An Evolutionary Theory of Economic Change

Richard R. Nelson, Sidney G. Winter

• Publisher: Belknap Press
• Year: 1985
• Print ISBN: 9780674272286, 9780674272279
• eBook ISBN: 9780674256569
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

This book contains the most sustained and serious attack on mainstream, neoclassical economics in more than forty years. Richard R. Nelson and Sidney G. Winter focus their critique on the basic question of how firms and industries change overtime. They marshal significant objections to the fundamental neoclassical assumptions of profit maximization and market equilibrium, which they find ineffective in the analysis of technological innovation and the dynamics of competition among firms.

To replace these assumptions, they borrow from biology the concept of natural selection to construct a precise and detailed evolutionary theory of business behavior. They grant that films are motivated by profit and engage in search for ways of improving profits, but they do not consider them to be profit maximizing. Likewise, they emphasize the tendency for the more profitable firms to drive the less profitable ones out of business, but they do not focus their analysis on hypothetical states of industry equilibrium.

The results of their new paradigm and analytical framework are impressive. Not only have they been able to develop more coherent and powerful models of competitive firm dynamics under conditions of growth and technological change, but their approach is compatible with findings in psychology and other social sciences. Finally, their work has important implications for welfare economics and for government policy toward industry.

I

OVERVIEW AND MOTIVATION

1

Introduction

IN THIS VOLUME we develop an evolutionary theory of the capabilities and behavior of business firms operating in a market environment, and construct and analyze a number of models consistent with that theory. We propose that the broad perspective provided by an evolutionary theory is useful in analyzing a wide range of phenomena associated with economic change stemming either from shifts in product demand or factor supply conditions, or from innovation on the part of firms. The specific models we build focus in turn on different aspects of economic change—the response of firms and the industry to changed market conditions, economic growth, and competition through innovation. We draw out the normative as well as the positive implications of an evolutionary theory.

The first premise of our undertaking should be noncontroversial: it is simply that economic change is important and interesting. Among the major intellectual tasks of the field of economic history, for example, certainly none is more worthy of attention than that of understanding the great complex of cumulative change in technology and economic organization that has transformed the human situation in the course of the past few centuries. Among policy issues regarding the world economy today, none present a more critical mix of promise and danger than those that reflect the wide disparities in present levels of economic development and the strains that afflict societies struggling to catch up. In the advanced economies, meanwhile, successful modernization has brought forth new concerns about the long-term ecological viability of advanced industrial society and renewed questions about the relation between material success and more fundamental human values. Among the focal concerns of theoretical economics in recent years have been the roles of information, the formation of expectations by economic actors, detailed analysis of markets functioning given the presence of various “imperfections, “ and new versions of old questions about the efficiency of market systems. Much of this work seeks to comprehend, in stylized theoretical settings, the unfolding of economic events over time. Thus, any significant advance in understanding of the processes of economic change would cast new light on a range of intellectually challenging questions that are of great social consequence.

We expect, however, that many of our economist colleagues will be reluctant to accept the second premise of our work—that a major reconstruction of the theoretical foundations of our discipline is a precondition for significant growth in our understanding of economic change. The broad theory that we develop in this book, and the specific models, incorporate basic assumptions that are at variance with those of the prevailing orthodox theory of firm and industry behavior. The firms in our evolutionary theory will be treated as motivated by profit and engaged in search for ways to improve their profits, but their actions will not be assumed to be profit maximizing over well-defined and exogenously given choice sets. Our theory emphasizes the tendency for the most profitable firms to drive the less profitable ones out of business; however, we do not focus our analysis on hypothetical states of “industry equilibrium,” in which all the unprofitable firms no longer are in the industry and the profitable ones are at their desired size. Relatedly, the modeling approach that we employ does not use the familiar maximization calculus to derive equations characterizing the behavior of firms. Rather, our firms are modeled as simply having, at any given time, certain capabilities and decision rules. Over time these capabilities and rules are modified as a result of both deliberate problem-solving efforts and random events. And over time, the economic analogue of natural selection operates as the market determines which firms are profitable and which are unprofitable, and tends to winnow out the latter.

A number of our fellow economists do share with us a sense of general malaise afflicting contemporary microeconomic theory.¹ It is widely sensed that the discipline has not yet located a path that will lead to a coherent and sustained advance beyond the intellectual territory claimed by modern general equilibrium theory. The discovery of such a path will, it is believed, require a theoretical accommodation with one or more of the major aspects of economic reality that are repressed in general equilibrium theory. Much of the most interesting theoretical work of the past two decades may be interpreted as exploratory probing guided by a variety of different guesses as to which of the possible accommodations are the most important ones to make. Considerable attention has been given to imperfections of information and of competition, to transaction costs, indivisibilities, and increasing returns, and to some of the relations among these. It has been recognized that general equilibrium theory’s austere description of the institutions of capitalism becomes woefully inadequate as soon as any of these accommodations to reality are made—and, on the other hand, that the actual institutional devices employed in real market systems constitute a complex and challenging object for theoretical study. The fruits of these exploratory efforts include a good deal of work that is intellectually impressive when taken on its own terms, much that is directly useful in understanding certain portions of economic reality, and some that seems likely to be of lasting value regardless of the future course that economics may take. But the great majority of these exploratory probes have carried along (or at least intended to carry along) almost all of the basic conceptual structure that orthodoxy provides for the interpretation of economic behavior.

We regard that structure as excess baggage that will seriously encumber theoretical progress in the long run, however much its familiarity and advanced state of development may facilitate such progress in the short run. Here, obviously, our appraisal of the situation is more radical than anything that can be associated with the “general malaise” referred to above. What we offer in this book is, we believe, a plausible promise that fundamental reconstruction along the lines we advocate would set the stage for a major advance in understanding of economic change—and, at the same time, make it possible to consolidate and preserve most of the discipline’s significant achievements to date. To make full delivery on such a promise is not a task for two authors, or for a single book.

1. THE TERMS OF THE DISCUSSION: “ORTHODOX” AND “EVOLUTIONARY”

We have above made the first of many references to something called “orthodox” economic theory. Throughout this book, we distinguish our own stance on various issues from the “orthodox” position. Some such usage is inevitable in any work that, like the present one, argues the need for a major shift of theoretical perspective on a wide range of issues. However, there may be some who would deny that any “orthodoxy” exists in economics, apart from a widely shared commitment to the norms and values of scientific inquiry in general. Others would agree that an orthodoxy exists in the descriptive sense that there are obvious commonalities of intellectual perspective and scientific approach that unite large numbers of economists. But they would strenuously deny there is an orthodox position providing a narrow set of criteria that are conventionally used as a cheap and simple test for whether an expressed point of view on certain economic questions is worthy of respect; or, if there is such an orthodoxy, that it is in any way enforced. Our own thought and experience leave us thoroughly persuaded that an orthodoxy exists in this last sense, and that it is quite widely enforced. We do concede that contemporary orthodoxy is flexible and ever-changing, and that its limits are not easily defined. It therefore seems important to attempt, if not an actual definition, at least a clarification of our use of the term.

We should note, first of all, that the orthodoxy referred to represents a modern formalization and interpretation of the broader tradition of Western economic thought whose line of intellectual descent can be traced from Smith and Ricardo through Mill, Marshall, and Walras. Further, it is a theoretical orthodoxy, concerned directly with the methods of economic analysis and only indirectly with any specific questions of substance. It is centered in microeconomics, although its influence is pervasive in the discipline.

To characterize the actual content of contemporary orthodoxy is a substantial undertaking, with which we will concern ourselves recurringly in this book. Here we address the question of how one might check our claims that particular views and approaches are “orthodox”—or, alternatively, the question of how we would defend ourselves against a claim that we are attacking a straw man or an obsolete, primitive form of economic theory. The first recourse should be to the leading textbooks used in the relatively standardized undergraduate courses in intermediate microeconomics. These texts and courses expound the theoretical foundations of the discipline at a simplified level. They are generally viewed as providing important background for understanding applied work in economics—often, in fact, as providing essential background for applied work done at a respectable intellectual level. The best of the texts are notably insistent on the scientific value of abstract concepts and formal theorizing, and offer few apologies for the strong simplifications and stark abstractions they employ. Neither do they devote much space to caveats concerning the theory’s predictive reliability in various circumstances. In these respects and others, they prefigure the treatment of the same issues in advanced texts and courses in theory. Indeed, it often appears that doctoral-level courses in economic theory are distinguished from intermediate-level courses primarily by the mathematical tools employed, at least so far as the core topics are concerned.

There is, admittedly, a degree of caricature involved when texts aimed at college sophomores and juniors are nominated to represent modern economic theory. Many of the strong simplifying assumptions commonly employed—perfect information, two commodities, static equilibrium, and so on—are emphasized in such texts for reasons having to do with the perceived limitations of the students, and not because the discipline has nothing better to offer. And if the conclusions of the analysis are sometimes put forward without due emphasis on the qualifications to which they are subject, it is not necessarily because the importance of those qualifications is not recognized by the author. It is more likely because the students are seen as deserving a reward for their struggles with the logic of the argument, and as positively demanding clear-cut answers to put in the exam book. In many respects, orthodoxy is more subtle and flexible than the image of it presented in the intermediate texts.

There are, however, some very important respects in which the portrait is drawn true. First of all, the logical structure of the intermediate texts underlies much of the informal discussion of economic events and policies engaged in by economists and others with substantial economics background. This is particularly the case with views concerning the efficiency properties of market systems: there seems to be a remarkable tendency for discussion of this question to throw off the encumbrances of advanced learning and revert to a more primitive and vigorous form. In this sense, the conclusions of intermediate analysis seem much more indicative of “where the discipline stands” than do appraisals that are theoretically more sophisticated, but also more difficult and less familiar to nontheorists. Second, the strong simplifying assumptions of the intermediate texts often have close analogues in advanced work, right out to the theoretical frontiers. It is a caricature to associate orthodoxy with the analysis of static equilibria, but it is no caricature to remark that continued reliance on equilibrium analysis, even in its more flexible forms, still leaves the discipline largely blind to phenomena associated with historical change. Similarly, defenders of orthodoxy may justifiably disdain to reply to criticisms of perfect-information assumptions, but they have something at risk if the criticism focuses instead on the assumption that all possible contingencies can be foreseen and their consequences weighed. Thus, although it is not literally appropriate to stigmatize orthodoxy as concerned only with hypothetical situations of perfect information and static equilibrium, the prevalence of analogous restrictions in advanced work lends a metaphorical validity to the complaint.

Last, there is one key assumption in the structure of orthodox thought that does not get significantly relaxed or qualified as one passes from intermediate to advanced theory; on the contrary, it becomes stronger to support a greater weight. This is the assumption that economic actors are rational in the sense that they optimize. In elementary instruction or in popular exposition, this assumption of economic rationality may be presented as a conceptual expedient justified by the realistic observation that people have objectives which they pursue with a certain amount of consistency, skill, and forethought. At the intermediate level, the assumption takes on a stark appearance that strains credulity, but then intermediate theory is pretty stark overall. In advanced forms of orthodoxy, while recognition of informational and other “imperfections” softens the general theoretical picture regarding what the actor knows, no such compromise with reality affects the treatment of economic rationality. As theoretical representations of the problems faced by economic actors increase in realistic complexity and recognition of uncertainty regarding values of the variables, there is a matching increase in the feats of anticipation and calculation and in the clarity of the stakes imputed to those actors. Never is such a theoretical actor confused about the situation or distracted by petty concerns; never is he trapped in a systematically erroneous view of the problem; never is a plain old mistake made. It is a central tenet of orthodoxy that this is the only sound way to proceed; recognition of greater complexity in the problem obligates the theorist to impute a subtler rationality to the actors. Thus, with regard to rationality assumptions, to allow orthodox theory to be championed by its elementary and intermediate versions is to waive a set of objections that become particularly telling at the advanced level.

The foregoing discussion should make clear the sources of a problem that will arise repeatedly in the analysis that follows. Theoretical orthodoxy is manifested at a variety of levels, and displays a variable mix of strengths and shortcomings. Some of the shortcomings of elementary versions are corrected in advanced treatments; others are merely papered over. Sometimes a deficiency undergoes mutation to a new but analogous form, and some deep problems get exacerbated as the theory gets “better” We attempt to cope with this complex situation by modifying our references to orthodoxy with clarifying phrases—“textbook” or “simple” orthodoxy versus “advanced” or “recent developments,” and so forth. We also distinguish between “formal” orthodoxy, displayed in logically structured theorizing, and the “appreciative” version which is more intuitive and modified by judgment and common sense. (This distinction is discussed further in the following chapter.) These devices are not entirely adequate to the task, but it does not seem reasonable to interrupt our discussion repeatedly for the sake of clarifying and documenting each criticism of orthodoxy. We hope that we have here provided an adequate guide, at least for those familiar with economic theory, to the way in which such detailed indictments might be developed.

Our use of the term “evolutionary theory” to describe our alternative to orthodoxy also requires some discussion. It is above all a signal that we have borrowed basic ideas from biology, thus exercising an option to which economists are entitled in perpetuity by virtue of the stimulus our predecessor Malthus provided to Darwin’s thinking. We have already referred to one borrowed idea that is central in our scheme—the idea of economic “natural selection.” Market environments provide a definition of success for business firms, and that definition is very closely related to their ability to survive and grow. Patterns of differential survival and growth in a population of firms can produce change in economic aggregates characterizing that population, even if the corresponding characteristics of individual firms are constant. Supporting our analytical emphasis on this sort of evolution by natural selection is a view of “organizational genetics”—the processes by which traits of organizations, including those traits underlying the ability to produce output and make profits, are transmitted through time. We think of organizations as being typically much better at the tasks of self-maintenance in a constant environment than they are at major change, and much better at changing in the direction of “more of the same” than they are at any other kind of change. This appraisal of organizational functioning as relatively rigid obviously enhances interest in the question of how much aggregate change can be brought about by selection forces alone.

The broader connotations of “evolutionary” include a concern with processes of long-term and progressive change. The regularities observable in present reality are interpreted not as a solution to a static problem, but as the result that understandable dynamic processes have produced from known or plausibly conjectured conditions in the past—and also as features of the stage from which a quite different future will emerge by those same dynamic processes. In this sense, all of the natural sciences are today evolutionary in fundamental respects. Perhaps the most dramatic illustration of this point is the increasing acceptance of the cosmological theory of the Big Bang, a conception that regards all of known reality as the continuously evolving consequence of one great antecedent event. At a less cosmic level, science has come to see the continents as shifting with sporadic violence beneath our feet, the changing behavior of the Sun as a possible factor in human history, and the world’s climate as threatened with major and perhaps irreversible change as a consequence of industrialization. Against this intellectual background, much of contemporary economic theory appears faintly anachronistic, its harmonious equilibria a reminder of an age that was at least more optimistic, if not actually more tranquil. It is as if ...

Table of contents

• Cover
• Title
• Copyright
• Preface
• Contents
• Part I: OVERVIEW AND Motivation
• Part II: ORGANIZATION-THEORETIC FOUNDATIONSOF ECONOMIC EVOLUTIONARY THEORY
• Part III: TEXTBOOK ECONOMICS REVISITED
• Part IV: GROWTH THEORY
• Part V: SCHUMPETERIAN COMPETITION
• Part VI: ECONOMIC WELFARE AND POLICY
• Part VII: CONCLUSION
• References
• Index