Evolutionary theory of Economic Change

September 12, 2015
Slide 7

The publication of these two books is a landmark in the development of economic theory. Singly and jointly, they represent a fundamental challenge to the reigning neoclassical orthodoxy. The more sophisticated practitioners of that theory have long recognised that it is in deep trouble, but have stuck to it because of the lack of a viable alternative, on the principle that you can’t beat something with nothing. Whatever objections one may have to neo-classical economics, it certainly is something: a highly-developed and formalised body of thought which has been applied to a wide range of practical and theoretical issues. One would hesitate before saying that the work of Marx, Schumpeter or Herbert Simon was ‘nothing’, and the ‘sophisticated practitioners’ referred to above would certainly not make any such judgment. Yet they would tend to say that their writing, though not lacking in insights, is amorphous, their ideas unformalised and unformalisable. They might well agree with Lord Robbins, who is reported to have said of Schumpeter’s Capitalism, Socialism and Democracy that it was a piece of ‘supremely intelligent after-dinner talk’. In any case, they would insist on the global and general character of these theories, and the absence of testable hypotheses to be derived from them.

The two books under review make the most important contributions for decades towards the construction of plausible alternatives to the neo-classical mode of theorising. Nelson and Winter offer an ‘evolutionary’ alternative which derives in equal amounts from Schumpeter and Simon. From the first they take the idea that competition is a process that involves winners and losers, not just a feature of markets which have so many firms that each must take the prices as given. From the second they take the idea of bounded rationality or ‘satisficing’, a neologism coined to provide an alternative to the postulate of maximisation at the core of neo-classical theory. Roemer offers a different heterodoxy, by focusing on the Marxist notions of class and exploitation. To understand these non-neo-classical phenomena he uses standard neo-classical tools, no doubt to the surprise of many and the dismay of some of his Marxist readers. The two departures from orthodoxy therefore have nothing in common with each other. Nelson and Winter affirm that they have not found the Marxist notion of class useful, while Roemer draws extensively upon the theoretical tools to the demolition of which their book is devoted.

Here is a first approximation of what the textbook orthodoxy looks like. A market economy is made up of firms and households. Firms produce outputs using inputs produced by other firms and labour offered by households. Households buy goods with the payment for labour services offered and with income derived from shares in firms. Firms and households make choices, the former guided by profit maximisation, the latter by their preferences. Firms must decide how much they want to produce and how to produce it. With respect to the first question, it is assumed that the firm is so small that it is unable to affect the prices of the product it makes or of the input it buys: it has no monopoly power. With respect to the second, it is assumed that the firm faces a well-defined set of production possibilities, i.e. distinct input combinations that will give the same output. Among these the firm chooses the input combination with the lowest total costs. Households must decide how much labour to offer and how much to buy of which goods, within the constraints set by their income and the ruling prices. The central theorem of neo-classical economics states that given these assumptions, and other more technical postulates, there exists a set of prices that will clear all markets, i.e. a set of prices that will induce the consumers to buy exactly the amount of each good that producers are induced to make. A second theorem, almost equally important, states that if firms and consumers only interact via the market mechanism, the equilibrium will also be an optimum, in the sense that it would not be possible to improve the situation of one household without making another worse off. A third theorem states that any optimum can be achieved in this way, by suitable redistribution of shares in firms.

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