Why? As Warsh explains, it wasn’t about ideology it was about following the line of least mathematical resistance. Therefore, the idea that free markets always get it right depends on the assumption that returns to scale are diminishing, not increasing.įor almost two centuries, the assumption of diminishing returns dominated economic theory, with the Pin Factory de-emphasized. But for the invisible hand to work properly, there must be many competitors in each industry, so that nobody can exert monopoly power. 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 increasing returns create a natural tendency toward monopoly, because a large business can achieve larger scale and hence lower costs than a small business. 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. These two concepts, however, are opposed to each other. 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. The pin factory’s employees, by specializing on narrow tasks, produce far more than they could if each worked independently. Using the example of a pin factory, Smith emphasized the huge increases in efficiency that could be achieved through increased size. Warsh calls it the struggle between the Pin Factory and the Invisible Hand. David Warsh’s book describes a great contradiction inherent in economic theory since 1776, when Adam Smith published The Wealth of Nations.
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