Published in Review of Political Economy, 18:2 (2006), pp.193-208
The Role of Pecuniary External Economies and Economies of Scale in the Theory of Increasing Returns RAMESH CHANDRA & ROGER SANDILANDS ∗ Department of Economics, University of Strathclyde, Glasgow, UK ABSTRACT This paper investigates some issues relating to the phenomenon of increasing returns: (1) What is the role of economies of scale in the theory of increasing returns? (2) Do pecuniary external economies lead to market failure and justify intervention in the market mechanism? (3) Are increasing returns sector-specific or generalised, and if they are sector specific, is it possible to identify and promote these sectors from a policy point of view? We argue that economies of scale are incidental to the broader phenomenon of increasing returns and therefore cannot adequately explain their existence. On the second question, we argue that the presence of pecuniary external economies is characteristic of a well-functioning market system rather than an indication of market failure. Finally, increasing returns are generalised, so that policies intended to identify and promote specific sectors will tend to distort intersectoral relationships. Sector-specific polices should not be based on the logic of increasing returns, but should aim to correct sector-specific handicaps.
1. Introduction There is much misunderstanding surrounding the concept of increasing returns. For example, some influential literature (Romer, 1987, 1989; Krugman, 1990, 1993; Murphy et el. 1989) argues that economies of scale at the micro level (or fixed costs) are the chief basis of increasing returns. It has also been argued that the presence of pecuniary external economies leads to market failure (Scitovsky, 1954; Rosenstein-Rodan, 1961; Murphy et al., 1989; Krugman, 1993). Another widely held position views manufacturing industry as more amenable to increasing returns, and hence advocates an important role for government promotion of manufacturing (e.g. Kaldor, 1966, 1975, 1986; Krugman, 1993; Murphy et al., 1989). This paper argues that all this runs counter to the ideas of the original pioneers in the field of increasing returns namely, Adam Smith and Allyn Young. The objective of this paper is thus to clear up the misunderstanding surrounding increasing returns, and particularly to address the following issues: (1) What is the role of economies of scale in the theory of increasing returns? (2) Do pecuniary external economies lead to market failure and justify intervention in the market mechanism? (3) Are increasing returns sector-specific or ∗
Published in Review of Political Economy, 18:2 (2006), pp.193-208. Correspondence Address: Roger Sandilands, Department of Economics, University of Strathclyde, Sir William Duncan Building, 130 Rottenrow, Glasgow G4 0GE, UK. E-mail:
[email protected]
generalised, and if they are confined to certain sectors, is it possible to identify and promote them for policy purposes? In his famous presidential address to the British Association for the Advancement of Science, Young (1928) argued that economies of scale are largely incidental to the broader conception of increasing returns. Increasing returns mainly derive from external economies; internal economies of scale do not play an essential role. Expansion of the market creates opportunities for the profitable introduction certain processes, products, technologies, methods, materials, etc, which otherwise would remain uneconomic. 1 Although Young did not use the term ‘pecuniary external economies’—it was perhaps first used by Viner (1931) and later popularised by Scitovsky (1954)—the expression neatly captures how increasing returns operate through the market system by expanding opportunities and pressures to reduce costs and prices. 2 Continuously falling costs and prices in turn lead to further increases in the overall market, thereby contributing to a cumulative self-sustaining process. The importance of external economies has been noted in the development literature (e.g., Scitovsky, 1954; Murphy et al. 1989; Krugman, 1993) and the present paper also aims to assess the extent to which these later writings reflect Allyn Young’s insights. In his celebrated article ‘Two Concepts of External Economies’ Scitovsky (1954) identified pecuniary external economies as the most relevant type of external economies in economic development. According to Scitovsky the market mechanism gives rise to an indirect form of interdependence among producers whereby the actions of one producer or set of producers, in increasing demand or cutting costs, enhances the profits of other producers. Scitovsky insisted that this type of interdependence must be distinguished from direct technological external 3 economies (as when, for example, an orchard benefits directly from a neighbour’s beekeeping). The distinction between the two concepts is important because while pecuniary external economies are all-pervasive, examples of technological external economies are rare in industry. Thus it is the pecuniary external economies which are most relevant from the point of view of industrialisation. Similarly, Krugman (1993) focuses on pecuniary external economies in what he terms the ‘high development theory’ of the 1950s. In a ‘big push’ model based on Murphy et al. (1989) Krugman highlights the importance of these pecuniary external economies, but he makes no mention of technological external economies. If one assumes economies of scale at the plant level, and that producers have access to an elastic labour supply, then according to Krugman, the interaction of these two circumstances leads to de facto pecuniary external economies. Alluding to Hirschman’s (1958) concept of backward linkages, Krugman (1993, p. 22) asserts that ‘the central concept of high development theory circa 1958 was the idea of economies of scale at the level of the individual plant translated into increasing returns at the aggregate level through pecuniary external economies.’ The presence of pecuniary external economies has generally been interpreted as constituting a kind of market failure because they lead to a divergence between private and social benefit. As Rosenstein-Rodan (1961, p. 58) observes, ‘Given an imperfect investment 1
Note that in the Youngian conception the emphasis is both on existing as well as new knowledge (or technology) as opposed to the more recent endogenous growth literature which emphasises new knowledge only.
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In the Youngian conception, there could be two ways of looking at the concept of pecuniary external economies. Firstly, since they lie outside a firm and are all pervading, they can be viewed as the main source of increasing returns to the whole economy. Even the economies achieved by a firm through large-scale production, specialisation and innovation are greatly influenced by them. Alternatively, since they operate through the price mechanism in the form of reduced costs and prices, they can be viewed as a vehicle through which increasing returns are transmitted.
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The distinction is explained in more detail in Section 2.
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market, pecuniary external economies have the same effect in the theory of growth as technological external economies. They are a cause of a possible divergence between the private and social marginal net product. Since pecuniary, unlike technological, external economies are all-pervading and frequent, the price mechanism does not put the economy on an optimum path.’ Similarly, it is argued that the presence of pecuniary external economies may generate multiple equilibria, and an economy may stay trapped in a low-level equilibrium unless a planned and coordinated industrialisation over many sectors is pursued. For example, Murphy et al. present models with multiple equilibria where ‘the source of multiplicity of equilibria is pecuniary externalities generated by imperfect competition and large fixed costs’ (Murphy et al., 1989, p.1004). Rosenstein-Rodan (1943, 1961) and Nurkse (1953) also highlight the constraint that the small domestic market imposes on growth. Nurkse writes of the vicious circle on the demand side which limits the inducement to invest. Similarly, Rosenstein-Rodan writes of demand complementarities in planning for the ‘big push’. 4 If undertaken in isolation, individual investments may not be profitable, but if undertaken as a part of a ‘big push’ programme, coordinated by a central planning board, the overall market size would increase making these individual investments profitable. 5 For example, if an investment is made in a shoe factory alone, the workers are not expected to spend their entire income on shoes. But if a large number of such complementary investments in wage goods are made, then workers can act as each others’ buyers, expanding the overall market. Thus, ‘What was not true in the case of one single shoe factory will become true for the complementary system of one hundred factories and farms. The new producers will be each other’s customers and will verify Say’s law by creating an additional market’ (Rosenstein-Rodan, 1961, p. 62). Rosenstein-Rodan therefore argued that the industrial sector needed to be planned and created as though it were one huge firm or trust. Scitovsky (1954, p. 149) likewise emphasised the need to expand all industries simultaneously if pecuniary external economies were to be reaped. He suggested that ‘vertical integration alone would not be enough and complete integration of all industries would be necessary to eliminate all divergence between private profit and public benefit.’ More recently, Murphy et al. (1989) and Krugman (1993) have explored the idea of a coordinated investment programme in developing countries characterised by demand spillovers and imperfect competition. The presence of pecuniary external economies generates a multiplicity of potential equilibria; the big push or planned, comprehensive industrialisation consists of switching ‘from cottage production equilibrium to industrial equilibrium’ (Murphy et al., 1989, p. 1004). Thus Krugman (1993, p. 32) concludes, ‘there is an intellectually solid case for some government promotion of industry.’ 6 The justification for governmental intervention is also based on the idea that increasing returns are sector-specific, that these sectors can be identified, and that policies to 4
‘Complementarity of different industries provides the most important set of arguments in favour of a large-scale planned industrialisation’ (Rosenstein-Rodan, 1943, p. 205). In this context, RosensteinRodan regarded the bulk of wage goods as complementary.
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The ‘big push’ could be undertaken either directly by the state, aided by a huge inflow of foreign aid; or alternatively, if the private sector is involved, then the price mechanism would need to be supplemented by additional signalling devices to arrive at optimal results, particularly with regard to the size and composition of investment. In both cases, the market is viewed as an unreliable device.
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Thus the idea of a government sponsored ‘big push’ seems to have come full circle. Starting with Rosenstein-Rodan (1943, 1961), Nurkse (1953) and Scitovsky (1954), the idea was lost in the neoclassical reaction against what were widely judged to be misguided government interventions of the 1950s and 1960s. In his 1993 paper, Krugman hoped to launch a ‘counter-counterrevolution’ to resurrect the core of earlier development theory by putting it in a more rigorous mathematical form.
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promote them can be instituted to realise these increasing returns. Much of the literature regards manufacturing as subject to increasing returns and agriculture as a classic diminishing returns sector (e.g. Kaldor, 1986). However, another body of literature suggests that increasing returns are generalised rather than sector-specific, and that such sectors cannot be identified a priori for policy purposes (see Clapham, 1922; Buchanan & Yoon, 2000). This latter perspective is also consistent with Young’s insistence that reciprocal exchange characterises and determines the overall size of the market: policies that promote or protect a particular industry at the cost of others would disrupt or distort this reciprocal exchange relationship. As a result, the total exchange nexus would be reduced, and this in turn would adversely affect the extent of the increasing returns that can be reaped. Thus if increasing returns are viewed as generalised, rather than sector-specific, quite different policy conclusions emerge. This paper will argue that the presence of pecuniary external economies does not constitute a market failure. If these economies operate through the market, centralised command and control mechanisms are likely to interfere with their realisation and hence also with the realisation of increasing returns. Young, and before him Smith, argued that growth occurs most strongly in a well-functioning competitive market system. While Smith in general argued that an artificial direction of economic activity is likely to misdirect a country’s capital, 7 Young showed that a competitive market system was necessary for transmitting pecuniary external economies (in the form of reduced costs and prices) and that this in turn led to an expansion of the market. The paper is structured as follows. In the next section, we examine the alleged link between pecuniary external economies and market failure. In Section 3 we examine whether economies of scale provide an adequate basis for the emergence of increasing returns. Section 4 explores whether increasing returns are sector-specific or generalised. Section 5 presents the conclusions. 2. Pecuniary External Economies and the Market Failure Argument Scitovsky (1954) notes that the concept of external economies is one of the most elusive in the economics literature. He draws a distinction between technological external economies, which fit into static equilibrium theory, and pecuniary external economies, the relevant concept in the context of industrialisation. Since Scitovsky’s exposition of this distinction is representative of the misleading tendency to look at the phenomenon of increasing returns from a microeconomic perspective, we examine his ideas at some length. Consider the production function of a firm whose output (x1) depends not only on the factors of production (l1, c1, …) it utilises but also on the output (x2) and factor use (l2, c2, …) of another firm or a group of firms. Thus, x1 = f (l1, c1, …; x2, l2, c2, …), where the existence of external economies is indicated by the presence of positive elements to the right of the semicolon. Since f ( ⋅ ) is a production function, the external economies here are defined as technological external economies. They are external economies of direct dependence among producers and arise within a general equilibrium framework. The above definition is due to Meade (1952). Meade’s examples had to do with bees, orchards and woods, not with industry; examples of technological external economies from industry are rare. Scitovsky could identify only two industrial cases which fit the above definition. The first is the case of a firm benefiting from the labour market created by the establishment of other firms; and the second 7
‘No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain. It can only divert a part of it into a direction into which it might not otherwise have gone; and it is by no means certain that this artificial direction is likely to be more advantageous to the society than that into which it would have gone of its own accord’ (Smith, 1776, I, p. 475).
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is the case of several firms exploiting the same resource, such as an oil field, giving rise to a negative externality or external diseconomy. Now let us suppose that the profits of one producer are affected by the actions of other producers. If a firm’s profits depend not only on its own output and factor inputs but also on output and factor inputs of other firms, then P1 = F (x1, l1, c1, …; x2, l2 c2, …), where P1 is the profit of firm 1. 8 External economies arise when the variables to the right of the semicolon are positive. This definition is much broader, as it not only includes direct, or non-market, external economies but also indirect interdependence among producers arising out of the market mechanism. This latter type of external economy is what Scitovsky has defined as a ‘pecuniary external economy.’ 9 But interdependence through the market mechanism is allpervading, so it is this type of external economy which is most relevant for development theory. Scitovsky argued that the presence of pecuniary external economies leads to market failure because of the divergence between private and social benefit. As a result, the amount and composition of investment in an economy will be suboptimal. Individual decision-making based on private gains does not take into account all possible benefits which arise from investment: Investment in an industry leads to an expansion of its capacity and may thus lower the prices of its products and raise the prices of the factors used by it. The lowering of product prices benefits the users of these products; the raising of factor prices benefits the supplier of the factors. When these benefits accrue to firms, in the form of profits, they are pecuniary external economies—Marshall called, or would have called, them (together with the benefits accruing to persons) consumers’ and producers’ surplus, respectively. According to the theory of industrialization, these benefits, being genuine benefits, should be explicitly taken into account when investment decisions are made; and it is usually suggested that this should be done by taking as the maximand not profits alone but the sum of the profits yielded and the pecuniary external economies created by the investment. (Scitovsky, 1954, p. 147)
Scitovsky was puzzled by the finding that market interdependence here prevents the achievement of the socially desirable optimum, since equilibrium theory comes to the opposite conclusion that market interdependence produces an optimal outcome. Nevertheless, market interdependence, in Scitovsky’s view, does lead to market failure from a dynamic perspective. The total amount of investment, if left to the market, is likely to be suboptimal. Scitovsky thus concludes that pecuniary external economies are incompatible with equilibrium theory. He identifies three reasons why market interdependence might generate suboptimal outcomes: (1) investment is often lumpy and thus the assumption of perfect divisibility is not satisfied; (2) investment is not a static but a dynamic phenomenon, and so leads a system away from equilibrium rather than closer to it; and (3) if pecuniary external economies accruing to foreigners are excluded from a nation’s private investment calculations, this would call for more investment in import-competing industries and less in export industries.
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The function F should include not only outputs and inputs but also their prices, as profits are meaningless without price information. Moreover, in both the functions, external economies require not just that the elements to the right of the semicolon be positive, but also that the partial derivatives of f or F be positive with respect to these elements. Scitovsky seems to overlook these points.
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Note that this definition differs from what Young had in mind. Here the emphasis is microeconomic whereas Young’s emphasis was macroeconomic. See footnote 2.
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For the above-mentioned reasons, social profits diverge from private profits in a market economy. To bridge this gap, Scitovsky advocates complete integration of all industries. In a market economy, prices are more useful in guiding current production decisions than for coordinating investment decisions which have a delayed effect. Hence ‘there is a need either for centralized investment planning or for some additional communication system to supplement the pricing system as a signalling device’ (Scitovsky, 1954, p. 150). In brief, the argument is that the failure of individual firms to capture pecuniary external economies leads to a market failure which can only be corrected through centralising investment decisions. However, this argument involves a fallacy of composition. From the microeconomic perspective the representative firm may indeed fail to capture all the pecuniary external economies. But the representative firm is constantly losing its identity. New specialist firms and industries are constantly emerging to take advantage of changes in the external field. In the aggregate, therefore, total social benefits are likely to exceed the sum total of the individual internal economies of each firm. As Young (1928, p. 528) observes, ‘Although the internal economies of some firms producing, let us say, materials or appliances may figure as the external economies of other firms, not all of the economies which are properly to be called external can be accounted for by adding up the internal economies of separate firms.’ Thus the total social picture is more than the sum of its parts. In the ‘big push’ models of increasing returns deriving from Rosenstein-Rodan (e.g. Murphy et al., 1989; Krugman, 1993) internal economies of scale at the microeconomic level are essential for the generation of pecuniary external economies at the economy level. By contrast, Young (1928) showed that economies of scale are incidental to the broader phenomenon of increasing returns. 10 Thus they cannot be regarded as the sole or main source of pecuniary external economies. Rather, it is the division of labour or specialisation among firms and industries that provides a more solid basis for generating pecuniary external economies. As the size of the market expands, the degree of specialisation increases, and increasing returns largely arise from industrial fragmentation rather than industrial concentration. No doubt some of the increasing returns may result in greater industrial integration; but the opposite process of differentiation is often the more important source of increased productivity. As the industrial division of labour develops, an industry becomes increasingly subdivided into specialist firms and industries. As Young explains: Much has been said about industrial integration as a concomitant or natural result of an increasing industrial output. It obviously is, under particular conditions, though I know of no satisfactory statement of just what those conditions are. But the opposed process, industrial differentiation, has been and remains the type of change characteristically associated with the growth of production. Notable as has been the increase in the complexity of the apparatus of living, as shown by the increase in the variety of goods offered in consumers’ markets, the increase in diversification of 10
This, however, does not imply that there is no empirical case for increasing returns to scale. At least for certain industries, such as sugar and steel, scale economies may be quite important. For example, Tribe & Alpine (1986, 1987) found that they were significant in the sugar industry of some developing economies. But the important point to be emphasised is that the scale at which a firm is able to operate is itself adjusted to the overall market and cannot be regarded as independent of it. Certain roundabout methods of production become economical only when their advantages can be spread over the whole industry (or economy). Thus, as Young (1928, p. 539) notes, the scale on which firms and industries are able to operate ‘is only incidentally or under special conditions a matter of the size of the individual firm’ and ‘merely reflects the size of the market for the final products of the industry or industries to whose operations their own are ancillary.’
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intermediate products and of industries manufacturing special products or groups of products has gone even further. (Young, 1928, p. 537)
Young also gives an example of printing industry where the growth of the industry enables it to become subdivided into specialised undertakings and industries. The successors of early printers are not only the printers of today, with their own specialised establishments, but also the producers of wood pulp, of different kinds of paper, of inks and their different ingredients, of type metal and type, of specialised tools and machines. Young points out that the printing trade is not exceptional; the process of industrial differentiation is widespread and it also manifests itself in greater product differentiation. A large variety of consumer products are available to the consumer within the same product category, for example different brands of car or toothpaste. Since the products within a category are not perfectly homogenous, some element of imperfect competition is always involved. The important point is that greater differentiation, in all its manifestations, occurs in response to an increase in the size of the market. But this does not imply that artificially created market power is a sound basis for augmenting growth. It does not provide a rationale for the deliberate creation of market power in the form of patents, intellectual property rights or protectionist privileges (see Chandra & Sandilands, 2005). Of course the dynamic process of growth itself may lead to some temporary privileges or market power, which are quickly wiped out (or replaced by new privileges) by the process of growth itself. Competition forces the producers to innovate and reduce costs. Innovators may initially reap supernormal profits, but as others enter the field these temporary privileges tend to be eroded and to reappear elsewhere. To recapitulate the discussion of this section, two broad points may be made. First, the conventional market failure argument about pecuniary external economies is misplaced. The presence of such economies does not constitute a market failure and therefore does not justify replacing the market system with the type of centralised planning that Rosenstein-Rodan (1943, 1961) recommended. Rather it calls for strengthening the market process and its institutions so that fuller realisation of increasing returns is achieved. Secondly, it is not the economies of scale but the phenomenon of industrial differentiation, in all its manifestations, that is the main source of increasing returns. This implies that some form of market power may result from the growth process itself, but it does not imply that artificially created market power is a sound basis for augmenting growth. 3. Economies of Scale and Increasing Returns Since influential authors such as Romer (1987, 1989), Krugman (1990, 1993), Murphy et al. (1989) regard economies of scale (or increasing returns to scale) at the micro level as the chief basis for increasing returns, it is important to look into this issue carefully. The concept of increasing returns to scale is problematic for a number of reasons. First, the idea of returns to scale is based on a production function concept. It looks at the issue from a supply perspective, where output is input driven. While this may be true at the micro level, controversy surrounds the concept of an aggregate production function. At the macro level supply of inputs is not the main driving force in Young’s conception of increasing returns; rather it is the size of the market, and the resulting greater specialisation at firm and industry levels. 11 In this perspective, the concept of an aggregate production function 11
In the Youngian vision inputs are seen as an effect rather than a cause of growth. Considerable evidence exists to suggest that growth is not caused by inputs of labour or capital. For a summary of this evidence in the case of the US, see Currie (1997). See also Blomström et al. (1996) and Chandra & Sandilands (2003) for evidence that capital accumulation is not a cause but an effect of growth.
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suffers from a fallacy of composition: it does not depict the social picture, which may be much broader than the simple addition of its parts. Thus Young (1990, p. 26) urged that when dealing with aggregate supply and demand we guard against oversimplification: in contrasting J. B. Say’s aggregate reciprocal-supply-demand approach with that of Marshall, he warned that ‘Marshall’s supply and demand curves hold ceteris paribus, and cannot be integrated to give the whole economic structure.’ Secondly, the concept of internal economies of scale implies that a representative firm is able to maintain its identity. As we have seen this is rarely the case as change in the external field is both quantitative and qualitative. As the size of the market expands, specialised undertakings and industries emerge, and the representative firm loses its identity: ‘With the extension of the division of labour among industries the representative firm, like the industry of which it is a part, loses its identity. Its internal economies dissolve into the internal and external economies of the more highly specialised undertakings which are its successors, and are supplemented by new economies’ (Young, 1928, p. 538). Thirdly, even if a firm is able to maintain its identity, in the sense of devoting itself to a given range of activities, the concept of economies of scale assumes that we are moving along the same long-run average cost schedule until the lowest point of that curve is reached. Because of the presence of external economies, cost schedules are constantly shifting downwards. Thus the firm does not move along the same cost schedule for an indefinite length of time. For part of the time perhaps the movement may be along a given curve; but this soon gives way to movement along a lower curve. If further external economies become available in the meantime, there is a shift to a still lower curve, and so on. So even in a situation where the firm does not lose its identity, the appropriate conception is that of ‘dynamic economies of scale’ rather than movement along a given cost schedule. Fourthly, economies of scale is an equilibrium concept. Under perfect competition, the long-run equilibrium will be reached at the lowest point on the long-run average cost curve. Under imperfect competition or monopoly, equilibrium will occur below the optimal capacity. But in a dynamic context, equilibrium is an exception rather than a rule, and it is in this context that increasing returns exert their influence: ‘No analysis of the forces making for economic equilibrium, forces which we might say are tangential at any moment of time, will serve to illuminate this field, for movements away from equilibrium, departures from previous trends, are characteristic of it’ (Young, 1928, p. 528). New products, new processes, new technologies, new materials are continuously emerging and changing the external environment of a firm. A firm is constantly trying to adjust to the changing external environment with the result that disequilibrium, rather than equilibrium, is the main characteristic of an evolutionary economic system. Fifthly, the conception of economies of scale assumes that increasing returns emerge at the level of the firm. While it is true that scale economies do contribute to cost reductions as fixed costs are spread over larger output of a firm, increasing returns do not mainly manifest themselves in this manner. Young emphasised the need to look at industrial operations as an ‘interrelated whole.’ As the total market (which he defined as ‘an aggregate of productive activities tied together by trade’) expands, fixed costs are spread over the whole industry, indeed the whole economy. Thus increasing returns are mostly macroeconomic rather than microeconomic, generalised rather than sector-specific. Because they are macroeconomic, their realisation does not always involve a reduction of competition. 12 So the
12
It is true that some advantages may result from the market process itself, but as new firms enter the field they are likely to disappear. However, in cases where monopoly power confers persistent unfair advantages on some firms, the state can intervene to regulate monopolies or ensure more competition.
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models of increasing returns which assume some kind of output-restricting market power or imperfect competition are based on a microeconomic conception of increasing returns. The generalised or macroeconomic nature of increasing returns also implies that the largeness of a firm or industry is not an essential feature of increasing returns. In fact if we look for them in large firms or large industries we are most likely to miss them. Although large size may matter for some industries, Young’s basic point is that the size of a firm or industry is only incidental to the broader conception of increasing returns. It is in this context that he emphasised the importance of large production (macroeconomic) instead of largescale production (microeconomic) in increasing returns. 13 Finally, the scale of a firm may be important in a few cases where the product can be standardised, and the various processes can be reduced to a succession of routine operations (Young, 1929a). Since the size of a firm merely reflects the size of the overall market, economies of scale become market determined and do not have an independent existence of their own. This has an important implication: these economies are not available for the taking simply through following a policy of mass production, standardisation or simplification. Socalled rational economic reforms have their limits; and ‘pressed beyond a certain point they become the reverse of rational’ (Young 1928, p. 531). 4. Are Increasing Returns Sector-Specific or Generalised? There is controversy over whether increasing returns are generalised or sector-specific. While authors such as Currie (1974, 1981, 1997), Buchanan & Yoon (1999, 2000), and Sandilands (2000) view increasing returns as generalised, Kaldor (1966, 1975, 1986) and Blitch (1983), for example, view increasing returns as largely confined to manufacturing. A related question is whether it is possible to identify the increasing returns industries for policy purposes. Ironically it was Smith who gave the impression that the division of labour was better carried out in manufacturing than in agriculture. In his famous pin factory example, job specialisation within a firm leads to a dramatic increase in output and labour productivity. In each line of manufacture when different trades and occupations collaborate, the impact on productivity is equally dramatic. By contrast, Smith believed that the nature of agriculture does not allow as extensive a degree of specialisation as is possible in manufacturing: The nature of agriculture, indeed, does not admit of so many subdivisions of labour, nor of so complete a separation of one business from another, as manufactures. It is impossible to separate so entirely, the business of the grazier from that of the corn farmer, as the trade of the carpenter is commonly separated from that of the smith. The spinner is almost always a distinct person from the weaver; but the ploughman, the harrower, the sower of the seed, and the reaper of the corn, are often the same. The occasions for those different sorts of labour returning with the different seasons of the year, it is impossible that one man should be constantly employed in any one of them. This impossibility of making so complete and entire a separation of all the different branches of labour employed in agriculture, is perhaps the reason why the improvement of the productive powers of labour in this art, does not always keep pace with their improvement in manufactures. (Smith, 1776, I, pp. 9–10) 14 13
‘Large production, not large scale production, permits increasing returns’ (Young, 1990, p. 54).
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Smith pointed out that nations differed from each other not so much in the state of their agriculture but in the state of their manufactures: ‘The most opulent nations, indeed, generally excel all their neighbours in agriculture as well as in manufactures; but they are commonly more distinguished by their superiority in the latter than in the former…. In agriculture, the labour of the rich country is not always much more productive than that of the poor; or, at least, it is never so much more productive, as it commonly is in manufactures’ (Smith, 1776, I, p. 10).
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Though Smith maintained that manufacturing was more amenable to increasing returns, he did not argue that manufacturing should be promoted through protection. On the contrary, he insisted that an artificial direction to economic activity would divert an economy from its natural course, and affect the rate at which wealth could be created or capital could be accumulated. 15 He pointed out that high duties and prohibitions on imports not only hurt consumer interest but diminish society’s income, which in turn affects the pace of capital accumulation: ‘the immediate effect of every such regulation is to diminish [society’s] revenue, and what diminishes its revenue is certainly not very likely to augment its capital faster than it would have augmented of its own accord, had both capital and industry been left to find out their natural employments’ (Smith, 1776, I, p. 479). While Smith concentrated on ‘the nature and causes of the wealth of nations’, for Ricardo the principal problem of political economy was to determine the laws which regulate the distribution of the social product among the three classes, namely, landlords, stockowners and labourers. For this purpose he made the conditions prevailing in the agricultural sector a major focus of his enquiry. Scarcity of land and the operation of the law of diminishing returns would lead to a situation of rising rents and a falling rate of profit which, in the absence of technical change, would lead to the emergence of a stationary state. Smith in his Wealth of Nations also wrote of a falling rate of profit and the hypothetical emergence of a stationary state. But he believed such a possibility was far away: perhaps no country in Smith’s time had acquired the full complement of riches its circumstances permitted. Was Ricardo’s gloomy prophecy justified? Young believed that the principle of diminishing returns operates in an exceedingly elastic manner and does not pose any fixed or rigid barrier to economic progress. It was Young’s view that ‘In the law of diminishing returns, taken as a statement of tendency, there was nothing fallacious. Taken as a prophecy, however, it was, or has been thus far, mistaken. The possibilities of improvements in agricultural techniques were underestimated, and the rapid extension of the cultivation of new lands of good quality, brought nearer to the world’s industrial centres by cheap transport, was unforeseen’ (Young, 1929b, p. 1928). This did not mean that the law of diminishing returns was not operative, but only that it could be counteracted by other powerful factors such as improvements in agricultural methods and, more importantly, revolution in transportation. Hence the law is of limited usefulness as a basis for pessimistic prophecies regarding growth. A more interesting question from the point of view of policy is whether increasing returns sectors can be identified and promoted to maximise an economy’s growth prospects. In his Wealth and Welfare, A. C. Pigou (1912) suggested that increasing cost industries should be taxed and decreasing cost industries subsidised in order to bridge the gap
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However, Smith was not a dogmatic laissez faire economist. He advocated self-interest as long as it promoted public interest. When self-interest conflicted with public interest or when public interest was inadequately promoted, Smith favoured intervention. For example, he advocated public education to the poor ranks of people to counter the ill effects of the division of labour. He advocated public health measures to eradicate disease. He favoured military training to provide for national defence. To enlarge the size of the domestic market he favoured public investment in transport and communications (along with free trade). He also wanted the legal rate of interest, in those countries where a maximum rate is fixed, to be a little above the lowest market price, to channel credit to prudent borrowers (who can make profitable use of funds) and to discourage prodigals and projectors. See Viner (1928) for a long list of functions which Smith believed the state could legitimately perform, depending on the merits of the case.
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between marginal social and private costs which leads to the misallocation of resources. 16 This assumes that policy makers could identify increasing and decreasing costs industries for policy purposes. Clapham (1922) challenged this position, insisting that any attempt by economists to identify increasing, decreasing or constant costs industries would yield only ‘empty economic boxes.’ Clapham inter alia refers to several practical difficulties in identifying industries in accordance with the laws of return. There is, for example, the problem of separating the additional output due to changes in organisation from those due to invention. Or if an industry was previously experiencing modestly diminishing returns (e.g. British coal), a relative rise in its price may stimulate reorganisation and invention to restore it to at least a state of constant returns. So before an economist can give his considered judgement as to where a particular industry belongs, the world may have moved on. Moreover, if one allows some appreciable period of time before successive doses of resources are applied, the inquiry itself becomes ‘history’ and its results may no longer be relevant. Clapham was therefore not surprised that in the nearly one thousand pages of Pigou’s Economics of Welfare (1920), there is not one illustration indicating which industries are in which boxes. If different industries cannot be classified according to the laws of returns, there is no use making policy recommendations to tax or subsidise particular industries to increase human welfare: ‘Unless we have good prospect in the near future of filling the boxes reasonably full, there is … grave danger to an essentially practical science such as Economics in the elaboration of hypothetical conclusions about, say, human welfare and taxes in relation to industries which cannot be specified’ (Clapham, 1922, p. 312). Buchanan & Yoon (1999, 2000) have argued that the Smithian proposition relating the division of labour to the extent of the market is best captured by the notion of generalised increasing returns rather than sector-specific increasing returns: ‘In its minimalist formulation, the Smithean proposition does not normatively imply or require any classification or distinction among separate industries or sectors of the economy. It implies only that a larger economic nexus is more efficient than a smaller one because specialization is more fully exploited’ (Buchanan & Yoon, 2000, p. 46). As for Young, his logic of seeing the economy as an ‘interrelated whole’, in which various sectors or industries are tied together in a reciprocal exchange relationship, leads to a generalised perspective on increasing returns. Young’s conception of the market was inclusive; he viewed it not as an outlet for the products of a particular industry, and therefore external to that industry, but as an outlet for goods in general. Under competitive conditions and elastic demand for each commodity ‘an increase in supply of one commodity is an increase in demand for other commodities, and it must be supposed that every increase in demand will evoke an increase in supply’ (Young, 1928, p. 534). Given the reciprocal nature of the exchange relationships, any measure aimed at facilitating the market exchange process will facilitate growth as well. In the Smith–Young view, therefore, policies promoting one sector at the cost of another, or blocking the mobility of goods or resources, or curbing freedom of entry and exit, are likely to upset the trade relationship between sectors and hence the fuller realisation of increasing returns. Smith himself had emphasised competition, and warned that an artificial 16
In his review of Pigou’s Wealth and Welfare, Allyn Young (1913) suggested that in increasing cost industries the rise in costs is not due to use of more resources but to bidding up of prices of specialised factors as the output expands. So there is just a transfer of purchasing power from industries using specialised inputs to the owner of factors. Pigou (1920, p. 798) at first tried to refute Young’s contention in the revision of his book, retitled the Economics of Welfare, but later corrected his error in the 1924 edition after additional criticisms from Frank Knight and Dennis Robertson. See also Blitch (1995, pp. 38–39).
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direction of economic activity is likely to end up diverting resources from more productive to less productive lines thereby reducing a country’s national income. 17 Despite the generalised nature of increasing returns, the temptation to identify increasing returns sectors remains strong, and in the post-war period it manifested itself in the ‘balanced growth’ or ‘big push’ doctrines propounded by Rosenstein-Rodan (1943), Nurkse (1953) and Scitovsky (1954) among others. Again, the underlying assumption was that while agriculture is subject to diminishing returns, Marshallian-style external economies can be realised by promoting the industrial sector as a whole. More recently, it has manifested itself in the revised versions of the ‘big push’ models (e.g. Murphy et al., 1989; Krugman, 1993) or in endogenous growth models (e.g. Romer 1986, 1987; Lucas 1988) which, through a policyinduced market power, seek to promote the ‘knowledge sector’ as the key to growth. Finally, in light of the discussion in this section, it may be argued that a leading-sector strategy (for example, Currie, 1974) to promote housing and export sectors goes against the generalised view of increasing returns, and may therefore be misguided. Chandra (forthcoming), in a recent appraisal of this strategy, shows that Currie did not base his case on the logic of increasing returns. Rather these sectors suffered from certain handicaps relative to the rest of the economy: the exports sector is often handicapped by a chronically overvalued exchange rate, and housing tends to suffer from a lack of adequate finance in high inflation Latin-American economies. Currie’s approach was not to give these sectors a favoured treatment but to eliminate the institutional bottlenecks which frustrated the operation of the market in these areas. It is consistent with the Smith–Young framework of maintaining a neutral stance between sectors, as it only seeks to level the field by removing bottlenecks so that latent demand in these sectors is released, thereby giving impetus to the other sectors of the economy as well. Viewed in this way, Currie’s leading-sector strategy is a misnomer. The logic of handicap removal need not be confined to specific sectors, but could be extended to the entire economy, and the process of growth would itself throw up winners and losers. 5. Conclusions In contrast to much of the development literature that regards the presence of pecuniary external economies as a sign of market failure, this paper has argued that this argument is largely misplaced. Economies of scale are only incidental to the broader phenomenon of increasing returns. For a number of reasons the concept of economies of scale itself is slippery and an inadequate basis for the theory of increasing returns. Also, increasing returns are better viewed as generalised rather than sector-specific. And even when they are sector-specific, it is difficult to identify and promote such sectors. The main policy implication deriving from the Smith–Young framework is that the market needs to be strengthened rather than replaced. Institutional arrangements underlying a competitive market system need to be provided or strengthened. Policies should aim at widening the market through transport and communications, freer trade, removal of barriers to entry and exit, and the removal of barriers to mobility of goods and resources. The same framework also suggests that policies aimed at promoting specific sectors and industries are 17
The conception of competition in Smith is very different from the neoclassical idea. While Smith viewed competition as a process, the neoclassical conception implies an end result such as Paretooptimality. Moreover, in Smith the division of labour arises in exchange, so institutional arrangements facilitating market exchange are desirable. The state should therefore ensure two things: first, each individual’s liberty to pursue his own interests, subject only to the laws of justice, and second, a secure climate for the accumulation of private property. For details of Smith’s institutional approach see Chandra (2004). In the neoclassical version, the end-state conception of competition appears devoid of an institutional setting (see for example Hodgson, 1999).
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likely to distort intersectoral trade relationships; may distort the terms of trade between sectors (e.g., between agriculture and industry); may distort the intersectoral allocation of resources; and may curb the growth of the total exchange nexus rather than enhance it. Acknowledgment The authors are grateful to two anonymous referees for helpful comments and suggestions. References Blitch, C. P. (1983) Allyn Young on increasing returns, Journal of Post Keynesian Economics, 5, pp. 359–372. Blitch, C. P. (1995) Allyn Young: the Peripatetic Economist (Houndmills, Basingstoke & London: Macmillan). Blomström, M., Lipsey, R. E. & Zezan, M. (1996) Is fixed investment the key to growth? Quarterly Journal of Economics, 111, pp. 269–276. Buchanan, J. M. & Yoon, Y. J. (1999) Generalised increasing returns, Euler’s Theorem, and competitive equilibrium, History of Political Economy, 31, pp. 511–523. Buchanan, J. M. & Yoon, Y. J. (2000) A Smithean perspective on increasing returns, Journal of the History of Economic Thought, 22, pp. 43–48. Chandra, R. (forthcoming) Currie’s leading sector strategy of growth: an appraisal, Journal of Development Studies. Chandra, R. (2004) Adam Smith, Allyn Young and the division of labour, Journal of Economic Issues, 38, pp. 787–805. Chandra, R. & Sandilands, R. J. (2003) Does investment cause growth? A test of an endogenous demand-driven theory of growth applied to India 1950–96, in: N. Salvadori (Ed) Old and New Growth Theories: An Assessment (Cheltenham: Edward Elgar). Chandra, R. & Sandilands, R. J. (2005) Does endogenous growth theory adequately represent Allyn Young? Cambridge Journal of Economics, 29, pp. 463–473. Clapham, J. H. (1922) Of empty economic boxes, Economic Journal, 32, pp. 305–314. Currie, L. (1974) The ‘leading sector’ model of growth in developing countries, Journal of Economic Studies, 1, pp. 1–16. Currie, L. (1981) Allyn Young and the development of growth theory, Journal of Economic Studies, 8, pp. 52–60. Currie, L. (1997) Implications of an endogenous theory of growth in Allyn Young’s macroeconomic concept of increasing returns, History of Political Economy, 29, pp. 413–443. Hirschman, A. O. (1958) The Strategy of Economic Development (New Haven: Yale University Press). Hodgson, G. M. (1999) Evolution and Institutions: On Evolutionary Economics and the Evolution of Economics (Cheltenham: Edward Elgar). Kaldor, N. (1966) Causes of the Slow Rate of Economic Growth of the United Kingdom (Cambridge: Cambridge University Press). Kaldor, N. (1972) The irrelevance of equilibrium economics, Economic Journal, 82, pp. 1237–1255. Kaldor, N. (1975) What is wrong with economic theory, Quarterly Journal of Economics, 89, pp. 347–357. Kaldor, N. (1986) Limits on growth, Oxford Economic Papers, 38, pp. 187–219. Krugman, P. (1990) Rethinking International Trade (Cambridge, MA: MIT Press). Krugman, P. (1993) Toward a counter-counter revolution in development theory, World Bank Economic Review (Supplement: Proceedings of the Annual World Bank Conference in Development Economics 1992), 7, pp. 15–38. 13
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