The Economics of Business

The Economics of Business Class 3 outline Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

Revisit Class Two Alchian and Demsetz, “Production, Information Costs, and Economic Organization” How do Alchian and Demsetz differ from Coase in explaining the origin of firms? What is a cooperative team, what are its important characteristics? What do Alchian and Demsetz view as the fundamental distinguishing characteristic of firms? Incomplete without oral accompaniment

Revisit Class Two… Alchian and Demsetz, continued What role does shirking play? Why do people tend to shirk? Who meters and monitors the managers? How is management shirking discouraged? What compensation characteristic can be used to distinguish types of firms? Incomplete without oral accompaniment

Revisit Class Two continued… Stigler, “The Division of Labor is Limited by the Extent of the Market” • What is meant by vertical integration? • How does vertical integration relate to “make-or-buy” • What factor does Stigler focus on in explaining the degree of vertical integration? • How does the degree of vertical integration sometimes change over the life of the firm? • What insights into outsourcing can you derive from Stigler’s analysis? Incomplete without oral accompaniment

Nature vs. Nurture Marshall, “The Mecca of the economist lies in economic biology rather than in economic dynamics.” Tension between Darwinian and Newtonian systems perspective Role of man versus nature in determining success Management hubris e.g., “inventing the future” Collins et al notion of super manager and super firm Incomplete without oral accompaniment

In Search of Superfirm • Collins et al employ an exemplary firm process based on sorting databases for high performers • Statistical flaw of “selecting for the dependent variable” • Leads to a very truncated distribution; no basis for evaluating the larger population • Not scientific • Does not test a hypothesis • Does not examine range of variables, e.g. as in regression • No dynamic model, no “if-then” capacity • Firm is not directly the unit of competition or selection Incomplete without oral accompaniment

Uncertainty and Survival • Knight’s distinction between measurable risk and unmeasurable uncertainty • We cannot see the future but must still make decisions • Uncertainty necessary for existence of economic profit* (No profit if all can see the future.) • Entrepreneur makes decisions under uncertainty and reaps the rewards or losses (e.g. pays factors at current value, receives future value) • Eventually limits of survival are reached • Entrepreneurial capacity is the ultimate fixed factor and he is not omniscient • Environment moves in unanticipated manner • Prior adaptations inhibit reaction • Others are found more fit and selected or adopted by the environment * Profit or residual over and above the opportunity cost of capital necessary to attract it to the endeavor Incomplete without oral accompaniment

Models and Judgment • Models are a way to capture and apply knowledge and experience • May be informal or formal • Seek to reduce the degree of uncertainty • If system modeled is completely deterministic (“if-then”), quality of prediction depends on knowledge of initial conditions and the continuity of system characteristics. E.g. Physics as expressed by LaPlace • If system’s dynamics are very sensitive to initial conditions and those are difficult to precisely measure, results are effectively uncertain (complexity) • If a system produces emergent phenomena which are different from the initial set, the outcome is not predictable • But models also create an intellectual feedback loop and influence our view of the world. • Most applied models used in decision making under uncertainty implicitly assume way too much certainty and a strict notion of equilibrium Incomplete without oral accompaniment

Achieving Equilibriums vs. Tendencies Simple physical systems tend to reach equilibrium quickly Complex physical systems may take a long time, e.g. the expansion of the universe. But, so far as we know, it will get to some sort of cold death equilibrium one day Economics generally conceived as a quickly equilibrating system that is normally in equilibrium until disturbed whereupon it quickly finds a new equilibrium as illustrated by comparative statics Austrian school didn’t accept the notion of a normal state of equilibrium and argued that there was only a tendency toward equilibrium Evolutionary economics views the economy as having a tendency to equilibrium but there is no reason to believe it necessary to get there and the trip itself is very interesting Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” Alchian sets out an evolutionary approach to describing firm behavior: Embodies principles of biological evolution and natural selection (recall Marshall) Economic system is an adoptive mechanism that selects from “exploratory” actions generated by adaptive pursuit of profits or success Alchian establishes his notion of environmental adoption and then combines it with a notion of behavior under uncertainty and incomplete information Under these conditions, people engage in adaptive, trial and error, imitative, innovative behavior This contrasts starkly with the typical picture of foresight and perfect rationality often ascribed to economic actors Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued “Profit Maximization” Not a Guide to Action Under Uncertainty: Economic behavior was often modeled as being undertaken by highly rational creatures with perfect foresight seeking optimum outcomes Gerhard Tintner, a pioneering econometrician, argued that under uncertainty, the notion of “profit maximization” is meaningless Without perfect foresight, i.e. certainty, there is no basis for profit maximization as a guide to behavior (of course with perfect foresight there is no need for “profit”) Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued Without perfect foresight, i.e. certainty, there is no basis for profit maximization as a guide to behavior Without uncertainty there is no profit The market can price risk but not uncertainty Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued Frank Knight’s famous distinction between risk and uncertainty • Risk; known potential and measurable outcomes and probabilities • Uncertainty; unknown outcomes and probabilities • Judgment; the phenomena that converts uncertainty into basis for action (probably related to entrepreneurial capacity) • People differ wrt to judgmental capability • Some specialize in offering judgment Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” (an aside) Complexity theory provides perspective on flawed foresight: • The study of complex dynamical systems, aka science of surprise • Insight into why we are “surprised” • Models fail us in depicting reality especially in the presence of uncertainty Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” resumed “Success Is Based On Results, Not Motivation” Realized profits (not maximum) are the mark of success and ticket to continue playing It doesn’t matter how they came about, their existence is sufficient Success reflects relative superiority, doesn’t require motivation and may simply reflect luck The environment selects (adopts) from among those offered on the basis of fitness Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued “Chance Or Luck Is One Method Of Achieving Success” Conscious decision making is not necessary in a selective and adoptive environment If a success factor is randomly acquired, e.g. an unplanned trip route that happens to include gas stations, the selection’s success is valid and can be explained Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued “Chance Does Not Imply Nondirected, Random Allocation Of Resources” Borel’s illustration of the surprising persistence of some random games precludes ascribing longevity to foresight and rationality Random horse race bettors will produce ex post set of perfect “forecasts” A set of people acting with some foresight and motivation may not be distinguishable from a group of random actors Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued A chance-dominated model does not preclude prediction, explanation, or diagnoses: • Realized requisites for survival under alternative conditions permit statements about likely results under various situations • Economists like everyone else have 20-20 hindsight and can use their tools to explain past outcomes • It is not necessary that any particular firm change its behavior but only that the set of firms selected for the next round behave in a manner “fit” for environment • Questionnaire methods are often invalid tests of marginalist conditions. • Responder may declare intentions different from marginalist behavior but survivors will be those whose characteristics fit the new environment Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued “Individual Adapting Via Imitation And Trial and Error” • Firms will imitate successful behaviors, imitation of successful actions is a justifiable reaction. Adopting standard or orthodox rules of behavior, especially those of winners makes sense when: • There may be no obvious criterion for the decision-making • Environmental variability may discourage new models • The problem may be very complicated • Uncertainty may make the problem intractable • Superiority to rivals is crucial • There may be no practicable trial-and-error mechanism Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued Imitation is a way to avoid making decisions and being accountable (“No one was ever fired for buying IBM”) Much of the passion for “benchmarking” and “world-class practices” is based on avoiding a painful and risky analysis of options. Much of innovation is accounted for by imperfect or flawed imitation resulting in unintended innovation (analogous to new characteristics emerging from DNA copying errors) Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued In addition to imitation, trial-and-error is a conscious form of adaptive behavior under uncertainty Trial-and-error does not guarantee an eventual optimum will be reached The near-sighted grasshopper may find a local maximum but not see the distant global maximum Trial-and-error may work when the function is continually rising, without dips, to the optimum Incomplete without oral accompaniment

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued “The economic counterparts of genetic heredity, mutations, and natural selection are imitation, innovation, and positive profits” Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” Earlier interest in dynamics, disequilibrium, and trial-and-error searches for profitable positions was displaced by the notion of highly rational searches for optimum solutions Interest revived with increasing interest in industries subject to technological disruption Schumpeterian notions of continual disequilibrium and creative learning and destruction regained attention Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” Nelson and Winter describe four characteristics of dynamic economic systems Variety refers to the number of different approaches or models present at various rounds and subject to selection Behavioral continuity is necessary to give selection validity. Selection from among randomly behaving actors is pointless. Profit induced growth is necessary to equip the winners in one round with additional resources to contest the next Limited path dependence rules out a powerful feed-back mechanism from quickly eliminating all but one player Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” In their section on competence, learning and routines, Nelson and Winter address what they call the “competence puzzle” Dichotomy between competence exhibited in routinized actions and poor performance in novel situations or cases where complex logical analysis is called for Competency can be acquired by learning and training involving short term feed back Complex and effective behavior is routinized behavior Routines persist in part because they economize on learning related costs and reduce frictions caused by unanticipated experimentation or novel behavior The heart of the development puzzle is how incredibly complex technologies, systems, and organizations emerge – they evolve in incremental steps Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” Nelson and Wilson argue that evolutionary approaches are more concerned with consistency with current science of learning (as opposed to looking for evidence of consistency with rationality assumptions) Separate parts of the brain are involved in mastering routines and in engaging in complex rational analysis Once learned, routines or skills are difficult to adjust quickly (game example) Persistence of routines and inherited practices can and often does inhibit adaptive behavior (e.g. Polaroid) Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” Nelson and Winter describe Schumpeterian competition as evolutionary behavior: Schumpeter was particularly interested in cases where change was driven by technological innovations In models where internally generated innovation resulted in greater profitability and a cycle of innovation driven profitability resulted, there is a tendency toward concentration When the technological innovations come from outside the industry, the tendency toward concentration is eliminated or greatly reduced A distinction is drawn between “science-based” and “cumulative” innovation. Science-based innovation tends to be external and offers no particular firm-specific advantage Cumulative innovation tends to favor firms with well-funded and effective in-house R&D Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” The dominant design model of industry life cycles involves: A new, unsettled technology stimulates a number of different views on how best to achieve its benefits An early period of high levels of entry with many different models Firms continue to enter and try new approaches, failed attempts exit (a high level of variety continues) Eventually methods and approaches converge on a dominant design Thereafter competition is less product-based and innovation efforts shift toward process improvement As some firms become significantly more efficient, the rate of exit increases and Finally a relatively few large firms remain The dominant design model has been tested and succeeded in explaining industry structure and evolution in a number of sectors Next week’s Klepper article provides a comprehensive exposition Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” Incumbents are more at risk when the change is external, science-driven, and changes the architecture of the system Incumbents can often weather change that comes from within the industry, is of the cumulative sort, and affects components of the system The power of foresight in explaining technological innovation is surprisingly weak or absent. Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” Nelson and Winter isolate some common characteristics of new technology paths: A great deal of uncertainty prevails and expert opinions have a wide variance Winners and losers usually don’t emerge until significant investments have been made in rival approaches Anyone, in government or out, who believes they can pick winners among emerging technologies is ignorant of the history of technology and innovation and incredibly arrogant Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” Technological advance is a source of disruption and growth and the process displays certain features: Most scholars view it as an evolutionary system Industry structure and technology tend to co-evolve – rapid growth and progress, stable period, followed by concentration when the technology matures Technology involves both artifacts (practice) and a body of understanding which, over time, tend to advance together Current efforts to define “innovation systems” Incomplete without oral accompaniment

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics” Evolutionary economic models are similar in many respects to those used in biology: In contrast to the analytical engines of neoclassical modeling, evolutionary models often seek to replicate or explain patterns and paths In a subject which assumes that foresight is rare and usually flawed, it is difficult to build “predictive” models In general, evolutionary economics is more open and amenable to outside science and approaches. But it is not much more so than other new branches such as behavioral economics. The rejection of the neoclassical assumptions of highly rational behavior and foresight accounts for most of the openness to other disciplines. Incomplete without oral accompaniment

Next Week Steven Klepper models a dynamic process of product sector evolution through the entry-exit-concentration cycle found in many industries Provides a rigorous explanation for commonly observed “regularities” and especially the emergence of a “dominant design” Forges a logical connection between innovation and business success over the product life cycle Contains calculus Some people may find the more accessible but less economically rigorous article “Dominant Designs and the Survival of Firms” by Fernando F. Suarez and James M. Utterback in Strategic Management Journal, Vol. 16, No. 6 (Sep., 1995) helpful to read before Klepper. Incomplete without oral accompaniment

The Economics of Business