Increasing Returns and Efficiency

Increasing Returns and Efficiency

Increasing Returns and Efficiency

Increasing Returns and Efficiency


Increasing returns to scale is an area in economics that has recently become the focus of much attention. While most firms operate under constant or decreasing return to scale on their relevant range of production, some firms produce goods or services with a technology which exhibits increasing returns to scale at levels of production which are large relative to the market. These goods are an important component of economic activity in a modern economy and are typically commodities produced either by a public sector or, as in the U.S., by regulated utilities. In this study, the author analyzes increasing returns using general equilibrium theory to take into account the interactions between production in the public and the private sector, and the effects of financing the public sector on the redistribution of income.


This monograph studies the theory of resource allocation in an economy with increasing returns. Its focus is on the problem of achieving efficient allocations through a mechanism that is as decentralized as possible. Since efficiency cannot be achieved if increasing returns firms are permitted to exploit their monopoly power, such firms must be subject to some measure of regulation. The economy thus consists of two sectors: a private sector with consumers and competitive firms with decreasing returns and a public sector consisting of regulated firms producing with increasing returns. The problem reduces to studying how a price system can coordinate the activities of these two sectors.

The objective of efficiency leads to the concept of a marginal cost pricing equilibrium which is a natural extension of the classical concept of a competitive equilibrium. Even though this concept is motivated by considerations of efficiency, the resulting equilibria are not necessarily efficient. In contrast with a convex economy, conditions of compatibility between the supply and demand for the commodities produced by the public sector are needed to ensure that equilibria are efficient.

Marginal cost pricing introduces a second problem which is not encountered in convex economies, the need to finance the deficit of the public sector. Finding ways of financing the deficit which are acceptable to all agents and more generally to all subgroups of agents leads naturally to the abstract problem of finding allocations which lie in the core of an economy with increasing returns. Once again conditions of compability between the supply and demand sides of the public sector are needed to ensure that core allocations exist.

Here in short is the content of this monograph. While the formal analysis proceeds with the standards of rigor expected of modern theoretical economics, I have attempted to keep the discussion and exposition of the key ideas as intuitive as possible. Simple examples and a geometric approach are used to illustrate basic points and to motivate the reader's intuition. While based on the work of this author, this monograph also draws extensively on the recent literature on increasing returns. Since some of this literature is quite technical the intuitive and geometric approach emphasised in this monograph should provide a more accessible account of recent developments in this field.

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