Increasing and Diminishing Returns – Africa’s Opportunity to Develop

A drone shot of colorful shipping containers in a shipping terminal

‘This tendency to Diminishing Returns was the cause of Abraham’s parting from Lot, and of most of the migrations of which history tells’ wrote the founder of neo-classical economics, Alfred Marshall, in the first edition of his textbook Principles of Economics (1890). In a footnote he refers to the Bible’s Genesis xiii : 6: ‘And the land was not able to bear them that they might dwell together; for their substance was great so they could not dwell together’. (Marshall 1890: 201)

Marshall’s observation also applies to today’s migration patterns: from countries where most activities are subject to constant or diminishing returns to countries whose key economic activities are subject to increasing returns to scale. Diminishing returns occur when one factor of production is limited by nature, which means that it occurs in agriculture, mining, and fisheries. Normally the best land, the best ore, and the richest fishing grounds are exploited first, and – after a point – the more a country specialises in these activities, the poorer it gets. OECD (2018) shows how this occurs in Chilean copper mining: every ton of copper is produced with a higher cost than the previous ton.

In Alfred Marshall’s theory, the ‘Law of Diminishing Returns’ is juxtaposed with ‘The Law of Increasing Returns’, also called economies of scale. Here we find the opposite phenomenon; the larger the volume of production, the cheaper the next unit of production becomes. Traditionally economies of scale were mainly found in manufacturing industry, and increasing returns combined with technological change has for centuries been the main driving force of economic growth. Increasing returns creates imperfect competition, market power and large barriers to entry for challengers – companies or nations – making it difficult for them to enter these industries. In contrast to the rents produced under conditions of increasing returns, raw materials – commodities – on the other hand, are subject to perfect markets, and productivity improvements spread as lowered prices. This is the essence of the theory which explains why former World Bank Chief Economist Justin Yifu Lin was correct hen he asserted that ‘Except for a few oil-exporting countries, no countries have ever gotten rich without industrialization first’ (Lin 2012 : 350).

In line with his analysis above – recognising that ‘the free play of demand and supply’ may produce suboptimal results – Alfred Marshall suggests ‘One simple plan would be the levying of a tax by the community on their own incomes, or on the production of those goods which obey the Law of Diminishing Returns, and devoting the tax to a bounty on the production of those goods with regard to which the Law of Increasing Returns acts sharply.’ (Marshall 1890 : 452). Here Marshall describes what all presently wealthy countries have done, mostly through the protection of increasing returns activities through tariffs, ever since England in 1485 started to tax the export of raw wool, while at the same time subsidising the production of woollen cloth. This was the essence of import-substitution industrialisation that took some non-Western countries out of economic colonialism. For centuries colonies were essentially areas where the production of most industrial products was prohibited, as in the United States until 1776.

Last time this theory was used in the West was in Germany after World War II. A plan prohibiting industry in Germany – the so-called Morgenthau Plan – approved by the Allies in 1943, was rapidly turned to the exact opposite – to the Marshall Plan – when it was understood that a poor West Germany would become an easy prey for the Soviet Union. In March 1947 former President Herbert Hoover sent a crystal clear message back to Washington: ‘There is the illusion that the New Germany left after the annexations can be reduced to a ‘pastoral state’. It cannot be done unless we exterminate or move 25.000.000 out of it’. Hoover understood that the population density of a country is determined by its economic structure: industrialisation makes it possible to dramatically increase the population carrying capacity of a nation.

However, as neo-classical economics developed The Laws of Diminishing and Increasing Returns had to yield for another part of Alfred Marshall’s theory that made ‘equilibrium’ to the basic metaphor of standard economic theory. Through the many editions of Marshall’s Principles we can trace how these Laws – respectfully written with a capital L – gradually became tendencies (not capitalised). During the 1930s increasing returns disappeared from economic theory because this key factor was not compatible with equilibrium. Without diminishing returns the supply curve would not slope upwards, and there would be no equilibrium. This equilibrium is the basis for the rest of the theoretical edifice of mainstream economics. Had realism been the goal, equilibrium would have disappeared from theory because it was not compatible with increasing returns.

Around 1980 Paul Krugman managed to model increasing returns in international trade. When his papers on the subject were published in book form (Krugman 1990), the introduction revealed an important insight: «The long period of dominance of Ricardo…. – of comparative advantage over increasing returns – was largely due to the belief that the alternative was necessarily a mess. In effect, the theory of international trade followed the perceived line of least mathematical resistance’ (Krugman 1990: 4 ). In other words, it was the inherent characteristics and limitations of the mathematical tools chosen – rather than the factors that were important for human wealth and poverty – that came to determine the research agenda of mainstream economics. Krugman admitting this was most welcome.

So, what did Krugman find when he started using models with increasing and diminishing returns? He came to the same conclusion Marshall did in 1890 and US economist Frank Graham later had rediscovered (Graham 1923): countries specialising in increasing returns activities in many ways specialise in being wealthy, while countries specialising in activities subject to diminishing returns specialise in being poor (my formulation). In this connection Krugman praises classical development economists Gunnar Myrdal and Arthur Lewis, and in his 1981 article he rediscovers the Marxist theory of uneven development, twice referring to Lenin’s theory of imperialism (Krugman 1981: 101-102). As regards the problem of migration, Krugman sees the northern (industrialised country) workforce becoming a ‘labor aristocracy’: ‘This might mean that in addition to exporting capital, the industrial region might, in the second stage of growth, begin importing labor – a point also noted both by Hobson and Lenin’. Krugman’s references are Hobson (1902) and Lenin (1939).

Paul Krugman’s articles from around 1980 provided an enormous opportunity for mainstream economics not only to catch up with insights from its pre-mathematical period, but also for bridging a widening divide with Marxism in its various forms. As I first hinted at in an article almost 25 years ago, Krugman had opened a Pandora’s Box where hope was released (the second time she opened the box), but he very soon decided to sit on the lid: hope was stopped. When, in 1996, England marked the 150th anniversary of The Repeal of the Corn Laws – the abolishing of import duty on agricultural products (by definition produced under diminishing returns –– Krugman had taken the classical neoclassical position of defending David Ricardo at all costs. At the time Krugman was annoyed that neither intellectual nor businessmen understood Ricardo’s idea of comparative advantage, which he saw as ‘utterly true, immensely sophisticated – and extremely relevant to the modern world.’ (Krugman 1998 : 35). After this, any references to the dichotomy increasing/diminishing returns are – as far as my students and I have been able to find – not to be found in Paul Krugman’s work.

The kindest explanation of why Krugman did not follow the path taken around 1980 is one of demand. There was – at the time – little demand in the West for theories that «proved» Lenin to be right. In my 1980 Ph. D thesis I had empirically tested the dichotomy increasing/diminishing returns – as found in Antonio Serra (1613) and Frank Graham (1923) – in three Latin American countries – bananas in Ecuador, cotton in Peru, and tin in Bolivia – all worked deeply into an area of diminishing returns: every time production was reduced, productivity increased considerably. I compared this to the combined effects of increasing returns and technological change – what Schumpeter referred to as historical increasing returns – and showed how countries producing under increasing returns got rich, while raw material producing countries remained trapped in poverty under diminishing returns and perfect competition (Reinert 1980). My advisers praised the thesis, but I was warned that there was no demand for such ideas. The ruling ideology was to resurrect David Ricardo.

As we can observe in the n-gram below, the references to David Ricardo skyrocketed at the start of the Cold War, when Samuelson’s ‘proof’ that – under the standard assumptions of neo-classical economics global free trade would create ‘factor price equalization’, the prices for capital and labour would tend to be equalised under free world trade. This came to form an ideological response to the communist promise of ‘from each according to his ability, and to each according to his needs’. In the words of Lionel Robbins, economics had become a Harmonielehre, a science predicting universal economic harmony.

Figure 1. N-Gram for ‘David Ricardo’ 1817-2008.
Most economists are not aware of how recent his universal popularity is.Screenshot 2018-07-26 at 14.44.13.png

We find a steep increase number of references to David Ricardo starting around the 1917 Russian revolution. At the time the new Soviet Union embarked on a protectionist industrial policy inspired by Sergei Witte, a former Minister of Finance under two Tsars and the Russian translator of Friedrich List.

The spike in the academic interest in David Ricardo starting in the late 1940s is somewhat surprising. This was the time when in ‘the real world’ the Marshall Plan was extremely successful, but – seemingly – at the same time the science of economics was busy building a theory that proved the same Marshall Plan – creating wealth by having all nations specialise in increasing returns activities – utterly wrong. This conflict was to have a profound impact on the OECD in the decades to come. The positive experiences from practice faded.

Figure 2 shows the increase in the frequency of the term ‘comparative advantage’ from the publication of Ricardo’s theory on the subject in 1817. Again, we see that the start of the Cold War represents a steep increase in the use of this term, just as with the name of its originator David Ricardo (Figure 1). The frequency of the use of the term ‘comparative advantage’ is significantly reduced shortly after the collapse of the Soviet Union.

Figure 2. N-gram for ‘comparative advantage’, 1817-2008.
‘Comparative advantage’ as a Cold War term.Screenshot 2018-07-26 at 14.45.48.png

When Europe today faces mass migrations that are – at least regarding the number of people involved – of biblical proportions, the time is due to rediscover the insights from the young Alfred Marshall and from Herbert Hoover in 1947. In the context of poor countries they represent the opposite view of that of David Ricardo and the idea of comparative advantage. But their insights did not reach the Washington Institutions – the World Bank and the IMF – which, in spite of formal independence in Africa, through their conditionalities continued to push the agenda of ‘comparative advantage’ preserving a de-facto colonial status.

From a Third World point of view it is important to observe that the only time in the 20th century the West left the ideology of comparative advantage was when it was politically necessary in order to stop communism, and it is unlikely that it will be done again unless it is in the acute interest of the West itself. Stopping – or reducing – migration is now of an urgency similar to that of stopping communism in 1947. This gives Africa a chance to exploit this window of opportunity. Here we can learn from the experience of Zimbabwe, which managed to turn the blockade into a very successful industrialisation programme, with manufacturing industry exceeding 30 per cent of GDP at one point.

Today around 900 million people on the planet do not have enough food. Some of these will try to move to other countries where they can find work and better possibilities for feeding their children. The only meaningful way to «help the migrants where they are» is to change the world trade policy, making it possible for African nations to follow the same path to industrialisation that all wealthy nations have followed. The wave of migration creates new demand for a theory that has been there from 1613 (with Antonio Serra), but which was neglected during the Cold War ideological fights. Trade agreements should no longer make it impossible to create jobs in increasing returns industries in Africa. At a recent OECD meeting in Paris Morocco presented an ambitious industrial plan. Hopefully others will follow.

In 1947 the insights of Alfred Marshall and former president Herbert Hoover on the importance of manufacturing industry stopped the advances of communism. They were assisted by George Marshall, the first 5-Star general of the United States and Secretary of State at the time. They were all practical men. Alfred Marshall, the theorist, had many ‘wandering years’ of experience working around factories behind him (he himself used the German term Wanderjahre). Herbert Hoover was a mining engineer by education and had led the US relief programme to Germany after World War I. George Marshall had the astonishing task of being in charge of US military logistics during World War II. They were all persons with broad practical experience who – when they were unhindered by the restrictive assumptions of neo-classical economics – understood these processes.

Now the insights of Antonio Serra (1613), Alfred Marshall (1890), and Herbert Hoover (1947) may make it possible for Africans to find a decent living where they were born. The metaphor of ‘equilibrium’ – doing away with the importance of increasing returns and consequent imperfect competition – has become a deadly one in the Mediterranean.

Bibliography:

Erik Reinert is Professor of Technology Governance and Development Strategies, Tallinn University of Technology 

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