Twentieth Century Virtuous Circle Theories

Economies of scale and learning by doing are both "endogenous," that is, they are instances of labor productivity growth as a result of economic events. In this they are similar to "endogenous innovations," and the three are often linked together in a common twentieth-century virtuous circle theory:

More and cheaper production leads to larger scale, more learning and innovation, and these lead to more and cheaper production, starting the cycle over.

However, just as the circle has more links, there are more ways the virtuous circle might be broken, causing growth to slow or stop.

The Infant Industry Problem: An industry that is small and new may be unable to compete with more established similar industries in other countries, or even with low-wage industries in the home country, and thus never obtain the resources necessary to grow and take advantage of its economies of scale and learning potential.
The Spillover Problem: According to the endogenous innovation theory, businesses invest money in research and development because it is profitable. But many of the benefits of innovation "spill over" and are of benefit to other companies. For example, the company that invented Visi-Calc, the first computer spreadsheet, paved the way for imitators who made most of the money from spreadsheets.
The Big Business Problem: When we look at industries and whole economies, "economies of scale" means that they will be able to produce more, more cheaply, when they operate on a large scale. But the same may be true of companies: the business that produces and sells on the largest scale produces most cheaply, and so can drive the others out of business. Thus monopolies emerge not because an interfering government created them (as Smith supposed) but because of the economic growth process themselves. But as Smith did suspect, the monopolies break the virtuous circle because, instead of expanding production, they use the increased productivity to push their profit margin up. But with no expansion of production, no increased scale, there is no next round of growth, and the virtuous circle grinds to a halt. The great American economist of midcentury, John Kenneth Galbraith, put stress on that possibility.

The first two of these possibilities has led economists such as A. C. Pigou and many others to suggest that government might need to give special support to industries that -- because of their economies of scale, learning potential, and/or innovation spillovers -- have special promise for the future. This is the basis of "industrial policy." On the other hand, the third item, the Big Business Problem, led Galbraith to say that government might need to use its regulatory power to keep big business prices down and the output expanding -- whether it is profitable or not.

Like Smith, twentieth century virtuous-circle theorists would rely on good government to assure that the circle is not interrupted; but some of them would have a quite different idea of what kind of government is "good government."