Wednesday, June 04, 2008

Boudreaux on Smithian Growth

Donald Boudreaux, who blogs at Café Hayek, writes some of the best pieces in Blogland and everybody interested in economics should bookmark his site (HERE) /and visit it daily. His reports of his almost daily letters to US newspapers are little gems in the application of Smithian-type economics in contrast to the everyday rantings by politicians.

An article of his is picked up in Redorbit (HERE) 3 June: in a book review Knowledge and the Wealth of Nations: a story of economic discovery, by David Warsh:

The work that launched economics as a distinct discipline is Adam Smith's An Inquiry Into the Nature and Causes of the Wealth of Nations. Note well the title, especially the first eight words that typically are left off when people mention this book.

That great Scottish scholar inquired into the nature and causes of prosperity. Worded only slightly differently, Smith asked, "What causes economic growth?" His inquiry brilliantly identified as the chief proximate cause of prosperity the division of labor. The jack of all trades becomes a master of none. So a world full of jacks is poor. But let each of those jacks specialize at performing a distinct task, and the same number of workers can produce a much greater quantity of output than they could produce when each was a jack.

A fuller account of this wealth-creation process, of course, must be told. Smith himself told much of it, as did David Ricardo and lots of-well, some-economists over the past 230 years. The sorry fact is that, for all its contributions to our understanding of economy and society, economics has only recently returned in a serious way to the Smithian question of economic growth. For most of its history, economics has revealed the logic of allocating a given stock of resources to satisfy a given set of consumer demands with a given stock of knowledge. The economics of growth-or what came to be called development economics-suffered. All too true was a remark I heard the late Fritz Machlup make in 1981 at New York University: "[Development economics attracts the least developed economists."

Unknown to Machlup and his students (and to most economists at the time), a turnaround was underway. Its leader was a young economist named Paul Romer from the University of Chicago. Romer (now at Stanford) is no typical Chicagoan. And what makes him least typical of that school is his recognition that externalities exist and often matter.

Externalities are effects of voluntary activities that spill over onto persons who are not party to the agreements that give rise to the activities. These effects can be negative (as when a factory dumps soot on the homes of nearby residents) or positive (as when a lighthouse guides whatever ships pass by). So-called "newgrowth theory" builds on the latter by explaining how capital goods and human capital not only increase workers' productivity, but also that this increase in productivity often occurs at a faster rate as more capital goods and human capital come into existence. That is, the productivity of existing assets often increases as these are combined with additional assets. Such assets, then, are said to produce "increasing returns"-which means that their rate of output (say, per worker) increases when they are combined with other assets.

Although Romer is the central character in the book, Warsh's summary of the economic theory of growth from Adam Smith's day to our own is wonderfully clear. Indeed, in my opinion this is the best part

David Warsh’s book is indeed well worth reading. And so is the follow up reading of the ideas, economists and their articles that he discusses. Visit his site Here. They can change your entire perspective on how economies grow, something that is lost in the sterile growth theory that I and my generation of economists (1960s-70s) were inducted into (Harrod-Domar, Solow, and such like). All economists should read Allyn Young, 1928. ‘Increasing returns and economic progress’, Economic Journal, 38: 527–42, which can be found on the Internet via Google).

Boudreaux, typically, focuses on the essentials of the argument, namely, increasing returns. Large swathes of microeconomics, since Ricardo, and in modern neoclassical economics, centres on diminishing returns; Smithian economics, in the propensity to exchange and the division of labour, centres on increasing returns, admirably set out in the Boudreaux’s review of Warsh’s Knowledge and the Wealth Of Nations.

I would add to Boudreaux’s potent comments in his review of David Warsh, that the essential deepening of the division of labour in the single plant that re-organises through specialisation of its labourers’ tasks, is the consequence for all firms that use that firm’s outputs as inputs into their own processes, their own unit costs fall too. And this occurs across the entire spectrum of industry, the more so as outsourcing spreads, and more roundabout modes of production proliferate.

Taking the trivial pin factory as the end of the growth process for that plant stops short of the full potential of competitive market economies. Adam Smith goes on to discuss the manufacture of the common labourer’s woollen coat, and shows just how extensive, even in the mid-18th century, were the supply chains within a small manufacturing base in a largely agricultural economy. Within all these contributing sectors, opportunities for raising productivity abounded in every part of them.

Take just one area: timekeeping. The Harrison Chronometer enabled Captain Cook to navigate with pin-point accuracy across vast oceans because with it he knew exactly on which degree of longitude he was sailing. Instead of confinement to parallels of latitude and within sight of land, he could head into the open sea with confidence and accurately plot on his charts exactly where he had been. The impact of this innovation in timekeeping opened the seas to safer sailing and shorter journey times, which improved the merchant shipping trades.

Thus, unconnected innovations, new dexterities in labour, tighter times of production and facilities to abridge labour, sharply increased productivity, within the existing technologies practised in Smith’s day, and led inexorably to the technological leaps that featured so strongly thereafter.
Growth theory need not be sterile, unless conceived of as an equilibrium process, fitted into models in which people are absent.



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