Static Selection Equilibrium: Complications and snags

The simple formal model we have presented and analyzed above hardly does justice to the sweep of intuition that has led some econo­ mists to propose that selection forces provide support for the as­ sumptions and conclusions of orthodox theory. In this sense, the model is almost a parody of those intuitive arguments. We would be the first to insist that there is more to the evolutionary perspecti ve than this model captures. On the o ther hand, the exercise does h ave the virtue of provoking an explicit confrontation with the question of what sorts of assumptions actually suffice to generate strictly ortho­ dox conclusions. Obviously, our basic model above is only one member of a very large class of economic evolutionary models having the property that a selection equilibrium exists and having basically the properties of an orthodox competitive equilibrium. We maintain, however, that all members of this class would have to contain as­ sumptions that bear a family resembl ance to those incorporated in the particular model just examined.6 Here we treat the assumptions of that sim ple formal model as a point of departure and standard of comparison in a less formal discussion of the issue of evolutionary support for orthodoxy.

1. Search and the Set of Feasible Routines

The model contains very s trong assumptions about the set of feasible routines and the effectiveness and persistence with which finns search that set. These assumptions are clearly at odds with our analy­ sis in the previous chapters. We argued strenuously that there is no set of blueprints that completely describes available production tech­ nologies. In the first place, much of the knowledge of a particular technique is not published information, and firms often exert con­ siderable effort to keep knowledge of their production techniques private. Second, aside from efforts to preserve privacy or legally to block access to a technique through such devices as patents, there is the issue that much production technology is tacit, not explicit, and not that easy to imitate even with the cooperation of the firm that possesses the technique in question. In many industries, further� more, the set of production techniques is not fully known at anytime ; exploration is continually finding new regions that have not been described or much thought about before. In a sense, no “best” is ever fo und by anybody . We have argued that explicit recognition of this is an essential characteristic of models examining contexts and industries in which technical advance is important.

Regarding the search for a capacity utilization rule, the assump­ tion that the “best” could soon be found by intelligent searchers may seem more acceptable. Surely it does not require great insight to rec­ ognize that if price is a parameter, it is profitable to produce when­ ever variable cost is covered. This assessment ignores, however, the realistic complications of the problem. Decisions on production for the market must ordinarily be based on past price data that provide an imperfect guide to the price at which the output will actually be sold. The problem of predicting the market price is thus intertwined with the problem of deciding what to do on the basis of any given prediction; this should be reason enough to warn economists against assuming that the problem is trivial and already conclusively solved. More broadly, it is important to avoid the fallacious supposition that, because a decision problem is simple in the context of an economic model (by virtue of the modeler’s own choices), it is permissible to argue as if it were simple in the real situation modeled. For example, the model may abstract from small and variable amounts of market power possessed by firms in the real situation-amounts trivial enough to neglect for some analytical purposes, but not so trivial as to make the choice of an output level entirely straightforward.

The simple model follows orthodoxy in abstracting from the costs of search, whether for techniques or capacity utilization rules. To rec­ ognize that positive search costs of some magnitude are always a feature of real situations is to recognize the shakiness of the model’s assumption regarding persistent search by potential entrants . Who is paying the bill for all this search?

There is no problem in developing evolutionary models that re­ flect in various ways these features of search that are neglected or distorted by the simple model . Some of the possibilities are illus­ trated by models appearing later in this volume. The only problem is one faced by those who would invoke selection arguments in sup­ port of orthodoxy: the plausible models thus constructed do not, in generat support orthodox conclusions. For example, it is possible to specify a model incorporating costly, groping search that will achieve a “pseudo-orthodox” equilibrium in which all surviving routines are optimal relative to the set of alternatives displayed along the evolu­ tionary path. But any disruption of that equilibrium will reinitiate search, and, in general, the search will uncover new routines supe­ rior to those in the previous equilibrium. For both positive and nor-mative analytical purposes, therefore, the “optimality” of routines in the pseudo-orthodox equilibrium is only pseudo- optimali ty.

2. Investment

Regarding investment, the model contains both some rather tech­ nical assumptions and some that are typical of evolutionary models generally. In the former category are those that are needed to support the particular argument used to prove that static selection equilib­ rium is achieved, such as the assumption th at firm s that are ex­ panding or contracting can do so, with positive probability, by a single machine, and the assumption that firms making zero profit maintain their capacity with probability one. Closely related, of course, is the technical assumption that asserts the existence of an inte gral industry capacity level at which eligible firms precisely break even.

As we have already suggested, the model’s focus on the precise achievement of static equilibrium involves an element of artificiality, and the technical assumptions reflect that artificiality. Absent a via­ ble orthodox analysis of disequilibrium, it would be more to the point to ask whether selection mechanisms tend to move the in­ dustry rather promptly to the neighborhood of orthodox equilibrium and hold it there with reasonable consistency. For an affirmative answer to that question to be possible, it certainly is not necessary that a break-even firm never change capacity, or that break-even con­ ditions be precisely achievable. On the other hand, that question cannot be addressed without first focusing on a number of essen­ tially quantitative questions about investment, search, the elasticity of demand, an d, indeed, everything bearing on the quantitative sta­ bility characteristics of the selection mechanism. Then it would be necessary to establish an appropriate metric for “closeness” to equi­ librium, which for substantive relevance should presumably involve the rate at which economic surplus is generated. Finally, the terms “promptlyll and ilwith reasonable consistency” would have to be given precise and objective meanings. Although this may define a feasible approach for a simulation study, it hardly seems to be the sort of thing that can be accomplished by analytic methods or with any great generality. In spite of the artificiality, the static equilibrium approach seems more fruitful, at least as a starting point.

The more general qualitative features of the investment assump­ tions seem reasonable, and we will make identical or highly similar assumptions repeatedly. But they nevertheless warrant some critical scrutiny. The model assumes that firms that lose money tend to de-cline.  While  this  seems  plausible,  it  ignores  the  possibility  (re-marked on but not explored  by Friedman) that  such  firms might be sustained by resources ‘Ifrom the outside.  Temporarily, at least, an individual firm may be sustained by funds supplied by stockholders or creditors rather than by customers. Contexts in which entry is (or appears to be) easy may be ones in which these sources of support are of continuing importance to industry functioning. In other con­ texts, the existence of economies of scale or of tendencies for effi­ ciency to be improved through learning provide affirmative reasons for a firm in current difficulty to seek its salvation through growth, as well as arguments with which to support appeals to investors for ad­ ditional funds.

There are similarly a number of circumstances in which the as­ s umption that firms making positive profits tend to expand might not be warranted. In many industries, successful small proprietors seem to be quite content with being small; consider chef- owned French restaurants, for example. And, contrary to the model’s as­ sumption that all firms are price takers, large firms may consciously constrain their growth of capacity in recognition of the e ffect of this growth on price. If profitable firms do expand, there is the question of whether they behave like simple multiples of their former selves, as the model assumes they do. Larger size confers opportunities for economies and the threat of diseconomies- but to the extent that either of t hese is significant in reality, the s imple evolutionary story about growth in the relative importance of the more profitable rou­ tines req uires qualification.

3. Endogenous Profitability Rankings and Transient Environments

The above discussion of complications relating to the assumptions about search and investment has been quite general . Although we have not seen much discussion of the particular issues that we raise, we have reason to believe that many economists are at least roughly familiar with  them.  There  are,  however,  two  less  obvious snags for evolutionary arguments that aim to provide a prop for ortho­ doxy, and to which we wish to draw particular attention. These are, first, that the relative profitability ranking of decision rules may not be invariant with respect to market conditions. And, second, that profitable survival in equilibrium may require that a firm first sur­ vive an extended episode of unprofitabili ty.

In the model examined above, there was an unambiguous best production technique, more profitable than any other technique for any capacity utilization rule employed, and for any market price. Moreover, the complete ranking of techniques, not merely the iden-tity of the best, was insensitive to market conditions and to the iden­ tity of the capacity utilization rule employed. Similarly, one could easily identify a best (profit-maximizing) capacity utilization rule: produce zero output if price is less than variable costs, and produce at full capacity output if price equals or exceeds the variable costs. However, the situation was more complicated regarding the ranking of capacity utilization rules. As noted earlier, in equilibrium there was a whole class of capacity utilization rules that did as well as the orthodox best one. And out of equilibrium, the ranking of various capacity utilization rules, other than the o rthodox best, was not in­ variant with respect to the technique being employed by the firm or to product price. Thus, if growth is assumed to be related to profita­ bility, it is not true in this model that eligible firms necessarily grow relative to noneligible firms in disequilibrium states.

More generally, sensitivity of the profitability ranking of routines to market conditions may stymie the selection process in an evolu­ tionary modeC and very likely in the dynamic processes of the real economic world as well. The problem is particularly serious when the routines that would be viable in equilibrium are dominated by other decision rules out of equilibrium. If the system is not initially in equilibrium, the selection forces operating in disequilibrium states may prevent it from ever reaching equilibrium.

For example, it is possible that, at equilibrium prices, techniques that employ little labor and a considerable amount of semiprocessed materials may entail lower costs than a more labor-intensive tech­ nique. However, at low levels of industry output, labor may be cheaper relative to semiprocessed inputs. If firms start out small and take time to grow, firms initially employing processed material­ intensive techniques may be out-competed in the early stages of the industry’s evolution by labor- intensive firms, and driven out of busi­ ness. This story presumes an upward-sloping labor supply curve and a flat or downward-sloping processed materi al supply curve to the industry. But a comparable phenomenon m ay obtain if returns to scale are not constant, and techniques that are efficient at relatively low levels of output are very different from those that are efficient at high levels of output. If firms are small in the early stages of industry growth, those that start with techniques that are efficient only after the firm has grown considerably may be defeated in the evolutionary struggle by firms whose techniques are better suited to low levels of output-unless, of course, they can persuade potential lenders of their long-run strength. Clearly, adequate evolutionary models of cases in which the best techniques are sensitive to industry and firm size must include careful modeling of capital markets as an important component of the analysis.

Even if the initially disadvantaged fi rms do not survive, as the in­ dustry grows larger and the surviving firms grow al ong with it, firms that have techniques suitable to low industry and firm size may search and find techn iques more appropriate to the new conditions. But to assume such “rediscovery” of techniques that would be op­ timal in equilibrium is to make a strong commitment about search processes.

There is also the problem that certain episodes of an industry’s evolution may be characterized by negative profits for virtually all firms. For example, assume that there is a once-and-for-all drop in the demand for a product, or an increase in factor prices. Even if the profit ranking of routines were invariant with respect to prices, the firm s that would have survived in equilibrium may drop out of busi­ ness before equilibrium is achieved. For example, they might be small firms with limited access to credit. Here again, assumptions about investment and capital markets, or assumptions about search, can salvage the selection argument (and the “best” routines) . But this only underlines the critical nature of these assumptions.

There are two analytically distinct problems here. The first is that the routines of extant firms determine, to some degree at least, the environment that selects on routines. The second is that in order to play a role in an actual equilibrium, a routine must be consistent with survival in a previous disequilibrium. In the biological litera­ ture on evolution, the first problem was for a long while imperfectly recognized . The second has been recognized by biologists, but we do not think it has been adequately recognized in economic evolu­ tionary arguments .

It is interesting that the first diffi culty appears to have been ne­ glected until relatively recently in the biological literature on evolu­ tion.8 The problem stated for the two contexts in parallel, is this: the comparative fitness of genotypes (profitability of routines) deter­ mines which genotypes (routines) will tend to become predominant over time. However, the fitness (profitability) clearly depends on the characteristics of the environment (market prices) confronting the species (collec tion of firms with similar routines). The environment (price vector) in turn depends, however, on the genotypes (routines) of all the individual organisms (firms) existing at a time -a depen­ dency discussed in the subdiscipline called ecology (market theory), Therefore, no theory of long-run evolutionary change logically can take the environment of the individual species (collection of firms) as exogenous. Hence, the notion of fitness (profitability) contributes much less to the understanding of the long-run pattern of change than might at first glance appear. What does play a crucial though obscure role is the character of the whole evolving system’s interac­ tions with the truly exogenous features of the environment, repre­ sented in the current model by product demand and factor supply curves, and in the context of biology by consi derations that have not, to our knowledge, been specified in biological theory. A theory that omits to explain how significant properties of that interaction affect the changing requirements for fitness (profitability) over time cannot be regarded as an adequate explanation of the evolution of the system.

That organisms often face an environment in which there is some variation, including some occasions in which the environment is un­ usually harsh, has been recognized in the biological literature on biological evolution . Two different “strategies” for a species in coping with a varied environment and occasional hardship have been analyzed .

According to the first strategy, the behavior patterns (presumably built in by the genes) of the organism are quite flexible so that the organism can, for example, shift from one source of fo od to another, survive in dry seasons and in wet, and so forth. In a fluctuating envi­ ronment, a flexible organism may survive where organisms better suited to the modal environment will not. In terms of the model under consideration here, a better “policy” regarding capacity utili­ zation can help a firm with a poor technique survive when prices are low (by shutting down to minimize losses), whereas a firm with a better technique but an inflexible decision rule (always produce at capacity output) might fail under adverse market conditions.

The second strategy is to have a high mutation rate. Existing geno­ types of such species may be able to survive only in a limited range of conditions, but if their offspring are variegated there is a high likelihood that some of the next generation will be capable of coping with environments that would kill their parents. In the context of the model under consideration here, prevailing decision rules can be quite inflexible in themselves, yet the industry may respond quite flexibly to changed market conditions if there is a lot of search either by extant firms or by potential entrants.

These strategies are ones that are favored by a changing environ­ ment. The characteristics of such strategies -flexibility, and con­ siderable continuing exploration of alternatives to prevailing routines- are not virtues of the type considered in most economic analyses employing the selection metaphor.

We argued earlier that most interesting problems of economic analyses have to do with change-change either in external market conditions or resulting from innovation within the industry itself. If the analytic task is to deal with change, then analysis of static selec­ tion eq uilibrium of the sort considered in this chapter is not a direc­ tion that one can fruitfully pursue very far. Evolutionary economic theorizing must deal explicitly with dynamics, and not get drawn into spending undue time considering selection equilibrium as a counterpart to more orthodox economic equilibrium concepts. This is certainly so when the focus is on processes of long-range economic growth or on Schumpeterian competi tion. But it is also true when the analytic focus is on the canonical positive problem of the price theory textbooks-the problem of the response of firms and the industry to changed market conditions. To this analysis we now turn.

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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