“…The history of every science, including that of economics, teaches us that the elementary is the hotbed of the errors that count most.”-Nicholas Georgescu-Roegen (1970, p. 9)
Abstract
A fundamental error was built into economics in 1939, by a bald assertion of decreasing returns over the widely-accepted truth of increasing returns, against all logic and evidence. A literature on equilibrium models of competition was then developed and richly rewarded with Nobel Prizes. This mistake was then wrongly reinforced in the 1960s. Equilibrium models were roundly attacked in the 1970s, but the competitive view was so well-established the charges had little impact. Absent this costly error, economics would have unfolded differently, into an increasing returns case for cooperation based on time and planning horizons in a formalization of Herbert Simon’s notion of “bounded rationality.” In this horizonal framework, competition is seen as spawning a harmful myopic culture resulting in ethical and ecological losses, symptoms of human need deprivation, and other troublesome welfare impacts. A revision of economics is urgently needed on more realistic grounds, based on increasing returns and generalized complementarity.
1. Introduction
These things just shouldn’t happen in a respectable discipline. A fundamental mistake imprinted on economics in 1939 has severely corrupted the field, its focus, and sensible discourse on meaningful issues, especially those about time. The error was richly rewarded; most of those who exploited it won Nobel Prizes. I unearthed this anomaly in the late 1970s, but only endorsed it fully in a 2005 conference paper (Jennings 2008). My initial findings in my Ph.D. dissertation (Jennings 1985, ch. 5) were published 30 years later (Jennings 2015). Identifying and fixing this error remains urgently relevant to a more sensible economic analysis.
What happened goes back a century to the post-Marshallian debates. A critical paper “On Empty Economic Boxes” (Clapham 1922) raised questions on the shape of the cost curve in production theory, saying economists could not distinguish decreasing returns (rising costs) from increasing returns (falling costs or scale economies), despite their great importance to how economics is done. What followed, after increasing returns were declared a universal truth in the late 1920s by the dominant economist of that time (Pigou 1927, 1928), was a raging debate over how to incorporate increasing returns into economics, after revelations during these 1930s debates that competitive equilibrium models and static conceptions were ruled out of play. Basic questions on how economics should be reconstituted on this new foundation were raised and discussed, but never fully resolved.
Instead, economists simply walked away from the issue, imposing an “Age of Denial” on increasing returns suppositions, which were ruled “taboo.” Models of competitive equilibrium based on decreasing returns were rewarded with many Nobel Prizes; such analyses were cemented into economics as rigid doctrine not to be questioned or challenged. The discipline closed to alternative views on more realistic grounds, where increasing returns remain a logical implication of what we know as well as fitting the evidence on how production costs change with scale. The whole case for competition as a source of efficiency – in terms treated as almost synonymous in neoclassical theory – stands on false suppositions of decreasing returns and substitution never properly justified or adequately secured.
Decreasing returns locked economics into short-term analyses. They also foster a dangerously myopic culture resulting in ethical and ecological losses, along with other social ills, that threaten our very existence. Ethical and ecological principles stress long-term effects, so are neglected in a myopic culture. When we initiate ongoing impacts ignored until too late to fix, we find ourselves beset with crises we cannot repair. This is the role of foresight in an irreversible, interlinked world.
In this essay, the mistake is described and discussed, referring to previous papers (Jennings 2017ab). Few economists know of this problem. Microeconomics stands on unfounded claims that, once revised, will lead to a paradigm shift in favor of complex systems approaches showing cooperation as efficient, not competition. We are doing it wrong…
2. The Start to an “Age of Denial” over Increasing Returns
Concepts of time and attempts to move economics from static to dynamic models have long been a part of the discipline, ever since Alfred Marshall (1890) gained dominance in the field during the late 19th century with a widely-read text defining the discipline. Clapham’s paper challenged Marshall’s synthesis as unattached to reality, arguing for more realistic content. A series of symposia and discussions raged across the field, sifting through ways to fill Clapham’s “empty boxes,” until Pigou (1927, 1928) rocked economics with two papers on cost and supply in which he asserted increasing returns as a general case in production theory, declaring that “cases of increasing costs … do not occur.” Period. The whole competitive frame, based on rising costs, worked to constrain and limit the growth in scale of firms. Without decreasing returns, all these competitive models and claims collapse.
What followed during the 1930s was a creative explosion to figure out how economics might adapt to and incorporate increasing returns. People like E.H. Chamberlin (1933) and Joan Robinson (1933) – simultaneous developers of the twin theories of “monopolistic” and “imperfect” competition – framed models of equilibria based on increasing returns. John M. Keynes (1936) then traced a macroeconomic theory of economic growth that mimicked increasing returns and complementarity without an explicit endorsement of either. This formative time saw many diverse approaches in microeconomics explored in terms of their larger ramifications. The 1930s was a formative moment in 20th-century economics.
But something strange happened next, causing economists to walk away from all these seminal findings. A young economist, John R. Hicks (1942, pp. 82-85), published in 1939 what became a doctrinal textbook for economists. After over a decade of ferocious debate founded on an acceptance of increasing returns as a given and accepted truth, Hicks baldly asserted decreasing returns, saying that abandoning perfect competition has “very destructive consequences for economic theory.” He added: “this get-away seems well worth trying” though “we are taking a dangerous step.” But he ended this section with a curt dismissal, doubting whether “the problems [based on increasing returns] we shall have to exclude … are capable of much useful analysis by … economic theory.” Period. His next section starts: “Let us, then, return to the case of perfect competition…” End of discussion. I call this ‘The Hicksian Getaway.’ Enter World War Two, which both ended and fatally interrupted these important discussions…
3. 1940s through 1960s Developments in Equilibrium Theory
After the war we see Paul A. Samuelson’s (1947) Harvard Ph.D. dissertation on The Foundations of Economic Analysis putting forth an equilibrium model of competition based on the 1939 Hicksian framework, followed by years of valiant effort to develop General Equilibrium models of competition based on the Hicks-Samuelson foundation by many economists such as Kenneth J. Arrow (1954, 1971) working with Gerard Debreu and Frank H. Hahn, all later rewarded with Nobel Prizes for this specialized work. In sum, this historical summary reveals how an unjustified departure from reality became a rigidly enforced doctrine not to be questioned or challenged within academic economics (e.g., cf. Reder 1982, and Leontief 1982). How did this situation occur? Worse, this false claim was almost upturned during the late 1950s, but instead was wrongly reinforced by ‘The Hirshleifer Rescue’ of the ‘orthodox’ model of competition with decreasing returns.
This next mistake commenced with Armen A. Alchian’s (1958) nine propositions on cost showing how concepts of time could be folded into production theory based on the “equity value” of firms, as a way to include its complexities. Julius Margolis (1960) then related firms’ prices to their planning horizons: longer and broader horizons reduce unit costs, markups and prices and provide important information about sales growth potentials at the cost of a firm’s short-term profits. Margolis stated – years before my own work on this subject – a horizonal theory of pricing, even if it was left incomplete in his work. Margolis’ seminal insight was dismissed as a minor refinement of viable and dominant theories of perfectly competitive equilibria by the discussant on his paper (Farrell 1960).
Next came Jack Hirshleifer’s (1962) paper which was motivated by his intention of “rescuing the orthodox cost function,” to show “the classical analysis is consistent and correct.” Hirshleifer saw Alchian’s (1958) framework as flirting too closely with increasing returns. Hirshleifer claimed to have proven that marginal and average cost curves must eventually turn upward, justifying “the powerful logic of the law of diminishing returns.” The economic literature then absorbed ‘The Hirshleifer Rescue’ as a justification for ignoring the roles of time, learning, technical change and planning horizons in production theory and in economics, because such phenomena were already incorporated into Hicks’ dynamics. Walter Y. Oi (1967) closed his paper on all these developments with: “To sum up, a dynamic theory of production along the lines of Hicks provides us with an essentially neoclassical explanation for progress functions. … To attribute productivity gains to technical progress or learning is, I feel, to rob neoclassical theory of its just due.” Consequently, ‘The Hirshleifer Rescue’ won the day for decreasing returns and perfectly competitive equilibrium models, at the cost of any more realistic approaches in economics, save in heterodox circles.
Alchian (1968) closed out the argument in an essay on “Cost” for the International Encyclopaedia of the Social Sciences that declared, on the basis of Hirshleifer’s claim, decreasing returns as “a general and universally valid law” of economics, not to be questioned or challenged. This doctrine was seen as secure. Ralph Turvey (1969) ended this sequence of arguments with a paper on “Marginal Cost” summarizing all this work as saying that time must be incorporated into our theories of cost, calling static models “too simple to be useful” because “both cost and output have time dimensions…” Though time kept lurking around the corner, with decreasing returns still sacrosanct there was no need for refinements to or revisions of static competitive frames. Decreasing returns solved all that.
4. The 1970s Critiques of General Equilibrium Theory
All seemed well for orthodox theory until the early 1970s, which saw a series of strong critiques of equilibrium models, based on their unrealistic assumptions and destructive effects. Martin Shubik (1970) called the Hicks-Samuelson equilibrium model sterile and specious, saying it set economics back more than advancing it: “An exploration of a dead end can be extremely useful if we realize that it is a dead end, and why it is so.” But that truth was never really absorbed into economics.
A year later, Polish socialist Janos Kornai (1971) published his Anti-Equilibrium, rejecting mathematics and equilibrium models for systems theories. Next, E.H. Phelps Brown (1972), in a presidential address before the Royal Economics Society entitled “The Underdevelopment of Economics,” decried the paucity of economic contributions to “the most pressing problems of the times” and called for a removal of fixed disciplinary boundaries between the social sciences.
However, the strongest salvos came from Nicholas Kaldor (1972, 1973, 1975), rejecting equilibrium models, reviving a case for increasing returns, and tying it all to a generalized complementarity based on a Keynesian growth model, referring to Allyn A. Young’s (1928) seminal paper on “Increasing Returns and Economic Progress” published near the end of the 1930s debates on increasing returns. When I first encountered Kaldor’s work, I had developed a microeconomic model of pricing in transportation networks that took Kaldor’s findings on complementarity and extended them into a whole theory of planning horizons and their impact on pricing and on social relations in general. Kaldor had sowed a fertile seed that gave an impelling impetus to my own research into interdependent network phenomena.
Even more dramatically, we heard again from Hicks (1977) about ‘The Hicksian Getaway,’ after he’d won the 1972 Nobel Prize for his 1939 Value and Capital. He said he received this honor “with mixed feelings” since he had outgrown this work. Hicks called his getaway “nonsense … an indefensible trick, which ruined the ‘dynamic’ part of Value and Capital” leading “it back in a static, and so in a neoclassical, direction.” Recall that Oi’s dismissal of learning, technical change, increasing returns and planning horizons stood fully on Hicks’ “ruined” dynamics.
Neither Kaldor’s salvos, other economists’ critiques, nor Hicks’ stated retraction, had much of any effect on neoclassical theory. Economists stuck to their dogma, and foundational claims of decreasing returns, despite their lack of support. Recall Turvey’s closing comment, that time must be incorporated into economic analysis to make any sense of production costs. Hicks assumed decreasing returns against a wide acceptance of increasing returns, but later retracted this ploy. What about ‘The Hirshleifer Rescue’? Was his asserted proof of decreasing returns as vapid as Hicks’ getaway? Did anyone check closely Hirshleifer’s argument? Apparently not.
5. Debunking ‘The Hirshleifer Rescue’
When I first encountered Hirshleifer’s (1962) paper, I was skeptical. His was the only purely technical argument I had been able to find for decreasing returns. Hirshleifer’s claim was seamlessly incorporated into the economics literature because what he said he had proven was what most economists sought to believe. His so-called “proof” could not have been closely scrutinized; in its very first step, after revising Hirshleifer’s frame to make time more explicit, an insight jumps out at us to reveal Alchian’s (1958) case for decreasing returns rested specifically on the role of time, the very variable Hirshleifer had removed from his own analysis! Alchian’s increasing returns stemmed from a longer time horizon that, shortened, raised the costs of production, showing ‘decreasing returns.’ The key difference between rising and falling unit costs, at least in Alchian’s model, explicitly turned on time; it did not justify Hirshleifer’s stronger claims. Decreasing returns had actually just been asserted, by both Hicks and Hirshleifer, without any substantive validity. The only proper use of decreasing returns was for short-term models and theory. For all long-term analyses, increasing returns must prevail, in line with Pigou’s (1927, 1928), Young’s (1928) and Kaldor’s (1972, 1973, 1975) claims.
In my 1985 Ph.D. dissertation, after a cumbersome disproof of ‘The Hirshleifer Rescue’ (cf. Jennings 2015 for a more compact version), I wrote that “Hirshleifer’s ‘rescue’ does not really follow from Alchian’s statements at all! … Its status reduces to simple assertion,” adding: “The upshot of this grievous mistake is that any incorporation of learning by doing and technical change into cost and price theory has been deferred” along with important horizonal insights. What went wrong in ‘The Hirshleifer Rescue’ was that the role of time was suppressed, when it played a critical role in shaping the analytical outcome. Restating Hirshleifer’s argument to make time explicit destroyed his claim, suggesting no one had checked this proof with any skeptical eye. Now we offer a brief history of time as addressed by well-known economists during the 20th century. Once again, we reach back over one hundred years for a start to our answer on the proper role of falling unit cost through time, and thus on the place of increasing returns in economics.
6. A Brief History of ‘Time’ in Economic Analysis
During the post-Marshallian years (Marshall died in 1924; Pigou assumed his chair at the University of Cambridge), Frank H. Knight (1921) wrote a paper on “Cost of Production and Price over Long and Short Periods,” only a single year before Clapham’s critique. Knight explained how time periods affect our approach to economic analysis, since “the data or given conditions are different when different periods of time are under consideration.” Knight’s “main conclusion” in this paper was “that decreasing cost with increasing output is a condition incompatible with stable competition,” which anticipated later findings by Nicholas Kaldor (1933-34, 1934). Next, how the specific difference between decreasing and increasing returns was related to time periods was discussed, as a means to open a path into a new horizonal economics, following Margolis’ (1960) lead, in which that difference is identified as implicitly based on the participating agents’ planning horizons.
The 1930s debates over increasing returns, so abruptly ended by ‘The Hicksian Getaway,’ were mostly concerned with the irrelevance of static equilibrium models of competition in the presence of falling unit costs and thus increasing returns. But there was never a claim that short-term models did not show decreasing returns. The reason was implied by Knight. For short-term models, some productive inputs must be treated as fixed – plant size, for example – so any expansion in scale against such constraints will likely yield rising unit costs due to those constraints.
But for long-term expansions of scale, however, the worst one might do is to replicate what one did on a smaller scale, making constant unit costs a worst-case upper bound as output grows. But larger scales also bring new opportunities for reorganization, so invite greater efficiencies at lower unit costs. This, along with Kaldor’s point on the three-dimensional nature of space combined with two-dimensional costs (think of expanding the diameter of a gas pipeline), imply all long-term production must entail increasing returns. Such concerns moved Pigou (1927, 1928), Young (1928) and Kaldor (1972, 1973, 1975) to endorse increasing returns as a universal economic truth. The difference between decreasing and increasing returns depends on the run length, and thus on the time periods and planning horizons implicit in agents’ decisions. The lesson is that time matters, as Turvey had said and Margolis showed by treating time as the psychological range and inclusive extent of agents’ anticipations in their sequential pricing decisions.
In the year of ‘The Hicksian Getaway,’ George J. Stigler (1939) of the Chicago School (a core of free-market advocacy) published a paper on “Production and Distribution in the Short Run,” which outlined a framework that projected a third axis for time (or run length), making cost curves surfaces in a dynamic analysis. Stigler argued that just treating time is not enough to embrace potential plant alterations and expectations of future price shifts. As a result, Stigler concluded, “whether alterations of plant are continuous or discontinuous, it is no longer possible to handle the problem of the rate or extent of alteration by the use of plane geometry, since future prices are now important variables.” The upshot was that time could not be included in any static model of price-setting decisions.
John M. Clark (1940, 1955), in two papers on this subject, came to the same conclusion, stating in 1940 that, due to interdependence and other issues: “Action by one producer would provoke responses by others… Changes in quality are … not represented. …The whole functional relationship is probably so complex as to defy mathematical plotting.” Coming back to the matter in 1955, Clark concluded: “This complex of variables would overload any possible system of graphic presentation.” The problem with these findings is that they sought to base the role of time in economic analysis on predictable known facts, where expectations of future events – on which all our actions are based – are inherently indeterminate in the face of chronic uncertainties. The error lay in restricting attention to observed phenomena, instead of in terms of our range of awareness, and thus the bounds of our rationality and therewith our planning horizons.
The difference between decreasing and increasing returns is, as Stigler and Clark understood, a question of run length or, to put it differently, it is based on an issue of agents’ implicit time horizons in their decisions, such as in the setting of prices. Our imagined projections of outcomes, on which we base every decision, do not just reach ahead of us in time but extend outward in all causal directions in any process of choice. If so, instead of just time horizons, we must think of planning horizons and their role in decisions. To access a longer run or time horizon, we need to understand virtually everything involved, i.e., all dimensions of knowledge to which we have any access. The means to longer runs and a broader range of awareness is through our understanding and embrace of all relevant factors.
Margolis (1960) had it right when he posited planning horizons as a key to pricing decisions. The longer and broader the planning horizons implicit in the setting of prices, the lower prices will be and the faster the growth rate of sales. The relevant tradeoff here is between the lure of immediate profits generated by higher prices against the potential for future growth realized through lower prices. Margolis made the issue horizonal, lying in the divergence of myopic concerns from larger views, which can be framed as an ethical issue of social and ecological conscience.
7. Documenting the “Age of Denial”
So, what have we described thus far? ‘The Hicksian Getaway’ threw economics into an “Age of Denial” over increasing returns. Lest one think this too extreme, in M. Mitchell Waldrop’s (1992, p. 18) book on Complexity a story is told about Brian Arthur’s encounter with his former professors at UC-Berkeley where, when asked about his current research on “increasing returns,” they reacted with laughter. The department chair responded: “But – we know increasing returns don’t exist.” Another senior colleague chimed in to say that “if they did, we’d have to outlaw them!” Arthur was crushed. Two economists he respected just wouldn’t listen. This is an attitude of denial not at all limited to academic economists at UC-Berkeley…
A decade earlier, Melvin W. Reder (1982, pp. 17-19) published a report about the economics program at the University of Chicago. Citing Hicks’ Value and Capital as the basis for “the authority of neo-classical price theory in general,” Reder described the training of students in economics, making it clear that departures from the Hicksian framework were “repugnant” and actively “penalized as evincing failure to absorb training” at the University of Chicago. This is in no way education; it comes across as indoctrination. Nobel Laureate Wassily Leontief (1982), after reading Reder’s review, excoriated academic economists for their “tight control” over economic colleagues, comparing “methods used to maintain intellectual discipline in this country’s most influential economics departments” to “those employed by the Marines to maintain discipline on Parris Island.”
This is behavior reflective of a discipline that is suppressing dissent rather than encouraging it, as any real learning community should do. The ongoing cost of ‘The Hicksian Getaway’ and ‘The Hirshleifer Rescue’ has been to implement a belief in competition throughout economics, despite its lack of justification, in an “Age of Denial” about increasing returns and their wide implications. At the close of the 1930s, absent these unfounded assertions, economics would have taken a radically different turn that was snuffed out. We next explore its ramifications.
8. The Economic Implications of Increasing Returns
In what direction would this field have gone without ‘The Hicksian Getaway’ and ‘The Hirshleifer Rescue’? That is the question we address. Kaldor (1975, p. 348) said increasing returns will make complementarity “far more important for an understanding of the laws of change and development of the economy than the substitution aspect.” My research into transportation networks as an integral system marked by public goods and increasing returns showed that the balance of substitution and complementarity in any context is horizonal. Positive horizon effects – ordinal extensions of our rational bounds or ranges of awareness (Simon 1982-97) – tip that balance toward complementarity, abundance and concerts of interest, and away from substitution, scarcity and conflicts of interest. In other words, horizonal growth works to align our social relations and therefore resolve violence and conflict. Also, horizon effects are contagious; they introduce another form of interpersonal linkage into economics, opening new research directions.
What are the cultural implications of a horizonal economics? First of all, we must examine and assess our rules and social systems on their horizon effects. When economic incentive structures support or reward short planning horizons, they cause serious problems since horizonal growth will make us all far more efficient in navigating connected economic endeavors. How do we foster horizonal growth? The best way is through practical learning that extends our ranges of vision. But education – trading information – is not substitutional; it is totally complementary.
When I share my knowledge with you, I do not lose what I had; quite the contrary, such exchanges bring new learning to all participants. That is why education calls for cooperation, not competition; rivalries stifle learning in complementary realms. Here what we need is an open sharing of fruitful information. The same will hold for love, or for any intangible good like smiles on the street: the more you freely share with others, the more these goods circulate outward to everyone. This is a tale, not about scarcity or substitution, but about abundance and complementarity.
But if learning is a complementary process in need of cooperation, what does this say about competition’s impact on our planning horizons? The horizon effects of imposing competitive frames on complementary environments – most especially in education – spawn and support a very dangerously self-destructive myopic culture. Why should we care about myopia? We are living the effects of terrible ethical and ecological losses due to a habitual lack of foresight in our decisions. When we are socialized by fear to avoid error in school, that will lead to a fear of learning and substance in our relations. How does that manifest in our behavior? It shows up in racism, sexism, in reacting to ‘others’ as a threat! Those with insatiable curiosities seek out people different from us as a chance to expand our horizons beyond the paltry limitations of our own life experience. A passionate urge to learn changes everything. Minds open like blooming flowers to embrace diversity.
That is the way of complementarity in network contexts: they show a horizonal balance of substitution with complementarity, where horizonal growth will tip that balance in favor of concerts of interest by aligning individual aims further away from conflicts of interest and socially-inconsistent actions. What does this suggest? It means an economics of complementarity would have emerged during the 1950s and 1960s, building upon a foundation of mutual gains (and losses) rather than on this unfounded case for social opposition. A recognition of complementarity as the general form of socio-economic relations shifts the whole paradigm of economics.
Furthermore, the role of time – in the form of time and planning horizons, since the latter encompasses time by linking foresight to knowledge – would have achieved a lead role in a new horizonal economics. Economics would encourage decisions based on The Biggest Picture we can muster of how the world works, instead of adopting a narrowly specialized view of our social behavior. Horizonal growth – in its open inclusion of social and ecological impacts – also entails a rise in the role of conscience in society, as we look out for each other’s well-being, knowing our needs are aligned, not opposed. The frame of neoclassical economics is wrongly founded on conflict, due to claims of decreasing returns, substitution and scarcity, when our interests are really aligned if increasing returns, complementarity and abundance are the norm. In any such context, competition creates strife where otherwise absent. As Dierdre McCloskey (1990, pp. 142-43) noted: “conserving on love, treating it as … scarce … may be a bad way to encourage its growth.” This is the way of complex networks standing on increasing returns and complementarity.
9. Conclusions
A terrible and costly error was injected into economics in 1939 by ‘The Hicksian Getaway’ – and then incorrectly reinforced in 1962 by ‘The Hirshleifer Rescue’ – that was never acknowledged or repaired in the discipline, despite Hicks’ retraction and my disproof of Hirshleifer’s claims. A critical part of the reason for resistance to learning and change is the competitive frame imposed upon academics that fosters defensive protection of views against new input. Look at how innovative ideas are often treated in academics. Novel departures from orthodoxy are seldom welcomed by its supporters; these diversions are seen as a threat to practitioners’ invested capital built through a lifetime of intellectual output whose value must be protected from challenge. So are new ideas suppressed instead of encouraged.
Real learning communities do not operate thus. New, unexplored departures are sought out as chances to learn and think about things in novel ways. Science should be an open-minded quest for alternative viewpoints. There is a reason why it is not: academics was corrupted by a competitive frame improperly imposed upon this complementary setting with pathological effects. To guard what we think we know against input – an often-observed characteristic in academic cultures – reflects sicknesses stemming from deprivation of Maslovian (1954, 1968) higher-order social needs left unserved by competitive frames due to a deviant economics.
Reversing this deeply instantiated disaster will not be easy in the face of an entrenched discipline stubbornly resistant to change. Our systems must shift to cooperation; that will give us a workable start toward a healthier culture more conducive to well-being for all instead of for just the few. We have squandered 80 years on a wrong conception of how our economy works. There is much to fix…
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