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Introduction
As worked out a century ago, the neoclassical theory of distribution was analytically as well as
ideologically satisfying. The simultaneous determination of input and output prices through the
operation of factor and product markets seemed to close the explanatory gap left by the classical
organized economy, at least as stylized, and served to put a quietus on Marxian claims to the
effect that labor is exploited in the shortfall between product and payment.1
This major analytical achievement, with its profound implications for the organization of
societies, was, however, attained only at considerable cost. Buying into the neoclassical theory
of distribution seemed to require the abandonment of the central principle of Adam Smiths
Wealth of Nations (1776) which stressed the importance of the division of labor and its
size of the resource base and in technologyleft no room for direct linkage between policy action
on the size of the economic nexus and the rate of growth. For any given market size, competitive
organization of the economy serves to maximize value by assuring that all resources are directed
to their most productive uses. But there is nothing in this idealized neoclassical model to suggest
Neoclassical economists may have shied away from follow-on inquiry into Smiths
proposition because they thought that acceptance of Smiths relationship would have wreaked
increasing rather than constant or decreasing returns, and the observation that industries did not
seem everywhere to become more and more concentrated suggested that abandonment of Smiths
theorem was, empirically as well as analytically, less damaging than abandonment of the constant
Aside from the very brief excursus into external economies by Alfred Marshall (1890),
Allyn Youngs oft-cited but little-understood 1928 paper, and Nicholas Kaldors (1972; 1985)
insistent criticism of neoclassical orthodoxy, increasing returns, as a topic for analytical inquiry,
disappeared for more than three-quarters of a century. This situation changed somewhat
broadly related, applications (endogenous growth theory, international trade theory, economic
geography, unemployment theory, economics of ethics, and path dependence). As the title of
our jointly-edited volume, The Return to Increasing Returns (1994), was intended to suggest,
there has been a major shift of interest toward this subject matter by modern economists.
Modern economists do not, however, exhibit the history-of-ideas focus that would lead
them to reexamine the late nineteenth and early twentieth century neoclassical developments in
the theory of distribution. They remain apparently unconcerned with either the continuing
contradiction or the potential for reconciliation between Adam Smiths theorem and the
conventional postulate of constant returns in general equilibrium theory. More specifically, few
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if any modern economists seem concerned with the implications of the reintroduction of
increasing returns for either the theory of distribution or the theory of competitive equilibrium.
We shall first, in Section II, lay out several alternative conceptualizations of increasing
returns as these have variously appeared in recent works and then concentrate our attention on
what we have called generalized increasing returnsthe phenomenon that seems to be most
returns and the theory of distribution, especially with reference to the adding up problem that
application of Eulers theorem. Here we suggest that generalized increasing returns, properly
introduced and understood, need not generate results that violate the Euler conditions.
In Section IV, we extend the analysis and examine the implications of generalized
increasing returns for the existence of competitive equilibrium. And, as with Eulers theorem, we
need not directly imply Pareto optimality, even in the absence of Marshallian external economies.
Externalities may remain at those margins of behavioral adjustment that affect the size of the
economic nexus.
Section V discusses the meaning of technology in our construction, which may differ from
the meaning that is incorporated in much of standard discussion. Section VI concludes the paper.
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19
Adam Smiths pin factory example is misleading because it concentrates attention on the
advantages of labor specialization in the production of a single good. Increasing returns, defined
in this restricted sense, has occupied center stage in both neoclassical and modern formulations,
If there exists advantages to scale in the production of a well-defined good and with a
given technology, competitive organization is not viable, and the prospect for monopoly-
generated inefficiency in resource usage substantially weakens the normative argument for
markets. Alfred Marshall (1890) recognized the difficulty here, and introduced a model in which
firms production functions are interdependent over a whole sector but in which scale advantages
are not within the exploitation potential for any single firm.
politicized correction. Some recent models of endogenous growth (Romer, 1990; Lucas, 1988)
doing. Other models (Arthur, 1994) isolate possible effects of positive feedbacks in a dynamic
setting, stressing the importance of start-up positions for exploiting scale advantages, and
essentially abandoning the uniqueness, and the necessary efficiency, of neoclassical competitive
equilibrium.
Each of these formulations of increasing returns (along with others not noted here2) raises
issues for either the theory of distribution and/or the efficiency of competitive equilibrium that
need not arise in the more general formulation implied by Adam Smiths specialization principle.
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If Smiths pin factory example is disregarded, and attention is placed on his emphasis of the
importance of the division (specialization) of labor as related to the extent of the market, the
notion of increasing returns may be applied over the whole of an integrated economic nexus of
production and exchange. In this formulation, specialization occurs continuously as the size of
the nexus expands. Persons increasingly shift from self-production to market production as
increasingly narrow specializations become viable.3 And, as such specialization takes place, the
This process may occur (but, of course, need not) even if there are no scale advantages in
the production of any single good, beyond those that arise from the initial specialization by one
monopolistic competition, as several economists have done (Dixit and Stiglitz, 1977; Ethier,
1982; Krugman, 1979; and Romer, 1987) in order to reconcile the existence of viable competition
This concept of generalized increasing returns may be easily reconciled with the
distribution theory, which typically assumes constant returns to scale globally or locally and
Central to the marginalist revolution of the 1870s was the recognition that values are set
by the simultaneous working of forces on two sides of potential exchanges. The one-way,
supply-side causation of classical economics was rejected. First applied to product market (to
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resolve the diamond-water paradox), the extension of the explanatory model to input or factor
markets now seems an inevitable next step. Resource inputs are valued both because they
involve opportunity costs and generate potential final product value. No prospective supplier of
an input unit will accept less than the units opportunity cost, and no demander will pay more
than the anticipated increment to value promised from use of the unit.
Closure seemed to have been accomplished; the explanatory model seemed complete. But
a dangling question disturbed the early neoclassical converts. How can we know that the product
value paid out to input owners, on the basis of marginal contributions, exhausts the total value
placed by users on final output? The adding-up problem commanded much attention until a
The Euler construction is pure mathematics. The theorem states that when a function
exhibits certain properties (i.e., homogeneity of degree one) then certain consequences follow.
Specifically, the theorem states that when a function, y = F(K, L), that relates a dependent
variable y to one or more independent variables, K and L, is homogeneous of degree one, the sum
of the separate partial derivatives multiplied by the corresponding independent variables is equal
to the total value of the function or the dependent variable 4: y = FKK + FLL where FK is the
In its distribution theory application, Eulers theorem states that payments to all inputs,
in accordance with separate marginal value products, exhausts the total product value when the
production function that relates inputs to output exhibits the properties indicated. Economists
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are familiar with these properties under the postulate of constant returns. If equiproportional
changes in all inputs generate equiproportional change in output, the required conditions are
satisfied. Marginal productivity payment, in value units, exhausts total value of product. There
is no surplus or deficit, as would emerge under decreasing returns in the first case, or under
restrictive if defined to apply over the whole scale of any possible production operation. For
scale from some initial nonspecialized base of economic self-sufficiency. This apparent
analytical hurdle was clarified by more sophisticated understanding of the competitive process.
Production is organized through firms, and profit-seeking firms will seek to extend scales
of operation in order to take full advantage of increasing returns. But under conditions where
aggregate demand is sufficiently high, firms may attain all scale advantages while remaining small
relative to the total market for product. Each firm will be forced by pressures of competition to
produce efficiently, at a level where there exists neither scale advantages nor disadvantages.
productive unit, operates at constant returns in all activities. Increases in any one productive
activity will be reflected in an increase in the number of efficiently operating firms, accompanied
by a decrease in the number of such firms in other lines of activity. Almost no attention was
paid to the effects of a net increase in the inclusive size of the network of economic interaction,
and economists seemed willing to neglect the Smithean proposition about the continuing
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advantages of specialization. Eulers theorem simply did too much work in the whole
There were at least two reasons why economists seemed willing to remain locked into
what must, in one sense, appear to be an arbitrary position. They could, with little more than
disadvantages of scale should seem to describe the operation of the whole economy, or any part
thereof, some input is either not properly counted and its productivity measured or some input
is used inefficiently. Correct accounting for all inputs along with efficient usage suggests that any
all inputs. In this analytical exercise, the production function is made to conform to the
tautology. And, if such a construction is used to eliminate decreasing returns from consideration,
it would seem equally applicable for increasing returnsthe phenomenon that is inferred by
The analytical rejection of the increasing returns hypothesis was reinforced by the
empirical observation, noted earlier, to the effect that concentration ratios did not increase in all,
or even in many, lines of productive activity. There seemed to be little need to reexamine the
theory.
We suggest here that the implications of Smiths principle were not at all those that most
neoclassical economists implicitly inferred, and that generalized increasing returns may be
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incorporated into the neoclassical model without undermining the distributional validity of
Eulers theorem in application, and without damage to the existence proofs for general
The conditions within which the neoclassical theory of distribution are derived must be
carefully specified. As noted earlier, the size of the resource basedefined as the number and
productionthe processes that dictate how these inputs can be most efficiently transformed into
valued outputis also parametrically set. There was a general failure to recognize that any
incorporation of Smiths principle of specialization into the model necessarily violates the fixed
advantages of specialization are fully consistent with constant returns to scale for all activities
and for the economy as a whole operating within the parameters of resources and technology.
Payments of inputs in accordance with marginal value products exhausts total value; the
conditions for Eulers theorem to apply are met. Expansion in scales of operation takes place
as a whole will not take place within the parametric constraint of a given technology. The
extended specialization dictates that efficient operation requires a shift to a new technology, to a
different production function. Again, once attained, a change in inputs and outputs along the
modified function exhibits constant returns. There is no shortfall between value as produced and
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value as assessed since production must take place within the specific technology dictated to be
Competitive Equilibrium
A second, conceptually related but different, problem haunts neoclassical orthodoxy when
increasing returns appear. How is competitive equilibrium possible unless constant or decreasing
and alternative models, as sketched out in Section II. If increasing returns are present for
productive activities that are identified by product or industry, the scale advantages will be
exploited by entrepreneurs who get there first. Industries will be monopolized; allocative
inefficiency will emerge; and competitive entry will be unprofitable. In an economy-wide sense,
an equilibrium, of sorts, may be defined, but this equilibrium could not be classified as
competitive.
If, however, increasing returns exist only for the operation of the economy as a whole, or
for major sectors, and remain unexploitable by entrepreneurs at the level of firms, there need be
parameters, competitive pressures will move the economy toward an equilibrium that may be
analytically defined and that will exhibit the central properties of the neoclassical construction.
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Firms will operate at zero profit; resource returns will be equalized over all uses; aggregate value
How can these familiar conditions be met in a model that postulates the existence of
generalized increasing returns? As the size of the economy increases, reflected through a shift in
the size of the resource base, specialization is extended; the value of product increases
disproportionately with the increase in the size of the resource base. The competitive
Note precisely how the relevant externality here differs from the more familiar
Marshallian version. In the Marshallian setting, as the output of one firm increases, positive
external effects are exerted on the production functions of other firms in the industry. A
simultaneous expansion expansion in output in all firms in the relevant industry (or sector) at the
expense of reduction in output in the remaining sectors of the economy will generate increased
overall efficiency within the fixed parameters of the system (resources and technology). By
returns, no such within parametric adjustment can be efficiency enhancing. The externality
occurs at the margin of adjustment in the parameters of the system. With given technology, if the
size of the resource base is fixed, there is no externality present and the equilibrium meets all the
Pareto conditions.
If, however, individuals in the economy can, themselves, affect the size of the resource
base through changes in their own behavior, that is, if individuals can modify the parameters of
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the model, the externality described by increasing returns phenomena may not be internalized by
separate individual actions. If the parameters of the system are treated as variables subject to
technology, all of the conditions required for competitive equilibrium may be met, including the
optimality result.
As we have discussed in some detail in our earlier work (Buchanan and Yoon, 1994;
Buchanan, 1994), individual adjustments in the supply of effort to the market nexus do act to
modify the resource base, thereby changing the parameters of the structure. And here there is a
direct linkage between Adam Smiths proposition and potential policy action that may be taken
to exploit scale advantages and thereby to increase rates of aggregate growth in the economy.
technology in our argument. Confusion may have arisen because of failure to recognize, first, that
changing technology as the size of the economy changes, and second, that neoclassical production
functions treat technology as an index parameter invariant over the size of economy.5 Production
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functions can all exhibit constant returns while, at the same time, the economy exhibits increasing
returns.
Consider Figure 1, which relates aggregate output Y to a composite input Z. The heavily-
shaded curve, R, depicts increasing returns. But, R is not a production function. Separate
aggregate production functions that relate Y to Z, for given technologies, are shown as P1, P2, and
so on, each of which exhibits constant returns to scale. Note that the dotted portions of the P
lines depict positions that are unattainable; the quantity of inputs, Z, is not sufficient to bring
these indicated modes of production into being.6 Note, also, that the expansion path, R, could
never exhibit decreasing returns because that technology appropriate for very small scale
operation could always be multiply replicated (or recreated) so as to make R coincident with,
say, P1.
There is what we may call a sea of technologies available, with the unique optimal technology
from the sea depending upon (or determined by) the quantity of inputs, Z. Given any value
for Z, the corresponding position on R depicts the optimal or efficient technology which is, itself,
described by a production function (within that technology) that relates inputs to output. In this
construction, there would seem to be no reason to think that R is linear; Adam Smiths
proposition that there are continuing advantages from specialization as market size increases
Note that, in this construction, exogenous innovations in technology, given any quantity
of generic input, would be shown by a shift upward in the whole curve, R, or some parts thereof,
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along with possible changes in curvature. Endogenous improvements in technology that might be
In Conclusion
In retrospective examination of off-and-on analytical discourse over a full century, we can
only wonder why the phenomena of increasing returns, if defined to incorporate Adam Smiths
theorem about specialization, should have evoked such concern, both as expressed and as
wide, is the sole source of the enhanced efficiency generated by an expansion in market size, there
is no negative inference to be drawn for the neoclassical theory of distributive sharing. Further,
Confusion may have emerged, at least in some part, from a failure to sense fully the
analytical consequences of the shift between the dynamic adjustment processes crudely modeled
elaborated with increasing sophistication by neoclassical theorists. Adam Smiths question was:
How does an economy grow? His suggested answer: An economy grows by growing, by
extending the size of the market nexus, both internally (by shifting from nonmarket to market
production) and externally (by opening up trade). The neoclassical question was: How does an
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economy, given its resources and its technology, secure maximal value? The suggested answer:
from the separate research programs to the agreed upon objectives of growth and efficiency.
Analytically, problems arise only when the Smithean principle is incoherently introduced into
the neoclassical theory of allocation, when increasing returns describe the operation of separately
Empirically, of course, increasing returns may or may not be sufficiently general to allow
distributional and equilibrating concerns to be ignored. But the analytical as well as the
practicable attractiveness of the Smithean construction comes from its normative generalizability.
Policy aimed at extending the size of the market may be defended, and without any necessity of
prior identification of the industries or products that may exhibit, or may possibly exhibit, scale
economies. Normative support for policies aimed to enhance a generalized work ethic and to
open up markets need not invoke the epistemological arrogance required for support of
References
Arthur, Brian. 1994. Increasing Returns and Path Dependence in the Economy. Ann Arbor:
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Buchanan, James M. and Yong J. Yoon (eds.). 1994. The Return to Increasing Returns. Ann
Dixit, Avinash K. and Joseph E. Stiglitz. 1977. Monopolistic Competition and Optimum
Returns, 16788.
Ethier, Wilfred J. 1982. National and International Returns to Scale in the Modern Theory of
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Hicks, John R. [1932] 1966. The Theory of Wages. 2d ed. London: Macmillan.
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Krugman, Paul. 1979. Increasing Returns, Monopolistic Competition, and International Trade.
Lucas, Robert E., Jr. 1988. On the Mechanics of Economic Development. Journal of Monetary
Economics 22:342.
Marshall, Alfred. [1890] 1961. Principles of Economics. 9th variorum ed. Edited by C. W.
Robinson, Joan. 1934. Eulers Theorem and the Problem of Distribution. Economic Journal
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Romer, Paul. 1987. Growth Based on Increasing Returns Due to Specialization. American
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Young, Allyn. 1928. Increasing Returns and Economic Progress. Economic Journal
*. Helpful comments were provided by Tyler Cowen, Mark Crain, Roger Faith, S. Kim,
Hartmut Kliemt, Axel Leijonhufvud, David Levy, Mancur Olson, John Riew, Richard Wagner,
and participants in the Public Choice Seminar, George Mason University. We are especially
1. For a summary discussion of this analysis see Hicks 1932 [1966] (especially the Appendix)
2. For a listing and brief comparison of alternative models of increasing returns, see our review
article (Buchanan and Yoon, 1995). Many of the modern, as well as earlier, treatments are
3. This progression of specialization over the whole economy is developed in the analysis of
means, when each of the independent variables is increased by a common factor, , the
dependent variable increases by the same rate: F( k, L) = F(k, L). For CES functions this
economy may reveal an aggregate input-output relationship that exhibits increasing returns to the
size of nexus as formulated in our earlier paper (Buchanan and Yoon, 1994) and by others
6. For an individual firm, of course, the production function faced would exhibit constant returns