The Crisis in Economic Theory

Jon Elster

  • An Evolutionary Theory of Economic Change by Richard Nelson and Sidney Winter
    Harvard, 437 pp, £20.00, October 1982, ISBN 0 674 27227 7
  • A General Theory of Exploitation and Class by John Roemer
    Harvard, 298 pp, £22.00, September 1982, ISBN 0 674 34440 5

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.

Actual applications of this abstract theory deviate from it in a number of ways, either by imposing more structure on the economic relations or by modifying some of the assumptions. For instance, by specifying the nature of the production possibilities (‘the production function’) one can derive that workers will be paid according to their marginal product. Some authors refer to payment below marginal product as ‘exploitation’, although this is not the usual neo-classical approach to normative issues. The standard way of handling normative questions of distribution is, rather, to assume the existence of a ‘social welfare function’ which is determined by the political system. Another modification is to give up the ambition of understanding how everything is connected with everything else, as in general equilibrium theory. Thus macro-economics considers aggregate entities such as industries or even the economy as a whole, rather than innumerable small firms. Partial equilibrium situations take into account the behaviour of a few firms considered as price-setters rather than passive price-takers. One may also introduce uncertainty, in the form of probability distributions entertained by the firm, and time, in the form of intertemporal markets. Technical change may be incorporated by multiplying the production function by some constant and letting that constant increase over time. The state is introduced to resolve the market failures that may arise when firms and consumers interact outside the market – for example, when firms create pollution for each other or for the consumers.

By these and numerous other adaptations neo-classical theory has evolved into an incredibly elaborate, increasingly rigorous, ever-expanding construction. Yet the whole edifice rests on shaky foundations. As Nelson and Winter put it, ‘orthodoxy builds a rococo logical palace on loose empirical sand.’ Their basic objection is simple: orthodoxy neglects or misconceives the role of information in economic life. This refers not only to the fact that information-gathering is costly, and that there is a trade-off between collecting information and using it. It refers more fundamentally to the fact that we do not know what that trade-off is. Leif Johansen, whose recent death was a great loss to the economic profession, once offered the following illustration: ‘It is like going into a big forest to pick mushrooms. One may explore the possibilities in one limited region, but at some point one must stop the exploration and start picking because further exploration as to the possibilities of finding more and better mushrooms would defeat the purpose of the outing. One must decide to stop on an intuitive basis, i.e. without actually investigating whether further exploration would have yielded better results.’ In other words, there is a process of search that stops when one has found something that is good enough, or ‘satisfactory’, without it being assumed that what has been found is in any way ‘optimal’.

From this and other considerations Nelson and Winter argue that the behaviour of firms cannot be explained as a process of optimal adjustment to market conditions. Instead, they see firms as adopting a set of fixed routines that remain in operation as long as they do not give results deemed ‘unsatisfactory’. This applies immediately to the ‘choice’ of technique. Nelson and Winter deny that firms have costless access to techniques other than the one they are currently using. To acquire knowledge about other techniques is costly, and the firm will not do so without some inducement. That inducement cannot be the prospect of profit, since one cannot know whether the other techniques will in the event prove profitable. It is adversity that stimulates the search for new techniques. Necessity is the mother not only of invention, but also of what is usually called ‘substitution’ – i.e. the switch from one set of inputs to another within the same ‘production function’.

The argument also applies to higher-level routines. If, for instance, the routine technique leads to unsatisfactory performance, then a routine for searching for new techniques is switched on. This will be a rule of thumb telling the firm to spend some time looking at what other firms are doing and some time looking for fresh techniques that are not too distant from what it is currently doing. There is no guarantee that this search rule is optimal, i.e. that the imitation-innovation mix is the one which is associated with the greatest expected profits. Yet if the rule has performed reasonably well in the past, the firm will use it to solve its current problem. Nelson and Winter are of course well aware of the fact that in large modern corporations innovation is carried on as a matter of routine, i.e. that it does not need adversity to trigger it off. Here the argument would be that the level of innovative activity, i.e. the budget for research and development within the firm, is determined by satisficing rather than maximising, as is the allocation of this budget between imitation and innovation.

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[*] Allen and Unwin, 244 pp., £5.95, 24 February, 0 04 335049 6