LN-13 From pin factory to endogenous growth. Looking backwards from - PDF document

LN-13 From pin factory to endogenous growth. Looking backwards from Paul Romer to Adam Smith. Introduction One of the new breakthroughs in economics in recent decades has been endogenous growth theory . The out spring was Paul Romer’s article Endogenous technological change (JPR 1990). Romer’s paper was received with great enthusiasm and immediately inspired research all around the globe. Perhaps one should have expected this development to have led to Nobel Prize but so far it hasn’t. Why it hasn’t is an interesting questions and I cannot enlighten you on that. I am confident that Romer must have been proposed for the Nobel award but clearly not found a worthy candidate - yet. The Nobel Prize Committee may have been right about this - or wrong! And a number of candidates (e.g. Haavelmo, Markowitz, Nash, Schelling) got their prizes 40 years or more after the achievements they were awarded for. And Paul Romer is not in either one of our textbooks. Romer’s 1990 paper had due reference to Solow’s 1956 paper which established growth theory. The first paragraph of Romer’s paper had the following sentence: “The distinguishing feature of …technology as an input is that it is neither a conventional good nor a public good; it is a non-rival, partially excludable good… .” Solow may not have disagreed with this statement but Solow’s treatment of technological change was, as we know, entirely exogenous. We also know from the growth theory class that long-term growth per capita in the Solow model is entirely exogenous. Then what is endogenous growth? It is defined (in Palgrave) as long-run economic growth at a rate determined by forces that are internal to the economic system, particularly those forces governing the opportunities and incentives to create technological knowledge. Endogenous growth theory thus explains long-run growth as emanating from economic activities that create new technological knowledge. Romer’s aim relative to Solow is thus easy to understand in general terms but his way of endogenizing technological change is anything but easy. Romer’s work is rooted in his doctoral dissertation at Chicago in 1983. He first presented the ideas of his dissertation in a paper titled Increasing returns and long-run

growth (1986) with more complicated mathematics and some differences in content from the 1990 paper. Romer’s 1986 title is more telling than the 1990 title about what this is really about, namely about long-run growth. Why have human societies which at some stage joined in the industrial development which started in 18C England grown in income per capita so much more than in previous millennia. The historians may have something to say about my generalizations here but let me keep on by stating also that the growth rate has even increased, as a grandiose average of countries and a couple of centuries of time. Let us say that Romer’s aim was to try to catch key essentials of this explanation in a formula, which by any means is extremely ambitious. ‘Technical change’ is a kind of technical term for what Romer was after, namely the growth of (useful) knowledge. He wanted to succeed where Solow dropped out, namely in explaining the role of the knowledge factor. Solow had however succeeded in his 1957 paper to show the importance of the unexplained exogenous factor. Romer at some early stage in his work looked back how predecessors in economics had dealt with and understood the growth of knowledge. Notice the title of his 1986 paper – Increasing Returns . So where would he start his search? Back to Adam Smith We have been through the history and remember well so ‘increasing returns’ reminds us immediately about the opening lines, in fact the opening chapters of the Wealth of Nations : I.1.1 The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour. A little further down this passage (which we didn’t read out): One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.

Then we are told that an unskilled worker would be lucky if he could make a single pin in one day, while 10-15 men in the factory with the labour divided up in the best way could make 48,000 a day or a million pins every two weeks. But would it be possible to sell a million pins every fortnight? The answer is in chapter 3 The Division of Labour is Limited by the Extent of the Market . Maybe I repeat myself from lecture 3 but it is something odd that these passages appear so prominently in WN . Clearly Smith must have found this insight he had worked out – he had never been to a pin factory – very important. So what is odd? If we ask a qualified panel what was the most important message derived from Smith’s WN , we would probably hear about the invisible hand and that Smith showed a competitive economy to be possible and highly beneficial, elaborated on its workings. This was later corroborated by a serious of successors with increasingly sophisticated mathematical tools to prove it. We recognize this as the general equilibrium world of Walras, which indeed has some nice properties, built up around small (atomic) agents each in a world characterized by decreasing returns But in this picture the pin maker does not really fit in well. Suppose we consider a pin maker gets into the market early, expands, invest in new equipment and pin making R&D, developing better steel more attractive packaging, more efficient distribution channels. The bigger the market, the greater the specialization. The more efficient his production, the lower the price at which he can offer the pins. The lower the price, the more pins he can sell, the higher the profit. Where does it end? The inevitable logic is that the economics of the pin factory is that the advantages of falling costs implies that whoever starts out first in the market, can run everybody else out of the pin business. Does this mean that big business is good; that monopolies are inevitable, and perhaps desirable? If scale economies are so important, how do small firms manage to exist at all? These questions are unexplored in WN . We are left with tentative conclusion that the two main insights of Smith iconized by the Pin Factory and the Invisible Hand seems contradictory. One is about falling costs and increasing returns , the other about rising costs and decreasing returns . So to Romer it may have seemed that growth associated with accumulation of knowledge of how to produce more efficiently, which was associated with increasing returns, which could lead to monopoly. Hence he was lead to study the undercurrent in the history of economics comprising increasing returns and monopoly.