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Long-Run View of the Dismal Science

An intellectual history of economics tells how its practitioners have addressed (or avoided) a contradiction in Adam Smith's theories.

July 02, 2006|Tim Harford | Financial Times

Some experts have the kind of obsession with petty detail that seems likely to make for dull dinner-party conversation.

But the best intellectual guides win us over to enjoy the nerdy details as much as they do. David Warsh is one of these rare creatures.

Warsh, who wrote for the Boston Globe for many years, has an obsession with economics and economists. He now writes a newsletter called Economic Principals, which deals with the comings and goings of the profession. The first chapter of "Knowledge and the Wealth of Nations" is an anthropological study of the American Economic Assn. that, miraculously, is riveting.

In what is, at its heart, an excellent intellectual history, Warsh shows how the ideas of innovation and economic growth began with Adam Smith and bubbled up only to be submerged again and again.

There was a contradiction at the heart of Smith's work. His two key ideas were the power of specialization to muster productive forces and the power of competition to turn those productive forces to the benefit of society.

Increasing returns to scale are exemplified by the tale of the pin factory. "One man draws out the wire, another straights it, a third cuts it ... 18 distinct operations ... are all performed by distinct hands."

Smith calculated that a dozen men could make about 5,000 pins each a day, but it would require a large market for pins. If increasing returns to scale are as important as he believes, businesses need to be very large to be efficient.

Smith also emphasized the importance of competition, which drove prices to their natural levels and prevented the exploitation of workers and customers.

When competition worked well, the "invisible hand," as conceived by Smith, would turn private selfishness into public virtue: The baker bakes us bread not because he loves us but because he wants to make money.

The contradiction between increasing returns and competition was not widely recognized for many years. If larger companies have lower costs, then industries will be dominated by few of them, or perhaps by one. Where, then, is the competition?

Historically -- with some notable exceptions -- economists have focused on competition and ignored increasing returns, which they found conceptually and mathematically hard to deal with.

That was, perhaps, forgivable in the 18th century, when economies of scale tended to be modest enough to allow competition to thrive. But the economy Smith described is not the one we have today.

Microsoft Corp., protected by intellectual property law, is a near-monopolist in the world of desktop operating systems. EBay Inc. is dominant thanks to the economies of scale in bringing together buyers and sellers.

The industry for making large aircraft is big enough for only two players, Airbus and Boeing Co. Competitive pressures do not operate well in a world of increasing returns.

Warsh's story moves from Smith through David Ricardo, Joseph Schumpeter, John Maynard Keynes, Kenneth Arrow and most of the other key figures in economic thought before arriving at Paul Romer's attempts to put increasing returns at the heart of understanding economic growth.

Romer, a peripatetic figure who always seemed on the verge of dropping out of the profession, is now a Stanford University professor.

His work in the 1980s tried to resolve the contradictions inherent in Smith. He was helped by rapid progress in the mathematics of increasing returns that his contemporaries were applying to industrial organization and international trade.

Economists had long appreciated that economic growth was made possible by a combination of capital investment and technological change. They even recognized that technological change was much the more important of the two. But being unable to analyze it, they focused on models of capital investment instead -- looking for the lost keys under the street lamp. Romer fashioned himself a torch and went farther afield.

Technological change is hard to model in part because it is the most extreme example of increasing returns to scale. An idea -- such as Microsoft's Windows XP or the formula for a vaccine -- can be impossibly expensive to create and impossibly cheap to copy.

Ideas have always been vital to economic growth, and they are now more important than ever. Thanks to Romer's modeling, economists have a much better handle on the process of innovation and are even venturing some thoughts as to what governments might do to foster it.

Warsh's story is not without flaws. His view of Romer's contribution occasionally verges on hagiography. The book also gives a sense of petering out as it arrives in the present. As Warsh himself concludes: "What has changed as a result?"

The answer, it seems to me, is not much. That is obviously a little disappointing.

Yet, overall, this is a fascinating story of discovery, meticulously reported and essential reading for anyone curious about what makes economics tick.

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Tim Harford is an economics commentator for the Financial Times, where this review first appeared.

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Economic theory

* "Knowledge and the Wealth of Nations: A Story of Economic Discovery"

* By David Warsh

* W.W. Norton, $27.95, 320 pages

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Source: Publisher

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