A firm or an industry, having a given technology, exhibits increasing returns to scale if an increase in the inputs it uses to produce a particular product increases its output more than proportionately. This effect is evidenced in a decreasing long-run average cost curve. While the increasing returns concept has relevance for both microeconomics and contemporary growth theory, historically it dates from Adam Smith’s Wealth of Nations (1776), which links the cost experiences of manufacturing firms to the division of labor (Smith 1776, Book I, Chapter 3). The practice leads to specialization and therefore the capability among those who specialize to trade their surpluses, which has the effect of expanding the market. Under perfect competition, declining cost has the effect of reducing selling prices. Although it reduces profits, it increases the real incomes of all classes.
Antoine Augustin Cournot, a French mathematician, was the first among several thinkers to note that increasing returns to scale are incompatible with price-taking behavior by competitive firms (Cournot 1838, pp. 59–60). A decade later, John Stuart Mill also became cognizant that economies of scale could compromise competitive markets. This possibility was, however, categorically negated by Alfred Marshall, who rejected the idea that increasing returns to scale characteristically cause industries to become monopolized. He invented external economies in the form of “general improvements,” which are equally available to all firms in the industrial environment and were believed to account for the already observable tendency in the England of his day to explain declining commodity prices. Economies that are internal to firms are self-limiting, Marshall believed, partly because the full effects of economies of scale are likely to be impeded because over time “the guidance of business falls into the hands of people with less energy and less creative genius” (Marshall 1890, p. 316). Thus, Marshall maintained that monopolistic tendencies would be curbed, and competition would continue to prevail, rendering unfounded Mill’s fear that increasing returns to scale would compromise pure competition; that is, firms and industries invariably produce under conditions of increasing supply price, which explains the upward slope of the industry supply curve.
The definitive theoretical challenge to Marshall’s conclusion that increasing returns to scale are compatible with ongoing pure competition was articulated by Piero Sraffa, who maintained that the economies needed to satisfy Marshall’s logic “were nowhere to be found” (1926, p. 540). Marshall’s particular equilibrium analysis was designed to explain price determination in a competitive industry that is identifiable in terms of the cost curves of its “representative firm.” These cost curves must be independent of those of all other firms in the industry and the industry’s factor suppliers. Thus, economies that are external to the representative firm but internal to the industry of which it is a part, which is a requirement of the particular equilibrium method, are incompatible with Marshall’s methodology. If these economies exist at all, they are “in the middle where nothing or almost nothing is to be found” because Marshall’s explanation of increasing returns is methodologically inconsistent (Sraffa 1926, p. 542). Sraffa recommended that economists give up trying to explain competitive prices and turn their attention instead to explaining prices under imperfect competition. Shortly afterward this became the objective of Joan Robinson (1933) and Edward Chamberlin (1933).
More recently, Marshall’s concept of increasing returns to scale has been “rediscovered” by contemporary “new growth” theorists (Romer 1986, 1987), who have taken the “internal-external economies” construct out of its original particular equilibrium setting in which it was intended to explain competitive price determination. They have placed it into a Walrasian general equilibrium context in which the prices of all commodity and factor markets are interdependent. The premise of the model is that the external effects of knowledge and capital accumulation can amend the Cobb-Douglas productions function by a multiplicative factor to generate endogenous growth in the affected economies. It is ironic that the theoretical problem that Sraffa identified as being associated with Alfred Marshall’s concept of external economies to explain the compatibility of increasing returns and competitive equilibrium has been revived within a general equilibrium framework that is clearly incompatible with the cost-independence requirement of Marshall’s particular equilibrium analysis.
By the mid-1920s, with the assembly-line production of automobiles and other industrial products already a fact of life, a trend toward oligopoly—that is, competition among the few—was already apparent. Shortly afterward, the advent of the theories of “imperfect” and “monopolistic” competition (Robinson 1933; Chamberlin 1933) challenged the predominance of pure competition on the premise that product demand curves had come to exhibit a downward slope because firms engaged in differentiating their output had become able to charge prices in excess of the competitive “law of one price.” While they were not monopolists of their own commodities, they were able to establish demand curves for their particular brands that were less price elastic than would be the case in competitive markets in which product homogeneity assured that buyers had no basis for preferring one seller’s product over another. More recently, despite the institutional and theoretical relevance of the theory of imperfect and monopolistic competition, many thinkers maintained that economies of scale could be theoretically reconciled with perfect competition. A case in point is the interpretation by contemporary trade theorists. Helpman and Krugman (1985) argue that increasing returns might prevail as an external effect that can generate economic growth as an endogenous phenomenon and thus preserve Marshallian perfect competition.
The most forward-looking post-Marshallian interpretation about the relationship between increasing returns and market competition came from Allyn Young’s return to Smith’s theme of division of labor. In his presidential address to the British Association for the Advancement of Science, “Increasing Returns and Economic Progress,” Young noted that “the most important single factor in determining the effectiveness of its industry appears to be the size of its market” (1928, p. 122) and whether it is sufficiently large to generate increasing returns. Except for the impetus that comes from new knowledge, economic progress is principally generated by division of labor to realize more fully the economies of capitalistic or roundabout methods of production. Thus, Young’s “Increasing Returns” paper specifically separated Marshall’s increasing returns concept from its particular (i.e., microeconomic) industry setting and, following Smith, extended increasing returns to the economy as a whole. Thus, Young anticipated the role of Keynes’s emphasis on aggregate demand and Nicholas Kaldor’s theory of increasing returns in the process of economic growth. Yet it is only comparatively recently that Young’s special insight into the process of growth as “self perpetuating, rather than self-exhausting” has been recognized (Blitch 1983; Sandilands 2000; Rima 2004).
SEE ALSO Returns; Returns to a Fixed Factor; Returns to Scale; Returns to Scale, Asymmetric; Returns, Diminishing
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Ingrid H. Rima