Constant Returns to Scale: Can the Neoclassical Economy Exist?

Abstract

This note argues that the competitive paradigm of neoclassical economics breaks down in the presence of constant returns to scale (CRS). With CRS, all goods can be produced at identical unit costs by all economic agents, making self-production a feasible alternative to market production. In the event, an infinite number of equilibria become possible with a mix of markets and self-production. If labor is the only factor of production, self-production is the only option and the market economy ceases to exist. All too often the competitive paradigm of neoclassical economics has been faulted for its unrealistic assumptions, but rarely for logical inconsistency. These critics have also developed several new variants of economics based on more realistic assumptions. 2 Nevertheless, these critiques have failed to dislodge the competitive paradigm from its preeminent position in economics. Kenneth Arrow (1994: 451) has argued that this is because the competitive paradigm “is still the only coherent account of the entire economy.” Others point to the ideological function of neoclassical economics: in particular, its defense of the capitalism of unfettered markets. 3 This note presents a different critique: it shows that the competitive paradigm is inconsistent with constant returns to scale (CRS). At least since Leon Walras, economists have constructed mathematical models to establish the exact conditions under which a market economy – with fixed resources, tastes and technology – can attain an equilibrium that is also Pareto-efficient. CRS – or the more general assumption of non-increasing returns to scale – has been a cornerstone of all these models. Allyn Young (1928) and later Nicholas Kaldor (1967 and 1972) have shown that equilibrium economics becomes irrelevant in the presence of increasing returns to scale. We argue that neoclassical economics is in trouble even with CRS: and this is a problem that has gone unnoticed. Our concern is not with the existence – or uniqueness and stability – of solutions to the system of equations that define the neoclassical economy. Instead, we ask a more basic question. Can a market economy exist in the presence of CRS?