Increasing Returns and Growth

Don Boudreaux (George Mason University) posts on Café Hayek HERE  from a recent post by his colleague, Alex Tabarrock on Marginal Revolution HERE  (7 October) that summarises important new research on trade.  

The opening paragraph covers a subject that I think is much neglected in standard Economics classes, which tend to focus on absolute and comparative advantage with economic growth as a prime objective:

“Trade increases development but the main driver appears not to be comparative advantage and the standard microeconomic “gains from trade” but rather factors emphasized by Adam Smith and Paul Romer such as the increasing returns to scale that drives innovation and investment in R&D and also the ways in which trade increases exposure to and adoption of foreign ideas”.

Comment

So true. Adam Smith wrote about trade and growth when political economy was focused on Absolute Advantage and fairly primitive ideas about longer run economic outcomes that were believed to lead to pessimistic outcomes of general stagnation as rising real wages, from increased demand for labour in booming economies, reducing the share going to profits to the point where investment stops, and growth ends.  If this continued right across the economy it would set off an epoch of general stagnation.

Comparative advantage theory did not solve the problem of eventual stagnation in market societies. This led to some commentators in the 1960-70s concluding that Adam Smith thought “capitalism” (not that Smith knew the word, first used in English in 1854 in Thackeray’s “The Newcomes”) was doomed, and he regarded modern commerce - the “4^th Age of Man” - as emerging from the agricultural societies – the “3^rd Age of Man), but with nowhere to go, so to speak, after that.

David Ricardo’s ideas of economic development as one of “diminishing returns” dominated classical political economy, which ideas dominated early neoclassical through to the 20^th century.  Teachers across the Academy taught such ideas of diminishing returns, backed by proofs using simple maths and common sense, and delighted in setting them as exam questions in Econ 1.  Students who did not grasp these ideas persistently were discouraged (mainly from self-awareness of their limitations) from continuing on to subsequent years when the maths were perceived to get more “difficult”.  That changed from the 1980 when students (and faculty) for Econ 101 and above were required to understand and use basic maths and statistics just to register for the courses, and advanced maths was compulsory for post-graduate work.

However, there were occasional flurries of unrest in the late 1920s in debates about increasing versus diminishing returns.   One paper by Allyn Young “Increasing Returns and Economic Progress”, Economic Journal. vol. 38. No 152. Dec 1928. pp. 527-542, should have been taken up in the debates and, especially in the painfully slow progress of neoclassical growth theory from the 1950s (Harrod/Domar, etc.,)

Paul M. Romer was among the first neoclassical growth theorists to take up the influence of increasing returns in his paper, “Increasing Returns and Long-Run Growth”, The Journal of Political Economy, Vol. 94, No. 5. (Oct., 1986), pp. 1002-1037.

Adam Smith in the 18^th century was limited to contemporary knowledge and the fact that while markets had a long history over several millennia in Europe and elsewhere, they had not developed very far along the path to the industrialization of manufacturing that was about to take-off while he was alive, though unwell.  He died in 1790 after some years of steady physical decline.