Allies and antecedents of evolutionary theory

In intellectual evolution, as in other sorts, the accidents and inci­ dents along the way play an important role in the transformation of relatively simple and amorphous beginnings into the complex struc­ tures of later times. Thus, while traits of economic theory today be-tray both its classical origins and its present scientific utility, it would be a mistake to suppose that these considerations, either sep­ arately or in combination, fully account for the form that this theory takes today. Adam Smith might have had other and more robust intellectual descendants than contemporary orthodoxy-and more adequate interpretations.

A distinctive feature of intellectual evolution is that successive generations of the contending “species” often leave to poste rity their own interpretations of the evolutionary struggle itself- though without, of course, the benefi t of full foresight as to its future course. The choices and accidents, the refinements and extensions that molded present orthodoxy have been discussed and disputed both as they occurred and retrospectively. Many of the theoretical issues with which we are concerned in this volume have a long, complex, and sometimes tedious history in the literature of the discipline. They are treated in the work of economists now considered in the “mainstream,” but more particularly in the writings of others now classified primarily as critics and heretics. There are broad themes around which the individual issues may be organized- the nature and behavior of the firm and of market processes and structures, the character of capitalist social institutions more generally, and a range of questions concerning methodology, philosophy, and value. These themes inte rweave, however, and the historical dimension of the pattern contributes further complexity.

In the preceding section we have laid out our central agreements and disagreements with contemporary orthodoxy; here we do the same for a number of the critics and for earlier mainstream authors. This survey is, necessarily, neither exhaustive nor detailed, but it should suffice to suggest the main patterns of contrast, complemen­ tarity, and intellectual indebtedness that define the place of our work in the literature.

1. Managerialism and Behavioralism

We begin by considering two heterodox approaches to analysis of the business firm that have been developed in recent decades and that are marked by a comparatively strong commitment to some type of formal theorizing.

“Managerialist” thinking diagnoses the problem of orthodox theory as a failure to represent correctly the motives that directly operate on business decisions. Contrary to the tenets of orthodoxy, the obj ectives pursued by firms include more than merely profits. B aumol (1959), who proposed to replace profits with another simple obj ective- revenue (subj ect to a profit rate constraint)- and Wil-liamson (1964), who proposed a more general model of managerial utility maximization, are two important examples of the class. Some authors have paid particular attention to the processes and means by which stockholders or the capital market as an institution imperfectly constrains the pursuit of managerial objectives. Under this heading one can place Marris (1964), Williamson (1970), Jensen and Meckling (1976), and Grossman and Hart (1980) . As -the last two examples illus­ trate, and as we further argue in Chapter 3, the gap between manage­ rialist and orthodox analysis is sometimes small.

In our view, these proposals yield useful insights into questions of managerial behavior and performance that obviously cannot be ad­ dressed within the strict orthodox framework (since in that frame­ work management is just another input) . However, the particular problems with traditional theory that we have discussed above, and to which our analytic proposals are addressed, are not stressed by the “managerial motivation” theorists. Baumol, Williamson (in this guise), and other creators of managerial models generally have as­ sumed that managers maximize whatever it is they seek to achieve, with full cognizance of all possible actions they might take and the consequences of choosing any. Our central concern is with the maxi­ mization postulate as a characterization of how managers make deci­ sions given their objectives. And that concern is relevant whether the obj ective is profit or something different or more general.

Distinct from the managerialist view, but consistent with many elements of it, is the “behavioralist” position. Behavioralists, taking their lead from the work of Herbert Simon (1955a, 1959 , 1965), stress some or all of the following elements. Man’s rationality is “bounded”: real-life decision problems are too complex to compre­ hend and therefore firms cannot m aximize over the set of all conceiv­ able alternatives. Relatively simple decision rules and proced ures are used to guide action; because of the bounded rationality problem, these rules and procedures cannot be too complicated and cannot be characterized as “‘optimal” in the sense that they reflect the results of global calculation taking into account information and decision costs; however, they may be quite satisfactory for the purposes of the firm given the problems the firm faces. Firms satisfice; a firm is unlikely to possess a well-articulated global objective function in part because individuals have not thought through all of their utility tradeoffs and in part because firms are coalitions of decision makers with difbrent interests that are unlikely to be fully accommodated in an intrafirm social welfare function.

We accept and absorb into our analysis many of the ideas of the behavioral theorists. Our basic critique of orthodoxy is connected with th e bounded rationality pro blem. We base our modeling on the proposition that in the short and medium run the behavior of firms can be explained in terms of relatively simple decision rules and pro­ cedures. Much more than the behavioralists, however, our concern has been with economic change. Therefore, we have put much more stress than they on processes that link changes in firm decision rules and procedures (including productive techniques) to a changing eco­ nomic environment.

We are in sympathy with the behavioralist position that firms should not be viewed as having stable, finely graded yardsticks for the comparison of alternatives, and in some of our models we have included a variant of the “satisficing” idea put forth by Simon (1955a, 1959), and Cyert and March (1963). Leibenstein (1966) has made use of a similar idea, calling it “inert areas.” However, in other models we have employed the profit yardstick in a relatively conventional way. We remain pragmatic about this issue . Finally, we follow the behavioraIists in regarding computer simulation as a legitimate ap­ proach to the formal representation of theoretical schemes that, for one reason or another, do not lend themselves to analytical treat­ ment. There are, however, some differences of philosophy and emphasis that distinguish our uses of simulation techniques from those illustrated in, for example, the work of Cyert and March.

We diverge from the behavioral theorists in our interest in build­ ing an explicit theory of industry behavior, as contrasted with indi­ vidual firm behavior. This means on the one hand that our character­ izations of individual firms are much simpler and more stylized than those employed by the behavioral theorists, and on the other hand that our models contain a considerable amount of apparatus linking together the behavior of collections of firms. Perhaps in the future it will become possible to build and comprehend models of industry evolution that are based on detailed and realistic models of individ­ ual firm behavior. If so, our work will at that point reconverge with the behavioralist tradition.

2. Analysts of Firm Organization and Strategy

A considerable literature has developed on the relationships linking the growth and profitability of a firm to its organizational structure, capabilities, and behavior. Several different but largely complemen­ tary strands are involved. Penrose (1959) provided the elements of an analysis linking firm growth, structure, and the nature of the man­ agement function. Though she was apparently unaware of Coase’s (193 7) transaction cost approach to the nature of the firm, her analysis is largely consistent with it. More recently, Williamson in a number of works has woven the transaction cost theme together with other conceptual strands in a series of highly insightful analyses of firm scope, organizational structure, and related policy issues (1970, 1975, 1979, 1981) .

A line of work centered in the Harvard Business School has ex­ plored a concept of business strategy in its relation to the organiza­ tion of the firm; Chandler’s (1962, 1977) historical analysis from this point of view has been particularly influential. The strategy concept involved in this tradition is distinctive. Implicitly, at least, it in­ volves acceptance of the basic premise of bounded rationality-that the economic world is far too complicated for a firm to understand perfectly; therefore the attempts of firms to do well must be under­ stood as being conditioned by their subjective models or interpreta­ tions of economic reality. These interpretations tend to be associated with strategies that firms consciously devise to guide their actions. Such strategies differ from firm to firm, in part because of different interpretations of economic opportunities and constraints and in part because different firms are good at different things. In turn, the capabilities of a firm are embedded in its organizational structure, which is better adapted to certain strategies than to others. Thus, strategies at any time are constrained by organization. But also a sig­ nificant change in a firm’s strategy is likely to call for a significant change in its organizational structure.

As should be obvious by now, we have considerable sympathy for these lines of analysis. Our treatment of firm behavior, in Part II, draws on the work of Williamson and others, as well as on that of the behavioralists. In some of our models, the higher-order decision rules or policies with which we endow our firms may metaphorically be interpreted as their strategies. In these models firms have dif­ ferent strategies, and a central analytic concern is the viability or profitability of firms with different strategies. And although in the models described in this book we do not permit firms to change their strategies, such changes are quite admissible within the logic of our theory. Indeed, within an evolutionary theory, change in strategy or policy can be treated in exactly the same way as change in technique. We also are strongly sympathetic with the proposition that firm organization is an important variable for analysis in its own right. There are strong connections both between a firm’s strategy and its appropriate organizational structure, and between the techniques commanded by a firm and its organization. Largely in the interests of establishing an understandable linkage between individual firm behavior and industry behavior, our formal models in this book suppress considerations of internal structure and organizational change. But in principle, an evolutionary theory can treat organiza­ tional innovation just as it treats technical innovation . The problems of business strategy, like the issues explored by the behavioralis ts, dearly call for a rich and detailed modeling of individual organiza­ tions; the long-run challenge is to discover modeling techniques and analytical methods that will make a rich treatment of the individual firm compatible with tractability in the analysis of larger systems.

One feature that distinguishes our analysis from most of the work under the present heading is the explicitness of our rejection of the orthodox view of firms as optimizing actors-a vi ew that tends to be presumed in the strategy literature. To our eyes, the situation here parallels that noted above in our discussion of Schumpeterian com­ petition. The sort of “maximizing” imputed to firms in these in­ formal analyses is so remote from the concept employed in orthodox formal models as to make its invocation plainly ritualistic. And in­ dulgence in the ritual merely tends to postpone the day when formal theory might actually have substantial and fruitful application in these areas.

3. Views of the Activist Firm

Several prominent critics have focused their attention on the passive nature of the firms depicted by orthodox theory. They have proposed that in the most dynamic industries firms try to modify the demand for their products and engage in the development of new tech­ nologies, rather than merely reacting to market conditions by choosing the most appropriate technology for those conditions . Economists like J. M. Clark (1955), Galbraith (1967), and, of course, Schumpeter have stressed that typical market structures are not per­ fectly competitive and that firms employ advertising and research and development as central competitive weapons. A corollary to this emphasis has been a tendency to downplay the i mportance of price competition, particularly of the idealized form represented by stan­ dard competitive models, and to view large firms and relatively con­ centrated market s tructures as the typical case in the “interesting” part of the economy, if not in the economy as a whole. These per­ spectives converge in an assessment of the large corporation as a crit-ical feature of the institutional dynamics of modern capitalism, as a relatively autonomous chooser of society’s means and to some extent of its effective ends, and as the stimulus for the development of new social institutions for its control and accommodation.

Of this bundle of concerns, it is really only the role of the large firm in technological change that we address seriously in this book. Even in that arena, our formal models are restricted, in the interests of simplicity, to the case of I I disembodied” process innovation in an industry in which firms produce a homogeneous product. We do not analyze advertising or, indeed, do anything about reforming con­ sumer theory: the theory implicit in our models is orthodox. And we touch only briefly on the implications of our theory for the complex institutional design problems in which the role of the large corpora­ tion is central. All of these limitations and lacunae simply reflect our inability to address all the important problems at once, and are not intrinsic features of the evolutionary approach. They remain, at the end of the book, on the long agenda of i mportant unfinished busi­ ness.

Where our proposals for theoretical revision diverge from those of the most prominent critics of the sort just mentioned is in our con­ cern with developing a formal theoretical structure with analytical power. Many of those economists who have criticized economic theory because of its static nature seem to be content with stressing that valid point and positing some generalities about Schumpeterian competition at a verbal level, but appear to have no particular inter­ est in developing a formal theory of Schumpeterian competition. We are centrally concerned with the development of formal theory.

4. Schumpeter

The influence of Joseph Schumpeter is so pervasive in our work that it requires particular mention here. Indeed, the term “neo­ Schumpeterian” would be as appropriate a designation for our entire approach as “evolutionary.” More precisely, it could reasonably be said that we are evolutionary theorists for the sake of being neo­ Schumpeterians-that is, because evolutionary ideas provide a workable approach to the problem of elaborating and formalizing the Schumpeterian view of capitalism as an engine of progressive change. Although Schumpeter had some harsh words for loose invo­ cations of evolutionary ideas in the analysis of economic develop­ ment (1934, pp. 57 -58), we believe that he would have accepted our evolutionary models as an appropriate vehicle for the expl ication of his ideas.

There are, of course, numerous points of varying i mportance on which our perspectives and conclusions differ from those of Schum­ peter. Their number, and the fact that many of them are subtle, make it impractical to attempt a survey here. It does seem appropriate to remark on the extent to which the influence of the Schumpeterian vi ­ sion has been limited over the years for want of adequate develop­ ment (particularly form al theoretical development) of constitutive or complementary ideas. For example, Schumpeter’s credentials as a theorist of bounded rationality could hardly be more incisively es­ tablished than in the following passage from The Theory of Economic Development:

 The assumption that conduct is prompt and rational is in all cases a fi ction . But it proves to be sufficiently near to reality, if things have time to hammer logic into men. Where this has happened, and within the limits in which it has happened, one may rest content with this fi ction and build theories upon it  .  .  .  Outside of these limits our fi ction loses i ts closeness to reality. To cling to it there also, as the traditional theory does, is to hide an essential thing and to ignore a fact which, in contrast with other deviations of our as­ sump tions from reality, is theoretically important and the source of the explanation of phenomena which would not exist without it. (Schumpeter, 1934, p. 80)

Because Simon and others have taught us much about what behavior is like when it is not “prompt and rational,” we are in much better a position to challenge the “traditional theory” from this point of view than was Schumpeter himself. On this issue and others, our position on the shoulders of the giant gives us a somewhat different perspec­ tive. ,

We are not alone in this regard. While the mainstream of eco­ nomic analysis of technical change has repressed the bounded rationality problem, many scholars of technical change have recog­ nized it, if sometimes implicitly. Our formal theoretical view is con­ sonant, we believe, with the writings on technical change of such economic historians as Rosenberg (1969, 1974, 1976) and David (1974), industrial organization economists like Peck (1962) · and Phillips (1971), scholars of contemporary industrial technical change and of public policy issues like Mansfield (1968, 1971, 1977), Pavitt (1971), Freeman (1974) , and Klein (1967, 1977). With few exceptions these scholars have not tried to formalize their implicit theory about what is going on. Gunnar Eliasson’s work (1977) is an exception, as is Carl Futia’s (1980), and our theoretical structure has much in common with theirs in being both formal and explicitly evolu­ tionary.

5. Frank Knight and the Modern Austrians

Schumpeter stressed innovation as deviation from routine behavior, and argued that innovation continually upsets equilibrium. Other scholars also have stressed the importance of breaking from routine , but have placed less emphasis on innovation-at least if that term connotes major novelty. Both Knight (1921) and Hayek (1945) have argued that the economic world is continually throwing up new situ­ ations that constitute opportunities to make a profit if the situation can be comprehended and seized appropriately. Perhaps a freeze destroys the citrus crop in Florida, or a new fad about Pandas develops, or an oil field is discovered under Cape Cod. What profit­ able business opportunities are thereby oper).ed up, or foreclosed? Hayek has stressed that the hard economic problem is to respond appropriately to such changes. Knight argued that a key character­ istic of such changes is that it is impossible to calculate the right thing to do; what is appropriate and what is not will be revealed only by events.

In recent years, Kirzner (1979) has drawn on and developed these ideas, articulating what he has called a (neo-) Austrian approach to analysis of market behavior. He has argued that the focus of theoreti­ cal attention ought to be on market processes, rather than on equilib­ rium conditions. We certainly are in accord. Littlechild and Owen (1980) have explored the neo-Austrian approach m at hematically. We apply evolutionary theory to analyze the effect of autonomous changes in market conditions, as well as change induced by en­ dogenous innovation. Our theory is a theory ‘ about market pro­ cesses .

6. Evolutionary Theorists

The general idea that market competition is analogous to biological competition and that business firms must pass a survival test im­ posed by the market has been part of economic thought for a long time. Systematic development of the idea is, however, much rarer in the literature . For the most part, it has been briefly invoked for broad rhetorical purposes or as an auxiliary defense for the assumption of profit maximization. We briefly survey its use in the latter connec­ tion in Chapter 6.

Among the contributions that have taken the evolutionary point of view more seriously, Alchian’s 1950 article “Uncertainty, Evolu­ tion and Economic Theory” stands out as a direct intellectual ante­ cedent of the present work. In that article, Alchian noted the diffi-cuities in extending standard microeconomic theory to the case of uncertainty, and particularly emphasized the importance of exam­ ining the role of uncertainty from the ex post viewpoint, when some actions are seen to be successful and others mistaken. He proposed that evolutionary mechanisms would tend to bring about responses to changed market conditions on the part of populations of firms that were in accord with the predictions of orthodox theory. And he suggested that such a line of argument might provide a sounder guide and rationale for the use of the standard tools of economic analysis  but did not emphasize that quite different tools might turn out to be appropriate if such a shift of foundations were to occur.

Alchian offered only a few sketchy suggestions for specific models reflecting his approach. Winter (1964) investigated some differential equation models of selection processes as part of a general examina­ tion of the economic natural selection argument. The models served to stress in particular the distinction (and relationship) between a behavioral routine or rule and a particular action: what matters to survival is the actions taken in environments that occur repeatedly, not those taken very infrequently or those that exist only as the po­ tential response a rule would yield to environmental states that never occur. Farrell (1970) explored a simple evolutionary model of specula­ tive behavior with a quite different mathematical tool- the theory of branching processes. Dunn (1971) presented a view of economic and social development similar in many ways to ours. However, he did not develop his analysis formally.

In her 1952 critique of the use of biological analogies in econom­ ics, Penrose raised, among other questions, the problem of whether there exists an economic counterpart of genetic inheritance. To some extent, this problem had been anticipa ted by Alchian (1950, pp. 215-216), who emphasized the “reproduction” via imitation of rules of behavior. Winter (1971) made the connection to the work of the behavioralists, proposing that the observed role of simple decision rules as immediate determinants of behavior, and operation of the satisficing principle in the search process for new rules, provided the required genetic mechanism.

There has recently developed a flurry of intellectual exchange activity across the interdisciplinary frontiers where biology meets economics, other social sciences, and law. Evolutionary theorists in biology have directly borrowed concepts from modern formal eco­ nomic theory (later we shall remark upon some of the awkwardness that is introduced to biological theory by taking the maximization and equilibrium notions too seriously). In turn, a number of econo­ mists have participated in the interdisciplinary literature on socio-biology that has burgeoned since the publication of E. O. Wilson’s book (1975) .9 Hirshleifer (1977a), in particular, has emphasized both the unifying and synthesizing value of sociobiological ideas in the social sciences and the range of specific inSights that sociobiology and economics can draw from each other. The sociobiological litera­ ture, or that part of it which applies evolutionary theory to human social behavior, links analysis of biological selection mechanisms to a long-standing tradition of study of sociocultural evolution. Campbell (1969) provided an excellent survey of that broad field and argued for the merits of a variation and cultural selection-retention theory of so­ ciocultural evolution. Our own work may be viewed as a specialized branch of such a theory, as may the work of economists and lawyers exploring the evolution of the common law and the efforts of organi­ zation theorists who have taken the evolutionary tack.lo Indeed, a great web of intellectual connections links all the work cited in this paragraph (and much more) : the shared ideas relate sometimes to specific substance, often to analytical concepts and formalisms, and always to a common evolutionary philosophy.

7. Classical, Marxian, and Neoclassical Antecedents

Although our theoretical views are clearly at odds with much of present orthodoxy, they are quite consonant with the tradition of mi­ croeconomic theorizing as it existed from the time of Adam Smith up until around World War II. What today’s orthodoxy represents is, above all, a particular (and not inevitable) refinement and elabora­ tion of the core ideas from that broader tradition relating to market functioning and self-interested behavior. The price paid for the refinement has been a considerable narrowing of focus and a tend­ ency to segregate from the main corpus of theory the questions and phenomena for which the refined theory is ill- suited.

The title of Book I of The Wealth of Nations is “Of the causes of improvement in the productive powers of labor and of the order ac­ cording to which its produce is naturally distributed among the dif­ ferent ranks of the people./I The book commences with a discussion of what today would be called the sources and consequences of tech­ nical advance. John Stuart Mill, like Smith, provides a rich historical discussion of the evolution of both productive techniques and eco-nomic institutions to set the context for the narrower economic anal­ ysis, and his economic theory is to a considerable extent dynamic, not static.

Much of Marxian economic theory is evolutionary. Many of the re­cent attempts to formalize Marx, both by economists sympathetic to Marx and by those of more orthodox leanings, have, we think, been tightly bound by the analytical tools of contemporary orthodoxy . As a result, they have failed to do justice to his ideas about the laws of economic change. Some of our own ideas are quite compatible with those of Marx, in that we stress both that capitalist organization of production defines a dynamic evolutionary system and that the dis­ tribution of firm sizes and profits also must be understood in terms of an evolutionary system. However, while in some of our models the share of labor and capital is endogenous, we have not followed Marx and his contemporary sympathizers to the extent of focusing our analysis on the determinants of the profits-wages split. Nor does the play of political power have much of a role in the formal evolu­ tionary models developed in this book, although in our discussion of normative economics from an evolutionary viewpoint, we do present some ini ti al outlines of an endogenous theory of the evolution of government policies. Where a Marxian would most likely fault our discussion is in our failure to employ the ideas of contradictions and of class in our positive evolutionary modeling and our normative analysis.  We have not found these concepts particularly useful.

Marshall is now generally regarded as a precursor or source of today’s formal neoclassical economics. So he was, in the sense that he introduced to economics a portion of its present technical appa­ ratus and stressed in particular that market analysis must consider both the supply and the demand side. But it is explicit in th e Princi­ ples that his real interest was in economic dynami cs:

The Mecca of economics lies in economic biology rather than economic me­ chanics . But biological conceptions are more complex than those in me­ chanics; a volume on foundations must therefore give a relatively large place to mechanical analogies; and frequent use is made of the term equilibrium, which suggests something of a statical analogy. This fact, combined with the predominant attention paid in the present volume to the normal conditions of life in the modern ageI has suggested the notion that its central idea is “statical” rather than “dynamicaL ” In fact it is concerned throughout with the forces that cause m ovement; and its key note is that of dynamics rather than statics. (Marshall, 1948, p. xiv)

Also, it is widely recognized that Marshall’ s writings reveal a some­ what agonized effort to balance the demands of rigorous theorizing with  those  of  descriptive  accuracy  in  the  analysis  of  an  evolving system (see Koopmans [1957], and Samuelson [1967]). A striking ex­ ample of the effect of these tensions is Marshall’s imperfectly drawn distinction between statical increasing returns to scale and what we would today call induced scale- augmenting technical change. Con­ temporary commentary on this tends to rebuke Marshall for his af­ front to the logic of purely static analysis; the fact that he quite cor­ rectly emphasized the role of (informational) increasing returns as an economic mechanism of irreversible change receives less attention. On this question and many others, our evolutionary theory is closer to the original Marshallian doctrine than is contemporary orthodoxy. Similarly, although Pigou (1957; parts first published as Wealth and We lfa re, 1912) is widely regarded as the source of contemporary welfare economics, he followed his teacher Marshall in attempting to analyze an economic world in continuing flux. Indeed, for Pigou eco­ nomic change and the slowness of economic institutions in respond­ ing effectively to change were prime reasons for the problems re­ counted in his Economics of Welfare. This is the position we ourselves shall adopt in our treatment of the normative issues illunlinated by an evolutionary theory.

Thus, while we break with contemporary orthodoxy on a number of issues that have concerned other critics before us, it is also true that our theory is compatible with, or even a natural extension oC a line of economic thought that goes back through Marshall to the classics. This appraisal raises two related questions. First why did economic theory take the “wrong road”? Second, why have contem­ porary critics of orthodoxy had so Iittle success in getting the error corrected? These and some wider questions about the intellectual forces operating in the development of the discipline are examined in the following section.

Source: Nelson Richard R., Winter Sidney G. (1985), An Evolutionary Theory of Economic Change, Belknap Press: An Imprint of Harvard University Press.

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