The parsing of an economic puzzle

Knowledge and the Wealth of Nations: A Story of Economic Discovery
By David Warsh
Norton, 426 pp., $27.95

James Watson's `` The Double Helix " is many people's favorite book about science because it depicts science as a human enterprise, giving a feel for how research is actually done. What ``The Double Helix" did for biology, David Warsh's `` Knowledge and the Wealth of Nations " does for economics.

Warsh, who used to write on economics for The Boston Globe and now writes online at EconomicPrincipals.com , offers an elegant narrative of the resolution of a major puzzle in economics. He focuses on a single article, Paul Romer's ``Endogenous Technological Change," published in the Journal of Political Economy in 1990. But he ranges broadly, going back as far as Adam Smith .

In the all-time greatest book on economics, to which Warsh alludes in his title, Smith proposed two big ideas that over the next two centuries, as Warsh points out, were to coexist uncomfortably.

One idea is economies of scale. As illustrated by Smith's celebrated pin factory, in some production processes, the cost of producing each unit falls as output rises. By dividing tasks ever more finely, workers are made more productive. Henry Ford's mass production was a rediscovery of what Smith, the ivory-tower academic, had already figured out 140 years earlier.

Smith's even bigger idea is in his metaphor of the invisible hand. Free markets, as if guided by an invisible hand, work to everyone's benefit. This may seem too good to be true. How could raw self - interest lead to a beneficent outcome? Generations of economists scrutinized the invisible-hand conjecture (culminating in the work of Kenneth Arrow and Gerard Debreu in the 1950s), concluding that it is correct. Untrammeled competition can generate an outcome that is, in a precisely defined sense, socially optimal.

The exercise of establishing the validity of the invisible-hand conjecture also showed its limits, by identifying a list of preconditions for free markets to be workable. One such precondition is the absence of economies of scale. Declining unit costs lead to monopoly. Whichever firm has the largest market share has a competitive edge. It can undercut its rivals' prices, grabbing a still larger market share, until it captures the entire market. Free competition contains the seeds of its own destruction.

Here, then, is the tension within Adam Smith. Markets work remarkably well, provided there are no economies of scale. In fact, though, economies of scale are pervasive. That might be enough to put an end to the invisible-hand idea -- except for one further conspicuous fact. Contrary to the pin-factory idea, with its implication that competitive markets are unsustainable, every affluent economy allocates most of its resources via competitive markets.

The affluent economies are those that have achieved economic growth. In the United States over the past hundred years, per-capita income grew sevenfold, and it is still growing. How can the economy continue to expand, apparently without limit, from an ever-larger base?

Economic growth, by definition, comes from either an increase in inputs of capital and labor or an increase in the effectiveness with which those inputs are converted into outputs. According to empirical research initiated in the 1950s by Robert Solow , much of economic growth is attributable to the latter; that is, to technological change.

Enter Romer. Economies of scale are intrinsically linked to technological advance, he pointed out, because a piece of technology can be used repeatedly without being used up. The link between technology and monopoly was cemented when governments created the patent system, providing an incentive to innovators by granting a monopoly on the use of an invention.

Romer eased the tension between economies of scale and competitive markets by invoking differentiated products: that is, items like a specific brand of automobile that, while unique, are similar to competing items. Patents prevent you from selling a product identical to your competitor's, but not from producing a close substitute. Competitive R&D ensures that all market niches are filled. There is effective competition in this model, even if it is not the perfect competition of the textbooks. Each producer is literally a monopolist, but only over a narrow slice of the market. Mixing together differentiated products, technology-induced economies of scale, and incessant innovation by profit-seeking firms, Romer's model predicts inexhaustible economic growth.

Warsh engagingly explicates all of this and much more. The broader significance of his book is as a case study in how research in economics progresses. Discrete breakthroughs on the order of the discovery of the double helix are rare in natural science. In economics they are nonexistent. Economics progresses by increments. When there is a paradigm shift, it comes not from a lone genius but from a group of likeminded but fractious pioneers contributing various pieces of the breakthrough.

The growth of knowledge, when you think about it, proceeds exactly as in Romer's model of the growth of an economy. Competing fiercely, researchers generate their own differentiated products, ideas. Gaps in knowledge, like unfilled market niches, attract theory-building investment. Economies of scale result, as new ideas give rise to still newer ones, and the stock of knowledge, like the economy, grows exponentially.

The most valuable aspect of `` Knowledge and the Wealth of Nations " is its description of how economists go about doing their work. Economic discovery occurs ``in intense intellectual competition among small groups of researchers working in rival universities," Warsh says. ``From this competition emerge occasional transformations in understandings of the world."

Asked why he wrote `` The Double Helix, " James Watson responded simply, ``I wanted to see if I could write a good book." David Warsh has written a very good book.

John McMillan is a professor at Stanford University's Graduate School of Business and author of ``Reinventing the Bazaar: A Natural History of Markets. "