I'm reading Knowledge and the Wealth of Nations by David Warsh, which is proving to be an interesting read, but I can't fully understand one of its central ideas: that there's a logical contradiction between the "pin factory" idea and the "invisible hand" idea, both of which are from Adam Smith's Wealth of Nations. (The book is specifically focused on the fact that in 1990, Paul Romer and some other brilliant young economists solved the contradiction---but before I begin reading the part where it talks about this, I'd like to understand how there was a contradiction in the first place!) Here is some background info on Adam Smith's "pin factory": [text in italics or quotes is quoted from Smith's Wealth of Nations; the other text is quoted or paraphrased from Warsh's analysis] The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour. ... To take an example ... one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. In this way, Smith calculated, ten or fifteen men can between themselves make enormous quantities of pins (in contrast with a single worker being lucky to produce a single pin a day). Lest the world quickly be covered with pins, Smith introduces a new topic in chapter 2: a proposition about the mechanism by which the division of labor is governed. It is the willingness to buy and sell, out of self-interest. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. How, then, to sell a million pins? Smith's answer was encapsulated neatly in the title of chapter 3---"The Division of Labour Is Limited by the Extent of the Market." That means that the degree to which you may specialize depends on how much of your product you can sell, on the scale of your business, because you must cover your fixed costs (whatever they are) and have at least a little left over. To Smith, this matter of scale---of the extent of the market---had to do mainly with transportation costs. In the Scottish Highlands, where villages were few and far between, every farmer must be butcher, baker and brewer for his own family. A man would have to go to a city before he could expect to make a living as, say, a porter. No little village can support a pin factory. So specialization is a matter of geography: where there is a river or a port, a city grows. There can be little or no commerce of any kind between the distant parts of the world without the sea. The division of labor is thereby limited by the extent of the market: wealth depends on specialization, and specialization depends on scale. Bigger nations with better-developed transportation networks will have more specialization and therefore be richer than smaller ones lacking rivers and roads, and nations with easy access to the sea will do best of all. That is the take-home message of the first three chapters of The Wealth of Nations. Background info on Smith's ideas on competition and the market's invisible hand: In chapter 7 of the Wealth of Nations, Smith states that in all markets for all things, there is a "natural rate" of wages, profits, and rent, regulated by the willingness of buyers and sellers to exchange at different rates for different things. From this "natural" price, market price sometimes departs: there may be a famine, or a blockade, or a sudden abundance of oranges. A public mourning raises the price of black cloth, as he writes. But either the cause of the perturbance is temporary, in which cases the price quickly falls again; or else a complicated concatenation of changes will set in. If oranges are too expensive, consumers will switch to apples or do without, sea captains will import more citrus, orange gorwers in Seville will plant more trees---and sooner or later the price will return to its natural level. What makes the system work is competition. All that is necessary for it to function smoothly is that everyone should be free to enter and leave the market, and change trades as often as he pleases---"perfect liberty," as Smith calls it. Intelligent self-interest will take care of the rest. People will seek to sell whatever they can at the highest price the market will bear, and buy at the lowest, and it will all balance out over time. Markets thus understood will, for the most part, be self-regulating, as a result of myriad little understandings of self-interested individuals in competition with one another. As every individual, therefore, endeavours ... to employ his capital ... so ... that its produce may be of the greatest value ... He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. ... [H]e intends only his own gain, and he is in this ... led by an invisible hand to promote an end which was no part of his intention. ... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. --- Apparently economists see a contradiction between the pin factory and the invisible hand, as David Warsh describes: Suppose the pinmaker gets into the market early, expands, specializes in pinmaking by investing in new equipment and pinmaking R&D. He develops better steel, more attractive packaging, more efficient distribution channels. The bigger his market, the greater the specialization of this sort he can afford. He replaces workers with machines. The greater the specialization, the more efficient his production, the lower the price at which he can afford to sell his pins. The lower the price, the more pins he sells, and the more he sells, the higher his profits: a greater return for the same effort, hence increasing returns to scale. The economics of the pin factory seem to be that, thanks to the advantages of falling costs, whoever starts out first in the market will run everybody else out of the pin business. Does that mean that big business is natural? That monopolies are inevitable? Desirable? If scale economies are so important, how do small firms manage to exist at all? How do we get the sort of competition essential to the Invisible Hand? These questions, which seem so pressing today, are unexplored in Wealth. The problem is that the two fundamental theorems of Adam Smith lead off in quite different and ultimately contradictory directions. The Pin Factory is about falling costs and increasing returns. The Invisible Hand is about rising costs and decreasing returns. Which is the more important principle? When Paul Romer read back over the literature, he found that one of his teachers had seen the dilemma perfectly clearly as a young man. In 1951 George Stigler had written, "Either the division of labor is limited by the extent of the market, and characteristically, industries are monopolized; or industries are characteristically competitive, and the [Invisible Hand]* theorem is false or of little significance." According to Stigler, they cannot both be true. These are the bifocals of Adam Smith. Through one lens, specialization (as in the Pin Factory) leads to the tendency we describe as monopolization. The rich get richer; the winner takes all; and the world gets pins, though perhaps not enough to satisfy its need for them. Through the other lens, the situation we describe as "perfect competition" prevails. The Invisible Hand presides over the situation among pinmakers (and all others). No manufacturer is able to achieve the upper hand. As soon as one raises his prices, someone else undercuts him and price returns to its "natural" level. There are exactly as many pins as people are willing to pay for. No one perceived the contradiction at the time. But then, it was only pins. --- Okay, so that's what the book I'm reading, David Warsh's Knowledge and the Wealth of Nations, says. The problem is, I don't follow his logic. I don't see any contradiction between the pin factory and the invisible hand. David Warsh is just a journalist, so I would have reason to be skeptical, except that George Stiger and Paul Romer (two major economists) also saw a contradiction. Adam Smith said that one's ability to specialize depended on the size of the market; Warsh then twists these words into specialization depending on the size of the specializer. Warsh is thereby twisting Smith's consideration of market size into a consideration of market concentration. Also, it is hard to see how "investing in new equipment" or "R&D" is "specialization." That's not specialization; that's simply becoming better at what you've already specialized in. If you make pins for a living, going on to make the pins with "better steel" is not further specialization; rather, an example of further specialization would be (to use one of Smith's examples) going on to only twist the steel of the pins, not straighten it (notice how Smith only talked about the specialization of the workers, not the specialization of the factory as a whole; the latter makes no sense). On the other side of the paradox, I cannot see how the invisible hand necessarily implies diminishing returns to scale. If you are able to rake in further profits by expanding your business, this does not violate the principle of the invisible hand: you are still competing with other people in the industry. Even if you were to gain a monopoly through your efficiency, Adam Smith's principles of the invisible hand, competition, and natural market rates would still apply: you would still face pressure to keep prices and quantity and quality at the natural rate; if you slip up, a competitor would be able to sweep in and undercut you, as long as we assume what Smith assumed: that the government allows for "perfect liberty." There is no contradiction, as far as I can tell, between benefits from specialization and benefits from competition. Can anyone show me what I'm missing here? *Warsh said [Invisible Hand], although I think this is a typo; I'm pretty sure it should read [Pin Factory].