Allyn Young's Increasing Returns to Scale

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In talking about increasing returns to scale, Allyn Young was referring to the achievement of the entire economic system rather than the performance of individual firms or industrial sectors.

This is what Young has in mind:


"The successors of the earlier printers are not only ... the printers of to-day, with their own specialised establishments, but also the producers of wood pulp, of various ..." 

Returns to Scale

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A quick overview:

For a critical application to equilibrium economics go here.

A Kaldorian Link Between Increasing Returns to Scale, Non-Equilibrium Growth, and Money & Banking

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Lord Kaldor argues that equilibrium economics ignores the fact that modern economies are characterised by increasing returns to scale — unlike models of equilibrium outcomes which expressly rely on the assumption of constant returns to scale.

The point here seems to be that constant returns to scale are compatible with the conservative, in fact stationary view of an economy underlying the notion of an economy tending toward or resting in a state of equilibrium. The equilibrium itself depends on a number of unchanging conditions. Whenever the "moving parts" of the overall system touch the unaltering walls of the equilibrium framework, they are deflected to fall into place as they are supposed to. It is a deterministic system without surprises. 

With increasing returns to scale things work out differently.

Progress and growth become more indeterminate, it is no longer a matter of tending toward an eternally identical arrangement of balanced rest.

Factors other than relative prices become efficacious — like the size of a market. It is possible for disproportions to build up, for competitors, products, and tastes to differentiate themselves into an unstable order far removed from the utter uniformity of the actors enlisted in the models of equilibrium economics.

In [...] markets where increasing returns to scale exist often producers carry their own stocks and adjust their output in response to demand (Kaldor 1972: 1250). 

The ability to increase production in response to demand is achieved in modern capitalism by an endogenous money supply: a banking and monetary system where capital investment can be financed by new money. 

Kaldor notes that 

“This is the real significance of the invention of paper money and of credit creation through the banking system. It provided the pre-condition of self-sustained growth. With a purely metallic currency, where the supply of money is given irrespective of the demand for credit, the ability of the system to expand in response to profit opportunities is far more narrowly confined.” (Kaldor 1972: 1250).

The source.

So, equilibrating processes cannot describe, let alone explain the dynamics of modern economies — increasing returns to scale can, and the ability to respond to profit opportunities implied in new patterns of demand. This capacity is supported by the banking system of a fiat money regime. 

Economics systematically ignores these two fundamental facts:

the absence of 

(1) equilibrating processes constrained by conditions of constant returns to scale driving the overall performance of the economy, and 

the presence of

(2) money (as an agent shaping the economy's real variables with the help of banks and other agents of the banking system characteristic of a regime of fiat money).

PS

What I gather from the below is at least that increasing returns to scale mean a market structure may evolve outside of a framework of perfect competition, mind you Allen had this in mind — Source:

It might sound intimidating but its easy to think of this question in two parts. Firstly, understand what increasing returns to scale (IRS)is  means and then look up the characteristics of perfect competition. Then, put these two thoughts together to see whether they are compatible.

One way to look at the incompatibility is to use the cost approach. Increasing returns to scale would mean that the average cost (AC) of producing a good decreases as more and more of that good is produced, that is as output increases. Now, the marginal cost (MC) curve which is the rate of change of the Total cost (TC) under IRS is always below the AC curve. Given this scenario, in a competitive industry the MC-pricing,

(P = AR = MC < AC)

means that the price being charged by the firm for the good is lesser than the average cost to produce it. Naturally, this translates into losses for the firm as it will not be able to recover even the cost of producing the good. This is evidence enough to conclude that increasing returns to scale (IRS) I snot compatible with perfect competition.

Further, as a consequence of P < AC, one by one firms posting losses will start exiting the industry/market, eventually boiling down to one firm which will remain leading to a situation that is referred to as natural monopoly.

P.S : We might encounter an IRS situation in traditional industries like utilities (water, electricity, gas) which are regulated to have one monopoly suppliers in a certain region. It is important to note however that, without regulation in these industries, it will lead to a natural monopoly which might not necessarily produce socially optimum quantities of output.

Balance-of-Payments Constrained Growth — Growth Theory

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Writes Thirlwall on pages 369-371 of Growth and Development, 2006: 

In national income accounting an excess of investment over domestic saving is equivalent to a surplus of imports over exports. The national income equation can be written from the expenditure side as

Income = consumption + investment + exports - imports

Since saving is equal to income minus consumption, we have

Saving = investment + exports - imports

or

Investment - savings = imports - exports

A surplus of imports over exports financed by foreign borrowing allows a country to spend more than it produces or to invest more than it saves.

Note that in accounting terms the amount of foreign borrowing required to supplement domestic savings is the same whether the need is just for more resources for capital formation or for imports as well. The identity between the two gaps, the investment-savings (I-S) gap and the import-export (M-X) gap, follows from the nature of the accounting procedures.

It is a matter of arithmetic that if a country invests more than it saves this will show up in the accounts as a balance-of-payments deficit. Or to put it another way, an excess of imports over exports necessarily implies an excess of the resources used by an economy over the resources supplied by it, or an excess of investment over saving.

Before going into dual-gap analysis in more detail, a reminder of elementary growth theory is in order. 

Growth requires investment goods, which may either be provided domestically or be purchased from abroad. The domestic provision requires saving; the foreign provision requires foreign exchange. If it is assumed that some investment goods for growth can only be provided from abroad, a minimum amount of foreign exchange is always required to sustain the growth process. In the Harrod model of growth (see Chapter 4), it will be remembered, the relation between growth and saving is given by the incremental capital-output ratio (c), which is the reciprocal of the productivity of capital (p) that is, g = s/c or g = sp, where g is the growth rate and s is the saving ratio. Likewise the growth rate can be expressed as the product of the incremental output-import ratio (LlY/M = m') and the ratio of investment-good imports to income ([M/Y] = i), that is, g = im'.

If there is a lack of substitutability between domestic and foreign resources, growth will be constrained by whatever factor is the most limiting- domestic saving or foreign exchange.

Suppose, for example, that the growth rate permitted by domestic saving is less than the growth rate permitted by the availability of foreign exchange. In this case, growth will be savings-limited and if the constraint is not lifted a proportion of foreign exchange will go unused.

For example, suppose that the product of the savings ratio (s) and the productivity of capital (p) gives a permissible growth rate of 5 per cent, and the product of the import ratio (i) and the productivity of imports (m') gives a permissible growth rate of 6 per cent. Growth is constrained to 5 per cent, and for a given m' a proportion of the foreign exchange available cannot be absorbed (at least for the purposes of growth). 

Conversely, suppose that the growth rate permitted by domestic savings is higher than that permitted by the availability of foreign exchange. In this case the country will be foreign-exchange constrained and a proportion of domestic saving will go unused.

The policy implications are clear: there will be resource waste as long as one resource constraint is dominant. If foreign exchange is the dominant constraint, ways must be found of using unused domestic resources to earn more foreign exchange and/or raise the productivity of imports. If domestic saving is the dominant constraint, ways must be found of using foreign exchange to augment domestic saving and/or raise the productivity of domestic resources (by relaxing a skill constraint, for example).

Suppose now a country sets a target rate of growth, r. From our simple growth equations (identities), the required savings ratio (s*) to achieve the target is s* = rip, and the required import ratio (i*) is i* = r/m'. If domestic saving is calculated to be less than the level required to achieve the target rate of growth, there is said to exist an investment-savings gap equal at time t to 1, - s, = s*Y, - sY, = (rip) Y, - sY, (15.1)

Similarly, if minimum import requirements to achieve the growth target are calculated to be greater than the maximum level of export earnings available for investment purposes, there is said to exist an import-export gap, or foreign exchange gap, equal at time t to M,- X, i*Y, - iY, (rim') Y, - iY,, (15.2) where i is the ratio of imports to output that is permitted by export earnings. If the target growth rate is to be achieved, foreign capital flows must fill the largest of the two gaps. 

The two gaps are not additive. If the import-export gap is the larger, then foreign borrowing to fill it will also fill the investment-savings gap. If the investment-savings gap is the larger, foreign borrowing to fill it will obviously cover the smaller foreign exchange gap.

The distinctive contribution of dual-gap analysis to development theory is that if foreign exchange is the dominant constraint, it points to the dual role of foreign borrowing in supplementing not only deficient domestic saving but also foreign exchange. Dual-gap theory thus performs the valuable service of emphasising the role of imports and foreign exchange in the development process. It synthesises traditional and more modern views concerning aid, trade and development. On the one hand it embraces the traditional view of foreign assistance as merely a boost to domestic saving; on

the other hand it takes the more modern view that many of the goods necessary for growth cannot be produced by the developing countries themselves and must therefore be imported with the aid of foreign assistance. 

Indeed if foreign exchange is truly the dominant constraint, it can be argued that dual-gap analysis also presents a more relevant theory of trade for developing countries that justifies protection and import substitution. If growth is constrained by a lack of foreign exchange, free trade cannot guarantee simultaneous internal and external equilibrium, and the gains from trade may be offset by the underutilisation of domestic resources. 

(Emphasis added)

Balance-of-Payments Constrained Growth — Dual Gap Analysis

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Writes Thirlwall in Growth and Development (2006), p. 444 pp;

Trade theory and dual-gap analysis

Another dimension to the protectionist argument draws explicitly on dual-gap analysis. The crucial question is whether a developing country's economic potential can be fully utilised at the same time as equilibrium is maintained externally. Free trade may not lead to the full employment of resources for two reasons: because of factor immobility; and because certain imports may be required to achieve full utilisation of resources, and these import requirements may exceed the availability of foreign exchange. 

In our discussion of dual-gap analysis in Chapter 15 we saw that if the import-export gap is dominant and foreign exchange is scarce, domestic resources may go unutilised in the absence of development policies to equate the import-export gap and the investment-savings gap ex ante. Potential domestic saving will fall either through a fall in the potential level of output or through a fall in the propensity to save through a redirection of expenditure. One solution, however, is to devote more domestic resources to import substitution or export promotion.

Linder (1967) has argued that in developing countries it may not be possible to solve the problem of the domestic underutilisation of resources through trade because of an export maximum. Classical trade theory, however, does not admit this. 

The notion of an export maximum is related to what Linder calls the theory of 'representative demand', which determines the relative price structure for goods. The theory of representative demand states that the production function for a commodity will be the more advantageous in a country the more the demand for a commodity is typical of the economic structure of a country compared with other countries. 

The chief determinant of demand structure is per capita income, so that goods in demand in advanced countries have unfavourable production functions in developing countries, and vice versa. The developing countries therefore face severe marketing problems if they decide to develop by trade. The goods they are best at producing are not demanded in developed countries, and they are inefficient at producing the goods that are demanded in developed countries. Productivity may not be high enough to support resources in the production of these goods, and imported inputs for export production might absorb more foreign exchange than the exports eventually yield.

These circumstances provide a case for protection to save foreign exchange and enable the full utilisation of domestic resources. This contrasts with conventional theory, which does not allow for protection for balance-of-payments reasons or to increase the effective demand for domestic products in order to eliminate underemployment.

Moreover protection in this model involves no allocation losses, because if foreign exchange is required to utilise domestic resources fully, the opportunity cost of using resources is zero. The only qualification Linder makes to his argument for development based on import substitution and the expansion of domestic demand is if value-added is negative; that is, if imported inputs for domestic production involve a higher foreign exchange cost than the importation of the end-products themselves.

Except in these circumstances, there is no conflict between allocation and capacity considerations or allocative efficiency and import substitution as long as a foreign exchange gap exists. Import substitution frees foreign exchange for imported inputs that allow the full utilisation of domestic resources.

Income Elasticity of Demand and the Balance-of-Payments

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Excerpt from Thirlwall (see bottom of post):

The income elasticity of demand for products and the balance of payments

According to Prebisch, the second factor working to the disadvantage of developing countries is the balance-of-payments effects of differences in the income elasticity of demand for different types of product. As mentioned, it is generally recognised and agreed that the income elasticity of demand for most primary commodities is lower than that for manufactured products.

On average, the elasticity is probably less than unity, resulting in a decreasing proportion of income spent on those commodities (commonly known as Engel's Law). 

In the two-country, two-commodity case the lower income elasticity of demand for primary commodities means that for a given growth of world income the balance of payments of primary-producing, developing countries will automatically deteriorate vis-a-vis the balance of payments of developed countries producing and exporting industrial goods. 

A simple example will illustrate the point (see also Chapter 7, p. 183).

Suppose that the income elasticity of demand for the exports of the developing countries is 0.8 and that the growth of world income is 3.0 per cent: exports will then grow at 2.4 per cent. Now suppose that the income elasticity of demand for the exports of developed countries is 1.3 and the growth of world income is 3.0 per cent; exports of developed countries will then grow at 3.9 per cent. 

Since there are only two sets of countries, the developing countries' exports are the imports of developed countries and the exports of developed countries are the imports of the developing countries.

Thus developing countries' exports grow at 2.4 per cent but imports grow at 3.9 per cent; developed countries' exports grow at 3.9 per cent and imports at 2.4 per cent. Starting from equilibrium, the balance of payments of the developing countries automatically worsens while that of the developed countries shows a surplus. 

This has further repercussions on the terms of trade. With imports growing faster than exports in developing countries, and the balance of payments deteriorating, the terms of trade will also deteriorate through depreciation of the currency, which may cause the balance of payments to deteriorate even more if imports and exports are price inelastic.

Moreover, this is not the end of the story if we take the per capita income growth between developed and developing countries. If population growth is faster in developing countries, the growth of income must also be faster than in the developed countries if the per capita income growth rates are to remain the same.

This will mean an even faster growth rate of imports into developing countries and a more serious deterioration in the balance of payments.

And if the goal is to narrow the relative or absolute differences in per capita income between developed and developing countries, the balance-of-payments implications will be even more severe. 

In the example previously given, which ignores differences in population growth, it is easily seen that the price of balance-of-payments equilibrium is slower growth for the developing countries. If their exports are growing at 2.4 per cent, import growth must be constrained to 2.4 per cent, which means that with an income elasticity of demand for imports of 1.3, income growth in the developing countries must be restrained to 2.4/1.3 = 1.85 per cent for balance-of-payments equilibrium.

In the absence of foreign borrowing to bridge the foreign exchange gap, or a change in the structure of exports, the result of different income elasticities of demand for primary and manufactured products is slower growth in the primary-producing countries - perpetuating the development 'gap'. 

In the absence of protection, the only other alternative is deliberate depreciation of the currency. This has several disadvantages. For one thing the price elasticities of exports and imports may not be right for foreign exchange earnings to be increased, and second, depreciation will encourage production in existing activities, the concentration on which contributed to the balance-of-payments difficulties in the first place.

There are certain equilibrating mechanisms in existence that may reverse the tendencies referred to, but they are likely to be weak and fairly slow in operation. First of all, it cannot be assumed that the industrial structure of the developing countries will remain unchanged. Over time it is natural that the proportion of total resources employed in the production of manufactured goods should increase, decreasing the rate of increase of imports of manufactured goods. Second, assuming that money income and the population grow at the same rate in both sets of countries, if the terms of trade are deteriorating for the developing countries, then real per capita income cannot be growing so rapidly in the developing countries.

Thus even with a high income elasticity of demand for imports in developing countries, the absolute increments in imports may eventually equal exports through a terms of trade effect. 

Prebisch recognised this latter equilibrating mechanism, but rejected reliance upon it because of the sacrifice of real growth that it clearly involves. For terms of trade and balance of payments reasons (which are connected), Prebisch therefore argued for the protection of certain domestically produced goods, and for monopoly export pricing by developing countries to protect their interests (as OPEC did in 1973).

Prebisch's balance of payments argument reinforces the classical infant-industry and optimum-tariff (terms of trade improvement) argument for protection.

There are several benefits that Prebisch expected from protection:

• Protection would enable scarce foreign exchange to be rationed between different categories of imports, and could help to correct balance-of-payments disequilibrium resulting from a high income elasticity of demand for certain types of import.

• It could help to arrest the deterioration in the terms of trade by damping down the demand for imports.

• It provides the opportunity to diversify exports and to start producing and exporting goods with a much higher income elasticity of demand in world markets.

Following our earlier argument, however, protection by tariffs is only appropriate if the arguments for protection do not arise from domestic distortions.

Source: (Thirlwall, Growth and Development, 2006, pp 440-441)

The Balance of Payments Constraint: Export Growth Over Income Elasticity of Imports

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What we are talking about:

The balance of payments (BP) constraint on growth is usually associated with Thirlwall’s (1979) model, which imposes balanced trade as a necessary long-run constraint on open economies. According to Thirlwall’s Law, international capital flows and interest payments balance out during long intervals of time so that, given a stable real exchange rate, the long-run growth rate of a small open economy is limited by the growth rate of its exports divided by the income elasticity of its imports.

Barbosa-Filho in "The balance of payments constraint: from balanced trade to sustainable debt", in "Essays on Balalnce of Payment Constrained Growth. Theory and Evidence, Mccombie, Thirlwall, 2004

In both the international economics and economic developmentliteratures, it has been noted that there is a tendency for the income elasticity of import demand to rise over time. In the first part of the paper, data from a large sample of countries is used to show that this tendency seems to be a general phenomenon. However, the previous studies on this issue have not offered a general explanation of this tendency. The second part of the paper develops a general explanation of why the income elasticity of import demand rises with the level of GDP per capita. The starting point of the analysis is that the process of economic development normally is associated with a rising share of manufacturing in GDP. In turn, this tends to increase the share of manufactured relative to nonmanufactured imports. Given that the income elasticity of import demand is higher for manufactured than nonmanufactured imports, the changing composition of imports increases the overall elasticity of import demand. The empirical results indicate that this is a plausible explanation for why the income elasticity of import demand rises with the level of GDP per capita.

Lo, Sawyer, Sprinkle

The World Economy — Three Beliefs and Five Economists

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 Writes Ramanan:

How did Keynes and the Cambridge Keynesians (such as Joan Robinson, Richard Kahn, Nicholas Kaldor and Wynne Godley) think the world economy works? 

A few important principles relevant here and of course not exhaustive: 

First, real demand, output and employment is determined by the fiscal and monetary policies of the government with the former having a more solid impact on demand. Second, fiscal policy has constraints due to the capacity to produce, and inflation. High inflation – although also influenced by demand – needs to to tackled by direct political means as it is also (highly) dependent on costs. Third, economies have a balance-of-payments constraint and a nation’s success depends crucially on how its producers perform in international markets.

MMT and the Balance of Payments Constraint

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Writes Ramanan of Concerted Action:

It is sometimes said that Neochartalism works for advanced/rich nations and not for poor nations. But this gives too much importance to Neochartalism. This is because the rise and fall of nations itself depends on competitiveness in international markets. Saying “MMT works for advanced nations” makes it look as if the success and failure of nations is to be explained elsewhere. It’s still true of course that advanced nations can expand domestic demand by fiscal expansion but they also have to look after the [ ... well? ] being of firms selling products in international markets, to stay competitive and not lose edge. Similarly as the blogger Lord Keynes says, “What is needed for much of the Third World is heterodox development economics, not MMT.” 

More generally a concerted action is needed by world political leaders in which fiscal policies are coordinated with a set of consistent balance of payments targets.

On the Limits of MMT

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Writes "Lord Keynes":

The Modern Monetary Theory (MMT) idea – or at least the idea shared by some supporters of MMT online – that imports are only ever a benefit and MMT is a viable policy for all nations are badly mistaken ideas. 

Now MMT would work for the US, Western Europe, Australia, Japan, South Korea or Taiwan, but not for much of the Third World.

That is, MMT-style policies are best suited for advanced capitalist nations, not necessarily for Third World countries, because most of them face severe balance of payments constraints. Increasing aggregate demand would, for many Third World nations, simply cause a balance of payments crisis, as imports surged. Moreover, a huge stream of imports from the developed world tend to cripple the development of a domestic manufacturing sector in developing world nations, just as in the 19th century our Western civilisation smashed up so much of the Third World by free trade and the de-industrialisation caused by pushing our manufacturing exports on them (Bairoch 1993: 88–89). What is needed for much of the Third World is heterodox development economics, not MMT.

And, unfortunately, MMT has its limits even in the developed world. Imports aren’t always a good thing. Domestic production matters a lot. Self-sufficiency is a good thing in many commodities, e.g., food, agricultural and primary industries. Energy independence matters a lot.

Exports matter a lot even for some developed countries, because exports bring in foreign exchange if you can’t attract foreign exchange via the capital account (that is, via people bringing in foreign exchange to buy your domestic financial and real assets).

Finally, manufacturing matters – a lot. You can’t be a really great power and maintain great wealth and an advanced modern economy without manufacturing. 

The US – despite what some people think – needs to remain a manufacturing colossus to remain a great power, and to be politically independent. Self-sufficiency in many commodities and a huge manufacturing sector translates into national power. You need national power to exist in a hostile world, to make credible trade deals, and to make sure you are not the victim of aggressive, bullying policies by other national powers.

Otherwise, any large enough trading power can start a trade war and cripple you by cutting off imports.

If you think imports are only a benefit, look at the devastating de-industrialisation of large parts of the Western world, e.g., in the US, look at the hollowed-out inner cities, devastated crime-ridden communities, the de-skilled, long term unemployed workers, and the collapse of all the related industries that rely on manufacturing.

BIBLIOGRAPHY

Bairoch, Paul. 1993. Economics and World History: Myths and Paradoxes. Harvester Wheatsheaf, New York and London.