CONTRIBUTONS TO ECONOMIC ANALYSIS 215 Honorary Editor: J. TINBERGEN Editors: D. W. JORGENSON J. -J. LAFFONT NORTH-HOLLAND AMSTRRnAM .LONDON · NEW YORK · TOKYO S P E C I A L I Z A T I ON A ND E C O N O M IC O R G A N I Z A T I ON A New Classical Microeconomic Framework Xiaokai YANG Yew-Kwang NG Department of Economics Monash University Clayton, Victoria, Australia 1993 NORTH-HOLLAND AMSTERDAM · LONDON · NEW YORK · TOKYO ELSEVIER SCIENCE PUBLISHERS B.V. Sara* Burgerhartstraat 25 RO. Box 211, 1000 AE Amsterdam, The Netherlands ISBN: O 444 88698 2 © 1993 ELSEVIER SCIENCE PUBLISHERS B.V. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the publisher, Elsevier Science Publishers B.V,, Copyright & Permissions Department, P.O. Box 521, 1000 AM Amsterdam, The Netheriands. Special regulations for readers in the U.S.A. - This publication has been registered with the Copyright Clearance Center Inc. (CCC), Salem, Massachusetts. Information can be obtained from the CCC about conditions under which photocopies of parts of this publication may be made in the U.S.A. All other copyright questions, including photocopying outside of the U.S.A., should be referred to the publisher. No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. This book is printed on acid-free paper. DDTvm^n TM THF MFTHFRT ANDS INTRODUCTION TO THE SERIES This series consists of a number of hitherto unpublished studies, which are intro­ duced by the editors in the belief that they represent fresh contributions to economic science. The term "economic analysis" as used in the title of the series has been adopted because it covers both the activities of the theoretical economist and the research worker. Although the analytical methods used by the various contributors are not the same, they are nevertheless conditioned by the common origin of their studies, namely theoretical problems encountered in practical research. Since for this reason, busi­ ness cycle research and national accounting, research work on behalf of economic policy, and problems of planning are the main sources of the subjects dealt with, they necessarily determine the manner of approach adopted by the authors. Their methods tend to be "practical" in the sense of not being too far remote from appli­ cation to actual economic conditions. In additon they are quantitative. It is the hope of the editors that the publication of these studies will help to stimulate the exchange of scientific information and to reinforce intemational cooperation in the field of economics. The Editors To Xiaojuan, Xiaoxi, James and Siang, Aline, Eve vil Preface As the subtitle indicates, this book attempts to develop a new classical microeconomic framework. From the titles of individual parts, chapters, and sections in the table of contents, it can be seen that this is a new unifying analytical framework that covers topics concerning intemational trade, development economics, growth theory, transaction costs economics, comparative economics, management economics, urban economics, industrial organization, and macroeconomics. Hence, this book can be used as a textbook for a graduate course in microeconomics as well as a supplementary text for courses in all these fields. In this book the new classical microeconomic framework is used to bring the analysis of economies of speciahzation, the division of labor, and the structure of economic organization into the central place of economics. The important issues had been largely ignored by economists due to the dichotomy between pure consumers and pure producers in neoclassical economics. By dismantling this dichotomy and introducing economies of specialization and transaction costs but retaining the methodology of individual optimization and market equilibrium, we show that the endogenous evolution of the division of labor based on a tradeoff between economies of specialization and transaction costs may explain the emergence of the firm, the emergence of regional and international trade, the increases in productivity, in trade dependence, in the level of specialization, in the number of final and intermediate goods, in the number of layers of a hierarchical structure of transactions and cities, in the degree of production concentration, in the degree of market integration, and in the degree of production roundaboutness, and the emergence of professional middlemen, cities, money, unemployment, and business cycles. We also show that the function of the market is much more sophisticated than generally recognized by economists. The function is not only to efficiently allocate resources, but also to search the efficient levels of specialization and division of labor, to discover the efficient market structure and institutional arrangements, to find the efficient hierarchical structure of transactions, and to determine the efficient monetary regime and efficient pattem of the business cycle. The names of individuals who have contributed to this ambitious viii Preface project are too many to mention here. We would like first to acknowledge the invaluable contribution of Jeff Borland to this book. He has carefully read every chapter of the book and made many extremely helpful suggestions and comments about the substance of the models and main concepts and about writing style. Also, he is the coauthor of several papers of which modified versions have been included as chapters in this volume. Chapters 4, 7,12, 16, and 17 are derived from Yang and Borland [1992c], Yang and Borland [1991a], Yang and Borland [1992d], Yang and Borland [1992a], and Yang and Borland [1992b], respectively. Thanks also to Ian Ward who had gone throughout the whole book and made helpful suggestions. We are grateful to Heling Shi, Ian Wills, Jianguo Wang, and Geoff Hogbin for their permission to include the modified versions of several papers coauthored by them in this volume. Chapters 8 and 13 are the variants of the two papers coauthored by Heling (see Yang and Shi [1992] and Shi and Yang [1992], respectively). Chapter 11 is a modified version of a paper coauthored by Ian (see Yang and Wills [1990]). Chapter 19 is a modified version of a paper coauthored by Jianguo and Ian (see Yang, Wang, and Wills [1992]). Chapter 14 is a modified version of a paper coauthored by Geoff (see Yang and Hogbin [1990]). The following sources are gratefully acknowledged Chapter 6: reprinted, with revisions, by permission from Joumal of Development Economics, Vol 34, 1990, pp. 199-222. Copyright © 1990 North-Holland PubUshing Company. Chapter 7: reprinted, with revisions, by permission from Joumal of Political Economy, Vol 99, 1991, pp. 462-480. Copyright © 1991 The University of Chicago. Chapter 8: reprinted, with revisions, by permission from American Economic Review, Vol 82, 1992, pp. 392-398. Copyright © 1992 The American Economic Association. Chapter 10: reprinted, with revisions, by permission from Joumal of Comparative Economics, Vol 14, 1990, pp. 177-198. Copyright © 1990 Academic Press, Inc. Chapter 14: reprinted, with revisions, by permission from China Economic Review, Vol 1, 1990, pp. 125-140. Copyright © 1990 JAI Press, Inc. Chapter 19: reprinted, with revisions, by permission from China Economic Review, Vol 3, 1992, pp. 1-37. Copyright © 1992 JAI Press, Inc. Preface ix We are greatly indebted to Gene Grossman, Edwin Mills, Barry Nalebuff, Sherwin Rosen, Whitney Newey, T. N. Srinivasan, Raaj Sah, Lloyd Reynolds, Joseph Stiglitz, Steven Cheung, Wilfred Ethier, Alan Siu, W. C. Suen, Yoram Barzel, Gustav Ranis, Wilham Baumol, Gregory Chow, Hugo Sonneschein, Avinish Dixit, Dahai Yu, Lin Zhou, Jianpin Mei, Linda Goldberg, Jim Levinsohn, Daniel Vincent, John Freebairn, Dietrich Fausten, Robert Rice, Richard Snape, James Schmitz, Jr., and Richard Arnott for their invaluable comments and criticism on the research papers which led to this book. Special appreciation to Ehzabeth Kwok for her excellent secretarial support for this project. Gratitude also to the anonymous referees of Joumal of Political Economy, American Economic Review, Intemational Economic Review, Econometrica, Review of Economic Studies, Joumal of Development Economics, Joumal of Comparative Economics, Joumal of Behaviour and Economic Organization, European Economic Review, Oxford Economic Papers, Económica, Economic Joumal, and China Economic Review for their helpful comments on our research papers. Many of the comments are incorporated in the revised versions of the papers which are included as chapters in this volume. Special appreciation is due to Jean Waelbroeck and an anonymous referee of the series Contributions to Economic Analysis for their comments on the manuscript and their encouragement for this project. We have benefited immensely from comments on our research papers which have been developed into the chapters in this volume from the participants of seminars at Yale University, Princeton University, University of Pennsylvania, University of Chicago, University of California at Berkeley, Australian National University, University of Hong Kong, Chinese University of Hong Kong, University of Melbourne, Monash University, University of Adelaide, University of New South Wales, and at the 1992 American Economic Association Meeting and other academic conferences. Our gratitude also goes to Department of Economics of the University of Chicago, the Yale Economic Growth Center, and the International Economics Research Center at University of Pennsylvania for their support for our research. The financial support for this project and related research from the Ford Foundation, the Open Society Fund, Princeton University, the Australian Research Council, Monash Research Funds, the Faculty of Economics Commerce and Management of Monash University, and the University of Hong Kong are gratefully acknowledged. Of course, any remaining errors in this book are solely our own responsibility. The second author wishes to emphasize that the anti-alphabetical χ Preface ordering of the two authors justly reflects the major contribution of the first author. Xiaokai Yang and Yew-Kwang Ng October, 1992. 1 Introduction An important distinction between humankind and animals is a much more sophisticated organization in a human society than in any animal society. As Adam Smith [1776] emphasized, a distinctive feature of the organization of a human society is the division of labor. It is easy to find organization in many animal societies. However, organizations that exist in animal societies generally are characterized by "simple cooperation" without the division of labor.^ Only a few of these animal societies, such as an ant society and a bee society, have the simplest division of labor. The division of labor in a human society is characterized not only by its complexity compared to an animal society, but also by an evolutionary process from the simple to the complex division of labor. In this volume we define economic organization by the following concepts. The level of specialization for individuals and the level of division of labor for society (which are defined in Chapters 2 and 5); numbers of consumer and producer goods (which are endogenized in Chapters 8, 12, 16); degree of production roundaboutness (which is endogenized in Chapter 13); market structure in organizing transactions, internal organization within a firm, and the structure of residual rights (defined in Chapter 9); number of layers of the hierarchy of transactions (endogenized in Chapter 14); monetary regime (endogenized in Chapter 17); and cycUcal pattern of economic growth (endogenized in Chapter 18). As you read this book, the economic mechanism that drives the evolutionary process from the simple to the complex division of labor will be deciphered. 0.1. Intrinsic Relationship Between the Evolution of the Division of Labor and Other Economic Phenomena More interesting than the evolutionary process per se is the concurrence of progress of productivity and the evolution of the division of labor. ^ Karl Marx [1933, Vol. 1, p. 368] drew a distinction between "simple cooperation" without the division of labor and cooperation based on the division of labor. Emile Dürkheim [1933, p. 131] took the distinction to be one between mechanical solidarity based on likeness and organic solidarity due to the division of labor.