see the world changed.

Now "Romer 1990" is a terrific paper — I wish I had written it, which is the highest praise one economist can give to another. Yet I don't think it can bear the weight Warsh places on it. Nor is it clear that increasing returns really did transform our understanding of economic growth. In fact, Warsh seems to concede as much. "So there is a new economics of knowledge. What has changed as a result? The answer, it seems to me, is not much."

Never mind. If you like reading stories of high intellectual drama, if you want to know the origin of ideas that, as Keynes said, "are dangerous for good or evil," this book is for you.

Comments

[slink]

love ya mark

but what was interesting here???
besides the
the Romer hip check ????

NOT I HOPE
this golden calf ALIBI

"it wasn't about ideology; it was about following the line of least mathematical resistance
Economics has always ... sought the rigor and clarity that comes from using numbers and equations to represent their ideas"

really ???? or just some economists ...ivy tower types
CAPITALISM'S WHITE KNIGHTS

" ... the economics of diminishing returns lend themselves readily to elegant formalism while those of increasing returns — the Pin Factory — are notoriously hard to represent in the form of a mathematical model"

not because
of
the nice tame marketsystem it produces
the near failure free leave it be for optimality
results
the welfare theorems
all the spontaneous fairness
and each according to his just deserts bull
that follows etc etc

not cause it went down so smoothly eh ??

not ideology ???

not usefully purblind
to crucial aspects of market reality
in a mechanizing industrial society
notthere fore
to the benefit of industrial corporations
wanting all eyes possible
firmly fixed on an illusion
of flat world effortlessly competitive exchange

how touching

[a]

Thanks for the post --- for an ignorant person like me, it is new and interesting. I will buy the book and read it.

[Bruce Wilder]

Thanks. It looks like an interesting book.

[gordon]

Certainly interesting, but "There have been no economics equivalents of, say, James Watson's book "The Double Helix," or James Gleick's biography of Richard Feynman"? Commanding Heights? Moggridge's biography of Keynes? JKGalbraith's autobiography and some of his essays?

[reason]

I'm puzzled by this - there was revolution but it didn't change much? Funny sort of revolution, isn't it? But this is interesting because, yes I was faintly (behaps subconsciously) aware of the paradox with increasing returns (but doesn't Krugmann explain it so well!), but it is not the only major problem in Economic theory.

But while we are thinking of increasing returns - if they are so prevalent, why didn't the communists win? They surely had the ultimate economies of scale? What about the conflict between growth (producing more of the same) and development (increasing diversity). And between organisation and change.

[slink]

i feel it only fair to add
my harsh strike was based on local knowledge

this warsh fellow
while a columnist at the boston globe
poured heeps of praise on krugman
and for years

i suspect paul the K
here is paying a little of that back...
but without really violating his sense of the truth

i respect this review for that reason

btw his two examples in other sciences
are both horrible travesties
one cause watson lied and in the process
tried to bury
the reputation of a far superior scientist

and the other
because the author like this warshing machine
is a shallow cheer leader

hence i deeply suspect this book's merit
based on years of reading
this chap's gush and gee gaws

[anne]

Cleverly done, and agreed, Slink :)

[a]

This sounds serious!
Although I have lots of respect of PK... I will wait to read the comments on Amazon then.

[anne]

No; I too will look through and possibly read through the book, for the development implications need to be thought through and the history of each of the ideas is likely to be interesting.

[anne]

"So it's odd how few popular books have been written describing the social and personal matrix from which economic ideas actually emerge."

John Kenneth Galbraith was largely ignored by economists, yes, largely ignored; Paul Krugman is routinely critized for writing social commentary and not economics, though there is economics in the social commentary; Jeffrey Sachs and Joseph Stiglitz and Benjamin Friedman are broadening and promising and interesting; and Mark Thoma is continually considering how broad the field of economics may be.

[Alan]

I'm not sure, as an historical matter, that the down-playing of the "pin factory" was so much due to mathematical issues. Carl Menger's Principles of Economics, which was the least mathematical of the books that triggered the marginal revolution, includes a critique of Smith's view of the relative importance of the division of labor and, hence, of increasing returns to scale. (Menger's book is available at the Mises Institute http://www.mises.org/etexts/menger/one.asp.) In his case, at least, it doesn't seem that formal modeling was key.

[slink]

you all must remember the u shaped cost curve

the real issue was resolved by markets big enough to clear the output
of many firms all operating on the up swing half

ie

beyond the point of lowest unit cost

of course this was static or steady state

add tecnical innovations and
the left arm of the u might obtain

as to the railroad

that was not devestating

it was the steel mill and later the car plant

ford cutting price below l;ast years cost
knowing he'd sell enough additional units to lower his cost per unit
etc etc etc

the race down the cost curve leads to dell hell

[nyuk]

So, a prudent operational step a company can make is to maximize efficiency in the smallest possible work unit, and then duplicate or destroy units as demand dictates. Or perhaps it is best to fail to fulfill demand by just a little, in the hopes of ensuring continued demand. Or will that possibly lead to other competition that may cut into my market? Or even the possibility that the function underlying the demand will be met in some other way? I'm left to ponder my own extinction.

[anne]

Interestingly enough, AOL became a monster company by briefly understanding increasing returns to scale and then forget about increasing returns to scale by creating an artificial limit to the service. Google and Skype have not made the mistake. Vanguard understood, but the financial services industry is so protected that Merrill Lynch never has to compete with Vanguard. A promising idea, increasing returns, to think more about :)

[reason]

Anne,
a note - increasing returns is increasing returns in terms of output. That may however, translate eventually to decreasing returns in terms of revenue (as I think Slink pointed out). If you are big enough, you may eventually also face increasing resouce costs.

I think the big change in recent years is however due to computerisation. Previously, increasing returns to production were cancelled out but decreasing returns administratively as the hierarchy grew out of control and communication problems and duplication cut into efficiency.

Computerisation has allowed management with a flat hierarchy and hence the productivity gains and monopolisation that we are seeing today. The information economy where information is very cheap to duplicate and distribute but expensive to produce has also had an effect. I think resource costs and market satiation will provide the next barrier as I mentioned in the previous paragraph.

But we then come to public policy issues. Efficiency and development may well be enemies. The trial and error of diversification, (not to mention the congestion of urban environments that tend to encourage it) are not well supported in monopolised or oligopolised market structures. Eventually, we may well be killing the golden goose if we allow this process to continue unchecked.