Chapter 2 discussed the macroeconomic stability of modern industrial economies in which substantial sectors are characterized by economies of scale in production. A related analysis appeared in our discussion of protectionism and managed trade in Chapter 3. In this chapter we outline the formal arguments that lie behind these discussions.

The model

Our aim is to study how prices, output levels, profits, and productivity move over time in an economy with increasing returns to scale. We use a straightforward framework: Prices are assumed to change in response to the difference between demand and supply, and supply is assumed to respond to profits, that is, to the difference between price and cost. Prices rise with excess demand, output rises with profits, and vice versa: When supply exceeds demand, prices fall, and when average cost exceeds price, output falls. This is the classical adjustment process discussed by Walras, who argued for “le loi de l'offre et de la demande” – the law of supply and demand, according to which prices move with the difference between supply and demand – and for “le loi de revient,” according to which production moves in the direction that increases profits.

Figure 9.1 presents a conventional picture: The curve AA shows how average cost c(q) changes with output q, which is measured horizontally. Price is measured vertically, and the curve BB shows how demand D(p) varies with the price.