Sunday, January 21, 2007

Adam Smith Not responsible for Neoclassical Decreasing Returns

I have commented on David Warsh’s book, Knowledge and the Wealth of Nations’, on ASLL and I return to what a reader has to say about it. I believe the reader, Tom Debevoise ( commits an error, first of attribution of ideas Smith did not have (yes, it’s good old invisible hand again) and then by extension heaps a problem on Smith that he did not, in fact, have in Wealth of nations.

Tom Debevoise writes:

“you should first read and grasp the two fundamental economic themes of Adam Smith’s 1776 book, “The Wealth of Nations” (If you don’t already know them).

Smith’s book addresses both microeconomic principles and practices using the example of a “Pin Factory”. It was an analogy, or model, for an individual enterprise with its division of labor. The model describes falling cost because of increase scale and managing the classic actors of production, and the pursuit of increasing returns. The story describes macroeconomic industry principles and practices using the notion of the “invisible hand of perfect competition”. The hand is a force that leads to new enterprises entering profitable markets and copying existing profitable enterprises. Supposedly this would lead to rising cost because of demands on scarce resources. Because of competition no enterprise in the industry will set and maintain their prices. The result is decreasing returns (profits) to all enterprises in a given industry.”

The first and second sentence may be acceptable (though it says nothing about the context) but from the third sentence is goes awry.

The division of labour within manufacturing: In Smith’s day this meant exactly that: made by hand, not by machines powered by some source, such as the yet to be invented workable steam engines that could turn objects and drive things. This associated manufacturing with increasing returns, to which growing markets added yet more fruitful divisions of labour.

But Smith never wrote anything about the ‘invisible hand of perfect competition’. This is an attribution of neoclassical economics. His use of the metaphor described human motivation having unintended consequences (not always benign – e.g., monopoly or protectionism – and today pollution).

Diminishing returns was related to agriculture, not manufacturing, and owes more to Ricardo and Malthus. At that time the economy was dominated by agriculture (around half of GNP). Manufacturing was stirring but not yet flooding across the economic landscape. Political economists tended to focus of the economics of agriculture from the Physiocrats through to all the classical economists. Smith did not get increasing returns wrong; what he said was right, but he did not address the question of the future changes in the economy with manufacturing, driven by power machinery (electricity) because he took an historical, not a prediction oriented, view of the economy he studied.

Neoclassical economics, post-1870 and the marginalists went down the diminishing returns road, even after the ‘industrial revolution’ (which Smith knew nothing about, nor did he know anything about the phenomenon of capitalism, a word invented in 1854).

Profits still fall in industries without innovation changes or replacement technologies. Neoclassical economics and general equilibrium theory, focused on the conditions of perfect competition, not Smith; it imported into economics diminishing returns as a general rule for all activity, not Smith.

That Romer has challenged the assumption of neoclassical economics of decreasing returns to industry is timely; that Smith set the profession on the wrong road is no true, unless, of course, you attribute to markets the myth that Smith found in them ‘an invisible hand’. You may do this safely, but you cannot establish that Smith had this view. If you think I am wrong, please educate us all from his Texts (not second-hand quotations and ascriptions).

The division of labour and new technologies challenge an individual enterprise’s increasing returns in their current product lines. In short, increasing returns are not infinite in a firm; they may be in an economy as a whole. The firm may adapt and continue with rising profits; it may, as so many have, go from profits to losses and extinction as other firms overtake them. That is what Schumpeter meant by the ‘perennial gale of creative destruction’ – the endogenous intervention, if you like, of new knowledge.

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