PrepTest 68, Section 4, Question 22

David Warsh's book describes a great contradiction inherent in economic theory since 1776, when Adam Smith published The Wealth of Nations. Warsh calls it the struggle between the Pin Factory and the Invisible Hand.

Using the example of a pin factory, Smith emphasized the huge increases in efficiency that could be achieved through increased size. The pin factory's employees, by specializing on narrow tasks, produce far more than they could if each worked independently. Also, Smith was the first to recognize how a market economy can harness self-interest to the common good, leading each individual as though "by an invisible hand to promote an end which was no part of his intention." For example, businesses sell products that people want, at reasonable prices, not because the business owners inherently want to please people but because doing so enables them to make money in a competitive marketplace.

These two concepts, however, are opposed to each other. The parable of the pin factory says that there are increasing returns to scale�the bigger the pin factory, the more specialized its workers can be, and therefore the more pins the factory can produce per worker. But increasing returns create a natural tendency toward monopoly, because a large business can achieve larger scale and hence lower costs than a small business. So given increasing returns, bigger firms tend to drive smaller firms out of business, until each industry is dominated by just a few players. But for the invisible hand to work properly, there must be many competitors in each industry, so that nobody can exert monopoly power. Therefore, the idea that free markets always get it right depends on the assumption that returns to scale are diminishing, not increasing.

For almost two centuries, the assumption of diminishing returns dominated economic theory, with the Pin Factory de-emphasized. Why? As Warsh explains, it wasn't about ideology; it was about following the line of least mathematical resistance. Economics has always had scientific aspirations; economists have always sought the rigor and clarity that comes from representing their ideas using numbers and equations. And the economics of diminishing returns lend themselves readily to elegant formalism, while those of increasing returns�the Pin Factory�are notoriously hard to represent mathematically.

Many economists tried repeatedly to bring the Pin Factory into the mainstream of economic thought to reflect the fact that increasing returns obviously characterized many enterprises, such as railroads. Yet they repeatedly failed because they could not state their ideas rigorously enough. Only since the late 1970s has this "underground river"�a term used to describe the role of increasing returns in economic thought�surfaced into the mainstream of economic thought. By then, economists had finally found ways to describe the Pin Factory with the rigor needed to make it respectable.

David Warsh's book describes a great contradiction inherent in economic theory since 1776, when Adam Smith published The Wealth of Nations. Warsh calls it the struggle between the Pin Factory and the Invisible Hand.

Using the example of a pin factory, Smith emphasized the huge increases in efficiency that could be achieved through increased size. The pin factory's employees, by specializing on narrow tasks, produce far more than they could if each worked independently. Also, Smith was the first to recognize how a market economy can harness self-interest to the common good, leading each individual as though "by an invisible hand to promote an end which was no part of his intention." For example, businesses sell products that people want, at reasonable prices, not because the business owners inherently want to please people but because doing so enables them to make money in a competitive marketplace.

These two concepts, however, are opposed to each other. The parable of the pin factory says that there are increasing returns to scale�the bigger the pin factory, the more specialized its workers can be, and therefore the more pins the factory can produce per worker. But increasing returns create a natural tendency toward monopoly, because a large business can achieve larger scale and hence lower costs than a small business. So given increasing returns, bigger firms tend to drive smaller firms out of business, until each industry is dominated by just a few players. But for the invisible hand to work properly, there must be many competitors in each industry, so that nobody can exert monopoly power. Therefore, the idea that free markets always get it right depends on the assumption that returns to scale are diminishing, not increasing.

For almost two centuries, the assumption of diminishing returns dominated economic theory, with the Pin Factory de-emphasized. Why? As Warsh explains, it wasn't about ideology; it was about following the line of least mathematical resistance. Economics has always had scientific aspirations; economists have always sought the rigor and clarity that comes from representing their ideas using numbers and equations. And the economics of diminishing returns lend themselves readily to elegant formalism, while those of increasing returns�the Pin Factory�are notoriously hard to represent mathematically.

Many economists tried repeatedly to bring the Pin Factory into the mainstream of economic thought to reflect the fact that increasing returns obviously characterized many enterprises, such as railroads. Yet they repeatedly failed because they could not state their ideas rigorously enough. Only since the late 1970s has this "underground river"�a term used to describe the role of increasing returns in economic thought�surfaced into the mainstream of economic thought. By then, economists had finally found ways to describe the Pin Factory with the rigor needed to make it respectable.