What difference does it make?

What difference does it make if one takes an evolutionary perspec­ tive or an orthodox one on firm and industry response to changed market conditions? By an evolutionary perspective here we mean the broadly define d point of view we discussed earlier in the chapter, rather than the particular model presented above. Just as the case for orthodox theory should not stand or fall on the evaluation of a partic­ ular model (say, one that involves a Cobb-Douglas production func­ tion and a linear demand curve), so our particular model of Section 2 should be regarded as a member of a class of models. It is a compari­ son of the class of evolutionary models with the class of orthodox ones that we want to consider here.

The theory of firm and industry response to changed market con­ditions plays a double role in economic theory. It is at once a theory with its own specific focus and a building block for larger structures. We contend that even if regarded as a special theory aimed at ex­ ploring the effect of changed market conditions on firm behavior, orthodox theory is inadequate. Some of the predictions it yields tend to be qualitatively correct, but a central argument of this chapter is that other broadly defined theories (in particular an evolutionary theory) also can generate the correct qualitative predictions. The quantitative reliability of models drawn from orthodox theory is not high. Since an evolutionary theory contains all the elements of an orthodox theory and more, presumably the econometric equations consistent with an evolutionary approach should predict at least as well as more narrowly based predictive equations.

If one backs off from debating the merits of orthodox versus evolu­ tionary theory in terms of accuracy of prediction, the consonance of the formal version of the theory with the appreciative theory of the phenomenon in question would seem to be an important criterion of merit; after all, the former purp orts to be an abstracted version of the latter. And appreciative theory is very often revealed when econo­ mists do applied research or engage in policy- oriented analysis. Economists doing applied work with the intention of influencing policy choices often find it necessary to stray far beyond the bounda­ ries of orthodox formal theory. They recognize, implicitly or explic­ itly, all of the mechanisms described in our evolutionary accounting for response.

Consider, for example, the argument in favor of letting petroleum or natural gas prices rise to induce substitution or conservation by energy-consuming firms . Few economists really believe, or have stated, that firms have built-in optimizing decision rules that will achieve the most efficient possible substitution. Although a number of utilities (for example) are capable of using different fuels and switch fuels routinely as prices vary, it seems apparent that these built-in decision rules are not expected to account for the bulk of the response of the economy to higher prices. Rather, it is presumed that higher fuel prices will stimulate firms (and consumers) to think more about possibilities for substitution, conservation, or doing without. Discussion of the supply-response aspects of energy pricing is simi­larly eclectic. Many economists, have argued that higher prices will induce greater supply, over both the short and long runs. It is appar­ent that many suppliers do have built-in procedures guaranteeing positive short-run response. However, long-run supply response is explicitly understood to involve search, in a literal sense. The expec­ tation is that higher prices will induce more search for new oil and gas fields, more R&D on ways to get more oil out of the ground, and so forth. It is not, of course, assumed that all oil companies will make the same adaptations, search in the same directions, and succeed or fail together. Rather, some will be smarter, luckier, or have more fa­ vored initial positions than others; they will tend to prosper, to grow, and to be at the focus of the imit ative efforts of others. Clearly, a story about firms responding to changed prices by picking a dif­ ferent point in a given choice set is an inadequate metaphor for all of this activity, and few economists, if any, would rely entirely on that metaphor to structure the analysis.

It is not merely that formal orthodox theory is not helpful in guid­ ing thinking about concrete cases, and that a broader conceptuali­ zation is in fact used. The problem is that because the broader con­ ceptualization tends to be implicit and ad hoc, rather than explicit and systematic, a number of important issues tend to be neglected. As a prominent example, consider concepts like “elasticity of substi­ tution” or “elasticity of supply. ” Contemporary formalism takes these as “technologically determined data” and not variables that themselves can be “explained” by a deeper structural analysis that may also reveal them to be manipulable. An evolutionary theory of firm and industry response would suggest that substitution and supply responsiveness would be a function of the quantity and qual­ ity of “searching” and “innovating” that higher prices draw forth. Some of the key parameters of orthodox theory thus become en­ dogenous in an evolutionary theory.

This and other differences between orthodox and evolutionary ways of theorizing lead to different perspectives on the policy issues involved . Suppose that the policy question is how to induce de­ sirable levels of substitution and supply response. An orthodox ap­ proach would examine the relationship between the price signals re­ ceived by the relevant economic actors and the social obj ectives that ultimately determine the desirability of various responses. The elas­ ticities of supply and substitution would be regarded as tech­ nological data. From an evolutionary point of view, since these vari­ ables are not taken as given, the analyst can begin to think about how they can and perhaps should be manipulated by governmental policies. In particular, the question of the appropriate role of govern­ ment in facilitating or guiding the R&D ende avor might become a topic of inquiry. Questions such as whether certain important R&D projects generate significant externalities, or require support on a scale beyond the resources of the firms in the industry, are naturally called forth . This is not to say that these issues a re easy to think through. But one of the advantages of evolutionary theory is that they are signaled, and both general and specific research would tend to be focused upon them. A serious indictment of the orthodox per­ spective is that in almost all analyses by economists of the energy policy q uestion they are ignored.

Relatedly, R&D receives awkward treatment in some of the more formal energy models, focused on identifying the optimal mix of technologies over time. Many of the “technologies” in the model are recognized as not now operational. Yet these technologies are as­ sumed somehow to become operational at the appropriate or as­ sumed time. The uncertainty about the cost of developing these tech­ nologies and their economic attributes is disregarded. As a result, the possible desirability of developing and exploring multiple alter­ natives is obscured. The heart of the R&D-innovation problem is that reaso nable people will disagree about what technologies w ill be best when. This is a major reason why it makes sense to have R&D largely conducted by competitive business firms who make their own bets, rather than place it under centralized control. But in such a system there is the question of R&D incentives and the R&D portfolio that the incentives will draw forth. The technologies that will get devel­ oped at various times depend on that portfolio . Thinking about the role of government should hinge on assessing th e way in which ac­ tive policies can modify incentives or fill out the R&D endeavor so that the portfolio makes sense from a social point of view, given both the “best bet” characteris tics of the technologies and the uncer­ tainties. Orthodox formalism does not lead applied researchers to build applied models that explore these questions .

The case for orthodox theory is even weaker in view of its inade­ quacies as a basic building block in modeling firm and industry behavior generally. Earlier we noted that the requirement for ab­ straction means that models-little theories – aimed at different phenomena will stress different things. G iven the inevitable diver­ sity of special-purpose models, it is of great value that the different models be recognized as special cases of a broader “master theory. ” The theory of firm and industry response to changed market condi­ tions is viewed by the profession not merely as a special theory but as in some sense the master theory. As such it has been proving structurally adequate. We noted earlier the failure of models within orthodox theory to deal adequately with growth or with Schumpe­ terian competition. One of the great advantages of the evolutionary theory we propose is i ts extendability to explicitly dynamic problems, li ke growth .and dynamic competition. In Parts IV and V we will explore these topics with the aid of models that closely re­ semble the ones used here to study more conventional problems. And the problems that have plagued the extensions of orthodox theory to these arenas will not be present.

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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