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.