Aaron Arnold's Reviews > Knowledge and the Wealth of Nations: A Story of Economic Discovery

Paul Romer shared half of the 2018 Economics Nobel for his work on endogenous growth theory, so I figured I'd pick up this 2006 look at his work to learn a bit more about what that was and why it matters (his co-Nobelist William Nordhaus' work on environmental economics is also given an all-too-brief mention). Popular works dedicated to technical theoretical economics of that sort aren't exactly common, so I was pleasantly surprised by what a good job David Warsh did of clearly explaining Romer's role in showing how Adam Smith's metaphor of the Pin Factory in The Wealth of Nations contained a fundamental tension between forces that increase concentration of economic activity, like increasing returns and falling costs, and forces that decrease it, like knowledge spillovers and competition, and how an improvement in mathematical modeling of traditional economic narratives both resolved that conceptual tension as well as advanced economics as a field, giving us a better explanation for how economic growth happens, especially in a "knowledge economy". There's some inside baseball in terms of how the economics profession is structured, so there are sections that can be skimmed if you're not interested in the conference circuit, the politics of academia, the structure of professional economics organizations, or the market for textbooks, but if you have an interest in the history of economic thought at the high level then this is a great explainer, and it provides a lot of excellent secondary reading if you then want to go back and read the debates firsthand themselves. It's always good to be reminded that discovery is an ongoing project, on important questions, between real people, still happening right now.

Paul Krugman, whose work on trade and economic geography comes up frequently in this book, once wrote a really interesting and directly relevant essay in 1996 that somehow wasn't cited here. Titled "Ricardo's Difficult Idea", its main subject is the idea of comparative advantage, and why such a simple economic concept is so hard for most people to internalize and then apply. He grounds that difficulty in the observation that there are two very different ways of thinking about the world: literary/narrative and mathematical/model-based, which don't always agree (this is perhaps for deep-seated cognitive-evolutionary reasons). When most people, even many professional economists, think about economic issues the default is to view issues in terms of simple zero-sum stories. For example, if Chinese companies are outcompeting American companies, then by imposing trade tariffs on China, American companies will be stronger, and hence America as a whole will be richer. Simple! This story has sounded very plausible for essentially all of human history, but explaining exactly why tariffs do not have the intended effects, and exactly how all sides become poorer from trade wars, requires an essentially mathematical understanding of economic logic that just does not come naturally to most people. Mathematical models by necessity make many simplifications of reality, but you can show how tariff revenue will almost certainly be smaller than costs to consumers in a simple diagram with just a few lines on paper, whereas forgoing the math means reverting to lengthy and complex expositions of concepts like deadweight loss, import/export price ratios, and currency exchange rates that sound plainly wrong to the uninitiated: what do you mean that making foreign products more expensive won't make us any richer?

Adam Smith faced precisely this difficulty in The Wealth of Nations, which is why it's so long and tedious to read today. Back then, the logic of specialization and division of labor had never really been laid out before, so Smith had to answer all the what-ifs and how-abouts at great length, just to be able to say that a pin factory can make more pins if each of the workers has specific steps of the pin-making process to perform. We can sum up in just a few neat equations what took him chapters to laboriously explicate, and another advantage of math is that it's easier to see when an idea has unexamined implications or hidden assumptions that lead to further problems. In the case of the pins, what sounds like a neat story about how a pin factory sees increasing returns from specialization, thereby creating economic growth, becomes more complicated when you consider multiple pin factories. Here the infamous invisible hand, acting as it does to increase competition and therefore decrease returns, should encourage competing pin factories to jump into the market until the total economic profit in the pin industry nears zero (or else you could increase economic growth forever by building endless pin factories, video game-style). But any theory of increasing returns should logically grant the first pin factory an insurmountable advantage until they come to monopolize the pin market, so how is it that most markets we see, while individual companies might come and go, are not in fact dominated by monopolies? One force rewards the most efficient pin maker, the other rewards their competitors, and it took until the advent of mathematical modeling for economists to get a real handle on how specific markets could work in any sort of equilibrium even as the total economy grew.

Ironically that's where Warsh's storytelling comes in so handy, as the progression of economics from a narrative discipline to a mathematical discipline is itself better-presented as a narrative. I'm sure there are people who would prefer that concepts like the effect that the size of the market has on specialization (why big cities have so many more and different high-skill and high-paying jobs than small towns) be directly conveyed to the reader in terms of the equations alone, but Warsh devotes a chapter to a single presentation in 1985, Robert Lucas' "On the Mechanics of Economic Development", with a quote showing what that would look like:

"Suppose there are N workers in total, with skill levels h ranging from 0 to infinity. Let there be N(h) workers with skill level h, so that N = N(h)dh. Suppose a worker with skill h devotes a fraction u(h) of his non-leisure time to current production, and the remaining 1–u(h) to human capital accumulation. Then the effective workforce in production - the analogue to N(t) in equation (2) - is the sum Ne = the indefinite integral of u(h)N(h)hdh of the skill-weighted manhours devoted to current production. Thus if output is a function of total capital K and effective labor Ne is F(K,Ne), the hourly wage of a worker at skill h is Fn(K,Ne)h and his total earnings are Fn(K,Ne)hu(h)."

It's perfectly readable if you have a math or econ background, but since economics is about human actions, the human context is important too. So while you do get some discussion of non-convexities and hyperplanes and other mathematical objects of interest, Warsh presents the slow accretion of various ideas into endogenous growth theory via the stories of the economists themselves trying to fit all the pieces of the puzzle together. It might seem faintly condescending to praise economists for being able to turn statements like "knowledge is important for economic growth", "when one person has an idea it doesn't take away from anyone else", or "you can sell more things when there are more people" into equations, like so many toddlers stacking brightly colored blocks into towers, but again: economics is full of deeply counterintuitive ideas, and things that make sense at one level often need to be refined or modified at another level. Building a model that captures enough about the real world to be insightful, yet simple enough to be tractable, is really hard, especially when you're also trying to explain why lasting growth occurs in some places but not others, and the reduction of such a broad concept as "innovation" into a system of equations necessarily involves a short-term loss of subtlety in exchange for longer-term power and insight. It's one thing to theorize that cities grow based on industrial concentration, intense competition, or economic diversity, it's another to use real data and formal models as Ed Glaeser did, to see which theories actually hold up.

This is where Paul Romer's two papers come in: 1986's "Increasing Returns and Long Run Growth", and 1990's "Endogenous Technological Change". "Increasing Returns" integrates knowledge into a model of economic growth, focusing on the positive externalities of new ideas, the increasing returns to the production of goods, and the decreasing returns to scientific research. Whereas previous models had lacked a way to account for creativity, implicitly assuming that innovation happens "outside" the economy, Romer was able to show how firms innovate, how those innovations can leave a market in equilibrium while society overall experiences growth, and how strategic interventions by the government can move markets from low equilibria to higher ones through the strategic strategic diffusion of knowledge (for example, via anti-trust actions against monopolies, public funding for research, or liberalizing adjustments to copyright laws). "Endogenous Technological Change" relates knowledge to growth slightly differently, crediting knowledge accumulation for capital accumulation and productivity growth, formalizing how market forces encourage technological change (though with the important caveat that much "pure research" is insulated from direct market forces, as at universities), and better defining the non-rivalrous and incompletely excludable nature of how innovations can be shared at zero marginal cost. These are important clarifications, because as societies accumulate more knowledge and human capital, forces which apply less or differently to traditional physical capital, like network effects, public goods, indivisibilities, and property rights, become much more important. Public policy becomes vital to ensuring that the simple ingredients of capital, labor, human capital, and the level of technological progress are combined in a way that allows for competitive markets and stable growth.

A vivid example of this comes from Romer's own career, when he provided expert testimony during the infamous Microsoft monopoly trials of the 1990s. The history of the internet is a case study in knowledge spillovers, increasing returns, and literal network effects, and Microsoft's attempts to maintain its dominance in crucial junctures of the industry, modeled as "monopolistic competition", demonstrate the incentives produced by particular attitudes towards intellectual property rights in a world of free reproduction of software. These philosophical differences between the proprietary model and open source model were famously pondered over in essays like "The Cathedral and The Bazaar" and "In the Beginning Was the Command Line", but from a practical perspective, the court system was attempting to decide whether a judicious intervention into the market would diffuse this non-rival knowledge and hence improve economic growth, or whether Microsoft's strategy of using its trade secrets and large scale to dominate the market were all in the game and hence just another example of a successful firm. The decision to break up the company was never implemented, but amusingly enough, in 2005 Microsoft reorganized itself into functional divisions that closely resembled the antitrust experts and the judge's recommendation of how to break up the company AT&T-style.

Much of the book is devoted to Paul Romer's life story, which is interesting if you pay attention to the econ blogosphere or have some familiarity with the field since many prominent names appear at key junctures. His work on the pricing of so-called "club goods" like ski-lift tickets or Disneyland passes, where he accidentally retread the same ground as James Buchanan, is a funny demonstration of how difficult it can be for knowledge to stick within a profession. His attempts to break into the textbook market, and his founding of a company specializing in online test administration, show how rare it is for academic economists to have practical business experience, how that affects their research, and how there might still be room for innovation in the ancient world of teaching. William Nordhaus, who shared the other half of the 2018 Economics Nobel, gets a brief discussion of his 1993 paper "Do Real Income and Real Wage Measures Capture Reality? The History of Lighting Suggests Not", which is a fascinating attempt to track the true price of light throughout human history. Based on his estimates, the shifts in energy sources from wood to coal to oil and so on from prehistory to the present has brought the price of light, measured in the number of labor-hours required to produce an hour of light, from 40 man-hours per lumen-hour in 2000 BC to .0001 man-hours per lumen-hour in 2000 AD, which represents a hundreds of thousands-fold drop in costs. This works as both a great critique of attempts to measure price inflation and a practical, objective measure of technological progress at the same time. I wish there had been more discussion of Nordhaus' research in environmental economics, but a single book can only cover so many things, and as the book itself shows, a loss of specialization would mean a loss in total consumer satisfaction. Warsh produced an excellent account of how knowledge is actually accumulated.