Marshallian External Economies

Author(s): Renée Prendergast

Source: The Economic Journal , Mar., 1993, Vol. 103, No. 417 (Mar., 1993), pp. 454-458
Published by: Oxford University Press on behalf of the Royal Economic Society

Stable URL: https://www.jstor.org/stable/2234784

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The Economic Journal, 103 (March), 454-458. ? Royal Economic Society I993. Published by Blackwell
Publishers, io8 Cowley Road, Oxford OX4 iJF, UK and 238 Main Street, Cambridge, MA 02I42, USA.

MARSHALLIAN EXTERNAL ECONOMIES

Renee Prendergast

In the infancy of modern political economy, Petty, Martyn and Mandeville

identified increasing returns and competition as key features of the emerging
capitalist economic system. Subsequent writers, including Adam Smith, took
both features for granted, and their argument that individuals, acting solely in
pursuit of private gain, were led by an invisible hand to promote the common
good rested in large part on the presence of both increasing returns and
competition.
Pace Adam Smith's famous theorem that the division of labour is limited by
the extent of the market, the classical economists saw increasing returns not so
much as a function of an increase in the scale of production but as a result of
general economic progress. In chapter 3 of Book I of Wealth of Nations (WN),
which has as its title the celebrated theorem, Smith simply attempts to explain
why it is that the division of labour is not carried as far in rural areas as in the
great cities, and why historically the first improvements of art and industry
took place in those countries which had access to water carriage either by sea
or navigable rivers. Elsewhere in WN, Smith made it clear that 'labour can be
more and more subdivided, in proportion only as stock is previously more and
more accumulated' and refers to a variety of new machines being invented as
the operations of each workman are 'gradually' reduced to a greater degree of
simplicity (WN II.3 and II.iii.32). Even where Smith refers to an increase of
demand 'never failing' to lower the price of goods in the long run, his
explanation is that is 'encourages production, and thereby increases the
competition of producers, who, in order to undersell"one another, have recou
to new divisions of labour and new improvements of art, which might never
otherwise have been thought of' (v.i.e.26).
Seen in this context, there seems to have been no automatic connection
between increasing returns and the scale of production and hence also no
necessary conflict between increasing returns and competition. However, once
the evolutionary element is dropped and an increase in output is seen as always
giving rise to a reduction in unit costs, it becomes necessary to ask why
specialisation is not everywhere pushed to its limits so that the economy is made
up of highly specialised monopolies rather than competitive industries with
large numbers of identical firms. This step seems to have been taken first by
Cournot (I838). Cournot concluded that declining marginal costs for the
individual firm were not compatible with unlimited competition.

MARSHALL ON COMPETITION AND INCREASING RETURNS

Around I 870, the young Alfred Marshall took up Cournot's method and began
to re-cast economics in diagrammatic form. In the course of an investigation of

[ 454 1

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 [MARCH I993] MARSHALLIAN EXTERNAL ECONOMIES 455

questions relating to the uniqueness and stability of equilibrium, he realised

that multiple equilibria were possible if an industry supply curve was
downward sloping. Then, while exploring how the transition between two
points of stable equilibrium might be made, Marshall was forced to confront
the problem of whether plausible sources of increasing returns were compatible
with a downward-sloping industry supply curve. If the source of cost reductions
were the use of extra machinery and a more elaborate division of labour by
individual firms, there was no obvious reason why the same cost reductions
could not have been achieved by displacement of other firms rather than an
expansion of industry output. Marshall's initial solution to this problem was to
make the tacit assumption that 'an increase in the economy of labour which
results from production on a large scale depends on an increase in the total
amount produced' (Whitaker, I 975, I). Twenty years later, by the time the first
edition of the Principles was published, his tacit assumption had metamorphosed
into 'external economies'. These were defined by Marshall as those economies
'which do not directly depend on the size of individual houses of business'. The
most important of them, he suggested, result from the growth of correlated
branches of industry which mutually assist one another, perhaps by being
located in the same area (Principles, I, p.3 I 7). Elsewhere, he described external
economies as those which depend on the general organisation of the trade, the
growth of knowledge and appliances common to the trade and on the
development of subsidiary industries (Marshall, I898, p. 50).
It is well known that, in addition to external economies, the life cycle of the
firm and the downward-sloping demand curve for the individual firm also
featfred in Marshall's reconciliation of increasing returns and competition
(Stigler, I95I, p. I86; Shove, I942, p. 304). It is widely agreed that each of
these elements could have had a role to play, but there remains considerable
controversy about the precise role of each and their relationship with each
other (Whitaker, I990, p. 44). As far as external economies are concerned,
Sraffa (I925) claimed that, in the Principles, they were the sole cause of
increasing returns in a regime of competition. This view has been contested by
Robertson (I930, I956) and most recently by Whitaker (I987) in his entry on
Marshall in The New Palgrave. Rather than discuss the relative merits of the
various interpretations, we proceed here by taking a detailed look at the
concept of external economies and what might be necessary to bring them
about.

EXTERNAL ECONOMIES

Scitovsky (I 954) described the concept of external

elusive in economic literature. This view is widely shared, and Chipman (i 965)
in his review of the subject suggests that Marshall's evasiveness on the matter
is so conspicuous that it is likely to have been deliberate. Chipman's own
assessment of external economies is that they were ' an inspired idea awaiting
adequate formalization' (Chipman, I965, p. 740). Others seem to have
thought that the problem lay not so much with the formalisation as with
( Royal Economic Society I993

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 456 THE ECONOMIC JOURNAL [MARCH

finding any corresponding phenomena in the real world (Young, I 9 I 3; Sraffa,

I926; Samuelson, I967).
A robust defence of what he terms 'parametric external economies of scale'
has been provided by Chipman (i 965, I 970). Each entrepreneur is assumed to
believe that his firm is operating under constant returns to scale, and any
departures from this 'are interpreted by him as brought about by a
perturbation in this unit-homogeneous production function' caused by changes
in the output of the industry as a whole (Chipman, I 970, p. 349). The concept
is illustrated by considering Adam Smith's pin industry. According to
Chipman, if a particular factory expands, some of the work can be subdivided
and specialities will develop, but only a substantial expansion of the industry
will provide enough openings for a pool of labour to develop with a specialised
skill. The contribution of any single firm to this process will be so imperceptible
that it will be neglected by the entrepreneur. Hence, the change in the
character of the labour force will be regarded as exogenous by all firms even
though each firm necessarily contributes to the process (ibid.). This
construction, Chipman (i 965, pp. 739-40) argued, 'makes possible a down-
ward sloping industry supply curve provided - to borrow a phrase from
Keynes (I930, p. 26) who analysed a similar situation with respect to banks -
the firms "move forward in step", but - it must be added - not in concert'.
Chipman seems to be under the impression that the main source of difficulty
with the concept of external economies is that the idea of treating production
functions parametrically is more subtle than that of treating market prices in
this way (Chipman, I970, p. 349). In this, I think, he is mistaken and as a result
fails to perceive where the chief difficulty lies. To see this, let us return to Adam
Smith's pin factories and imagine that the demand for pins has increased so
that each individual pin factory wishes to expand its output. Now let us ask
ourselves: u.nder what circumstances can a pool of labour with specialised skill
develop as a result of an expansion of industry output? First, we require that
the expanding firms should implement new subdivisions of labour and
secondly, we require that enough of them do so in the same way. Moving
forward in step is not a trivial matter and, unless there is some incentive for
each firm to subdivide its labour further as well as an obvious way of doing so,
it is difficult to see why it should often happen.
In the Principles, Marshall insisted that, while the history of an individual
man could not be made into the history of mankind, it was still the case that
the history of mankind was the outcome of the history of individuals (I, p. 459) .
Likewise, although the history of the individual firm was not the history of the
industry, the history of the industry was the outcome of forces which caused
individual firms to act in certain ways. Marshall, therefore, appreciated the
need to provide his individual firms with motives for making new divisions of
labour in such a way that they would generate external economies for the
industry as a whole.'

1 A concern with the practicalities of the development of the division of labour is evident in the Economics
of Industry, where - having noted that a small factory devoted to one stage of the process of manufacture
might have the best and most highly specialised machinery - the Marshalls continued: 'But such a factory

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 I993] MARSHALLIAN EXTERNAL ECONOMIES 457

The use of the life cycle of the firm and a biological concept of the firm's
equilibrium allowed Marshall to accommodate the attainment of new
economies by some 'wealthy' firm when industry output was constant and the
representative firm had constant internal economies. Since the addition to
output would be small relative to the total market, it would not much lower the
price so that the firm would reap great gains by its successful adaptation to its
surroundings (Principles, I, p. 378). The growth of such a firm would not go on
for ever, and as long as vast new economies were not immediately available the
decline of its fortunes would have set in long before it monopolised the
industry.2 However, the fact that it had grown beyond the norm and benefited
from doing so would mean that other firms would have a tried and tested path
along which to expand if such an opportunity arose. This would happen if an
increase in demand raised the market price above the normal supply price,
causing an increase in the growth of rising firms and slackening the decay of
falling firms (I, p. 343). As they grew beyond the previous norm, the expanding
firms would seek additional internal economies by emulating the innovations
of the 'wealthy' firm, and in the process of so doing they would generate new
external economies for the industry as a whole.

CONCLUSION

The point of this note is not to deny the possibility of parametric economies of
scale but to suggest that they are best considered within an evolutionary
framework. In the absence of indivisibilities, the expansion of an industry
cannot generate economies of scale unless individual firms introduce the same
changes in the way they carry out their activities. In the absence of signals of
any kind, there seems to be no good reason to expect this to happen.

Queen's University, Belfast

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would not come into existence until the advantage of having special machinery for this stage had become wel
established' (Marshall and Marshall, I879, p. 53).
2 In the event of such economies being readily available, only difficulties of marketing could prevent
monopolisation (Principles I, I, pp. 457-8).

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 458 THE ECONOMIC JOURNAL [MARCH I993]

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