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 / Winter 2006 / Issue 45(originally published by Booz & Company)


Best Business Books: Economics

Yes, the model was simplistic; yes, its mathematics was complex. But the paper’s core nimbly addressed one of the fundamental economic paradoxes reaching back to the days of Adam Smith. As Mr. Warsh observes:

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 [the author of the aforementioned autobiography] 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 a steady supply of pins, though, perhaps, not enough to satisfy its need. Through the other lens, the situation we describe as “perfect competition” prevails. The Invisible Hand presides over pinmakers and all others. No manufacturer is able to achieve the upper hand. As soon as one raises his prices, someone else undercuts him. There are exactly as many pins as people are willing to buy. No one perceived the contradiction at the time. But then, it was only pins.

But the dichotomy between increasing and diminishing returns for “goods” and “innovations” offers astonishingly rich frameworks for exploring how “ideas,” “knowledge,” and “things” can be combined to model all manner of economic growth. The inherent tensions between increasing and diminishing returns can be used to model the rise of entrepreneurial innovation and industrial organizations, competition within a firm and between industries, regional economic growth, and global trade rivalries. New models and methodologies based on this central division have provoked fierce controversy and rivalry in academe’s econosphere.

Pivoting deftly between microeconomic and macroeconomic theorists, Mr. Warsh describes how economists of all stripes and pedigrees compete in their discipline’s global marketplace. He leaves no Nobel economist unlearned. From Paul Samuelson’s epochal departure from Harvard for MIT to the University of Chicago’s Milton Friedman–esque culture of intellectual rigor to Ken Arrow’s taking up residence in Stanford, Mr. Warsh presents the backstories, backbiting, and institutional rivalries — not just competing ideas — that drive innovative thinking in world-class universities. The cults and subcultures — the so-called invisible colleges — that truly govern academic disciplines seep into the larger narrative that Mr. Warsh has chosen to tell.

The idea development process is messy, vulgar, inefficient, and brilliant. Good concepts get lost as the inertia of an intellectual status quo is preserved by aging intellectual aristocrats with cruel tongues and long memories. Force of personality is often indistinguishable from force of idea. Academic conferences and workshops become battlefields where intellectual ambushes are sprung on unsuspecting scholars. Adam Smith had a reputation as a genuinely nice man; his intellectual descendants play rougher. It’s a hoot.

In this war of ideas, Henry Kissinger’s academic aphorism is just wrong: The battles are so vicious because the stakes are so intellectually large. That is, what really best explains how companies, industries, cities, and societies grow rich? Is there an E=mc2 of economic growth? Can there be?

A former Boston Globe economics columnist, Mr. Warsh brings a journalist’s sensibility to these questions. He does a terrific job of showing how seemingly disparate ideas — drawn from, for example, the economics of joining a club or running a ski lift — can utterly transform the way economists think about rivalry and exclusivity in markets for intellectual property. At every step along the way, economists are adopting, adapting, and discarding mathematical tools designed to formally explain a nugget of insight that a previous model left untouched.

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