Nelson and Winter's An Evolutionary Theory of Economic Change

An Evolutionary Theory of Economic ChangeRichard Nelson and Sidney Winter’s An Evolutionary Theory of Economic Change is the book on which modern “evolutionary economics” is built. Published in 1982, Nelson and Winter took the ideas expressed by Armen Alchian and Joseph Schumpeter decades earlier and presented a direct evolutionary challenge to mainstream approaches to economic growth, technological progress and competition between firms.

Nelson and Winter’s conception of firms is a collection of heterogeneous organisations guided by routines, the evolutionary economic equivalent of genes. Firms search for innovative (or imitative) solution to improve their profits, with successful firms growing at the expense of the less successful. The process is fundamentally dynamic, as firms interact and create the relative competitive environment that each faces. That firms may not be able to find the best technological solutions, nor seek to optimise profit perfectly, further separates the evolutionary and orthodox approaches.

When Nelson and Winter describe their approach as evolutionary, it is not necessarily “evolution by natural selection” in a strict Darwinian sense. The “evolutionary” label relates to the focus on dynamic change, and even though they make suggestions such as viewing routines as genes, they do not seek to pin their approach precisely to the biology (Geoffrey Hodgson and Thorbjørn Knudsen, who advocate a Darwinian approach, seek to increase this precision). I don’t necessarily think this is problematic, as in a transparently specified model we can see how the dynamics work, be they Darwinian or not. Issues generally arise later when people generalise those results verbally, with a lack of precision then causing confusion.

There are a lot of things to like about this book. First, it is an example of a criticism of economics done right (although in some parts the criticism is a bit dated, in others as current as it ever was). Where Nelson and Winter have a specific criticism, they identify the mainstream economic approach, note the outcomes of that approach, undertake the analysis with their own approach and then show how the approaches produce different results. They then argue why their approach is superior. Whether you buy their arguments or not, its transparent and leads to a productive discussion.

For example, early in the book they take on Milton Friedman’s claim in “The Methodology of Positive Economics” in which Friedman states:

Let the apparent immediate determinant of business behavior be any­ thing at all – habitual reaction, random chance or what not. When­ ever this determinant happens to lead to behavior consistent with rational and informed maximization of returns, the business will prosper and acquire resources with which to expand; whenever it does not the business will tend to lose resources and can be kept in existence only by the addition of resources from outside. The process of natural selection helps to validate the hypothesis [of maximization of returns] – or, rather, given natural selection, acceptance of the hypothesis can be based largely on the judgment that it sum­marizes appropriately the conditions for survival

To test this, Nelson and Winter create a basic model of firm interaction, analyse it using an orthodox equilibrium approach as Friedman suggests can be done, and then examine it as a dynamic selection process between firms. They show that the orthodox and selection equilibriums do not correspond with each other, as in the selection approach nonoptimal rules may survive in equilibrium due to path dependency, novel environments may be created as the mix of firms changes (which changes what the optimal rules are, effectively creating an evolutionary mismatch), and firms may fail to discover the optimal rules.

Another part of the book I enjoyed was their analysis of skills. In the past, I have been critical of the level at which some evolutionary economic analysis occurs – this being generally at the firm level and not the level of the people within the firm (or even deeper, their genes). But in the chapter on skills, Nelson and Winter spend a lot of time asking how the people in a firm shape the behaviour of that firm. In later chapters and models, the limitations of firms in searching for new technologies or attempting to achieve their objectives are informed by this more atomistic analysis of the people in the firm. Nelson and Winter’s focus on the level of firms is a conscious choice of the most useful level of analysis rather than ignorance that the lower levels might matter.

Their discussion of the competition policy implications of some of their models was also interesting. Depending on the assumptions used, monopolies may drive faster technological progress and deliver greater benefits to consumers as they are able to capitalise on any innovations through their large market shares. This is particularly the case if imitation is easy, with imitators eroding the benefits that an innovator can obtain in the market. Conversely, a monopoly might then be the only source of innovation, which is problematic if it satisfices or has other decision rules that limit its investment in innovation when times are good. While producing at times ambiguous results, an evolutionary analysis could form the base for a decent critique of competition policy.

I’d read parts of the book before, but this was my first time reading it right through. For someone broadly interested in the topic but lacking a desire to play with specific models, I would recommend reading the first five and last two chapters. There is a lot of great material in it. The rest of the book is also useful, although harder work for the rewards delivered.

As an endnote, it is interesting how little effect this book has had on mainstream economics, despite the massive influence of this book in evolutionary economic (and to a lesser extent organisational theory) circles. I’ve posted about why this might be the case here.

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