How Innovation Works: And Why It Flourishes in Freedom

by Matt Ridley

David Warsh, in a book on the history of economics entitled Knowledge and the Wealth of Nations pointed out that Adam Smith himself created a contradiction that he never resolved and that in some form persists to this day. The famous ‘Invisible Hand’ is about the gradual emergence of equilibria in markets, so that neither the producer nor the consumer can improve upon the deal they have got. This implies diminishing returns: as the world settles upon the right price of a widget, so there are no gains to be made. By contrast, Smith’s other idea, the division of labour, implies the opposite: increasing returns. To use his own example, in a pin factory, as workers share out the tasks and get more specialized and innovative in their work, and therefore collectively more productive, so the cost of making pins comes down and down. Both producers and consumers get more for less. The first metaphor therefore implies negative feedback, the second positive. They cannot both be right.