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The Wealth of Nations, Wolf on Jacobs, Krugman on Warsh

By Polly Cleveland

Martin Wolf of the Financial Times, calls Jane Jacobs, who died last week, “a self-educated intellectual of astonishing originality.” He devotes most of his article, “National wealth on city life’s coat tails” http://news.ft.com/cms/s/352033dc-da02-11da-b7de-0000779e2340.html to a review of one of his and my favorite books, Jacob’s 1984 Cities and the Wealth of Nations — which he sees as a direct challenge to Adam Smith’s Wealth of Nations.

Jacobs, like Smith, rarely lets theory trump observation. And what a different world she observes from that of conventional economics! Economic growth happens, not at the national level, but in cities. “According to Jacobs, cities grow through explosive import-replacement. These new products then become their exports, which finance more imports. The expansion that derives from city import-replacement generates five sources of growth: enlarged markets for imports; increased numbers and kinds of jobs; increased transplants of city work into non-urban locations; new uses for technology, particularly to increase rural production and productivity; and growth of city-owned capital for investment in the city and elsewhere.”

Cities have largely stumped economic model-builders: what to do with economies of scale in infrastructure, economies of cooperation and communication, positive externalities of ideas and energy? Which brings me to David Warsh’s new book, Knowledge and the Wealth of Nations, reviewed by Paul Krugman in the Sunday New York Times: “The Pin Factory Mystery,” www.nytimes.com/2006/05/07/books/review/07krugman.html.

As Krugman relates, Warsh addresses a contradiction in Adam Smith: In the first pages of the Wealth of Nations, Smith celebrates the pin factory, where division of labor and economies of scale allow ten workers to make thousands of times more pins a day than they could working separately. Smith goes on to celebrate the market, which allows the same division of labor and economies of scale to proceed on a grand scale, engaging thousands of enterprises in the production of a single good.

The contradiction? It takes many competitors to make markets function. Yet if firms face increasing returns to scale, they will consolidate into monopolies. So to maintain a theory of competitive markets, model-builders have felt forced to assume that firms face diminishing returns to scale–banishing the pin factory to “an ‘underground river’ in economic thought.”

In Warsh’s account, recent developments in growth theory have resolved the contradiction. Krugman writes, “Economists had finally found ways to talk about the Pin Factory with the rigor needed to make it respectable. One after another, fields from industrial organization to international trade to economic development and urban economics were transformed.”

I am only slightly familiar with this literature. However, I long ago resolved the contradiction, at least to my own satisfaction, in models for my dissertation: I assumed that diseconomies of scale in supervision ultimately overpower technological economies of scale, setting limits on firm size. I look forward to Warsh’s book.

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