Generalized Increasing Returns, Eulers Theorem and Competitive Equilibrium*

James M. Buchanan and Yong J. Yoon

Introduction

As worked out a century ago, the neoclassical theory of distribution was analytically as well as

ideologically satisfying. The simultaneous determination of input and output prices through the

operation of factor and product markets seemed to close the explanatory gap left by the classical

economists. Seminal contributions by Wicksteed, Wicksell, J. B. Clark, Walras, Barone, and

others generated a logically rigorous explanation of the sharing of value in a competitively

organized economy, at least as stylized, and served to put a quietus on Marxian claims to the

effect that labor is exploited in the shortfall between product and payment.1

This major analytical achievement, with its profound implications for the organization of

societies, was, however, attained only at considerable cost. Buying into the neoclassical theory

of distribution seemed to require the abandonment of the central principle of Adam Smiths

Wealth of Nations (1776) which stressed the importance of the division of labor and its

relationship to market size as a primary determinant of economic well-being.

The neoclassical emplacement of a static framework for analysisdefined by fixity in the

size of the resource base and in technologyleft no room for direct linkage between policy action

on the size of the economic nexus and the rate of growth. For any given market size, competitive

organization of the economy serves to maximize value by assuring that all resources are directed
to their most productive uses. But there is nothing in this idealized neoclassical model to suggest

why and how market size, in itself, matters.

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Neoclassical economists may have shied away from follow-on inquiry into Smiths

proposition because they thought that acceptance of Smiths relationship would have wreaked

havoc on their newly-discovered theory of distribution. The advantages of specialization suggest

increasing rather than constant or decreasing returns, and the observation that industries did not

seem everywhere to become more and more concentrated suggested that abandonment of Smiths

theorem was, empirically as well as analytically, less damaging than abandonment of the constant

returns postulate so critical to their whole enterprise.

Aside from the very brief excursus into external economies by Alfred Marshall (1890),

Allyn Youngs oft-cited but little-understood 1928 paper, and Nicholas Kaldors (1972; 1985)

insistent criticism of neoclassical orthodoxy, increasing returns, as a topic for analytical inquiry,

disappeared for more than three-quarters of a century. This situation changed somewhat

dramatically in the 1980s by a resurgence of interest in increasing returns, in several different, if

broadly related, applications (endogenous growth theory, international trade theory, economic

geography, unemployment theory, economics of ethics, and path dependence). As the title of

our jointly-edited volume, The Return to Increasing Returns (1994), was intended to suggest,

there has been a major shift of interest toward this subject matter by modern economists.

Modern economists do not, however, exhibit the history-of-ideas focus that would lead

them to reexamine the late nineteenth and early twentieth century neoclassical developments in

the theory of distribution. They remain apparently unconcerned with either the continuing

contradiction or the potential for reconciliation between Adam Smiths theorem and the

conventional postulate of constant returns in general equilibrium theory. More specifically, few
 17

if any modern economists seem concerned with the implications of the reintroduction of

increasing returns for either the theory of distribution or the theory of competitive equilibrium.

We address these issues in this paper.

We shall first, in Section II, lay out several alternative conceptualizations of increasing

returns as these have variously appeared in recent works and then concentrate our attention on

what we have called generalized increasing returnsthe phenomenon that seems to be most

descriptive of Adam Smiths basic idea.

In Section III, we carefully examine the relationship between generalized increasing

returns and the theory of distribution, especially with reference to the adding up problem that

so troubled the neoclassical discoverers of marginal productivity and, in particular, to the

application of Eulers theorem. Here we suggest that generalized increasing returns, properly

introduced and understood, need not generate results that violate the Euler conditions.

In Section IV, we extend the analysis and examine the implications of generalized

increasing returns for the existence of competitive equilibrium. And, as with Eulers theorem, we

show that there need be no contradictionorthodox claims to the contrary notwithstanding.

However, the existence of competitive equilibrium, operationally and organizationally defined,

need not directly imply Pareto optimality, even in the absence of Marshallian external economies.

Externalities may remain at those margins of behavioral adjustment that affect the size of the

economic nexus.

Section V discusses the meaning of technology in our construction, which may differ from

the meaning that is incorporated in much of standard discussion. Section VI concludes the paper.
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Alternative Formulations of Increasing Returns

Adam Smiths pin factory example is misleading because it concentrates attention on the

advantages of labor specialization in the production of a single good. Increasing returns, defined

in this restricted sense, has occupied center stage in both neoclassical and modern formulations,

thereby offering a basis for sometimes confused interpretation of the implications.

If there exists advantages to scale in the production of a well-defined good and with a

given technology, competitive organization is not viable, and the prospect for monopoly-

generated inefficiency in resource usage substantially weakens the normative argument for

markets. Alfred Marshall (1890) recognized the difficulty here, and introduced a model in which

firms production functions are interdependent over a whole sector but in which scale advantages

are not within the exploitation potential for any single firm.

While in this model competition is viable, inefficiency remains, suggesting possible

politicized correction. Some recent models of endogenous growth (Romer, 1990; Lucas, 1988)

have analyzed Marshall-like external economies in the production of knowledge or learning by

doing. Other models (Arthur, 1994) isolate possible effects of positive feedbacks in a dynamic

setting, stressing the importance of start-up positions for exploiting scale advantages, and

essentially abandoning the uniqueness, and the necessary efficiency, of neoclassical competitive

equilibrium.

Each of these formulations of increasing returns (along with others not noted here2) raises

issues for either the theory of distribution and/or the efficiency of competitive equilibrium that

need not arise in the more general formulation implied by Adam Smiths specialization principle.
 20

If Smiths pin factory example is disregarded, and attention is placed on his emphasis of the

importance of the division (specialization) of labor as related to the extent of the market, the

notion of increasing returns may be applied over the whole of an integrated economic nexus of

production and exchange. In this formulation, specialization occurs continuously as the size of

the nexus expands. Persons increasingly shift from self-production to market production as

increasingly narrow specializations become viable.3 And, as such specialization takes place, the

value of the output bundle relative to inputs necessarily increases.

This process may occur (but, of course, need not) even if there are no scale advantages in

the production of any single good, beyond those that arise from the initial specialization by one

person, considered as the minimal unit of lumpiness. It is unnecessary to resort to models of

monopolistic competition, as several economists have done (Dixit and Stiglitz, 1977; Ethier,

1982; Krugman, 1979; and Romer, 1987) in order to reconcile the existence of viable competition

and economy-wide increasing returns.

This concept of generalized increasing returns may be easily reconciled with the

distribution theory, which typically assumes constant returns to scale globally or locally and

became the setting for the application of Eulers theorem.

Product Exhaustion and Eulers Theorem

Central to the marginalist revolution of the 1870s was the recognition that values are set

by the simultaneous working of forces on two sides of potential exchanges. The one-way,

supply-side causation of classical economics was rejected. First applied to product market (to
 21

resolve the diamond-water paradox), the extension of the explanatory model to input or factor

markets now seems an inevitable next step. Resource inputs are valued both because they

involve opportunity costs and generate potential final product value. No prospective supplier of

an input unit will accept less than the units opportunity cost, and no demander will pay more

than the anticipated increment to value promised from use of the unit.

Closure seemed to have been accomplished; the explanatory model seemed complete. But

a dangling question disturbed the early neoclassical converts. How can we know that the product

value paid out to input owners, on the basis of marginal contributions, exhausts the total value

placed by users on final output? The adding-up problem commanded much attention until a

relatively straightforward resolution was attained by the understanding of stylized interaction

processes made possible through application of Eulers theorem.

The Euler construction is pure mathematics. The theorem states that when a function

exhibits certain properties (i.e., homogeneity of degree one) then certain consequences follow.

Specifically, the theorem states that when a function, y = F(K, L), that relates a dependent

variable y to one or more independent variables, K and L, is homogeneous of degree one, the sum

of the separate partial derivatives multiplied by the corresponding independent variables is equal

to the total value of the function or the dependent variable 4: y = FKK + FLL where FK is the

partial derivative of F with respect to K, etc.

In its distribution theory application, Eulers theorem states that payments to all inputs,

in accordance with separate marginal value products, exhausts the total product value when the

production function that relates inputs to output exhibits the properties indicated. Economists
 22

are familiar with these properties under the postulate of constant returns. If equiproportional

changes in all inputs generate equiproportional change in output, the required conditions are

satisfied. Marginal productivity payment, in value units, exhausts total value of product. There

is no surplus or deficit, as would emerge under decreasing returns in the first case, or under

increasing returns in the second.

Economists recognized, however, that the assumption of constant returns is severely

restrictive if defined to apply over the whole scale of any possible production operation. For

instance, advantages could be empirically observed as production activities were increased in

scale from some initial nonspecialized base of economic self-sufficiency. This apparent

analytical hurdle was clarified by more sophisticated understanding of the competitive process.

Production is organized through firms, and profit-seeking firms will seek to extend scales

of operation in order to take full advantage of increasing returns. But under conditions where

aggregate demand is sufficiently high, firms may attain all scale advantages while remaining small

relative to the total market for product. Each firm will be forced by pressures of competition to

produce efficiently, at a level where there exists neither scale advantages nor disadvantages.

In the idealized competitive structure, therefore, the whole economy, considered as a

productive unit, operates at constant returns in all activities. Increases in any one productive

activity will be reflected in an increase in the number of efficiently operating firms, accompanied

by a decrease in the number of such firms in other lines of activity. Almost no attention was

paid to the effects of a net increase in the inclusive size of the network of economic interaction,

and economists seemed willing to neglect the Smithean proposition about the continuing
 23

advantages of specialization. Eulers theorem simply did too much work in the whole

explanatory enterprise to be jettisoned; constant returns was too essential to be challenged.

There were at least two reasons why economists seemed willing to remain locked into

what must, in one sense, appear to be an arbitrary position. They could, with little more than

plausible definitional rearrangement, eliminate the likely presence of decreasing returns. If

disadvantages of scale should seem to describe the operation of the whole economy, or any part

thereof, some input is either not properly counted and its productivity measured or some input

is used inefficiently. Correct accounting for all inputs along with efficient usage suggests that any

productive operation could, indeed, be expanded or contracted upon equiproportional changes in

all inputs. In this analytical exercise, the production function is made to conform to the

requirements that satisfy Eulers theorem by definitional conversion into an engineering

tautology. And, if such a construction is used to eliminate decreasing returns from consideration,

it would seem equally applicable for increasing returnsthe phenomenon that is inferred by

Smiths principle of specialization.

The analytical rejection of the increasing returns hypothesis was reinforced by the

empirical observation, noted earlier, to the effect that concentration ratios did not increase in all,

or even in many, lines of productive activity. There seemed to be little need to reexamine the

apparently unwelcome implications of Smiths proposition for either distribution or equilibrium

theory.

We suggest here that the implications of Smiths principle were not at all those that most

neoclassical economists implicitly inferred, and that generalized increasing returns may be
 24

incorporated into the neoclassical model without undermining the distributional validity of

Eulers theorem in application, and without damage to the existence proofs for general

competitive equilibrium, parametrically qualified.

The conditions within which the neoclassical theory of distribution are derived must be

carefully specified. As noted earlier, the size of the resource basedefined as the number and

quality of productive inputsis presumed to be exogenously fixed. Further, the technology of

productionthe processes that dictate how these inputs can be most efficiently transformed into

valued outputis also parametrically set. There was a general failure to recognize that any

incorporation of Smiths principle of specialization into the model necessarily violates the fixed

technology assumption, with feedback consequences for the theory of distribution.

Properly understood, generalized or economy-wide increasing returns stemming from

advantages of specialization are fully consistent with constant returns to scale for all activities

and for the economy as a whole operating within the parameters of resources and technology.

Payments of inputs in accordance with marginal value products exhausts total value; the

conditions for Eulers theorem to apply are met. Expansion in scales of operation takes place

under constant returns on the presumption that technology remains unchanged.

If there are advantages of specialization, however, an expansion in scale of the economy

as a whole will not take place within the parametric constraint of a given technology. The

extended specialization dictates that efficient operation requires a shift to a new technology, to a

different production function. Again, once attained, a change in inputs and outputs along the

modified function exhibits constant returns. There is no shortfall between value as produced and
 25

value as assessed since production must take place within the specific technology dictated to be

efficient by the size parameter.

Competitive Equilibrium

A second, conceptually related but different, problem haunts neoclassical orthodoxy when

increasing returns appear. How is competitive equilibrium possible unless constant or decreasing

returns describe the economy in operation?

At this point, we must distinguish categorically between generalized increasing returns

and alternative models, as sketched out in Section II. If increasing returns are present for

productive activities that are identified by product or industry, the scale advantages will be

exploited by entrepreneurs who get there first. Industries will be monopolized; allocative

inefficiency will emerge; and competitive entry will be unprofitable. In an economy-wide sense,

an equilibrium, of sorts, may be defined, but this equilibrium could not be classified as

competitive.

If, however, increasing returns exist only for the operation of the economy as a whole, or

for major sectors, and remain unexploitable by entrepreneurs at the level of firms, there need be

no incompatibility with competitive organization. Within fixed resource and technology

parameters, competitive pressures will move the economy toward an equilibrium that may be

analytically defined and that will exhibit the central properties of the neoclassical construction.
 26

Firms will operate at zero profit; resource returns will be equalized over all uses; aggregate value

of product will be maximized.

How can these familiar conditions be met in a model that postulates the existence of

generalized increasing returns? As the size of the economy increases, reflected through a shift in

the size of the resource base, specialization is extended; the value of product increases

disproportionately with the increase in the size of the resource base. The competitive

equilibrium, defined to be potentially attainable in such a setting, cannot be Pareto optimal, or so

it would seem. Externality must be present at some margins of adjustment.

Note precisely how the relevant externality here differs from the more familiar

Marshallian version. In the Marshallian setting, as the output of one firm increases, positive

external effects are exerted on the production functions of other firms in the industry. A

simultaneous expansion expansion in output in all firms in the relevant industry (or sector) at the

expense of reduction in output in the remaining sectors of the economy will generate increased

overall efficiency within the fixed parameters of the system (resources and technology). By

comparison, in the competitive equilibrium defined in the presence of generalized increasing

returns, no such within parametric adjustment can be efficiency enhancing. The externality

occurs at the margin of adjustment in the parameters of the system. With given technology, if the

size of the resource base is fixed, there is no externality present and the equilibrium meets all the

Pareto conditions.

If, however, individuals in the economy can, themselves, affect the size of the resource

base through changes in their own behavior, that is, if individuals can modify the parameters of
 27

the model, the externality described by increasing returns phenomena may not be internalized by

separate individual actions. If the parameters of the system are treated as variables subject to

changes through behavior, the competitive equilibrium may be non-optimal.

We may define the competitive equilibrium attainable in the presence of generalized

increasing returns to be parametrically constrained. Within the constraints of resources and

technology, all of the conditions required for competitive equilibrium may be met, including the

optimality result.

As we have discussed in some detail in our earlier work (Buchanan and Yoon, 1994;

Buchanan, 1994), individual adjustments in the supply of effort to the market nexus do act to

modify the resource base, thereby changing the parameters of the structure. And here there is a

direct linkage between Adam Smiths proposition and potential policy action that may be taken

to exploit scale advantages and thereby to increase rates of aggregate growth in the economy.

The Meaning of Technology

Our reconciliation of generalized increasing returns with neoclassical theories of

distribution and competitive equilibrium depends critically on the interpretation placed on

technology in our argument. Confusion may have arisen because of failure to recognize, first, that

generalized increasing returns stemming from exploitation of specialization require continuously

changing technology as the size of the economy changes, and second, that neoclassical production

functions treat technology as an index parameter invariant over the size of economy.5 Production
 28

functions can all exhibit constant returns while, at the same time, the economy exhibits increasing

returns.

Consider Figure 1, which relates aggregate output Y to a composite input Z. The heavily-

shaded curve, R, depicts increasing returns. But, R is not a production function. Separate

aggregate production functions that relate Y to Z, for given technologies, are shown as P1, P2, and

so on, each of which exhibits constant returns to scale. Note that the dotted portions of the P

lines depict positions that are unattainable; the quantity of inputs, Z, is not sufficient to bring

these indicated modes of production into being.6 Note, also, that the expansion path, R, could

never exhibit decreasing returns because that technology appropriate for very small scale

operation could always be multiply replicated (or recreated) so as to make R coincident with,

say, P1.

By presumption here, all positions along R may be known to exist as potentialities.

There is what we may call a sea of technologies available, with the unique optimal technology

from the sea depending upon (or determined by) the quantity of inputs, Z. Given any value

for Z, the corresponding position on R depicts the optimal or efficient technology which is, itself,

described by a production function (within that technology) that relates inputs to output. In this

construction, there would seem to be no reason to think that R is linear; Adam Smiths

proposition that there are continuing advantages from specialization as market size increases

becomes fully plausible.

Note that, in this construction, exogenous innovations in technology, given any quantity

of generic input, would be shown by a shift upward in the whole curve, R, or some parts thereof,
 29

along with possible changes in curvature. Endogenous improvements in technology that might be

expected to result from successful investment in knowledge or in research and development,

possibly complemented and reinforced by learning-by-doing, can be represented as increases in

composite inputs and, hence, in the size of the nexus.

In Conclusion
In retrospective examination of off-and-on analytical discourse over a full century, we can

only wonder why the phenomena of increasing returns, if defined to incorporate Adam Smiths

theorem about specialization, should have evoked such concern, both as expressed and as

implicitly feared. As we have suggested, so long as the extension of specialization, economy-

wide, is the sole source of the enhanced efficiency generated by an expansion in market size, there

is no negative inference to be drawn for the neoclassical theory of distributive sharing. Further,

there is no supplementary basis for criticizing the concept of competitive equilibrium.

Confusion may have emerged, at least in some part, from a failure to sense fully the

analytical consequences of the shift between the dynamic adjustment processes crudely modeled

in classical economics and the within-stationary-parameters adjustment processes that were

elaborated with increasing sophistication by neoclassical theorists. Adam Smiths question was:

How does an economy grow? His suggested answer: An economy grows by growing, by

extending the size of the market nexus, both internally (by shifting from nonmarket to market

production) and externally (by opening up trade). The neoclassical question was: How does an
 30

economy, given its resources and its technology, secure maximal value? The suggested answer:

By allowing competitive forces to work so as to equalize resource returns in all uses.

There is no conflict, contradiction, or inconsistency between these normative inferences

from the separate research programs to the agreed upon objectives of growth and efficiency.

Analytically, problems arise only when the Smithean principle is incoherently introduced into

the neoclassical theory of allocation, when increasing returns describe the operation of separately

identifiable industry or product categories, a situation that does preclude attainment of an

efficient competitive equilibrium within the parameters of resources and technology.

Empirically, of course, increasing returns may or may not be sufficiently general to allow

distributional and equilibrating concerns to be ignored. But the analytical as well as the

practicable attractiveness of the Smithean construction comes from its normative generalizability.

Policy aimed at extending the size of the market may be defended, and without any necessity of

prior identification of the industries or products that may exhibit, or may possibly exhibit, scale

economies. Normative support for policies aimed to enhance a generalized work ethic and to

open up markets need not invoke the epistemological arrogance required for support of

industrial policy in any form.

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_______________ . 1995. Constitutional Implications of Alternative Models of Increasing

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Hicks, John R. [1932] 1966. The Theory of Wages. 2d ed. London: Macmillan.

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 34

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*. Helpful comments were provided by Tyler Cowen, Mark Crain, Roger Faith, S. Kim,

Hartmut Kliemt, Axel Leijonhufvud, David Levy, Mancur Olson, John Riew, Richard Wagner,

and participants in the Public Choice Seminar, George Mason University. We are especially

grateful to an anonymous referee for constructive criticisms.

1. For a summary discussion of this analysis see Hicks 1932 [1966] (especially the Appendix)

and Robinson 1934. See also Stigler 1941 [1967].

2. For a listing and brief comparison of alternative models of increasing returns, see our review

article (Buchanan and Yoon, 1995). Many of the modern, as well as earlier, treatments are

reprinted in our edited volume (Buchanan and Yoon, 1994).

3. This progression of specialization over the whole economy is developed in the analysis of

Yang and Ng 1994. The advantage of specialization includes learning by doing.

4. Homogeneous functions play a prominent role in economics. Homogeneity of degree one

means, when each of the independent variables is increased by a common factor, , the

dependent variable increases by the same rate: F( k, L) = F(k, L). For CES functions this

means that the exponents of the independent variables sum to unity.

5. We do not assume an exogenous aggregate production function. However, ex post, the

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economy may reveal an aggregate input-output relationship that exhibits increasing returns to the

size of nexus as formulated in our earlier paper (Buchanan and Yoon, 1994) and by others

including Romer (1987, 1990) and Lucas (1988).

6. For an individual firm, of course, the production function faced would exhibit constant returns

as shown by the slope of P1 (given aggregate input Z1).