Economies of Scale

We see the last generation of economic growth theorists creating a new version of Smith's virtuous circle. But Smith's own approach was not entirely abandoned. It was developed early in the twentieth century by such great British economists as Alfred Marshall, A. C. Pigou, and Nicholas Kaldor.

For these economists, the key concept of economic growth is "economies of scale." Suppose all inputs are increased in the same proportion. For example, we increase the quantity of land, labor and capital in use, each by 20%. Will output increase by the same proportion -- by 20% -- or by more, or by less? Notice that the principle of diminishing returns does not answer that question, since it assumes that one input is fixed (and so the fixed input cannot increase in proportion to the rest). When it is possible to increase all inputs in proportion, the principle of diminishing returns is not applicable.

Here is the terminology:

Economies of scale or increasing returns to scale: output increases more than in proportion to inputs
Constant returns to scale: ouput increases just in proportion to inputs
Diseconomies of scale or decreasing returns to scale: output increases less than in proportion to inputs

Any of the three is possible, and perhaps all could be applied in particular cases. But the British economists mentioned above suggested that economies of scale would be the most important in general. They reasoned from Smith's principle of the division of labor. They reasoned that as in industry or an industrial economy grows larger, the larger size would allow for increased division of labor. This would increase the productivity of labor, and so output would increase more than proportionately to input.

If economies of scale exist in the economy as a whole, and if they are quite strong, they might overcome the limited quantity of land and allow continuous increases in the division of labor, the productivity of labor, and economic growth. In this way, Smith's insight on division of labor was extended into the twentieth century.