I
Increasing Returns to Scale
Spyros Vassilakis
The focus of this essay is the set of positive
propositions that can be obtained when technol-
ogy exhibits increasing returns to scale. The basic
incompatibility of perfect competition and
increasing returns to scale is examined separately
in a section on existence of equilibria, in which we
discuss how one should model economies
exhibiting such technologies, i.e. essentially how
to modify the Walrasian equilibrium concept in
order to guarantee existence of equilibria. Welfare
and purely empirical problems are not considered.
Definitions: A technology exhibits increasing
returns to scale if a proportionate increase in all
inputs allows for a more than proportionate
increase in outputs; in the single-output case,
this implies a decreasing average cost curve.
Division of Labour and Increasing
Returns to Scale
Adam Smith (1776), Babbage (1832), Marshall
(1890, 1919) and Young (1928) considered the
This chapter was originally published in The New
Palgrave: A Dictionary of Economics, 1st edition, 1987.
Edited by John Eatwell, Murray Milgate and Peter
Newman
# The Author(s) 1987
Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics,
DOI 10.1057/978-1-349-95121-5_746-1
process of division of labour as the main reason
why we observe technologies that exhibit increas-
ing returns to scale. A version of their arguments
runs as follows: Let A be the set of tasks to be
executed in order to produce good x; a partition
A1,. . ., An is called a first-stage division of labour.
Each sub-task Ai, i = 1,. . ., n is executed by
(potentially but not necessarily) different kinds
of machinery and primary factors, to be called
first-stage intermediate goods. The set of tasks to
be executed in order to produce each first-stage
intermediate good is also subject to division of
labour, to be called second-stage division of
labour. Each subtask generated by a second-
stage division of labour is executed by intermedi-
ate goods, to be called second-stage intermediate
goods. Clearly, this process can go on indefinitely.
We say that the process of division of labour stops
at the nth stage if the n-stage intermediate prod-
ucts are all primary factors; a process is feasible if
it stops after a finite number of stages and if the
demand for primary factors that it generates does
not exceed supply. Suppose, now, that production
processes are indivisible, i.e. that when an inter-
mediate good is utilized in the production of some
other good, its quantity cannot fall short of a
minimum irreducible amount, to be called a
fixed cost. An increase in the degree of division
of labour is defined as either a finer partition of the
set of tasks to be executed in order to produce
some good, with the number of stages fixed; or an
increase in the number of stages. Clearly, then, an
increase in the degree of division of labour implies
2 Increasing Returns to Scale
an increase in fixed costs; discarding inferior divi-
sions of labour, therefore, means that an increase
in the degree of division of labour has to imply a
decrease in variable cost coefficients.
Smith (1776, p. 7) gave three reasons for such a
decrease:
first, . . . the increase of dexterity in every particular
workman; secondly . . ., the saving of the time
which is commonly lost in passing from one species
of work to another; and lastly . . . the invention of a
great number of machines which facilitate and
abridge labour, and enable one man to do the work
of many.
(See also Babbage 1832, ch. xix.) From now
on, the (degree of) division of labour and the
degree of increasing returns are used as
synonyms.
Adam Smith
Adam Smith formulated the following
propositions:
(1) The division of labour is limited by the extent
of the market (Book 1, ch. 3).
(2) The extent of the market is positively related
to population size and density, the amount of
natural resources and accumulated capital
available, and the ease of transportation
(Book 1, ch. 3; Book 2, pp. 259–61).
(3) Small economies devote most of their
resources to agriculture, while large econo-
mies specialize in industry, because the latter
affords a greater degree of division of labour.
For exactly the same reason, increases in mar-
ket size decrease the price of industrial prod-
ucts relative to primary products, and as a
consequence the profit rate in industry
declines (Book I, ch. XI, pp. 242–7; Book
III, ch. I).
(4) Trade increases market size and allows each
trader (country, region, individual) to special-
ize and reap the benefits of increased division
of labour. Trade is therefore beneficial to all
parties involved, it increases real income of all
classes, and therefore should not be restricted
by governments (Book IV, ch. II; Book I,
ch. II).
(5) Economic activity is located in areas in which
transportation is least costly, and therefore in
areas with the largest potential for division of
labour and trade (Book I, pp. 18–21).
(6) The division of labour is limited by the stabil-
ity of the market (this is not explicitly stated
by Smith, but a number of passages indicated
that he was aware of it: Book I, p. 21; Book
IV, p. 430).
Notice that (1), (2) and (6) are general propo-
sitions, while (3), (4) and (5) are applications.
Proposition (1) has generated many important
subsidiary propositions, to be described below.
Smith used it to derive (3), (4) and (5) without
paying attention to the fact that he never demon-
strated how the division of labour is determined
(as opposed to limited) by the extent of the
market.
Marx (1867, Vol. I, Part IV, section 4), Young
(1928), Coase (1937) and Stigler (1951) utilized
Proposition (1), often unwittingly, to provide the
rudiments of a theory of vertical integration and
production roundaboutness. Marx (1867, Vol. I)
considered the two as different aspects of the same
problem, i.e. vertical (dis)integration is ‘division
of labour in the society’ and production round-
aboutness is ‘division of labour in the workshop’.
The following quotation is from Book I, ch. XIV,
section 4, p. 355:
But what is it that forms the bond between the
independent labours of the cattle-breeder, the tan-
ner, and the shoemaker? It is the fact that their
respective products are commodities. What, on the
other hand, characterizes division of labour in man-
ufactures? The fact that the detail labourer produces
no commodities. It is only the common product of
all the detail labourers that becomes a commodity.
Division of labour in society is brought about by the
purchase and sale of the products of different
branches of industry, while the connexion between
the detail operations in a workshop is due to the sale
of labour-power of several workmen in one capital-
ist, who applies it as combined labour-power. The
division of labour in the workshop implies concen-
tration of the means of production in the hands of
one capitalist; the division of labour in society
implies their dispersion among many independent
producers of commodities. While within the
Increasing Returns to Scale
workshop, the iron law of proportionality subjects
definite numbers of workers to definite functions, in
the society outside the workshop, chance and
caprice have full play in distributing the producers
and their means of production among the various
branches of industry.
Marx also saw that the degree of vertical inte-
gration is higher the higher the degree of market
imperfection:
the distinction between division of labour in society
and in manufacture was practically illustrated to the
Yankees. One of the new taxes devised at Washing-
ton during the Civil War, was the duty of 6 % ‘on all
industrial products’. Question: What is an industrial
product? Answer of the legislature: A thing is pro-
duced ‘when it is made’, and it is made when it is
ready for sale . . ..The New York and Philadelphia
manufacturers had previously been in the habit of
‘making’ umbrellas with all their belongings. But
since an umbrella is a mixtum compositum of very
heterogeneous parts, by degrees these parts became
the products of various separate industries, carried
on independently in different places. They entered
as separate commodities into the umbrella manu-
factory, where they were fitted together. The Yan-
kees have given to articles thus fitted together the
name of ‘assembled articles’, a name they deserve,
for being an assemblage of taxes. Thus the umbrella
‘assembles’ first, 6 % on the price of each of its
elements, and a further 6 % on its own total price’
(ibid., p. 355, footnote 2).
Coase (1937) rediscovered and generalized
these observations of Marx and constructed a
theory of the firm out of them: price-mediated
transactions are costly, and firms exist in order to
economize on these costs by organizing transac-
tions in a different, non-price mediated way. At
this level of generality, the theory is tautological.
Stigler (1951) was the first to try to make it oper-
ational: he assumes that a single-output firm exe-
cutes a set of functions, some of them subject to
diminishing and others to increasing average cost.
The reason why the firm does not become a
monopoly is that the increasing cost functions
eventually prevail over the decreasing cost ones,
so that the firm’s average cost curve is U-shaped.
(This is clearly not in the spirit of the classical
economists, who assumed global increasing
returns.) The reason why with small market size,
a firm performs the increasing returns functions
itself, instead of abandoning them to specialized
3
firms and so sharing fixed costs with other buyers,
is that the fixed cost of these functions is too high
relative to market size to allow for the survival of
even one specialized firm. This argument is based
on the implicit assumption that it is profitable for
an integrated firm to perform the increasing
returns to scale function, while a specialized firm
would make a loss because it would not be able to
capture all the surplus of the downstream firms,
i.e. it would be able to practise only a sufficiently
imperfect degree of price discrimination. As mar-
ket size increases, though, the position of the
specialized firm is strengthened, and eventually
it can extract enough surplus from the down-
stream firms to make positive profit; at this point
integrated firms abandon the increasing returns
function and become downstream firms (buyers)
as far as this function is concerned. Spence and
Porter (1977) have provided a formal, partial-
equilibrium model along these lines.
The nature of the trade-off is different in
Vassilakis (1986b): there are global increasing
returns to scale, and firms can choose both the
degree of division of labour in the production of
the final good (i.e. production roundaboutness)
and the extert to which they will make their own
intermediate goods (vertical integration). Inte-
grated firms do not buy their intermediate goods,
and so they avoid monopolistic exploitation asso-
ciated with the non-price taking behaviour of
intermediate goods sellers; on the other hand,
they have to pay the fixed cost of producing inter-
mediate goods. For specialist firms the trade-off is
reversed. Also, a firm that adopts a high degree of
division of labour has to pay higher fixed cost, but
lower variable cost, than a firm that produces the
same product with a lower degree of division of
labour. In equilibrium, the ratio of specialist to
integrated firms (the degree of vertical disintegra-
tion), and the degree of division of labour within
each firm (production roundaboutness), are such
that the costs and benefits of marginal changes
cancel out. Increases in market size (the number
of agents) increase vertical disintegration and pro-
duction roundaboutness for the same reason: it
pays to exploit economies of scale more fully
now both by sharing fixed costs with other buyers
instead of bearing them unilaterally, and by
4 Increasing Returns to Scale
reducing variable cost through increases in fixed
cost. In this sense, market size determines the
degree of division of labour. Very clear anticipa-
tions of these views on vertical integration are to
be found in Austin Robinson (1931, pp. 19, 65,
96, 110).
Proposition (3), another application of Propo-
sition (1), has not been subject to equally intensive
theoretical investigation. Kaldar (1978, Essay 9)
and Negishi (1986, ch. 3) provide some clarifica-
tions. Proposition (4) reappears in Ohlin (1933,
ch. 3). For the empirical puzzles that led to the
reintroduction of increasing returns to scale in
formal trade theory, see Helpman and Krugman
(1985, pp. 2–4).
Proposition (5) can be found in Ohlin (1933,
pp. 200–211), who generalizes it considerably;
increasing returns to scale in production and trans-
portation favour concentration of economic activ-
ity in as few points as possible, while the
dispersion of natural resources and the fact that
certain economics activities are resource-
intensive favour decentralization. It is also impor-
tant whether raw materials for final products are
cheaper to transport, with the obvious implica-
tions for localization of activities. The result of
these consicierations is a generalization of Propo-
sition (5).
[5] Districts with good transport relations tend to
attract pierty of labour and capital and become
important market; consequently they tend to spe-
cialize in industries which (1) are market-localized
and show important advantages from large-scale
production; and (2) produce goods which are diffi-
cult to transport. On the other hand, districts with
poor transport relations become scantily populated
and tend to specialize in goods which are easy to
transport and can be advantageously produced on a
small scale (Ohlin 1933, p. 208).
Implience in Ohlin et al. (1976, pp. 48–50) is
the proposition that increases in market size
increase geographical concentration of economic
activity; the reason seems to be that with increased
size there is more to be gained by fuller exploita-
tion of scale economies, i.e. by higher concentra-
tion of economic activity, and this gain more than
compensates for loss due to increased transporta-
tion costs.
Proposition (6) has been exploited by Piore and
Sabel (1984). Given that a reduction in demand
uncertainty is equivalent to an increase in market
size, reductions in uncertainty will increase the
degree of division of labour. Piore and Sabel
view the coexistence of large and small firms,
inventory holding, long-term contracts tying
buyers to sellers and vertical integration as
uncertainty-reducing devices that allow for a
higher degree of division of labour. Also, collec-
tive wage bargaining and government stabiliza-
tion policies are attempts to control that part of
uncertainty that cannot be affected by individual
firms. Weitzman (1982) and then Kaldor (1983)
went even further and argued that a necessary
condition for involuntary unemployment, and
therefore for Keynesian economics, is the pres-
ence of increasing returns to scale, otherwise the
unemployed can ‘produce themselves out of
unemployment’, since non-increasing returns to
scale imply that small-scale production is at least
as efficient as large-scale. (see also the Sympo-
sium on Increasing Returns and Unemployment
Theory 1985).
Mill and Marx
Mill and Marx gave two closely interrelated
propositions:
(7) Increases in market size result in increased
concentration of economic activity, in the
sense that a higher percentage of the popula-
tion earn income by selling labour (and not by
producing). See Mill (1848, Book I, ch. IX,
p. 3) and Marx (1867, ch. XXXII).
(8a) Increases in market size, and the resulting
concentration and increase in the scale of
production of each firm, is an unqualified
benefit from the efficiency point of view,
but not necessarily from the equity point of
view (Mill ibid.; Marx ibid. and ch. XXV).
Both (7) and (8a) are derived as a consequence
of the fact that concentration allows for fuller
exploitation of scale economies; Marx added
another reason, i.e. that the skills of small-scale
Increasing Returns to Scale
producers are ‘rendered worthless’ by division of
labour, which subdivides and simplifies the tasks
to be executed in order to produce a commodity
(Marx 1848, in McLellan 1977, p. 227).
Another proposition of Marx on the same sub-
ject is:
(8b) Increases in market size increase the distance
between the economy’s actual and potential
performance (Marx 1867, ch. XXXII); Elster
(1985, ch. 5), provides a rather exhaustive
discussion of the exact meaning of this
proposition.
We now make (8b) more precise by thinking of
increases in market size as generating two contra-
dictory forces: on the one hand, efficiency
increases because the increase in market size and
the resulting increase in concentration
(Proposition 7) allow for fuller exploitation of
scale economies; on the other hand, this very
increase in concentration that results in fuller
exploitation of scale economies, hampers effi-
ciency by increasing the distortionary effects
associated with non-price taking behaviour. In
other words, economies of scale are created faster
than they are exploited. Finally, we can safely
attribute to Marx the following proposition, a
variant of his law of the falling rate of profit
(Marx 1894, Vol. III, Part III).
(9) Increases in market size reduce the profit rate.
Proposition (9) differs from Proposition (3) of
Smith (and Ricardo), because it does not rely on
the law of diminishing returns due to land scarcity.
(In Marx’s words, Ricardo ‘fled from economics
to seek refuge in organic chemistry’ in order to
generate a falling profit rate). It is formulated in
this particular way, because it has been shown that
under constant returns to scale and a constant real
wage, the law does not hold, while with a rising
real wage it holds only under very restrictive
assumptions that turn the law into an improbable
special case (Roemer 1981, chs 4, 5 and 6). On the
other hand, Negishi (1985, ch. 4) has provided
some textual evidence to support the view that
Marx had in mind an economy with increasing
5
returns to scale technology and producers facing
downward sloping demand, so that (9) is the only
version of the law that might be sustainable.
Indeed, increasing concentration and a falling
profit rate have been obtained in Vassilakis
(1986a) as a result of increases in market size;
the profit rate, though, falls because both the real
wage and the proportion of workers in the popu-
lation rise in a full employment model, so this
version of the law is not entirely in the Marxian
spirit. As for Proposition (8a), the formal literature
supports the view that with increasing returns to
scale only in the neighbourhood of the origin,
increases in market size reduce Pareto inefficiency
and in the limit they eliminate it (Novshek and
Sonnenschein 1978; Hart 1979). On the other
hand, Hart and Guesnerie (1985) have found that
with global increasing returns, Pareto inefficiency
does not disappear in the limit, although per capita
inefficiency does; Vassilakis (1986a) finds that
even per capita welfare loss can be positive in
the limit, for a particular choice of technology;
the difference in the result is due to the fact that the
latter reference assumes that the alternative to
producing is being a worker and earning wage
income, while Hart and Guesnerie assume the
opportunity cost of a producer to be zero. So, it
is fair to say that there is some support for Prop-
osition (8a), while Proposition (8b) remains
untested.
Marshall
Marshall (1890, p. 318, 1919, pp. 186–9) believed
that all industries exhibit global increasing returns
to scale, checked only by short-run fixities or land
scarcities; in this case he agreed with the classical
economists. As Stigler (1941, p. 78) remarked,
though, ‘if the economies of large scale produc-
tion are so important . . ., how do small concerns
manage to exist at all?’ and ‘either the division of
labour is limited by the extent of the market, and,
characteristically, industries are monopolized; or
industries are characteristically competitive, and
the theorem is false or of little significance’
(Stigler 1951). Marshall tried to reconcile
6 Increasing Returns to Scale
economies of scale and perfect competition in
three different ways, namely:
(a) (Some) economies of scale are external to
the firm.
(b) Increasing returns to scale is a dynamic phe-
nomenon, and its full effects take so long to
manifest themselves that ‘the guidance of the
business falls into the hands of people with
less energy and less creative genius’
(Marshall 1890, p. 316).
(c) Transportation costs rise so fast in some
industries as to restrict the market area of
each firm.
Clearly, (a) assumes the problem away; in Mar-
shall’s own words,
. . . with the growth of capital, the development of
machinery, and the improvement of the means of
communication the importance of internal econo-
mies has increased steadily and fast, while some of
the old external economies have declined in impor-
tance (Marshall 1919, p. 167).
But even if we assume that most economies of
scale are external to the firm, competition is not
the most likely outcome; one still has to explain
why firms do not merge to internalize external
economies, in which case oligopoly is the most
likely outcome, or why markets for external
effects do not emerge, in which case again, exter-
nal economies become internal, and we are back
to square one. (Starret and Heller (1976) analyse
external effects as absence of markets; Makowski
(1980) analyses mergers as a way to internalize
external effects.)
Explanation (b) is at best of limited impor-
tance, unless one can show that expansion by
merger is impossible or that the market for man-
agers is so imperfect that a long-lived firm is
doomed to fall in the hands of the inept. Also, in
Stigler’s words, ‘if Marshall’s discussion of econ-
omies is correct and approximately complete, it
would not require an extraordinarily high calibre
of entrepreneurship to secure a monopoly, or at
least a dominant position, in almost any industry’
(Stigler 1941, p. 81). Finally, explanation (c) is of
limited applicability because it ignores increasing
returns to scale in transportation. Marshall himself
thought that it cannot be elevated to a general
explanation of the coexistence of competition
and increasing returns, so he had to invent expla-
nation (b); (Marshall 1919, pp. 315–16). We have
to conclude that (not only) in ‘competitive, sta-
tionary economies, Marshall clearly fails to pro-
vide the conditions of stable equilibrium’ (Stigler
1941, p. 81). Downward sloping demand and
non-price taking behaviour cannot be avoided,
therefore; based on Marshall’s cues (Marshall
1890, pp. 286–7, 453–8), Sraffa (1926), Robinson
(1933) and Chamberlin (1933) reintroduced
downward sloping demand almost one hundred
years after Cournot.
Despite the fact that Marshall did not have a
formal theory of increasing returns economies, he
relentlessly applied ‘the principle of Increasing
Return’ to generate propositions. He is the only
one after Smith, Marx and Mill to propose a new
general proposition (not an application), namely:
(10) ‘. . . almost every kind of horizontal exten-
sion tends to increase the internal economies
of production on a large scale, but as rule, an
increase in the variety of output lessens the
gain in this direction’ (Marshall 1919,
p. 216).
In other words, increasing variety reduces effi-
ciency. Proposition (10) is then utilized by Mar-
shall to explain the coexistence of large and small
firms, and to determine the range of products of a
multiproduct firm. Large firms produce those
goods that are most in demand and/or afford the
greatest degree of division of labour; their product
range is determined by the condition that the
addition of one more product would increase
cost (due to lost scale economies) by more than
it would increase revenue (due to increased mar-
ket area). Small firms produce goods whose
demand is so low, and/or afford so small a degree
of division of labour, that large firms do not want
to produce, because they can be better off devot-
ing their resources to increase production of the
commodities they already produce. As market
size increases, there is more to be gained by con-
centration, so firm size tends to increase. On the
other hand, though, small firms will survive at all
Increasing Returns to Scale
market sizes, because of three factors (Marshall
1919, ch. III and IV).
(a) The increased income generated by increased
market size allows consumers to demand
goods closer to their ideal specifications, so
the variety of goods demanded increases.
(b) Increased market size increases household
specialization, i.e. goods previously produced
within the household become commodities.
(c) Increased size increases vertical
disintegration.
An obvious implication of this theory is that
increases in market size will have different effects,
depending on the degree of demand homogeneity
and on whether demand is concentrated on goods
that afford considerable division of labour. Mar-
shall (1919, Book I) attributes the different growth
patterns of industrial economies to differences in
the size stability and perfection of their respective
markets.
Existence of Equilibrium
The incompatibility of pricetaking behaviour and
increasing returns to scale was first noticed by
Cournot (1838, pp. 59–60), but rigorous exami-
nation of the issue has been taken up only very
recently.
No general existence theorems are available
because there is no generally accepted model to
imperfect competition. What is available, though,
points to the importance of the following three
factors: (i) downward sloping demand; (ii) a var-
iable number of firms; (iii) a large number of
agents relative to the degree of increasing returns.
Downward sloping demand is clearly a necessary
condition for existence in economies with global
increasing returns to scale, for otherwise firms
would have an incentive to produce an unlimited
amount of some output. The number of firms
should be variable for three reasons: first, because
of fixed costs, the number of firms cannot be too
large for otherwise profit would be negative; sec-
ondly, the number of firms should be sufficiently
large to ensure that the demand price faced by
7
each firm is lower than average costs for large
enough output levels, otherwise firms would pro-
duce arbitrarily large amounts; thirdly, the number
of firms should be sufficiently large to discourage
entry, so as to ensure that if one more agent sets up
a firm, he will earn less than his earnings in the
best alternative occupation. Finally, one needs a
large number of agents relative to the degree of
increasing returns to ensure that the number of
firms is large enough to satisfy the conditions
above, and in order to convexify reaction corre-
spondences, so that fixed-point theorems can be
applied (see Roberts and Sonnenschein 1977, and
Novshek and Sonnenschein 1978). All models in
the literature on increasing returns to scale base
their existence results on (i), (ii) and (iii) above,
although they differ in specifics. Thus, we have
Bertrand models, in which the agents’ strategic
variable is price, and Cournot models, in which
agents compete in quantities. Also, we have sym-
metric models, in which all agents are allowed the
same strategic possibilities; and non-symmetric
models, in which the set of agents is, a priori
and once and for all, divided into two disjoint
sets: the set of consumers–factor suppliers–price
takers, and the set of producers–factor
demanders–price makers (or quantity setters).
Existence in non-symmetric Cournot models
with increasing returns only in a small
neighbourhood of the origin is proved in Novshek
and Sonnenschein (1978), and with global
increasing returns in Hart and Guesnerie (1985);
existence in symmetric Cournot models with
global increasing returns is proved in Vassilakis
(1986a). All proofs with global increasing returns
refer to a single-input, single-output economy. For
non-symmetric Bertrand games, with a single
input, see Hart (1985) and Economides (1982,
1983); for the single-output many-inputs case
see Sharkey (1982, ch. 8).
See Also
▶ Competition
▶ Division of Labour
▶ Learning-by-Doing
8 Increasing Returns to Scale
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