An Evolutionary Theory of Economic Change (Belknap Press)

Although this book is positioned to challenge some of the fundamental assumptions of orthodox economic theory, it has made a much greater impact on management science than on economics. That being said, the ideas presented here are a clear step forward in economic theorizing. To set the stage for their economic models, which are covered in a later part of their book, the writers begin with a description of the modern organization. Although perhaps no their intention, it is this part of the book that is so pivotal to contemporary thinking about organizations. Their evolutionary theory is today a key to understanding the boundaries of organizations as well as what it is that makes some organizations successful. This is a book for academics. Casual readers or management practitioners will not find the concepts here so interesting.

This is the standard text to introduce the modern era of evolutionary economics. It spawned two different approaches to doing evolutionary economics; both are related to Nelson and Winter. But much of what has transpired in simulation modeling and in the conceptual models of evolutionary systems is beyond this text. Read this as an introduction, but not as the state of the art.

A landmark in the economic literature

Undergraduate business students--and some liberal-arts majors--must take courses in economics. The second such is usually in microeconomics--the economics of the individual firm and its industry. Or so its adherents allege. The picture that this perspective paints of how things work resembles little that I have seen in the real world in a career that now spans 39 years; it's worth mentioning that five of those were spent in a Ph.D. program in strategic management. That experience taught me the value and the challenge of doing relevant research. More than most reviewers of a business book, I suspect I have a high tolerance for abstraction and an appreciation that the world is a whole lot more complicated than some in the government, media, business. . .and even economics would have us believe.

Unfortunately, the economics discipline operates from what scholars call a 'closed paradigm'. That means that there is no debate about the underlying basics of the field because The Powers That Be--those who control the editorial review boards of the academic journals in economics--will not publish dissenting views. In fact, doctoral students who express such views are usually prevented from getting their doctorates. So much for free speech and freedom of inquiry. Those who do survive are banished to second-tier universities because 'The Club' can't tolerate any diversity of opinion.

This closed-mindedness has prevailed for at least 64 years. In 1950, Friedrich von Hayek, who later won the Nobel Prize in economics in 1974, arrived at the University of Chicago from the faculty of the London School of Economics. Though senior University officials, including President Robert M. Hutchins, wanted him to join the faculty of the Department of Economics, that faculty, led by Milton Friedman and George Stigler, refused to accept him. They said he (a) didn't have a doctorate in economics, and (b) was then studying the philosophy of law. Hayek was also critical of the 'positivist approach' to economics that the faculty embraced then. So he ended up on the faculty of the Committee on Social Thought until 1962, when he returned to Europe.

I detour to tell this story about Hayek for good reason: pick up almost any introductory textbook about microeconomics and look in the index for Hayek's name. I've been doing that for years, and I've seen it once. They still don't want him in 'The Club'.

Like all theory, the 'neoclassical paradigm', as the reigning paradigm in microeconomics is called, makes simplifying assumptions. Theory must do that because the reality of the world in the social sciences is too variable to model with any degree of consistency and replicability. The problem in microeconomics is that its assumptions are so extensive as to make the theory that emerges almost useless to those of us who have to deal with reality. Here are its thirteen major assumptions:

1. All firms are price-takers (that means that no firm can set prices on its own - its prices are 'market' prices)
2. All company assets are fungible (can be used in other businesses)
3. All assets are infinitely divisible.
4. Buyers and sellers are perfectly rational.
5. Buyers and sellers have perfect information.
6. Property rights are well-defined.
7. Every single risk, benefit, and uncertainty is priced (i.e., has been anticipated and has a written contract covering it)
8. Returns to scale are constant (i.e., no economies of scale).
9. The actions of one firm or individual do not affect the actions of any other firm or individual.
10. There are no barriers to entry.
11. They are no externalities.
12. There are no transactions costs (no taxes, etc.)
13. There is no 'asymmetric information' (i.e., no one knows more or less than anyone else)

As a result of these assumptions, microeconomics assumes that a company is--not a collection of people who know how to do something that customers value--but a 'production function'--a line on a graph. All products of a given type (wine, jeans, diamonds, etc.) are the same. Therefore, all competition is price-based. There is no such thing as 'differentiation' (hear that, Lexus and Rolex?). If that were true, television networks of all stripes would be out of business because of the greatly reduced need to advertise. We would live in a different world from the one we have today.

Messrs. Nelson and Winter, whom I've had the pleasure of hearing and chatting with intermittently at conferences over the last 25 years, worked together at the RAND Corporation in the 1960s. During conversations there they found that they were both asking similar questions about microeconomics and questioning the incumbent paradigm. Later, Nelson went to Yale and Winter to the U. of Michigan. Still, they stayed in touch and eventually decided that said paradigm needed to be challenged. They agreed to write a book. Remember, there was no e-mail then, and the costs of faxing and long-distance telephone were stiff. Collaborative progress was slow; it involved the U.S. mail and a lot of travel between Ann Arbor and New Haven. But the literary effort gained steam in 1976 when Winter joined Nelson at Yale.

Let me quote from their preface what I believe is the essence of this book:

"Creative intelligence, in the realm of technology as elsewhere, is autonomous and erratic, compulsive, and whimsical. It does not lie placidly within the prescriptive and descriptive constraints imposed by outsiders to the creative process, be they theorists, planners, teachers, or critics. To progress with the task of understanding where creative thought is likely to lead the world, it is therefore helpful to recognize first of all that the task can never be completed. Our evolutionary theory of economic change is in this spirit; it is not an interpretation of economic reality as a reflection of supposedly constant 'given data,' but a scheme that may help an observer who is sufficiently knowledgeable regarding the facts of the present to see a little further through the mist that obscures the future." (p.viii)

Also in the preface, the authors acknowledge their "intellectual debts" to Joseph Schumpeter and Herbert Simon. Schumpeter, who described capitalism as 'a system of creative destruction' that renews itself by killing off parts of itself, spent his career studying innovation and the change that results from it. He was a colorful character who died much too young in 1950 at the age of 66, almost two decades before the first Nobel in economics was awarded. He was fond of saying that he aspired to be the world's greatest economist, its greatest horseman, and its greatest lover. He would then pause and allow as how he regretted that "the ponies aren't doing their part." Had he lived long enough, he probably would have been the first winner of the Nobel Prize in his field.

Herbert Simon, who did win the Prize in 1978, wasn't much closer to day-to-day academic economics than Hayek was. But it was Simon who deviated from economic orthodoxy by saying that people did not try to 'maximize' in their personal lives. They looked for solutions to needs and quit looking when they found one that worked well enough; Simon called this 'satisficing'. He also argued that it was impossible for people to know everything because there was only so much they could know; he called this 'bounded rationality'. In contrast to today's narrowly specialized scholars, Simon was multidisciplinary: spending most of his career at Pittsburgh's Carnegie-Mellon University, he authored or co-authored almost 1,000 papers, books, and conference presentations in the fields of cognitive psychology, computer science, public administration, economics, management, philosophy of science, sociology, and political science.

Back to the book: In 1982, Nelson and Winter published their groundbreaking book. In my view, their book eviscerates the neoclassical paradigm. Luckily both were tenured professors by then--Nelson at Columbia and Winter at the Wharton School of the University of Pennsylvania--so they were bullet-proof job-wise. As one would expect from two intellectuals, their book builds their case thought by thought, page by page, chapter by chapter. They begin the first of two chapters in Part I with two key premises:

1. "Economic change is important and interesting" (p. 3) because understanding it enables people to grapple with the problems and dangers of economic disparities, technological progress, and huge differences in living standards around the world; and

2. "A major reconstruction of the theoretical foundations of our discipline is a precondition for significant growth in our understanding of economic change. The broad theory that we develop in this book, and the specific models, incorporate basic assumptions that are at variance with those of the prevailing orthodox theory of firm and industry behavior." (p. 4)

In other words, the statics assumed by the closed paradigm not only fail to reflect reality; they are also decidedly unhelpful in anticipating and understanding change. Say the authors:

"The firms in our evolutionary theory will be treated as motivated by profit and engaged in search for ways to improve their profits [no profit-maximizing here - WDM], but their actions will not be assumed to be profit-maximizing over well-defined and exogenously given choice sets. Our theory emphasizes the tendency for the most profitable firms to drive out the less profitable one out of business; however, we do not focus our analysis on hypothetical states of 'industry equilibrium,' in which all the unprofitable firms no longer are in the industry and the profitable ones are at their desired size. Relatedly, the modeling approach that we employ does not use the familiar maximization calculus to derive equations characterizing the behavior of firms. Rather, our firms are modeled as simply having, at any given time, certain capabilities and decision rules ["routines" - WDM]. Over time these capabilities and rules are modified as a result of both deliberate problem-solving efforts and random events. And over time, the economic analogue of natural selection operates as the market determines which firms are profitable and which are unprofitable, and tends to winnow out the latter." [p. 4]

They say that "general equilibrium theory's austere description of the institutions of capitalism becomes woefully inadequate as soon as any accommodations to reality are made" (p. 5). That theory and its underlying assumptions (which I have previously enumerated) constitute "orthodox" economic theory. They go on to say that "it is a theoretical orthodoxy, concerned directly with the methods of economic analysis and only indirectly with any specific questions of substance" (p. 6). Hear, hear!

Nelson & Winter contrast their "evolutionary theory" with "economic orthodoxy" by saying that theirs "is above all a signal that we have borrowed basic ideas from biology, thus exercising an option to which economists are entitled in perpetuity by virtue of the stimulus our predecessor [Robert] Malthus provided to Darwin's thinking. We have already referred to one borrowed idea that is central in our scheme--the idea of economic 'natural selection'" (p. 9). They go on to talk about other decidedly un-economics-sounding terms such as "organizational genetics" and "the timely appearance of variation under the stimulus of adversity." They playfully note that "much of contemporary economic theory appears faintly anachronistic, its harmonious equilibria a reminder of an age that was at least more optimistic, if not actually more tranquil. It is as if economics has never really transcended the experiences of its childhood, when Newtonian physics was the only science worth imitating and celestial mechanics its most notable achievement" (p. 10).

Wow.

They go on to identify the two "structural pillars" of orthodox models: maximizing behavior (esp. profit-maximization) and equilibrium (the economy is 'in balance'). They take on the elegant and misleading calculus that attends research papers about equilibrium by saying, "Although the details may be different and much more complex, the spirit of equilibrium analysis in economics is almost always the same: to impose an equilibrium condition is to add an equation to the mathematical system characterizing the model and thus to provide for the determination, within the model, of the value of another variable" (p. 13). It's all about the math, and the result is predetermined. No need for anyone to show up to live their lives: economic orthodoxy can predict it all.

Hogwash. It's about time someone said the Emperor of Economic Orthodoxy was and is buck-naked.

As noted several paragraphs above, the idea of a 'routine' is a key construct of the book. Say N&W: "Our general term for all regular and predictable behavioral patterns of firms is 'routine'. We use this term to include characteristics of firms that range from well-specific technical routines for producing things, through procedures for hiring and firing, ordering new inventory, or stepping up production of items in high demand, to policies regarding investment, research and development (R&D), or advertising, and business strategies about product diversification and overseas investment. In our evolutionary theory, these routines play the role that genes play in biological evolutionary theory. They are a persistent feature of the organism and determine its possible behavior (though actual behavior is determined also by the environment); they are heritable in the sense that tomorrow's organisms generated from today's (for example, by building a new plant) have many of the same characteristics, and they are selectable in the sense that organisms with certain routines may do better than otehrs and, if so, their relative importance in the population (industry) is augmented over time" (p. 14).

But not all routines are created equal. N&W specific three types of routines: (1) "operating characteristics" - what a firm does at any given time; (2) "investment behavior" regarding the company's capital stock from period to period - which they call a 'selection mechanism'; and (3) rule-guided "modifying routines" that change the operating characteristics. The third type turns out to be characterized by 'searches' to determine the change that needs to be made; its analogue in biology is mutation. In contrast to the determinism of economic orthodoxy, N&W characterize changes in an evolutionary context as 'a Markov process'; that is, one that is driven by "partly stochastic" considerations (p. 19).

The other chapter in Part I is called 'The Need for An Evolutionary Theory.' As if the damage in Chapter 1 were not enough, Chapter 2 is a sizzling critique of economic orthodoxy. It begins with a question that sounds innocent enough: "What happens if the demand for the product of the industry increases, or if the price of a particular factor of production rises?" (p. 24). N&W point out that orthodoxy ignores 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" (p. 24). That is a silly assumption, of course, but that's the one orthodoxy imposes. In the real world, on the other hand, "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" (p. 24). N&W then point out that in that more-realistic scenario, competing firms can hardly be profit-maximizers because their industry is no longer in equilibrium. All firms are scrambling, trying to gauge what the near-term future holds. The results will run a continuum from right to wrong. Again, though, there's no profit-maximizing going on here, is there? Yet microeconomics textbooks are silent on this issue. Maybe they think that wet-behind-the-ears undergraduates don't notice. Well, some do, especially if they're not 18 or 19, but a little older, as so many part-time students these days are. They read about the Kool-Aid being proffered by orthodoxy, and they know it's bad, but they also see that there are no other possibilities presented in the textbooks or by the professors. So they go along to get along and get their ticket punched so they can put the miserable experience of traditional microeconomics behind them. The disagreeable and inconvenient real-world challenges of adaptive responses, less-than-perfect decision-making, and even DISequilibrium are never broached, much less discussed.

What about industries with high rates of innovation (think cell phones, iPads, medical equipment, and the like)? Here Schumpeterian competition kicks in. But the assumptions of maximization and equilibrium once again handicap the economic analysis. Sure enough, some more otherworldly assumptions arrive, but those "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 diversity with industry structure" (p. 30). In other words, "the orthodox assumption is that there is a global, faultless, once-and-for-all optimization over a given choice set comprising all objectively available alternatives" (p. 31). Sure. That assumption ranks right up there with, "If you like your doctor, you can keep your doctor." You get the idea. The rest of Chapter 2 is just as good as what I've excerpted here.

Some of it even gets into my home discipline of strategic management with references to Alfred Chandler's work and also to what has come to be known as the 'resource-based view of the firm', which first saw the light of day in 1959 with Edith Penrose's classic book, 'The Theory of the Growth of the Firm'. Nelson & Winter also talk about connections "between a firm's strategy and its appropriate organizational structure" (p. 38); that one is straight out of Chandler's seminal book, "Strategy and Structure: Chapters in the History of the American Industrial Enterprise" (1962).

I'm running out of both time and room here, so I'll briefly summarize the rest of this amazing book. Part II comprises three chapters--"The Foundations of Contemporary Orthodoxy," "Skills," and "Organizational Capabilities and Behavior." BEHAVIOR? Who'da thunk it? Part III ("Textbook Economics Revisited") is a snoozer with two chapters: "Static Selection Equilibrium" and "Firm and Industry Response to Changed Market Conditions." Tons and tons of math here. Thank you, Paul Samuelson, for your antidote to insomnia.

Part IV, "Growth Theory," begins with the shortest chapter in the book, "Neoclassical Growth Theory: A Critique." Some of us think that "neoclassical growth theory" is an oxymoron; no wonder the chapter is so short. But then N&W get back into the groove with lucid chapters entitled "An Evolutionary Model of Economic Growth," "Economic Growth as a Pure Selection Process," and "Further Analysis of Search and Selection." Lots and lots of analogues from biology here. And why shouldn't there be? If firms are living organisms comprising strategy, people, organization design, routines, and culture, shouldn't they, too, evolve? This is why 'evolutionary economics', 'Austrian economics,' and 'Marxist economics' are all called 'heterodox economics' - heterodox because, I guess, they are different. Does that make the closed neoclassical paradigm 'homodox economics'? I'll leave that one to other readers.

Part V, "Schumpeterian Competition," is a tougher slog. There are three heavy chapters with lots of math, lots of graphs, and lots of opportunities for some shut-eye, even though the writing is spicy. Well, it is as spicy as it can be, given the context. But these guys are scientists, too, so they need some running room to prove that to the orthodox Kool-Aid quaffers.

Part VI, "Economic Welfare and Policy," has the requisite genuflection to policy and to "welfare" implications of the new evolutionary theory. Welfare, in this context, is not a government program. It's about the efficient allocation of economic resources in a society.

The body of the book closes with a chapter entitled "Retrospect and Prospect." The first section summarizes at a high level the key ideas behind the book's title. There are three concepts: organizational routines, search, and selection. Evolutionary models tend to be more complex than their orthodox counterparts, and for good reason: the world is a lot more complicated than orthodoxy would have us believe. Evolutionary economics begins with an assumption of that real-world organizations hardly resemble orthodoxy's 'production function'. The models in this brand of economics "break out of the trap of regarding prices and markets as the only social mechanisms that actively transmit information--a trap that still restrains virtually all orthodox theorizing, including the most advanced" (p. 403). Evolutionary economics also embeds "the process of institutional development [as] an evolutionary process, both linked and akin to the process of firms and industries" (p. 404); in an economic context, the term 'institutions' refers to societal norms, regulations, rules, customs, and the like.

The last section of the chapter looks to the future. It is largely a self-critique of the weaknesses of their evolutionary model. Nelson & Winter briefly discuss theoretical problems and empirical challenges. The writing is crisp and forthright. When I took four semesters of microeconomics courses (two undergraduate, two graduate), I was sure that there had to be another way of looking at economics. But the profession wasn't going to tell me or anyone else what it was. Nelson & Winter let all of us who came away from the closed paradigm of economics frustrated by its surreal, Twilight-Zone-like dimension know that there is indeed, not only another way, but also a better way. A couple of decades later, I discovered Austrian economics, and that filled out the rest of the picture for me.

Nelson & Winter don't believe they have the entire solution to the problems of economic orthodoxy, but they clearly think they're well on the way. So do I.

As advertised and delivered on time.

Nelson and Winter address some of that era's deepest problems in understanding economic organization. Thirty years later their thinking is still fresh and entertaining. This is an academic book. I doubt most non-academics will find it that interesting. Any academic interested in business strategy, industry structure, and firm and industry evolution must read this. They are very good writers, clear and cogent thinkers. It is a classic.