LN-13 From pin factory to endogenous growth. Looking backwards from Paul Romer to Adam Smith.

Introduction One of the new breakthroughs in economics in recent decades has been endogenous growth theory. The out spring was Paul Romer’s article Endogenous technological change (JPR 1990). Romer’s paper was received with great enthusiasm and immediately inspired research all around the globe. Perhaps one should have expected this development to have led to Nobel Prize but so far it hasn’t. Why it hasn’t is an interesting questions and I cannot enlighten you on that. I am confident that Romer must have been proposed for the Nobel award but clearly not found a worthy candidate - yet. The Nobel Prize Committee may have been right about this - or wrong! And a number of candidates (e.g. Haavelmo, Markowitz, Nash, Schelling) got their prizes 40 years or more after the achievements they were awarded for. And Paul Romer is not in either one of our textbooks.

Romer’s 1990 paper had due reference to Solow’s 1956 paper which established growth theory. The first paragraph of Romer’s paper had the following sentence: “The distinguishing feature of …technology as an input is that it is neither a conventional good nor a public good; it is a non-rival, partially excludable good… .” Solow may not have disagreed with this statement but Solow’s treatment of technological change was, as we know, entirely exogenous. We also know from the growth theory class that long-term growth per capita in the Solow model is entirely exogenous.

Then what is endogenous growth? It is defined (in Palgrave) as long-run economic growth at a rate determined by forces that are internal to the economic system, particularly those forces governing the opportunities and incentives to create technological knowledge. Endogenous growth theory thus explains long-run growth as emanating from economic activities that create new technological knowledge.

Romer’s aim relative to Solow is thus easy to understand in general terms but his way of endogenizing technological change is anything but easy. Romer’s work is rooted in his doctoral dissertation at Chicago in 1983. He first presented the ideas of his dissertation in a paper titled Increasing returns and long-run growth (1986) with more complicated mathematics and some differences in content from the 1990 paper.

Romer’s 1986 title is more telling than the 1990 title about what this is really about, namely about long-run growth. Why have human societies which at some stage joined in the industrial development which started in 18C England grown in income per capita so much more than in previous millennia. The historians may have something to say about my generalizations here but let me keep on by stating also that the growth rate has even increased, as a grandiose average of countries and a couple of centuries of time.

Let us say that Romer’s aim was to try to catch key essentials of this explanation in a formula, which by any means is extremely ambitious. ‘Technical change’ is a kind of technical term for what Romer was after, namely the growth of (useful) knowledge. He wanted to succeed where Solow dropped out, namely in explaining the role of the knowledge factor. Solow had however succeeded in his 1957 paper to show the importance of the unexplained exogenous factor. Romer at some early stage in his work looked back how predecessors in economics had dealt with and understood the growth of knowledge. Notice the title of his 1986 paper – Increasing Returns. So where would he start his search?

Back to Adam Smith We have been through the history and remember well so ‘increasing returns’ reminds us immediately about the opening lines, in fact the opening chapters of the Wealth of Nations:

I.1.1 The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour.

A little further down this passage (which we didn’t read out):

One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. Then we are told that an unskilled worker would be lucky if he could make a single pin in one day, while 10-15 men in the factory with the labour divided up in the best way could make 48,000 a day or a million pins every two weeks. But would it be possible to sell a million pins every fortnight? The answer is in chapter 3 The Division of Labour is Limited by the Extent of the Market.

Maybe I repeat myself from lecture 3 but it is something odd that these passages appear so prominently in WN. Clearly Smith must have found this insight he had worked out – he had never been to a pin factory – very important. So what is odd? If we ask a qualified panel what was the most important message derived from Smith’s WN, we would probably hear about the invisible hand and that Smith showed a competitive economy to be possible and highly beneficial, elaborated on its workings. This was later corroborated by a serious of successors with increasingly sophisticated mathematical tools to prove it.

We recognize this as the general equilibrium world of Walras, which indeed has some nice properties, built up around small (atomic) agents each in a world characterized by decreasing returns

But in this picture the pin maker does not really fit in well. Suppose we consider a pin maker gets into the market early, expands, invest in new equipment and pin making R&D, developing better steel more attractive packaging, more efficient distribution channels. The bigger the market, the greater the specialization. The more efficient his production, the lower the price at which he can offer the pins. The lower the price, the more pins he can sell, the higher the profit. Where does it end? The inevitable logic is that the economics of the pin factory is that the advantages of falling costs implies that whoever starts out first in the market, can run everybody else out of the pin business.

Does this mean that big business is good; that monopolies are inevitable, and perhaps desirable? If scale economies are so important, how do small firms manage to exist at all? These questions are unexplored in WN. We are left with tentative conclusion that the two main insights of Smith iconized by the Pin Factory and the Invisible Hand seems contradictory. One is about falling costs and increasing returns, the other about rising costs and decreasing returns.

So to Romer it may have seemed that growth associated with accumulation of knowledge of how to produce more efficiently, which was associated with increasing returns, which could lead to monopoly. Hence he was lead to study the undercurrent in the history of economics comprising increasing returns and monopoly. Ricardo and Malthus Ricardo held as we now a rather gloomy picture of the society’s future. And he saw his role as economist as very different from that of Smith who sought to explain the growth of wealth. To Ricardo economics was about distribution among the three classes. But there are remarks here and there of relevance in our context, Ricardo acknowledged that prices of manufactured goods have a tendency to fall because knowledge is increasing:

“The natural price of all commodities, excepting raw produce and labour, has a tendency to fall, in the progress of wealth and population; for though, on one hand, they are enhanced in real value, from the rise in the natural price of the raw material of which they are made, this is more than counterbalanced by the improvements in machinery, by the better division and distribution of labour, and by the increasing skill, both in science and art, of the producers.”

While this quote reflects some knowledge about the real world the typical for Ricardo was the logical deductions which could produce real insight such as the comparative advantage theory. But Ricardo’s heavy convictions about diminishing returns limited the scope for scientific exploration and instead resulted in what Schumpeter called the Ricardian vice, the belief in the logical conclusions from plausible premises rather than factual study. In chapter 20 Of Value and Riches Ricardo argued that knowledge might increase wealth but still would not improve things for the worker, because value depended on labour alone.

Malthus’ picture of long-run prospects was not less gloomy than those of Ricardo. A remarkable fact is, however, that the subject of specialization simply disappeared from economics with the entry of Ricardo and Malthus, despite the prominence Smith had given it in WN. (The phrase “division of labour” appears only three times in Ricardo Principles, and only to dismiss its importance, and only once in Malthus’ Essay. (Cf. Krugman in Development, Geography, and Economic Theory on the “hollowing out” that might occur when scientists adopt formal methods.)

Marx and Mill Many years later Kenneth Arrow who also got deeply involved in the knowledge, increasing returns and growth conundrum from his own angle, reflected on the history saying the economics of the Pin Factory had become “an underground river springing to the surface only every two decades.” It surfaced at least briefly with Marx and Mill. Marx, whom we have ignored in the lectures but well covered in the textbooks, stuck to Ricardo for his value theory but had more interesting things to say on technology and the development of the whole economic system. John Stuart Mill made an effort to restate the vision that had been so persuasive in the WN, subject to the “scientific improvements” of Ricardo. As the son of Ricardo’s great friend James Mill, John Stuart Mill was almost to be regarded as an inheritor of the Ricardian system. His task was to square the highly visible results of the industrial revolution with the intuitively obvious logic of diminishing return.

In his Principles of Political Economy (1848) Mill, like Smith and Marx took growth as his starting point. But at the same time he named Ricardo as Britain’s “greatest political economist”. Thus Mill’s pure theory was basically Ricardian with the real limits to production determined by “the limited quantity and the limited productiveness of land”. But Mill also identified a tendency of “increasing returns”, meaning rising profits in certain industries thanks to falling costs and set this out in opposition to the “general law” of diminishing returns in agriculture. So towards the end of his book he on the one hand found that diminishing returns remained economics’ “most important principle” while he on the other hand found that the anticipated slowdown of growth could be suspended or temporarily controlled “by whatever adds to the general power of mankind over nature”.

Mill’s book became much appreciated by economists. It gave an adequate rejoinder to The Communist Manifesto. And it gave a commonsensical explanation of why the industrial revolution didn’t mean that Ricardo had been wrong. Increased returns overshadowed decreasing returns, but only for a while. And Mill concluded, as often quoted, that “there is nothing in the laws of value for the present writer or any future to clear up; the theory of the subject is complete.” In fact, Mill stopped doing economics after having reached this conclusion. Instead he became a supporter of good causes, a feminist, an environmentalist, a Victorian liberalist, and even a social democrat much ahead of his time.

The neoclassicals Mill clearly misjudged the situation somewhat; marginalism was on the verge of breaking through. The marginalists changed economics and Ricardo’s dominance in England disappeared. But with regard to the underground river there was surprisingly little change. The perspective was primarily the stationary equilibrium not long-run growth. The foundation of diminishing returns was firmer than ever. In fact the mathematics of the marginalists required diminishing returns. The invisible hand of the market was often compared to the law of gravity. Jevons’ concern with the limited remaining coal deposits played over in a more general fear of running out of resources.

Then Marshall entered the scene and conquered it with his Principles of 1890. Marshall explained how the industrialization of the preceding century had come about. He explained how specialization and competition coexisted in the modern world. He introduced the concept of external returns, quickly to be dubbed externalities.

We have been through Marshall with supply and demand, partial equilibrium and other novelties. Marshall resisted openly using mathematical methods, to some extent he also resisted embracing the idea of general equilibrium. He understood both but he saw no real use. Another idea he didn’t like was Cournot’s argument that falling costs/increasing returns might lead to monopoly. Marshall complained in a footnote of those who “follow their mathematics boldly, but apparently without noticing that their premises lead inevitably to the conclusion that, whatever firm first gets a good start will obtain a monopoly of the whole business of its trade in its district.”

It was the Pin Factory once again. The underground river had come to the surface. The marshallian externalities would be required to contain it.

Falling costs were even more obvious to Marshall than they had been to Mill. Living standards, also for the poor, had increased through the passed century, defying the iron logic of diminishing returns. With the mathematics injected in economics by marginalism, the way of stating the underlying ideas had improved substantially. Increasing returns in the Pin Factory meant that the marginal cost of one more pin was lower than the average cost of all pins. By the elaborate system that Marshall had built everything should sooner or later become more expensive to produce, not less expensive. If the latter were the case, whichever firm had the lowest cost of production would take overt the whole market for pins.

To deal with increasing returns Marshall decided that there had to be two sources of falling costs, two kinds of increasing returns. Both were associated with the scale of production, i.e. with the size of the market. One kind was “internal economies” which were the common kind and “dependent upon the sized of individual houses of businesses engaged in it, on their organizations and the efficiency of their management.” The other kind was “external economies” which were dependent upon “the general development of industry” as a whole. Internal economies were familiar to Marshall’s students and readers but externalities were a breakthrough, an economic discovery. Marshall’s understanding here differed from that of Mill by making productiveness internal to his system.

Increasing returns and its close association with monopolistic had perhaps not been demonstrated more clearly than in the development of railways in England. Railway companies had learnt the lesson the hard way by building parallel tracks until most of them went out of business. Marshall had indeed written that in modern transportation industries “the law of increasing returns operates almost unopposed.”

In Marshall’s view strong counterforces militated against increasing returns in normally competitive industries. But on the other hand every firm would benefit from external increasing returns, derived from the scale of the whole industry. That everybody would benefit served to maintain competition. These benefits were sometimes described as “neighbourhood effects” but more often “externalities” or “spillovers”. External economies were benefits that came without payment, they could be had simply by getting up in the morning.

Marshall didn’t inquire very much how exactly the spillover process worked to loosen a monopolist’s control and did not elaborate upon it. Much later, after WWII the unpriced costs got attention, the bad spillovers or negative externalities.

But the important thing about spillovers in Marshall’s system was that they were unpaid side effects of economic activity, they were not inputs, and they required no compensation. Spillovers kept Marshall’s system intact as a clever devise to reconcile increasing returns with the assumption of the invisible hand perfect competition.

But after Marshall’s death in 1924 considerable controversy arose over “the laws of return” on both side of the Atlantic. It was asserted that the external increasing returns was an “empty economic box”, i.e. a concept with not real example to show for itself. Piero Sraffa who had come from Italy to Cambridge to study with Keynes engaged in this issue.

Allyn Abbott Young (1876-1929), an American economist who in his time was regarded as very gifted. He did not write any voluminous works and that is one reason why he does not figure in the history books. (He is mentioned in Backhouse but not in Sandmo.) Much of what he wrote was critical. Schumpeter wrote of him that “his published work … [does] … not convey any idea of the width and depth of his thought and still less of what he meant to American economics”, while to Bertil Ohlin, he was “a man, who knew and thoroughly understood his subject – economics – better than anyone else I have ever met”. He is remembered today mainly for his contribution to the issue we are looking at here through a presidential address he gave in England in 1928 titled Increasing returns and economic progress.

Young revisited Smith suggesting that perhaps Smith had missed the point when he described specialization in the Pin Factory as consisting entirely of the subdivision of the same old tasks. Instead, wasn’t the division of labour mainly about using the knowledge gained thereby to undertake new and different tasks? Maybe pin makers found new applications for their pins? Maybe they created tools and dies that turned out to be useful to those engaged in the manufacture of other kinds of goods. Maybe other manufacturers in other industries brought new machines to the pin makers. In this way, industries themselves might grow more differentiated, in which case” the progressive division and specialization of industries is an essential part of the process by which increasing returns are realised.” Scale would be the important aspect.

Young argued that there was nothing inherently economical in roundabout methods, although the most economical methods often happen to be roundabout. The degree of roundaboutness which is most economical generally depended upon the amount of a particular kind of work which is to be done. The making and use of instruments involved an extension of the principle of the division of labour, and the division of labour, as Adam Smith observed, depends upon the extent of the market. The use of capital on a large scale in industry came later than its use in commerce, for the reason that not until there were markets able to absorb large outputs of standard types of goods was it profitable to make any extensive use of roundabout methods of production. Once established, however, industrial capitalism showed that it had within itself the seeds of its own growth. Cheaper goods, improved means of transport, and the increased advantages of specialization led to larger markets, so that the economies of industrial capitalism grew in a cumulative way. The increasing division of labour, by breaking up complex industrial processes into simpler parts, not only invited a larger use of instruments, but also prompted the invention of new types of instrument.

Young fitted some comments on real events into his story: the success of Henry Ford automotive venture and United States surpassing Great Britain as an economic power. In both cases it was a connection between scale and specialization, Young said. Young’s article evoked a wave of admiration in the profession as a vigorous dissent from the conventional wisdom, and persuading some young economists, such as Nicholas Kaldor, to reconsider their convictions.

Thus it was Arrow’s underground river coming to the surface once again. Apart from the discussion by Marx, Young's article was the first serious advance beyond Adam Smith on the relations between increasing returns and economic growth. But Young’s argument had been completely in the literary style. It would turn out that the problems of formalizing that persuasive vision into a tractable model have proved formidable indeed, the chief technical problems being those of non-convex technologies and as Romer would argue 60 years later, the introduction of new intermediate commodities. Young died prematurely in an influenza epidemic in 1929, coinciding with the Great Crash but also with a sharp turn in the profession towards a more mathematical direction.

So, old as it is, Young’s paper was important for later developments because there was not much else to find, and Young had thought deeply on this issue.

It has been suggested that the reason why Allyn Young is not in the history books, at least not for anything else is that he was above all a great critic, and great critics, like great journalists and great wits, seldom survive into posterity.

Modernizing economics Already in the 1920 a wave of new scientific thinking started to sweep through economics. We have looked at it earlier as the rise of econometrics with Ragnar Frisch as a kingpin. But it was wider than that and certainly inspired by the striking advances in physics. The wave raised the economists’ ambitions and produced new tools in their hands. One target was to supplant the ambiguities of verbal reasoning with more rigorous ways of expression. There was a mood of optimism about the possibilities of science in general spilling over into economics.

Some were concerned with building statistical thinking in to economic theory for the purpose of analysing data from the real world. Others were more concerned with the practical problems of planning. Still others were determined to construct purely formal schemes of mathematical analysis of human interaction, starting from a handful of basic axioms.

Another singular paper from this period, in fact it was published next to Allyn Young’s article was Frank Ramsey’s A Mathematical Theory of Saving, the first growth model deserving of the name, and a remarkable one at that. In the 1930 followed, as we know the Keynesian breakthrough, whether regarded as revolutionary or not. Keynes raised in General Theory many issues but one issue he did not address, was the tension between increasing and decreasing returns, despite it having been much discussed in Cambridge in the preceding years. There was nothing about externalities in Keynes’ book. The concern was with the stabilization of the business cycle, not economic growth.

Keynes had in fact been addressed growth issues a few years earlier in an article titled Economic possibilities for our grandchildren, an article which drew very much on the logic of Ramsey’s model. But Keynes’ concern was in view of the severe economic crisis much more that the economy would go off the road and collapse than the path towards the bliss of the Ramsey model.

(to be continued)