Increasing Returns and Efficiency.

• Author: Yoon, Yong J.

"Increasing returns" is an active area of research in economics now. But economists use "increasing returns" in at least three different ways. The most traditional concept of increasing returns comes from Adam Smith, Marshall, and Allyn Young (see Buchanan and Yoon). The idea is elegantly expressed by the Smithean proposition that "the division of labor is limited by the extent of the market." On the other hand, Brian Arthur and others |1; 3~ understand increasing returns as positive feedback of technology in economic dynamics.

The book is about neither of the two. This monograph is a formal analysis of natural monopoly, another concept of long history, in which the firm produces by falling average cost.

There is an extensive literature on partial equilibrium analysis of natural monopoly, but few works have been done on general equilibrium analysis. The economy consists of two sectors: a private sector with competitive firms with decreasing (or constant) returns and a public sector consisting of regulated firms producing with increasing returns.

The general equilibrium analysis of a competitive market introduced by Walras excludes the possibility of increasing returns. The Arrow-Debreu theory of general equilibrium exclude increasing returns in production, externalities, and entry of new firms. Thus the task is not a straightforward extension of Arrow-Debreu general equilibrium. The tradition of Debreu's theory of value is a topological approach. The "differential" approach taken in this book is more useful for the analysis of non-convex production sets.

The author discusses the origin of ideas and controversies on increasing returns and marginal cost pricing in the introductory chapter. The falling average cost proposed a dilemma since the production of each additional unit will cost less and increase the profit. This is incompatible with competitive market. Marshall introduced the internal and external economies of the firm to overcome this difficulty.

The debate whether increasing returns are compatible with competitive equilibrium sort of petered out because monopolistic competition can handle both increasing and decreasing returns conditions of production. The necessity to sell the output as a monopolist may determine the price rather than rising marginal cost determining the price.

After the turn of the century, Pigou, Lerner, Lange, and Hotelling all advocated marginal cost principles as a necessary condition for an efficient...