American Political Science Review Vol.94,No.2 importance of physical proximity in many aspects of may be,however,the relevance of increasing returns economic life,agglomeration effects are widespread. processes to the economics of trade is now widely That is,initial centers of economic activity may act like accepted.7 a magnet and influence the locational decisions and Economists also have applied increasing returns investments of other economic actors.Established arguments to economic change more broadly.The firms attract suppliers,skilled labor,specialized finan- most prominent development in recent discussions of cial and legal services,and appropriate physical infra- economic growth centers on "endogenous growth" structure.The concentration of these factors may in theory (Romer 1986,1990).Economists in the 1980s turn make the particular location attractive to other became puzzled by growth rates (notably in developed firms that produce similar goods.So do social net- countries after World War II)far greater than could be works,which allow for easy exchange of information explained by measured increases in inputs of capital and expertise.Increasing returns arguments help ex- and labor.Romer and others argue that increasing plain the prevalence of pockets of specialized eco- returns associated with economic applications of nomic activity,from Silicon Valley to the high-end knowledge help account for the anomaly.Unlike cap- textile manufacturers of northern Italy.Krugman ital and labor,many aspects of knowledge are nonri- (1991,80)concludes:"If there is one single area of val-their use in one firm does not prevent their use in economics in which path dependence is unmistakable, another.A single gain in knowledge can be applied in it is in economic geography-the location of production many settings and can lead to dramatic improvements in space.The long shadow cast by history over location in productivity.Economic growth generates the posi- is apparent at all scales,from the smallest to the tive feedback that defines increasing returns processes. largest-from the cluster of costume jewelry firms in A somewhat different analysis of growth based on Providence to the concentration of 60 million people in increasing returns emphasizes the importance of the Northeast Corridor." complementarities (Milgrom and Roberts 1990).Var- These claims closely parallel recent analyses of in- ious economic activities (e.g.,in information technol- ternational trade,an area in which arguments about ogy)are complementary to other related activities increasing returns have gained wide acceptance.Re- Improvements in a core activity can spill over by searchers began by focusing on economic trends that improving related parts of the economy(lowering costs appeared anomalous from the perspective of tradi- or increasing productivity).These improvements in tional trade theory-most notably,the explosion of turn may increase the attractiveness of the core activity. intraindustry trade after World War II (Krugman Economists are now applying increasing returns ar- 1996).If comparative advantage results from"natural" guments to a wide range of important economic phe- features of different countries,then one would expect nomena,but Douglass North's application to issues of most trade to occur between quite different countries, institutional emergence and change is perhaps most such as North-South trade of manufactured goods for important for students of politics.North (1990a,95) raw materials.Yet,most trade is North-North,includ- argues that all the features identified by Arthur in ing extensive exchanges within particular industries. investigations of increasing returns in technology can This pattern suggests a puzzle:Why have broadly be applied to institutions.In contexts of complex social similar countries developed highly specialized niche interdependence,new institutions often entail high comparative advantages? fixed or start-up costs,and they involve considerable Increasing returns provide an answer.Knowledge- learning effects,coordination effects,and adaptive ex- intensive sectors are prone to positive feedback.Coun- pectations.Established institutions generate powerful tries that gain a lead in a particular field,for whatever inducements that reinforce their own stability and reason,are likely to consolidate that lead over time. further development. The result is a high degree of specialization.Even North emphasizes that not just single institutions are countries with similar initial endowments develop di- subject to increasing returns.Institutional arrange- vergent areas of economic strength.Comparative ad- ments induce complementary organizational forms, vantage is not simply given,it is often created through which in turn may generate new complementary insti- a sequence of events over time. tutions.For social scientists interested in paths of It is worth noting that this research on trade has development,the key issue is often what North calls been used to derive some controversial policy implica- "the interdependent web of an institutional matrix." tions.If first-mover advantages are significant,then This matrix,he emphasizes,"produces massive increas- free trade may not be an optimal policy for a country ing returns"(North 1990a,95).Path dependent pro- whose trade partners are willing to subsidize emerging cesses will often be most powerful not at the level of sectors.Under certain (restricted)conditions,a policy individual organizations or institutions but at a more of picking winners may make economic sense (Krug- macro level that involves complementary configura- man 1996;Tyson 1993).There remains considerable tions of organizations and institutions (Hall and Sosk- dispute about the significance of such opportunities for ice 2000:Katznelson 1997). strategic intervention.Krugman,for instance,main- tains that they will appear relatively infrequently,not so much because path dependence is rare,but because 7 As Krugman (1996,109-10)notes,in the American Economic Association's classification system for journal articles,one now finds governments will not be able to identify winners ex "models of trade with increasing returns and imperfect competition" ante.Whatever the appropriate policy implications alongside the category for "conventional trade models." 255