The awkward treatment of economic change by orthodox theory

Much of economic analysis is concerned wi th predicting, explaining, evaluating, or prescribing change . Presumably, then, the adequacy of a theory of firm and industry behavior should be assessed in good part in terms of the light it sheds on such phenomena as the response of firms and the industry as a whole to exogenous change in market conditions, or how it illuminates the sources and consequences of in­ novation. We are not the first to point out that orthodox theory tends to deal in an ad hoc way with the first problem, and ignores or deals mechanically with the second .

The theory of firm and industry behavior put forth in contem­ porary textbooks and certain advanced treatises certainly appears to address the first problem directly; indeed, this is what positive theory seems to be mostly about. Formal orthodox theory purports to explain the determination of equilibrium prices, inputs, and outputs under various underlying product demand and factor supply condi­ tions. In the context of partial equilibrium industry analysis, for ex­ ample, the heart of the theoretical exercise involves the derivation of output supply functions (firm and industry output as a function of factor and product prices), functions relating input proportions of firms to relative factor p rices (presuming movements along iso­ quants), and so on. But, despite appearances to the contrary, the theory does not directly address the question: What happens if the demand for the product of the industry increases, or if the price of a particular factor of production rises? That is, it does not address the question unless one assumes both that behavioral adjustments are instantaneous and that these changes in market conditions and the resulting equilibrium prices are perfectly forecast in advance by everybody. More realistically, firms must be understood as making time-consuming responses to changed market conditions they had not anticipated on the basis of incomplete information as to how the market will settle down.

On this plausible interpretation, firm behavior in the immediate aftermath of a change in market conditions cannot be understood as “maximizing,” in the simple sense of that term embraced by the theory in question, and the industry must be understood as being out of equilibrium at least for a time after the shock. Absent the perfect- foresight assumption or something very close, one must admit that changes in market conditions may come as a surprise to at least some firms in the industry . Once the unanticipated change comes, firms’ prevailing policies, keyed to incorrect expectations, are not profit maximizing in the actual regime. Explicit models that rec­ ognize the problem tend to incorporate the assumption that, faced with a shock that makes old policies suboptimal, firms adapt to the changed conditions by changing their policies in an appropriate direction.2 Seldom do these models assume that the changes are made instantly or once and for all . Positing adaptive (rather than maximizing) responses to unforeseen shocks is partially an implicit or explicit concession to the existence of some adjustment costs or “friction” in economic adj ustment; friction, however, is a phenome­ non that is not generally considered in the textbook accounts of opti­ mizing behavior.

Some recent papers have recognized explicitly the adjustment cost/friction phenomenon, and have attempted to deal with it by treating the time path of response to an unforeseen shock as optimal, given adjustment costS.3 But such an approach founders if it is ad­ mitted that the response of firms in the industry to the initial set of disequilibrium prices will likely change those prices in ways that cannot be foreseen in advance, unless one goes back to the initial perfect-forecasting assumption. Indeed, it is a rather delicate and complicated theoretical matter even to define an optimum adj us t­ ment strategy in a context where there are many firms, unless some very stringent assumptions are made.

Thus, contrary to the apparent i mpressions of many economists, the operative theory (if one can call it that) of firm and industry response to changed market conditions is not derivable from the textbook formalism about profit maximizing and equilibrium con­ stellations. Rather, the theory actually applied in the interpretation of real economic events is one that posits adaptive change (specified in any of several plausible ways) and typically involves two key pre-sumptions. One of these is that the direction of adaptive response is the same as the direction of the change in profit maximization con­ stellations. The second is that the adaptive processes ultimately con­ verge to the new equilibrium constellation.

At best this theory is an ad hoc mix of maximizing and adaptive models of behavior, and is not at all consistent with orthodoxy’s rhe­ torical emphasis on the unique validity of the maximizing approach. At worst, there are some serious analytic stumbling points along the road. If decisions are taken at discrete time intervals, adaptive ad­ j ustment  in lithe  right  direction”  may  overshoot  the  goal-the well-known cobweb problem. Even in the absence of discreteness, differences in the presumed nature of adaptive response (for ex­ ample, whether output increases or price increases in response to excess demand) can affect the stability conditions. Adaptive models may or may not generate time paths that converge to equilibrium. And whether they do or do not in a particular case, if the adaptive behavior model is accepted as characterizing how firms respond to unanticipated events, it should be recognized that its account of the process is not the formal model expounded in most textbooks and treatises. Verbal descriptions of adjustment, especially in elementary texts, do carry an adaptive flavor. This sort of discrepancy is not un­ common in theoretical discussion.

In general equilibrium theory, the same basic problem appears in another form. The obj ectives of the analysis are, of course, less prag­ matic and applied, and more concerned with the functioning of highly idealized systems. F. H. Hahn (1970) , in his presidential address to the Econometric Society, surveyed the accomplishments of the mathematical theory of general equilibrium, and called atten­ tion to the fact that economists had made little progress in modeling plausible processes of disequilibrium adj ustment that converge to general competitive equilibrium. He noted that the institutional as­ sumptions on which most of the extant stability theorems depend (Walrasian tatonnement) are plainly artificial, while models slightly closer to reality fail to yield the desired result in realistic cases. He concluded that, absent understanding of dynamic adj ustment pro­ cesses out of equilibrium, lithe study of equilibrium alone is of no help in positive economics. Yet it is no exaggeration to say that the technically best work in the last twenty years has been precisely that. It is good to have it, but perhaps the time has now come to see whether it can serve in an analysis of how economies behave. The most intellectually exciting question on our subject remains: Is it true that the pursuit of private interests produces not chaos but co­ herence, and if so, how is it done?” (Hahn, 1970, pp. 11- 12) .

In spite of Hahn’s suggestion that lithe time has now come,” the years that have passed since he wrote have yielded no significant progress on the problems he identified. The reason is simply that thoroughgoing commitment to maximization and equilibrium analy­ sis puts fundamental obstacles in the way of any realistic modeling of economic adjustment. Either the co mmitment to maximization is qualified in the attempt to explain how equilibrium arises from dis­ equilibrium, or else the theoretical possibility of disequilibrium behavior is dispatched by some extreme affront to realism. Applied work has tended to take the former path, and more abstract theoreti­ cal work the latter.

Much the same strains have distorted orthodox attempts to ana­ lyze innovation and technical change. To begin with, it is note­ worthy that such analyses constitute a specialized literature, ignored not only in most of the theory textbooks, but also in the rest of the re­ search literature. This segregation certainly does not reflect any cor­ responding isolation of technical change and innovation from other phenomena of economic reality. Rather, it is implicit testimony that the orthodox theoretical engines operate more smoothly in (hypo­ thetical) environments from which these change phenomena are ab­ sent. The task of coping with the complications they introduce has been faced up to only when the particular characteristics of a specific subject matter have plainly left no other choice open- and some­ times not even then.

Technical advance is now acknowledged by economists to be a central force behind a wide variety of economic phenomena: pro­ ductivity growth, competition among firms in industries like elec:­ tronics and pharmaceuticals, patterns of international trade in manu.., factured goods, and many more. But recognition of its importance in these contexts long predated the attempts to represent its role in formal modeling. Such attempts have often reflected a grudging rec­ ognition that the data would continue to rebuff any theoretical struc­ ture from which technical advance is excluded. And the resulting models have typically grafted variables relating to technical advance onto orthodox theory in ways that aim to preserve as much as pos­ sible of the standard theoretical structure. In our view, these responses have been inadequate.

This intellectual syndrome surely marks the post-World War II theorizing about long-run economic growth. Empirical studies in the 1950s established that the historical growth of gross national product (GNP) per worker in the United States could not be accounted for by increases in complementary inputs per worker: there was a large un­ explained residual . When models appeared that “predicted” the appearance of such a residual as a result of something called iltech­ nical advance,” they preserved most other aspects of orthodox static theory. In particular, they maintained the basic assumptions that the firms in the economy maximize profit faultlessly and that the system as a whole is in (moving) equilibrium.

It is, however, an institutional fact of life that in the Western market economies -the economies that growth theory purports to model-much technical advance results from profit-ori ented invest­ ment on the part of business firms. The profits from successful inno­ vation are dis equilibrium phenomena, at least by the standard of equilibrium proposed in the models in question. They stem largely from the lead over competitors that innovation affords. And it is also a fact of life that the success of innovation is very hard to predict in any detail: different decision makers and firms make different bets even while under the same broad economic influences, and ex post some prove right and others wrong. Given these facts, the retention in growth theory of a static conception of profit maximization tended to hinder understanding of economic growth rather than facilitate it. Paradoxically, it had this effect because it underemphasized and ob­ scured the part that the pursuit of profit plays in the growth process. For the sake of a formal adherence to the orthodox canon, growth theory abstracted from the uncertainty, the transient gains and losses, the uneven, groping character of technical advance, and the diversity of firm characteristics and strategies-that is, from the key features of the capitalist dynamic.

In principle, these features could have been much better accom­ modated in a more sophisticated theory embodying subtler applica­ tions of orthodox theoretical principles. Indeed, the fact that such a theory does not exist today must be attributed largely to the difficulty of constructing it rather than to a failure to appreciate the desirability of doing so. But while the difficulties imposed by the complexity of the subject matter are certainly substantial, it is important to note that orthodox theorists operate under additional severe constraints that are self-imposed. When properly invoked (by orthodox stan­ dards), the notions of maximization and equilibrium that are re­ quired to model uncertaintyI diversity, and change are delicate and intricate intellectual devices. Extremely stringent criteria of consis­ tency must be satisfi ed in models properly built around these notions-so stringent that their effect is to make situations that have been simplified and stylized to the point of absurdity blossom into challenging puzzles. 5 There is no gainsaying the intellectual achieve-ment represented by the solution of such puzzles, but the achieve­ ment would be more interesting if only there were some reason to think that reality actually displays the consistency that the orthodox theorist struggles so valiantly to represent.

It is not surprising that growth theorists generally chose to rely upon simple conceptions of maximization and equilibrium, rather than attempting to carry the weight of the combined difficulties (inevitable and self-imposed) that the phenomena of growth present to orthodox theorizing. What is significant is that there was so little willingness to compromise further, that maximization and equilib­ rium retained the honored place in the theory while the key substan­ tive phenomena were ej ected.

A different response to the same problem has dominated the liter­ ature concerned with the nature of competition in industries marked by high rates of innovation. Schumpeter’s basic contributions have been widely invoked by economists in their verbal accounts of behavior in these industries, but have received only a few attempts at formalization. Economic theorists, working with ideas of profit maximization and equilibrium, have known in their bones that it would be extremely difficult to build a model of Schumpeterian com­ petition out of such components . As a result, until recently at least, economists whose motivation is to describe and explain econonlic phenomena as they see theIn, rather than to test or calibrate a partic­ ular body of theory against data, have had to work with verbal theo­ retical statements for which there is no established formal counter­ part. Sometimes, in obeisance to the canons of acceptable economic argument associated with prevailing formal theory, these economists point to profit-seeking behavior and call it profit maximization, and to tendencies of dynamic competition to wipe out quasi-rents gen­ erated by past innovative success and call this equilibrium. How­ ever, it should be recognized that these conceptions of profit maxi­ mization and equilibrium are a far cry from those of contemporary formal theory, whether at textbook or advanced levels. Moreover, the intellectual coherence and power of thinking about Schumpeterian competition have been quite low, as one would expect in the absence of a well-articulated theoretical structure to guide and connect re­ search.

There have been a number of attempts in recent years to model Schumpeterian competition. Most of these have employed the ortho-dox building blocks of maximization and equilibrium. Several have been quite ingenious. They have managed to call attention to certain phenomena that might obtain in the real world of Schumpeterian competition, and to provide at least pieces of plausible explanation for these. However, invariably they have two limitations. First, the require ment that the model adhere rigorously to the concepts of max­ imization and equilibrium has forced the theorists to greatly simplify and stylize the processes of R&D, industrial structure, the institu­ tional environment, and so forth . Second, the simplifying assump­ tions employed obscure what seems to us to be essential aspects of Schumpeterian competition- the diversity of firm characteristics and experience and the cumulative interaction of that diversi ty with industry structure.

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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