Annotations re An Evolutionary Theory of Economic Change

Nelson, R.R. . Winter, S.G . An Evolutionary Theory of Economic Change . The Belknap Press of Harvard University Press . Cambridge, Mass . 1982 . ISBN 0-674-27228-5

Preface: creative intelligence, technological or other, is autonomous and develops erratically. Its future cannot be known. The terms economic change and economic development are presupposed: what is their meaning? Later on: the unfolding of economic events over time.

Backdrop: doubts about disparities in economic development, long-term ecological viability, and the relation between economic success and fundamental human values, and the stresses related to each.

Introduction

First premise: economic change is relevant and interesting. Second premise: existing economic theory must be reconstructed.

Firms are assumed to be profit oriented (searching for ways to improve it), but not profit maximizers over choice sets. Also this theory does not focus on an industry equilibrium where the non-profitable are driven out until the profitable ones are at their desired size. Firms are not modeled using maximization calculus but as sets of capabilities and decision rules. These change over time as a result of deliberate problem solving as well as because of random events. The market, through a economic equivalent of natural selection, ferrets out the worst performers.

The section Introduction summarizes some complaints with regards to the general equilibrium theory in economics, including rational agents, information, competition, transaction costs, increasing returns &c. It is concluded that these critiques are confirmed by many economists, the authors feel they are members of a crowd.

The authors complain that there is an orthodoxy not just concerning the commitment to values and norms of scientific inquiry but also concerning commonalities in intellectual perspective and scientific approach, and even that there is a narrow set of criteria that serves as an acid test to establish if an expressed point of view is worthy of respect. They concede however, that it is temporary and ever-changing. The authors illustrate: ‘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 micro-economics although it is pervasive in the discipline’ [Nelson and Winter p 6].

The orthodox views and approaches have their own self-preserving connotative properties: ‘(concerning standard undergraduate textbooks prefiguring the advanced texts) 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. .. 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‘ [p 7]. And more specifically a drawback of the focus on equilibrium dynamics (and even more when statics DPB) is:’.. , but it is no caricature to remark that that continued reliance on equilibrium analysis, even in its more flexible forms, still leaves the discipline largely blind to phenomena associated with historical change‘ [p 8]. And with regards to the approach to assumed rationality of economic agents in intermediate and advanced textbooks: ‘As theoretical representations of the problems faced by economic actors increase in realistic complexity and recognition of uncertainty regarding values of variables, there is a matching increase in the feats of anticipation and calculation and in the clarity of the stakes imputed to those actors‘ [p8]

Malthus has made the connection between economics and biology, firstly natural selection: ‘Market environments provide a definition of success for business firms, and that definition is closely related to their ability to survive and to 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 analysis 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‘ [p 9]. This hints at a kind of cultural evolution: all kinds of traits of firms are evolved, including those enabling it to make profits &c.

With regards to the teleological trap: ‘It is neither difficult nor implausible to develop models of firm behavior that interweave ‘blind’ and ‘deliberate’ processes. Indeed, in human problem solving itself, both elements are involved and difficult to disentangle‘ [p 11].

Evolutionary Models

The Structure of Orthodox Models

Common denominators of ‘orthodox theory’ are A) a maximization model: 1) something gets maximized 2) there is a set of things that the firm knows how to do 3) the firm’s action is the result of an actionable choice (given constraints and conditions). It attempts to explain the rules of the firm in this way. B) Equilibrium calculus leads to explanations of the choices hence behavior of firms in specific circumstances. The equilibrium provides another equation to the set in order to determine the value of some variable. The suspicion is that this approach is not aimed at the explanation of economic principles and dynamics but at the wish for results from the calculus. The choice and use of mathematical tools have influenced the thinking about economics.

The Structure of Evolutionary Models

‘And we see ‘decision rules’ as very close conceptual relatives of ‘production techniques’, whereas orthodoxy sees these things as very different. Our general terms for all regular and predictable behavioral patterns is ‘routine’. .. In our evolutionary theory, these routines play the role that genes play in biological evolutionary theory‘ [p 14]. Some important features are: persistency, determining the behavior of the firm, heritable, and selectable. I agree with this statement because it is very similar to the Rodin Testament, roughly: once an idea exists, it can be considered done. An idea can be anything. Not everything in business can be described with routines as many things are not routinely. This is accommodated by the idea that some decision rules as well as their outcomes are characterized by stochastic rules. I am not so happy with that expression, because I am always hoping for an explicit model without the use of probabilities. The authors explain that stochastic terms are required to cover for what is not predictable; had they been predictable then they would have been an element of the set of routines.

‘Although the routines that govern behavior at any particular time are, at that time, given data, the characteristics of prevailing routines may be understood by reference to the evolutionary process that has molded them. For the purposes of analyzing that process, we find it convenient to distinguish among three classes of routines‘ [p 16]: 1) activities that cannot be changed at a short notice because of its stock of capital 2) period-by-period augmentation or diminution of the firm’s capital stock 3) firms possess routines which operate to modify aspects of their operating characteristics. Why do we need this classification into three kinds of routines?

‘These routine-guided, routine-changing processes are modeled as ‘searches’ in the following sense. There will be a a characterization of a population of routine modifications or new routines that can be found by search‘ [p 18]. This is the thought that a population of ideas pre-exists; once they are searched and uttered then they can be actioned. How they search is described as: ‘A firm’s search policy will be characterized as determining the possibility the probability distribution of what will be found through search, as a function of a number of variables – for example, a firm’s R&D spending, which in turn may be a function of its size. Firms will be regarded as having certain criteria by which to evaluate proposed changes in routines: in virtually all our models the criterion will be anticipated profit. .. Our concept of search obviously is the counterpart of that of mutation in biological evolutionary theory‘ [p 18]. This requires the assumption that people are capable of anticipating a profit; that they are capable of interpreting the effects of their anticipations on their actions. It is also left implicit why people do that fundamentally: they look for alternative routines to make more profit but why would they essentially do that?

The models in this book are of industries: situations where similar firms interact in a market context characterized by demand and supply curves. To keep clear of short term dynamics (single price on a market in a single period) a temporary equilibrium is assumed. No long-run equilibrium is assumed. The firms have a current operating characteristic, and exist in exogenously determined demand and supply conditions. This configuration determines the profitability. Profitability operates through firm investment rules as a determinant of expansion and contraction off the size of the firm. Through search and selection do firm evolve over time, every state the basis of the next. Operating characteristics of the firm change because of the searches of thát firm. But this is a stochastic process: at every state (not one but) a distribution of possible next states is generated. This method is easily translated to Markov chains. However, the processes in Markov chains are not very by themselves close to economic models.

The Need for an Evolutionary Theory

1 The awkward treatment of economic change by orthodox theory

Economic analysis deals with change. Its adequacy should be measured against its ability to shed light on change in a firm or an industry as a result of exogenous change and its adequacy to clarify innovation. It does not or in an ad-hoc way. Firm and industry behavior after an external shock is not derivable from profit maximizing and equilibrium formalisms of orthodox theory. ‘The most intellectually exciting question on our subject remains. Is it true that the pursuit of private interests produces not chaos but coherence and if so, how is it done?‘ [ Hahn 1970, pp. 11-12 on p 26].

Little progress was made (at he time) to theorize economic change because of the impediments of maximization and equilibrium. Note that those are two obstacles posed here, but others are: perfect markets and rational agents. And the same goes for innovation. In other words: orthodoxy operates better when change is absent. There has not been recognition of the central role and the autonomous character of technological development.

In the last half of the 20th century the central thought was that firms are profit maximizers and the economy (industries) are in a (moving) equilibrium. Technical advance comes from profit oriented investment of firms. By the standard of thee orthodox models profit is now a disequilibrium phenomena, because profits stem from an advantage a firm has over the competition afforded by innovation. In addition innovation is hard to predict: different competitors make different bets and only ex-post is it clear who was wrong and who was right. Profit maximization and static equilibrium does not explain economic growth. This originates in the adherence to orthodox tradition: it had to turn to abstractions and move away from key features of capitalist dynamic such as uncertainty, transience of gains and losses and unpredictabilities of technological advance.

In this vein it is extremely difficult to develop a model for Schumpeterian competition out of the components of maximization and equilibrium. This development risks getting stuck in verbal theorizing instead of formalization. This gap between orthodoxy and Schumpeterian insights had (at the time) not been bridged: business processes of change and innovation were to be over-simplified and the diversity of firm characteristics and hence of their interactions with the industry were obscured.

Diagnosis an Prescription

Main differences and agreements with orthodoxy:

1) Agreement: agents (esp. firms) have objectives, usually profit; profit is the main criterion for their choices. Difference: the choice is perfect and absolute and long term versus the choice is imperfect and as per the status quo at the time. ‘… Carrying out a new plan and acting according to a customary one are things as different as making a road and walking along it‘[ Schumpeter 1934 pp. 79, 85 in p. 31-2]. Change present problems that automaton maximizers are ill-equipped to solve and theories incorporating automaton maximizers are ill-equipped to analyze [paraphrased p 32].

2) Agreement: competition drives decision making in firms in their industries and so it is worthwhile to look for a state where the forces of competition would be in equilibrium and would no longer produce change. Difference: orthodoxy goes much further to introduce equilibrium at an early stage and narrowing down the possible states of the firm: ‘Such models do not explicate the competitive struggle itself, but only the structure of relations among the efficient survivors. .. This theoretical neglect of competitive process constitutes a sort of logical incompleteness, … It is only in equilibrium that the model of optimizing behavior by many individual actors really works. Disequilibrium behavior is not fully specified (unless it is by ad-hoc assumptions. But this means that there is no well-defined dynamic process of which the ‘equilibrium’ is a stationary point: consistency relations, and not zero rates of change, define equilibrium ‘ [p 32]. This is an important sub-conclusion: the design of the theory and the models are static in nature. Static situations are the norm, equilibrium is not a special case (zero change) of a system usually in disequilibrium, but it is the norm and disequilibrium can only be treated as a special case. The models do not explain how equilibrium comes about from disequilibrium, because they can only describe equilibrium situations as per their structure. 3) In conclusion the formalizations based on orthodoxy cannot deliver: ‘Increasingly, orthodoxy builds a rococo palace logical palace on loose empirical sand‘ [p 33].

Allies and Antecedents of Evolutionary Theory

Managerialist thinking diagnosis the problem of orthodox theory as a failure to represent correctly the motives that directly operate on business decisions. These insights are useful for insights into managerial behavior and performance, but they do not explain the problems with orthodoxy as described earlier above.

Behavioralists (Herbert Simon) adress some or all of these issues: bounded rationality because people cannot have complete information and they do not have computational power in some situation to maximize over all possible alternative utilities. Calculations are therefore global and situational, maximization is not absolute. Firms satisfice: their objectives function is limited because they don’t have the complete overview of their utility trade-offs and because they they are coalitions of decision makers associated with the firm. Disagreement with the behavioralists in the search of the authors for an explicit model of industries, instead of the behavior of individual firms. Evolutionary models are simpler but explain the industry compared to behavoralist’s.

Analysts of Firm Organization and Strategy

‘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‘ [p 37]. Assuming that organization is self-organization in an autopoietic sense then it is autonomous. Firm capabilities and strategy must logically flow from it. Strategy must logically be a narrative after the fact explaining the way that the business is conducted.

In the evolutionary models higher order decision rules can serve as strategies. Change in strategy or policy can be treated in the same way as change in technique. Connections exist between the firm’s strategy and its appropriate (or is it the other way around: the appropriate strategy to go with the organizational structure?) organizational structure and between the technique it commands and its organizational structure.

Views of the Activist Firm

‘.. to view large firms and relatively concentrated market structures as the typical cases in the ‘interesting’ part of the economy, if not in the economy as a whole. These perspectives converge in an assessment of the larger corporation as a critical feature of the institutional dynamics of modern capitalism, as a relatively autonomous chooser of society’s means and some extent of its effective ends, and as the stimulus for the development of new social institutions for its control and accommodation‘ [p 39]

Schumpeter

This theory is evolutionary in order to be able to be Schumpeterian.

Frank Knight and the Modern Austrians

‘Schumpeter stressed innovation as a deviation from routine behavior, and argued that innovation continually upsets equilibrium‘ [p 41]. Reality brings new opportunity to bear all the time and the economic problem is how to respond to it and make a profit. It is however, impossible to calculate the effects and only afterwards will become clear what was the right thing to do. This theory is a theory about market processes.

Evolutionary Theorists

The article of Alchian Uncertainty, Evolution and Economic Theory of 1950 is an antecedent of this theory: ‘.. this problem had been anticipated by Alchian who emphasized the ‘reproduction by imitating of rules of behavior‘ [ Alchian 1950 pp. 215-6 in p. 42]. Socio-biology is involved via E.O. Wilson 1975. Campbell 1969 argued for a focus on variation and cultural selection retention theory for sociocultural evolution. ‘Our own work may be viewed as a specialized branch of such as theory .. ‘ [p 43].

Classical, Marxian and Neoclassical Antecedents

This theory is consonant with the original ideas of the classical theory as per Smith and John Stuart Mill. Much of the economic theories of Marx are evolutionary and also in other aspects compatible with this theory: capitalist organization of production defines a dynamic evolutionary system and the distribution of firm sizes and profits must be understood in evolutionary terms. But this theory makes no distinction between profits and wages and also do politics not play a role. Lastly the ideas of contradictions and of class have no place in this theory.

Economics comprises two different styles of theorizing: formal and appreciative. In a broad theoretical framework phenomena are observed in a particular framework of appreciation. A theory defines economic variables and their relations and provides a language and a mode of acceptable explanation. Implicitly a theory distinguishes and ranks the elements considered more and less important, complete and sophisticated, respectively. Formal theory is an important source of ideas for invoked in appreciative theory and sharpens its tools. Experimental data that are not accounted for by existing theory are grist for extensions and amendments to them. Appreciative theorizing in a sense follows formal theorizing, because the odds are larger that it is more fruitful where the other is and in that sense the dependency is a constraint.

Heterodox tradition has not made it into mainstream economics because of vested intellectual interests and parochialism [Galbraith . The New Industrial State . 1967]. Conversely the existing theories are flexible and accommodating. However not everything is deemed important or interesting to cater for it; that obviously is a risk for theory development because orthodoxy decides what should be interesting and what not. It occurs that theories are not found interesting the real reason being that the new ideas could only be married to the existing theories implementing large adjustments.

The Foundations of Contemporary Orthodoxy

Systematic understanding of the activities inside firms is not a high ranking subject of interest of economists, but rather industries and national economies &c. The firm is treated as a functional element in the analysis at hand; it is a black box the input and output are gauged at the convenience of the observer. Firms in real life do not do these actions, respond to price changes, or manage productive input combinations or manage financing in isolation, but all of them in parallel. The emphasis in this book is similar, namely on the aggregate (industry, nation), not the individual firm. Different subjects have to be addressed separately in a laboratory firm because it is not logically feasible to observe them simultaneously. The authors keep in mind the events within the firm, having in mind the development of a model for the larger systems.

Orthodox theory treats ‘knowing how to do’ and ‘knowing how to choose’ as different things, namely the ability to choose from a clear set of options and the ability to choose optimally respectively. In this theory they are treated as very similar things: the range of things a firm can do is somewhat uncertain as is the capabilities to choose in a given situation. The parameters are, in that order: objectives > howto > optimal choice >< internal and external conditions. In what sense can business firms have objectives?

1 The Objectives of Business Firms

In the simplest orthodox model the objective is profit or business value and the more the better. Two opposite considerations: the business firm with the number of individuals involved, the diversity of their roles and the complexity of their relations VERSUS individualist utilitarian philosophy underlying neoclassical theory and optimality theorems. ‘In this philosophical framework, economic organization in its entirety is appraised for its effectiveness in satisfying the wants of individuals. ‘A forteriori’, the business firm is viewed as in some sense an instrumentality of individuals, rather than an autonomous entity‘ [p 54]. If Miller’s Mill is the subject of observation than the relation between the interests of the owner and the ‘interests’ of the firm are clear, but this relation becomes strained if the subject is General Mill. I can’t really believe there is a distinction: Miller has many roles to play and some of those can become mixed. In the case of the owner (and the employee and the CEO &c.) of General these roles are specialized and less mixed. But in my view there is no fundamental difference between small firms and large ones.

Managerialists argue that not the – often passive – shareholder’s interests are relevant but the manager’s. The manager’s interest is operational and can be associated with size and growth. Another school defines a firm as a nexus of bargaining between parties to get to a coalition (Cyert & March). ‘Goals’ and ‘Objectives’ of the firm cannot impose a coherent structure on a firm’s actions. In their view the matter cannot be resolved, because that would involve more bargaining than possible in practical terms. Instead the firm remains in a state of quasi-resolution of conflict. Even if top management manages to negotiate a common ground then the interests can be different during the implementation and result in a new round of bargaining such that it is an important factor in the behavior of the firm: objectives such as profit and revenue are useless unless they are made specific as to how to achieve them for all involved (ie associated with the firm).

In reality, firms’ goals can be vague, because even if a main objective is established then the partial objectives may remain unclear, unaligned or not sufficiently specified for their users. If this is true for reality and firms show behavior then it can also be true for the firms of this theory. What is in fact required is a procedure to determine which action is to be taken.

2 Production Set and Organizational Capabilities

In 1 some examples were discussed concerning the motivational aspects of the theory of the firm. There is little theory concerning the capabilities of firms: formally what a firm can do is catered for through production sets: the set Y of production possible for the j-th producer is a production set [Debreu 1959 p34 in p 59]. What is the firms production set? ‘The production possibility is set is a description of the state of the firm’s knowledge about the possibilities of transforming commodities‘ [Arrow & Hahn 1971 p 53 in p 60]. But what is the nature of knowledge? In orthodoxy the connotation is with ‘a way of doing something’ or ’technology’ as in a book with blueprints, the knowledge of scientists and engineers. DPB: I reckon in general it is what people believe to be true and specifically it is what they believe to be true concerning their business environment. If it is related to science or engineering then chances are larger that it is in fact true and not only believed to be so. ‘Implicit in both metaphors (‘blueprinted knowledge and knowledge of engineers and scientists, DPB’, and in other discussions, is that technological knowledge is both articulable and articulated: you can look it up. At least, you could if you had the appropriate training‘ [p 60].

Survey of Schools in Economics

Ecological economics/eco-economics refers to both a transdisciplinary and interdisciplinary field of academic research that aims to address the interdependence and coevolution of human economies and natural ecosystems over time and space.[1] It is distinguished from environmental economics, which is the mainstream economic analysis of the environment, by its treatment of the economy as a subsystem of the ecosystem and its emphasis upon preserving natural capital.[2]

Heterodox economics refers to methodologies or schools of economic thought that are considered outside of “mainstream economics”, often represented by expositors as contrasting with or going beyond neoclassical economics.[1][2] “Heterodox economics” is an umbrella term used to cover various approaches, schools, or traditions. These include socialist, Marxian, institutional, evolutionary, Georgist, Austrian, feminist,[3] social, post-Keynesian (not to be confused with New Keynesian),[2] and ecological economics among others.

Institutional economics focuses on understanding the role of the evolutionary process and the role of institutions in shaping economic behaviour. Its original focus lay in Thorstein Veblen’s instinct-oriented dichotomy between technology on the one side and the “ceremonial” sphere of society on the other. Its name and core elements trace back to a 1919 American Economic Review article by Walton H. Hamilton. Institutional economics emphasizes a broader study of institutions and views markets as a result of the complex interaction of these various institutions (e.g. individuals, firms, states, social norms). The earlier tradition continues today as a leading heterodox approach to economics. Institutional economics focuses on learning, bounded rationality, and evolution (rather than assume stable preferences, rationality and equilibrium). Tastes, along with expectations of the future, habits, and motivations, not only determine the nature of institutions but are limited and shaped by them. If people live and work in institutions on a regular basis, it shapes their world-views. Fundamentally, this traditional institutionalism (and its modern counterpart institutionalist political economy) emphasizes the legal foundations of an economy (see John R. Commons) and the evolutionary, habituated, and volitional processes by which institutions are erected and then changed (see John Dewey, Thorstein Veblen, and Daniel Bromley.)

The vacillations of institutions are necessarily a result of the very incentives created by such institutions, and are thus endogenous. Emphatically, traditional institutionalism is in many ways a response to the current economic orthodoxy; its reintroduction in the form of institutionalist political economy is thus an explicit challenge to neoclassical economics, since it is based on the fundamental premise that neoclassicists oppose: that economics cannot be separated from the political and social system within which it is embedded.

Behavioral economics, along with the related sub-field, behavioral finance, studies the effects of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and the resource allocation.[1] Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory; in so doing, these behavioral models cover a range of concepts, methods, and fields.[2][3] Behavioral economics is sometimes discussed as an alternative to neoclassical economics.

Prospect theory

In 1979, Kahneman and Tversky wrote Prospect Theory: An Analysis of Decision Under Risk, an important paper that used cognitive psychology to explain various divergences of economic decision making from neo-classical theory.[12] Prospect theory has two stages, an editing stage and an evaluation stage.

In the editing stage, risky situations are simplified using various heuristics of choice. In the evaluation phase, risky alternatives are evaluated using various psychological principles that include the following:

(1) Reference dependence: When evaluating outcomes, the decision maker has in mind a “reference level”. Outcomes are then compared to the reference point and classified as “gains” if greater than the reference point and “losses” if less than the reference point.

(2) Loss aversion: Losses bite more than equivalent gains. In their 1979 paper in Econometrica, Kahneman and Tversky found the median coefficient of loss aversion to be about 2.25, i.e., losses bite about 2.25 times more than equivalent gains.

(3) Non-linear probability weighting: Evidence indicates that decision makers overweight small probabilities and underweight large probabilities – this gives rise to the inverse-S shaped “probability weighting function”.

(4) Diminishing sensitivity to gains and losses: As the size of the gains and losses relative to the reference point increase in absolute value, the marginal effect on the decision maker’s utility or satisfaction falls.

Micro-Economics

This post contains notes from different sources about micro-economics. The backdrop is that a connection is needed between the economic models that are taught in schools and any new theory under development. Even if it were only to be able to translate from language to the other and to distinguish the conditions from the main issues, however the case may be.

’If the bold hypotheses … , that complex systems achieve the edge of chaos internally and collectively, were to generalize to economic systems, our study of the proper marriage of self-organization and selection would enlist Charles Darwin and Adam Smith to tell us who and how we are in the nonequilibrium world we mutually create and transform.‘ [Kauffman, 1993 p. 401]

How does this theory relate to economic subjects? In economic theory technology is an important factor in the development of an economy. Kauffman suggests it is the important pillar of economic development: the existence of goods and services leads to the emergence of new goods and services. And conversely: new goods and services force existing goods and services out. In this way, the economy renews itself [Kauffman, 1993, pp. 395-402]. The question is how an economic structure does control its means of transforming the entry and exit of goods and services. A theory is required that describes how goods and services ‘match’ or ‘fit’ from a technological perspective.

With this model an economy can be simulated as a population of ‘as-if’ goods and services, sourcing from external sources (basic materials), that supply to each other when complementary goods and substitute when substituting goods and that each represent a utility. The equilibrium for this simulated economy can be the production ratio in that economy at a maximum utility for the whole of all present goods and services. That ratio can also be the basis for a measurement of the unit of price in the simulated economy. How does this simulated economy develop?

Introduce variations to existing goods and services through random mutations or permutations to generate new goods. Generate a new economy by introducing this new technology into it. Determine the new equilibrium: at this equilibrium some of the newly introduced goods and services will turn out to be profitable: they will stay. Some will not be profitable and they will disappear. This is of interest for these reasons:

Economic growth is modelled with new niches emerging as a consequence of the introduction of new goods and services
This kind of system leads to new models for economic take-off. The behavior of an economy depends on the complexity of the grammar, the diversity of the renewable sources, the discount factor as a part of the utility function of the consumer and the prediction horizon of the model. An insufficient level of complexity or of renewable resources leads to stagnation and the system remains subcritical. If too high then the economy can reach a supra critical level.

This class of models depends on past states and on dynamical laws. The process of testing of the newly introduced goods and services in a given generation is the basis on which future generations can build and so it guides the evolution and growth of the system. Because it will usually not be clear a priori how new goods and services are developed from the existing, the concepts of complete markets and rational agents can not be maintained as such: classical theory needs to be adapted.

An important behavioral factor of large complex adaptive systems is that no equilibrium is encountered. The economy (or the markets) is a complex system and so it will not reach an equilibrium. However, it is possible that limited rational agents are capable of encountering the edge of chaos where markets are near equilibrium. On that edge avalanches of change happen, which in the biological sphere leads to extinction and in the economy may lead to disruption.

xxx

Whenever we try to explain the behavior of human beings we need to have a framework on which our analysis can be based. In much of economics we use a framework built on the following two simple principles.

The optimization principle: People try to choose the best patterns of consumption that they can afford.

The equilibrium principle: Prices adjust until the amount that people demand of something is equal to the amount that is supplied.

Let us consider these two principles. The first is almost tautological. If people are free to choose their actions, it is reasonable to assume that they try to choose things they want rather than things they don’t want. Of course there are exceptions to this general principle, but they typically lie outside the domain of economic behavior. The second notion is a bit more problematic.The second notion is a bit more problematic. It is at least conceivable that at any given time peoples’ demands and supplies are not compatible, and hence something must be changing. These changes may take a long time to work themselves out, and, even worse, they may induce other changes that might “destabilize” the whole system.

This kind of thing can happen . . . but it usually doesn’t. In the case of apartments, we typically see a fairly stable rental price from month to month. It is this equilibrium price that we are interested in, not in how the market gets to this equilibrium or how it might change over long periods of time. It is worth observing that the definition used for equilibrium may be different in different models. In the case of the simple market we will examine in this chapter, the demand and supply equilibrium idea will be adequate for our needs. But in more general models we will need more general definitions of equilibrium. Typically, equilibrium will require that the economic agents’ actions must be consistent with each other.

One useful criterion for comparing the outcomes of different economic institutions is a concept known as Pareto efficiency or economic efficiency. 1 We start with the following definition: if we can find a way to make some people better off without making anybody else worse off, we have a Pareto improvement. If an allocation allows for a Pareto improvement, it is called Pareto inefficient; if an allocation is such that no Pareto improvements are possible, it is called Pareto efficient.

A Pareto inefficient allocation has the undesirable feature that there is some way to make somebody better off without hurting anyone else. There may be other positive things about the allocation, but the fact that it is Pareto inefficient is certainly one strike against it. If there is a way to make someone better off without hurting anyone else, why not do it?

Let us try to apply this criterion of Pareto efficiency to the outcomes of the various resource allocation devices mentioned above. Let’s start with the market mechanism. It is easy to see that the market mechanism assigns the people with the S highest reservation prices to the inner ring namely, those people who are willing to pay more than the equilibrium price, p ∗ , for their apartments. Thus there are no further gains from trade to be had once the apartments have been rented in a competitive market. The outcome of the competitive market is Pareto efficient. What about the discriminating monopolist? Is that arrangement Pareto efficient? To answer this question, simply observe that the discriminating monopolist assigns apartments to exactly the same people who receive apartments in the competitive market. Under each system everyone who is willing to pay more than p ∗ for an apartment gets an apartment. Thus the discriminating monopolist generates a Pareto efficient outcome as well.

Although both the competitive market and the discriminating monopolist generate Pareto efficient outcomes in the sense that there will be no further trades desired, they can result in quite different distributions of income. Certainly the consumers are much worse off under the discriminating monopolist than under the competitive market, and the landlord(s) are much better off. In general, Pareto efficiency doesn’t have much to say about distribution of the gains from trade. It is only concerned with the efficiency of the trade: whether all of the possible trades have been made.

We will indicate the consumer’s consumption bundle by (x 1 , x 2 ). This is simply a list of two numbers that tells us how much the consumer is choosing to consume of good 1, x 1 , and how much the consumer is choosing to consume of good 2, x 2 . Sometimes it is convenient to denote the consumer’s bundle by a single symbol like X, where X is simply an abbreviation for the list of two numbers (x 1 , x 2 ).

We suppose that we can observe the prices of the two goods, (p 1 , p 2 ), and the amount of money the consumer has to spend, m. Then the budget constraint of the consumer can be written as

p 1 x 1+ p 2 x 2 ≤ m. (2.1)

Here p 1 x 1 is the amount of money the consumer is spending on good 1, and p 2 x 2 is the amount of money the consumer is spending on good 2.

p1 x1 + x2 ≤ m.

This expression simply says that the amount of money spent on good 1, p1 x1 , plus the amount of money spent on all other goods, x2 , must be no more than the total amount of money the consumer has to spend, m. equation (2.2) is just a special case of the formula given in equation (2.1), with

p 2 = 1

p 1 x 1 + p 2 x 2 = m

and

p 1 (x 1 + Δx 1 ) + p 2 (x 2 + Δx 2 ) = m.

Subtracting the first equation from the second gives

p 1 Δx 1 + p 2 Δx 2 = 0.

This says that the total value of the change in her consumption must be zero. Solving for Δx 2 /Δx 1 , the rate at which good 2 can be substituted for good 1 while still satisfying the budget constraint, gives

Δx 2 /Δx 1 = -p1/p2

This is just the slope of the budget line. The negative sign is there since Δx 1 and Δx 2 must always have opposite signs. If you consume more of good 1, you have to consume less of good 2 and vice versa if you continue to satisfy the budget constraint. Economists sometimes say that the slope of the budget line measures the opportunity cost of consuming good 1.

Consumer Preferences

We will suppose that given any two consumption bundles, (x 1 , x 2 ) and (y 1 , y 2 ), the consumer can rank them as to their desirability. That is, the consumer can determine that one of the consumption bundles is strictly better than the other, or decide that she is indifferent between the two bundles. We will use the symbol to mean that one bundle is strictly preferred to another, so that (x 1 , x 2 ) (y 1 , y 2 ) should be interpreted as saying that the consumer strictly prefers (x 1 , x 2 ) to (y 1 , y 2 ), in the sense that she definitely wants the x-bundle rather than the y-bundle. This preference relation is meant to be an operational notion. If the consumer prefers one bundle to another, it means that he or she would choose one over the other, given the opportunity. Thus the idea of preference is based on the consumer’s behavior. In order to tell whether one bundle is preferred to another, we see how the consumer behaves in choice situations involving the two bundles. If she always chooses (x 1 , x 2 ) when (y 1 , y 2 ) is available, then it is natural to say that this consumer prefers (x 1 , x 2 ) to (y 1 , y 2 ).

If the consumer is indifferent between two bundles of goods, we use the symbol ∼ and write

(x 1 , x 2 ) ∼ (y 1 , y 2 ). Indifference means that the consumer would be just as satisfied, according to her own preferences, consuming the bundle (x 1 , x 2 ) as she would be consuming the other bundle, (y 1 , y 2 ).

If the consumer prefers or is indifferent between the two bundles we say that she weakly prefers (x 1 , x 2 ) to (y 1 , y 2 ) and write (x 1 , x 2 ) (y 1 , y 2 ). These relations of strict preference, weak preference, and indifference are not independent concepts; the relations are themselves related! Indifference curves are a way to describe preferences. Nearly any “reasonable” preferences that you can think of can be depicted by indifference curves. The trick is to learn what kinds of preferences give rise to what shapes of indifference curves.

well-behaved indifference curves

First we will typically assume that more is better, that is, that we are talking about goods, not bads. More precisely, if (x 1 , x 2 ) is a bundle of goods and (y 1 , y 2 ) is a bundle of goods with at least as much of both goods (x 1 , x 2 ). This assumption is sometimes and more of one, then (y 1 , y 2 ) called monotonicity of preferences. As we suggested in our discussion of satiation, more is better would probably only hold up to a point. Thus the assumption of monotonicity is saying only that we are going to examine situations before that point is reached—before any satiation sets in—while more still is better. Economics would not be a very interesting subject in a world where everyone was satiated in their consumption of every good.

What does monotonicity imply about the shape of indifference curves? It implies that they have a egative slope. That is, if the consumer gives up Δx 1 units of good 1, he can get EΔx 1 units of good 2 in exchange. Or, conversely, if he gives up Δx 2 units of good 2, he can get Δx 2 /E units of good 1. Geometrically, we are offering the consumer an opportunity to move to any point along a line with slope −E that passes through (x 1 , x 2 ), as depicted in Figure 3.12. Moving up and to the left from (x 1 , x 2 ) involves exchanging good 1 for good 2, and moving down and to the right involves exchanging good 2 for good 1. In either movement, the exchange rate is E. Since exchange always involves giving up one good in exchange for another, the exchange rate E corresponds to a slope of −E.

If good 2 represents the consumption of “all other goods,” and it is measured in dollars that you can spend on other goods, then the marginal- willingness-to-pay interpretation is very natural. The marginal rate of substitution of good 2 for good 1 is how many dollars you would just be willing to give up spending on other goods in order to consume a little bit more of good 1. Thus the MRS measures the marginal willingness to give up dollars in order to consume a small amount more of good 1. But giving up those dollars is just like paying dollars in order to consume a little more of good 1.

Originally, preferences were defined in terms of utility: to say a bundle (x 1 , x 2 ) was preferred to a bundle (y 1 , y 2 ) meant that the x-bundle had a higher utility than the y-bundle. But now we tend to think of things the other way around. The preferences of the consumer are the fundamental description useful for analyzing choice, and utility is simply a way of describing preferences. A utility function is a way of assigning a number to every possible consumption bundle such that more-preferred bundles get assigned larger numbers than less-preferred bundles. That is, a bundle

(x 1 , x 2 ) is preferred to a bundle (y 1 , y 2 ) if and only if the utility of (x 1 , x 2 ) is larger than the utility of (y 1 , y 2 ): in symbols, (x 1 , x 2 ) (y 1 , y 2 ) if and only if u(x 1 , x 2 ) > u(y 1 , y 2 ). The only property of a utility assignment that is important is how it orders the bundles of goods. This is ordinal utility.

We summarize this discussion by stating the following principle: a monotonic transformation of a utility function is a utility function that represents the same preferences as the original utility function. Geometrically, a utility function is a way to label indifference curves. Since every bundle on an indifference curve must have the same utility, a utility function is a way of assigning numbers to the different indifference curves in a way that higher indifference curves get assigned larger numbers. Seen from this point of view a monotonic transformation is just a relabeling of indifference curves. As long as indifference curves containing more-preferred bundles get a larger label than indifference curves containing less-preferred bundles, the labeling will represent the same preferences.

Consider a consumer who is consuming some bundle of goods, (x 1 , x 2 ). How does this consumer’s utility change as we give him or her a little more of good 1? This rate of change is called the marginal utility with respect to good 1. We write it as M U 1 and think of it as being a ratio, MU1 = ΔU /Δx 1 = ( u(x 1 + Δx 1 , x 2 ) − u(x 1 , x 2 ) )/ Δx 1

that measures the rate of change in utility (ΔU ) associated with a small change in the amount of good 1 (Δx 1 ). Note that the amount of good 2 is held fixed in this calculation. This definition implies that to calculate the change in utility associated with a small change in consumption of good 1, we can just multiply the change in consumption by the marginal utility of the good:

ΔU = MU1 Δx 1

The marginal utility with respect to good 2 is defined in a similar manner:

M U 2 = ΔU /Δx 2 = u(x 1 , x 2 + Δx 2 ) − u(x 1 , x 2 ) ) / Δx 2

Note that when we compute the marginal utility with respect to good 2 we keep the amount of good 1 constant. We can calculate the change in utility associated with a change in the consumption of good 2 by the formula ΔU = MU2 Δx2 .

It is important to realize that the magnitude of marginal utility depends on the magnitude of utility. Thus it depends on the particular way that we choose to measure utility. If we multiplied utility by 2, then marginal utility would also be multiplied by 2. We would still have a perfectly valid utility function in that it would represent the same preferences, but it would just be scaled differently.

Solving for the slope of the indifference curve we have

MRS = MU1 / MU2 = – Δx2 / Δx1 (4.1)

(Note that we have 2 over 1 on the left-hand side of the equation and 1 over 2 on the right-hand side. Don’t get confused!).

The algebraic sign of the MRS is negative: if you get more of good 1 you have to get less of good 2 in order to keep the same level of utility. However, it gets very tedious to keep track of that pesky minus sign, so economists often refer to the MRS by its absolute value—that is, as a positive number. We’ll follow this convention as long as no confusion will result. Now here is the interesting thing about the MRS calculation: the MRS can be measured by observing a person’s actual behavior we find that rate of exchange E where he or she is just willing to stay put, as described in Chapter 3. The condition that the MRS must equal the slope of the budget line at an interior optimum is obvious graphically, but what does it mean economically? Recall that one of our interpretations of the MRS is that it is that rate of exchange at which the consumer is just willing to stay put. Well, the market is offering a rate of exchange to the consumer of −p 1 /p 2 —if you give up one unit of good 1, you can buy p 1 /p 2 units of good 2. If the consumer is at a consumption bundle where he or she is willing to stay put, it must be one where the MRS is equal to this rate of exchange:

MRS = − p1 / p2

Another way to think about this is to imagine what would happen if the MRS were different from the price ratio. Suppose, for example, that the MRS is Δx2 / Δx1 = −1/2 and the price ratio is 1/1. Then this means the consumer is just willing to give up 2 units of good 1 in order to get 1 unit of good 2—but the market is willing to exchange them on a one-to-one basis. Thus the consumer would certainly be willing to give up some of good 1 in order to purchase a little more of good 2. Whenever the MRS is different from the price ratio, the consumer cannot be at his or her optimal choice.

Revealed preferences

In Chapter 6 we saw how we can use information about the consumer’s preferences and budget constraint to determine his or her demand. In this chapter we reverse this process and show how we can use information about the consumer’s demand to discover information about his or her preferences. Up until now, we were thinking about what preferences could tell us about people’s behavior. But in real life, preferences are not directly observable: we have to discover people’s preferences from observing their behavior. In this chapter we’ll develop some tools to do this. When we talk of determining people’s preferences from observing their behavior, we have to assume that the preferences will remain unchanged while we observe the behavior. Over very long time spans, this is not very reasonable. But for the monthly or quarterly time spans that economists usually deal with, it seems unlikely that a particular consumer’s tastes would change radically. Thus we will adopt a maintained hypothesis that the consumer’s preferences are stable over the time period for which we observe his or her choice behavior.

‘I have had several occasions to ask founders and participants in innovative start-ups a question: “To what extent will the outcome of your effort depend on what you do in your firm?” This is evidently an easy question; the answer comes quickly and in my small sample it has never been less than 80%. Even when they are not sure they will succeed, these bold people think their fate is almost entirely in their own hands. They are surely wrong: the outcome of a start-up depends as much on the achievements of its competitors and on changes in the market as on their own efforts‘ [Kahneman, 2011, p. 261]

Competition neglect – excess entry – optimistic martyrs / micro economics modeling

WYSIATI – what you see is all there is. The inclination of people to react to what is immediately at hand, observable, while neglecting any other information available requiring slightly more effort. Inward looking. Basis for micro-economic model?

Utility theory as p/ Bernouilli (wealth > utilty) is flawed because 1) reference point for initial wealth and change in wealth. Utility theory is also the basis for most of economic theory, p. 274-76. Harry Markowitz suggests to use changes of wealth instead p. 278.