Posted:June 21, 2006

Since Adam Smith first published the Wealth of Nations more than 200 years ago, there has been an episodic tension in the dismal science between the concepts of deceasing returns to scale embodied in the image of the invisible hand and increasing returns to scale due to specialization and the division of labor in the pin factory.  Generally, most of us are more steeped in the views of competition, supply and demand and creative destruction arising from a view of the traditional factors of production of capital, labor and land.  Only in fits and starts has the economics profession turned its attention to the importance of knowledge and readily observed increases in wealth.

David Warsh in his new book, Knowledge and the Wealth of Nations:  A Story of Economic Discovery, attempts to bring Adam Smith’s story back into balance.  Using Paul Romer’s seminal paper, "Endogenous Technological Change," published in the Journal of Political Economy in 1990 as the centerpiece, Warsh first weaves a story of economic growth theories since Smith.  The contemporary economist Paul Krugman, himself a player in this story, noted in his review of this book in the New York Times that the struggle between the Pin Factory and the Invisible Hand had:

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.

Warsh argues that the early dominance of the decreasing returns of the invisible hand is partially due to the general sense of scarcity as embodied in early thinkers like Malthus and because its analysis and maths are more tractable.  It thus required the mathematical maturation of the profession for the question of the pin factory and increasing returns (and declining costs) to find a resolution.  Yet even as the theories and the profession itself become more mathematical in the 20th century, Warsh sticks to a literal and easy-to-read narrative.  His story covers virtually every major economist from Smith and Ricardo in the early years to the Nobel laureates Arrow to Solow prior to Romer.  He traces the eras of neglect with the slow discoveries as to the factors leading to growth.  The story really begins in earnest after World War II when the hidden X factor of technological change — in what came to be expressed as total factor productivity — came to the fore to complete the economic growth equation.

Like the missing "dark matter" still being sought to explain why the universe doesn’t fly apart, this TFP "X factor" remained elusive for many years and was generally viewed as something external – or exogenous — to the standard understanding of growth in output.  What Romer was able to argue in what came to be called New Growth Theory, was that this mysterious "dark matter" was itself knowledge and that it was an internal product — that is, endogenous — to the economic system.  As Warsh states:

Romer’s 1990 paper divided up the economic world along lines different from earlier ones.  Overnight for those who were involved in actually making the intellectual revolution, more slowly for the rest of us, the traditional "factors of production" were redefined.  The fundamental categories of economic analysis ceased to be, as they had been for two hundred years, land, labor, and capital.  This most elementary classification was supplanted by people, ideas, things. . . . Technical change and the growth of knowledge had become endogenous — within the vocabulary and province of economics to explain.

While Warsh has too great a tendency to lionize Romer, this story is indeed a fascinating yarn and very informative for the non-economist.  The theories that have emerged from Romer and other new growth theorists have special relevance in today’s Internet and information economy where increasing returns to scale and network effects so manifestly surround us.

As Krugman noted in his review:

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.

Warsh fills this gap with this fine tale.  So, if you can put up with a bit of journalistic license and economists-worship, do check out this fast, 400-pp read.  It’s a rousing good tale and educational to boot.  Not all economists can have beautiful minds, but a few fortunate ones can formulate beautiful equations.

Posted by AI3's author, Mike Bergman Posted on June 21, 2006 at 4:16 pm in Adaptive Information, Book Reviews | Comments (0)
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