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RICHARDR.NELSONANDSIDNEYG. WINTER &MJEW(Q)ILlUJ1rll(Q)M&m2f1rIHIJE(Q)m2f (Q)JFJECC(Q)M(Q)ItWllCCCCIHI&MCGIE THEBELKNAPPRESSOFHARVARDUNIVERSITYPRESS ANDLONDON,ENGLAND Copyright 1982 by the President and Fellows of Harvard College Allrights reserved Prin tedin the United Sta tes of America LIBRARYOFCONGRESSCATALOGINGINPUBLICATIONDATA Nelson, RichardR. An evolutionarytheory of economic change. Bibliography:p. Includesindex. 1.Economics.2.Economic development. 3.Organizational change.I.Winter,Sidney G. II.Title.III.Title:Economic change. HB71.N44338.9'00181-13455 AACR2 ISBN0-674-27228-5(paper) To KATHERINE GEORGIE MARGO JEFF LAURA KIT Preface WEBEGANTHISBOOKover a decade ago.Our discussions of the promise and problems of evolutionary modeling of economic change date back years before that.For both of us,this book representsthe culmination of workthat began with our dissertations. Ourinitialorientationsweredifferent.ForNelson,thestarting point was a concern with the processes of long-run economic development.Earlyon,thatconcernbecamefocusedontechnological change as the key driving forceand on the role of policy asan influence on the strength and direction of that force.For Winter, the early focuswas on thestrengths and limitations of the evolutionary argumentsthathadbeen put forwardassupport forstandardviewsof firmbehavior. This soon broadened toinclude the generalmethodologicalissuesof "theory and realism"in economics,the contributions of other disciplines to the understanding of firmbehavior, and reconsiderationoftheevolutionaryviewpoint asapossibleframeworkforamorerealisticeconomictheory of firmandindustrybehavior.FrOlnthe earliest daysof our acquaintance,the existenceof significantoverlapsandinterrelationsbetweentheseareasofresearchinterestwasapparent.Nelson'sstudiesof thedetailedprocessesof technologicalchangeledhim toappreciatetheuncertain, groping, disorderly, and error-ridden character of those processesand the difficulty of doing justice to that reality within the orthodox theoreticalscheme.In Winter's case,astudy of the determinants of firmspendingonresearchanddevelopmentformedtheempirical . arenain which it firstbecameapparentthat much of firmbehavior VlllPREFACE couldbemorereadilyunderstoodasareflectionofgeneralhabits and strategic orientations coming fromthe firm's past than asthe result of adetailed survey of the remotetwigs of the decision tree extending intothe future. It wasnot,however,untilthe collaborationthatledtothisbook waswellunderwaythatwerealizedthatitspurposeandpromise were well defined by two relationships between our areas of interest. First, among the many obstacles tounderstanding the role of technologicalchangeineconomiclife,animportantsubset arisefromthe intellectual constraints associatedwith the treatment of firmand industrybehavior thatisnowstandardineconomictheory.Second, amongthemanybenefitsthatmayderivefromatheoreticalapproach that reconciles economic analysis with the realities of firmdecision making, the most important relate to improved understanding of technological change and the dynamics of the competitive process. Our cooperative intellectual endeavor commenced when we were both atthe RANDCorporationin Santa Monicain the 1960s.Many peopleatthatremarkablystimulatingandintellectuallydiversified placeinfluencedour thinking.BurtonKleindeservesspecialmention.Heconveyedtousabodyoftruththathasbeenrecognized many times in the history of ideas, but that somehow always stands in need of rediscovery,reinterpretation, and persuasive illustration. 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 outsiderstothe creative process,bethey theorists,planners,teachers,orcritics.Toprogresswiththetaskofunderstandingwhere creativethought is likelyto lead the world,it istherefore helpfulto 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 interpretationof economicrealityasareflectionof supposedly constant "given data/' but ascheme that may help an observer who is sufficiently knowledgeable regarding the facts of the present to see a little furtherthrough the mist that obscures the future. WecommittedourselvestowritingthisbookafterNelsonhad moved on to Yaleand Winter to Michigan.For a few years the problemsoflong-distancecoauthorshipimposedsignificantcostsin terms of the rate of progress of the collaborative effort, but there were also some benefits in the form of opportunities to test ideas in forums providedbytwodifferentuniversities.(Of course,theairlinesand thetelephonecompanyderivedsubstantialbenefitsfromthearrangement,too.) With Winter's move toYalein 1976,the communication costs felland we began to take more seriously the idea of pullingtheworktogetherintheformofabook.Major effortsinthat I ixPREFACE directionweremadein1978and1979.Asour families,colleagues, andeditorsare wellaware,the"almostdone"phase oftheproject lastedalmostthree years. Inthisprotractedprocessofresearchandwriting,wereceived supportandassistanceinavarietyofformsandfromavarietyof sources.We will attempt here toacknowledgethe main elements of our indebtedness under several major headings,but areuncomfortably awarethat some of thelistsarefarfromcomplete. Our greatest intellectual debts are to Joseph Schumpeter and Herbert Simon. Schumpeter pointed out the right problem-how tounderstandeconomicchange-andhisvisionencompassedmanyof the important elements of the answer.Simon provided a number of specific insights into human and organizational behavior that are reflectedin our theoreticalmodels;but,most important, his work encouragedusintheviewthatthereismuch moretobe saidonthe, problem of rational behavior in the world of reality than can be adequately statedin thelanguage of orthodox economic theory. Financial support for our work came from several sources. A major grant fromthe National Science Foundation,through its Division of SocialSciences,providedimportantmomentumatanearlystage. Someofthemost recentresearchthatisreportedinthisbookwas also supported by the NSF,under a grant from the Division of Policy Research and Analysis. The Sloan Foundation, through a grant to the AppliedMicroeconomicsWorkshopatYale,wasamajor sourceof support for our research during the interval between the NSF grants. Inaddition, we received financialand other support fromthe Institute of Public Policy Studies at Michigan andthe Institution for Socialand PolicyStudies at Yale.Thedirectorsof these organizations during the period in question-J. Patrick Crecine and Jack Walker at IPPS,Charles E.Lindblomat ISPS-deserve special thanks for their encouragement and for their skill at t h ~tricky business of promoting intellectual contact amongthesocialscience disciplines. In our efforts todevelop computer simulation models as one type of formal evolutionary theory, we have depended heavily on the contributions of a series of skilled programmers and research assistants. Wehad thegood fortune toattracttothis roleindividuals whobecame intellectually engaged in the substance of our undertaking, and whocontributed,alongwiththeirtechnicalexpertise,suggestions and criticisms regarding the underlying economics. The first of these wasHerbertSchuette;hiscontributionstomuchoftheworkreported in Chapter 9 led to his inclusion as a coauthor of the principal previouspublicationofthatwork.Wewouldliketoacknowledge those contributions again here. Stephen Homer and Richard Parsons didmostof theoriginalprogramming forour simulationmodelof XPREFACE Schumpeteriancompetition,andcontributedanumberofhelpful suggestionstoitsformulation.LarrySpan cakehelpedustransfer that model tothe Yale computer. Abraham Goldstein and Peter Reiss followedinhisfootstepsaskeepersof thebeast atYale,feedingit andtraining it inresponsetoour requests and assisting in much of theanalysisthat helped usunderstandits behavior. Many scholarshave listenedtoour presentations,readour drafts and articles, and provided advice, encouragement, and criticisms.In Yaleseminars and conversations,we have learned particularly from SusanRoseAckerman,DonaldBrown,RobertEvenson,LeeFriedman,EricHanushek,JohnKimberly,RichardLevin,RichardMurnane, Guy Orcutt, Sharon Oster, Joe Peck, John Quigley, and Martin Shubik.During Winter's years at Michigan, he received similar benefitsfrominteractionswithRobertAxelrod,MichaelCohen,Paul Courant,J.PatrickCrecine, JohnCross,EverettRogers,Daniel Rubinfeld,PeterSteiner,JackWalker,andKennethWarner.Agreat many friends and colleagues elsewhere have also given us the benefit oftheirreactionsandsuggestionsononeoccasionoranother.We wishtothankparticularlyRichardDay,PeterDiamond,Avinash Dixit,ChristopherFreeman,MichaelHannan,JackHirshleifer, JamesMarch,KeithPavitt,AlmarinPhillips,MichaelP o r ~ e r ,Roy Radner,Nathan Rosenberg,Steve Salop,A.Michael Spence,David Teece,and Oliver Williamson. As our research progressed, we reported on it in articles published in TheEconomic Journal,TheQuarterly Journal of Economics,Economic Inquiry,ResearchPolicy,TheBell Journalof Economics,and TheAmericanEconomic Review.We thank the editorial boards of these journals forpermissiontouseparts of our earlier articlesin chapters of this book; specific citations are provided in the chapters involved. We are similarlyindebted toNorth-HollandPublishing Co.forpermission touse previously published material in Chapter 12. Threeindividuals-Richard Levin,Richard Lipsey, and B.Curtis Eaton-did usthe great favorof reading large portions of our draft manuscript and making detailed comments. We are greatly indebted tothem,andwishtotakeespecialcaretoexoneratethemfromresponsibility forthefinalresult.Many other peopleprovideduseful commentsonportionsofthemanuscript;weparticularlywantto thank Katherine Nelson and Georgie Winter. The preparation of the last typed version of the manuscript was a process haunted by theghost of deadlines passed.Under thosetrying circumstances, we were fortunateto havethe benefit of the outstandingtypingskills of MargieCooke. Inits finalphase, our project benefited substantially fromour decision tocommit the book to Harvard University Press.General edixiPREFACE tor Michael Aronson provided suggestions and encouragement.Our copyeditor,MariaKawecki,didwhatshecouldtoimproveour prose.Shedid sowith greattact,andwithremarkableinsightinto what it was that we had been trying to say. Whatever errors and infelicitiesofexpressionremainconstituteaminutefractionofthose originally present, andthat fractionmay wellbe largely attributable tothe stubbornness of the authors rather than to any lack of diligence onthe part of the copy editor. Each chapter of the book has its own history, and almost every one of those histories is complex. The informed reader may discern that a fewchaptersseemtobe predominantly Nelson,whireafewothers are predominantly Winter.But in most chapters our individual contributionsarethoroughly intermingled,andevery chapter has been shaped by the hands of both authors. We share responsibility for the work as a whole. Together, we wish toabsolve all of our friendsand criticsfromresponsibilityfortheproduct,whileagainexpressing our gratitude fortheir interest.Such absolution is more than a ritual in the case of this book, for there certainly are some among those acknowledged above who consider our effort tobe largely misguided. Our collaboration has not been a separate, self-contained segment of our lives.Rather,ithasbeenawayof lifeforourselvesandour families.Our children,youngwhen webegan,grewupwithlithe book."Intheearlydays,thebookprovidedtheoccasionforvisits betweenNew Havenand Ann Arbor.Inrecent years,thebookhas beenabackgroundthemeofsummer vacationsonCapeCod-or perhaps, on some occasions, it was the vacation that was in the background.Wehaveestablishedavirtualtraditionofcelebratorydinners marking the "completion" (to some stage) of the book. Our families have shared allthis with us;we know that they share a sense of fulfillment,relief,and even amazement that it isdone.Tothem we dedicatethe book. Contents IOVERVIEWANDMOTIVATION 1 2 Introduction The Need foran Evolutionary Theory 3 23 IIORGANIZATION-THEORETICFOUNDATIONS OFECONOMICEVOLUTIONARYTHEORY 3 4 5 TheFoundations of Contemporary Orthodoxy Skills Organizational Capabilities and Behavior 51 72 96 IIITEXTBOOKECONOMICSREVISITED 6 7 Static Selection Equilibrium Firm and Industry Response toChanged Market Conditions 139 163 IVGROWTHTHEORY 8 9 10 11 Neoclassical Growth Theory:ACritique An Evolutionary Model of Economic Growth Economic Growth asaPure Selection Process Further Analysisof Search and Selection 195 206 234 246 VSCHUMPETERIANCOMPETITION 12Dynamic Competition and TechnicalProgress 275 13ForcesGenerating andLimiting Concentration under Schumpeterian Competition 308 14The Schumpeterian Tradeoff Revisited 329 VIECONOMICWELFAREANDPOLICY 15Normative Economics froman Evolutionary Perspective 355 16TheEvolution of Public Policies andthe Roleof Analysis371 VIICONCLUSION 17Retrospect and Prospect399 References417 Index431 IT OVERVIEWANDMOTIVATION Introduction INTHISVOLUMEwe develop an evolutionary theory of the capabilitiesandbehavior ofbusiness firmsoperating inamarketenvironment,andconstructandanalyzeanumber ofmodels consistent with that theory.We propose that the broad perspective provided by anevolutionarytheoryisusefulinanalyzingawiderangeofphenomenaassociatedwitheconomicchangestemmingeitherfrom shifts in product demand or factor supply conditions, or frominnovationonthepartoffirms.Thespecificmodelswebuildfocusin tum on different aspects of economic change-the response of firms andtheindustrytochangedmarketconditions,economicgrowth, and competition through innovation.We draw out the normative as wellasthepositiveimplicationsofanevolutionary theory. The firstpremise of our undertaking should be noncontroversial: itissimplythateconomicchangeisimportantandinteresting. Amongthemajor intellectualtasksof the fieldof economichistory, for example,certainly none is more worthy of attention than that of understanding the great complex of cumulative change in technology andeconomicorganizationthathastransformedthehumansituationinthecourseofthepastfewcenturies.Amongpolicyissues regarding the world economy today, none present a more critical mix of promise and danger than those that reflectthe wide disparities in presentlevelsofeconomicdevelopmentandthestrainsthatafflict societiesstrugglingtocatchup.Intheadvancedeconomies,meanwhile,successfulmodernizationhasbroughtforthnewconcerns about the long-term ecological viability of advancedindustrial soci4OVERVIEWANDMOTIVATION ety and renewedquestions about therelationbetween materialsuccess and more fundamental human values. Among the focalconcerns of theoretical economics in recent years have beenthe rolesof information,theformationofexpectationsbyeconomicactors,detailed analysisofmarketsfunctioninggiventhepresenceof various"imperfections," and new versions of oldquestions about the efficiency of market systems.Much of this work seekstocomprehend,in stylizedtheoreticalsettings,theunfoldingofeconomiceventsover time.Thus,anysignificantadvanceinunderstandingoftheprocessesof economic change would cast new light onarange of intellectuallychallengingquestionsthatareof great socialconsequence. Weexpect,however,thatmanyof our economistcolleagueswill be reluctant toacceptthe secondpremise of our work-that amajor reconstructionofthetheoreticalfoundationsofourdisciplineisa preconditionforsignificantgrowthinourunderstandingofeconomicchange.Thebroadtheorythatwedevelopinthisbook,and thespecificmodels,incorporatebasicassumptionsthatareat variance with those of the prevailing orthodox theory of firmand industry behavior. The firmsin our evolutionary theory will be treated asmotivatedbyprofitandengagedinsearchforwaystoimprove their profits,but their actions will not be assumed tobe profit maximizingoverwell-definedandexogenouslygivenchoicesets.Our theory emphasizes the tendency for the most profitable firms to drive thelessprofitableonesoutofbusiness;however,wedonotfocus ouranalysisonhypotheticalstatesof"industryequilibrium,"in which allthe unprofitable firmsno longer are in the industry and the profitable ones areat their desiredsize.Relatedly,the modeling approachthat weemploydoesnotusethe familiarmaximizationcalculustoderiveequationscharacterizingthebehavioroffirms. Rather,our firmsaremodeledassimply having,at any giventime, certaincapabilitiesanddecisionrules.Overtimethesecapabilities and rules are modified asa result of both deliberate problem-solving efforts and random events. And over time,the economic analogue of naturalselectionoperatesasthemarketdetermineswhich firmsare profitable and which are unprofitable,and tends towinnow out the latter. Anumber of ourfelloweconomistsdosharewithusasenseof general malaiseafflicting contemporary microeconomictheory. 1It is 1.Itisnoteworthythat since 1970severalofthepresidentialaddressesgivenannually before the American Economic Association have lamented the state of economic theory.Leontief'saddress(1971)isexplicitlyconcernedwiththeinability of microeconomic theory tocome togrips with empirical realities. Tobin's address (1972),and Solow's(1980),are focusedonmacroeconomics,but are substantially concerned also 5INTRODUCTION widely sensedthatthedisciplinehasnot yet locatedapaththat will lead toa coherent and sustained advance beyond theintellectual territory claimedby modern general equilibrium theory.The discovery ofsuchapathwill,itisbelieved,requireatheoreticalaccommodation with one or more of the major aspects of economic reality that arerepressed in general equilibrium theory.Much of the most interesting theoretical work of the past two decades may be interpreted as exploratoryprobingguidedbyavarietyofdifferentguessesasto whichofthepossibleaccommodationsarethe mostimportant ones tomake.Considerableattentionhasbeen giventoimperfectionsof information and of competition,totransaction costs,indivisibilities, and increasing returns,and tosome oftherelationsamongthese.It hasbeenrecognizedthatgeneralequilibriumtheory'saustere description of the institutions of capitalism becomes woefully inadequateassoonasanyoftheseaccommodationstorealityare made-and, on the otherhand,thattheactualinstitutionaldevices employedinrealmarketsystemsconstituteacomplexandchallenging object for theoretical study. The fruits of these exploratory effortsincludeagooddealofworkthatisintellectuallyimpressive when takenonitsown terms,muchthat is directlyusefulin understandingcertainportionsof economicreality,andsomethatseems likelytobeof lasting valueregardlessofthefuturecoursethateconomicsmaytake.Butthe greatmajority of theseexploratoryprobes havecarriedalong(oratleastintendedtocarryalong)almostallof the basic conceptualstructurethat orthodoxy provides forthe interpretationof economicbehavior. Weregardthatstructureasexcessbaggage that willseriously encumber theoretical progress in the long run, however much its familiarityandadvancedstateofdevelopmentmayfacilitatesuch progress in the short run.Here, obviously, our appraisal of the situationismoreradicalthananythingthatcanbeassociatedwiththe "generalmalaise"referredtoabove.Whatweofferinthisbook is, withtheadequacyofthetheoreticalfoundationsthatorthodoxmicroeconomicsprovides formacroeconomics.Similar themeshavebeensoundedinaddressestoother professionalorganizations;see,forexample,Hahn(1970),PhelpsBrown(1972)and Worswick(1972).The sense of malaiseisalsoreflectedinanumber of thereview articlesinthe Journalof EconomicLiterature.Shubik(1970),eyertandHedrick(1972), Morgenstern (1972),Preston (1975),Leibenstein (1979),Marris and Mueller (1980), and Williamson (1981) all complain explicitly about the inability of the prevailing theory to cometogripswithuncertainty,or boundedrationality,orthe presence oflarge corporations, or institutional complexity, or the dynamics of actual adjustment processes. We do not aim in this footnote,or inthe book as a whole, toidentify allthe souls that arekindredatleastintheir surfacediagnosisoftheproblem,if notintheir deeper diagnosesor prescriptions.Weknowthat inthisrespectwearepart of acrowd. 6OVERVIEWANDMOTIVATION webelieve,aplausiblepromisethatfundamentalreconstruction alongthe lines we advocate would set the stageforamajor advance in understanding of economic change-and, at the same time,make it possible to consolidate and preserve most of the discipline's significant achievementstodate.Tomake fulldelivery on such apromise is not atask fortwoauthors,or forasinglebook. 1. THETERMSOFTHEDISCUSSION:"ORTHODOX" AND"EVOLUTIONARY" We have above made the first of many references to something called "orthodox" economictheory.Throughout thisbook, we distinguish ourownstanceonvariousissuesfromthe"orthodox"position. Some such usage is inevitable in any work that,like the present one, argues the need for amajor shift of theoretical perspective on awide range of issues.However,there maybe some who would deny that any"orthodoxy"existsineconomics,apartfromawidelyshared commitment tothe norms and values of scientific inquiry in general. Others would agree that an orthodoxy exists in the descriptive sense thatthere are obvious commonalitiesof intellectual perspective and scientific approachthat unite large numbers of economists.But they wouldstrenuouslydenythereisanorthodoxpositionprovidinga narrowsetofcriteriathatareconventionallyusedasacheapand simpletestforwhether anexpressedpointof viewoncertaineconomicquestionsisworthyof respect;or,if thereissuch anorthodoxy,thatitisin anyway enforced.Our ownthoughtand experienceleaveusthoroughly persuaded that an orthodoxy existsin this last sense,andthat itisquite widelyenforced.Wedo concede that contemporaryorthodoxyisflexibleandever-changing,andthatits limits are not easily defined. It therefore seems important toattempt if notanactualdefinition,atleastaclarification' ofouruseofthe term. Weshouldnote,firstof all,that theorthodoxyreferredtorepresents a modern formalization and interpretation of the broader traditionof Western economic thought whose line of intellectual descent canbetracedfromSmithandRicardothroughMill,Marshall,and Walras.Further,it is a theoreticalorthodoxy, concerned directly with the methods of economic analysisand only indirectly with any specificquestionsofsubstance.Itiscenteredinmicroeconomics, although itsinfluenceispervasiveinthediscipline. To characterize the actual content of contemporary orthodoxy is a substantialundertaking,withwhichwewillconcernourselvesrecurringlyinthisbook.Hereweaddressthequestionof howone 7INTRODUCTION mightcheckourclaimsthatparticularviewsandapproachesare "orthodox"-or, alternatively, the question of how we would defend ourselves against a claim that we are attacking a straw man or an obsolete,primitive formof economic theory.The firstrecourseshould betotheleadingtextbooksusedintherelativelystandardized undergraduate courses in intermediate microeconomics.These texts and courses expound the theoretical foundationsof thedisciplineat a simplified level. They are generally viewed as providing important backgroundforunderstandingappliedworkineconomics-often, in fact,as providing essentialbackground for applied work done at a respectableintellectual level.Thebest of the textsarenotably insistentonthescientificvalueofabstractconceptsandformal theorizing, and offer few apologies for the strong simplifications and stark abstractionsthey employ.Neither dothey devotemuchspace tocaveatsconcerningthetheory'Spredictivereliabilityinvarious circumstances.In these respects and others,they prefigure the treatment of the same issues in advanced textsand courses in theory.Indeed, it often appears that doctoral-level courses in economic theory aredistinguishedfromintermediate-levelcoursesprimarilybythe mathematicaltoolsemployed,atleastsofarasthecoretopicsare concerned. Thereis,admittedly,adegreeof caricatureinvolvedwhentexts aimed at college sophomores and juniors are nominated to represent moderneconomictheory.Manyof thestrongsimplifyingassumptionscommonly employed-perfect information,two commodities, staticequilibrium,andsoon-areemphasizedinsuchtextsfor reasons having todo with the perceived limitations of the students, and not because the discipline has nothing better to offer.And if the conclusionsoftheanalysisare sometimes put forwardwithout due emphasisonthequalificationstowhichtheyaresubject,itisnot necessarily because the importance of those qualifications is not recognizedbytheauthor.Itismorelikelybecausethestudentsare seen asdeservingarewardfortheirstruggles withthelogicofthe argument,andaspositivelydemandingclear-cutanswerstoput in the exam book.In many respects,orthodoxy is more subtle and flexiblethan theimageof it presented in theintermediatetexts. Thereare,however,someveryimportantrespectsin whichthe portrait is drawn true. First of all, the logical structure of the intermediatetextsunderliesmuchoftheinformaldiscussionofeconomic eventsand policies engaged in by economists and others with substantialeconomicsbackground.Thisisparticularlythecasewith views concerningtheefficiencyproperties of market systems:there seems to be a remarkable tendency for discussion of this question to throwofftheencumbrancesofadvancedlearningandreverttoa 8OVERVIEWANDMOTIVATION more primitiveand vigorousform.Inthis sense,the conclusions of intermediate analysis seemmuch more indicative of "where the discipline stands" than do appraisals that are theoretically more sophisticated,but alsomore difficult and less familiar tonontheorists.Second,thestrongsimplifyingassumptionsoftheintermediatetexts oftenhave closeanaloguesinadvancedwork,right out tothetheoreticalfrontiers.Itisacaricaturetoassociateorthodoxywiththe analysis of static equilibria, but it is no caricature to remark that continuedrelianceonequilibriumanalysis,eveninitsmoreflexible forms,stillleaves. thedisciplinelargelyblindtophenomenaassociated with historical change.Similarly,defenders of orthodoxy may justifiablydisdaintoreplytocriticismsofperfect-informationassumptions,buttheyhavesomethingatriskif thecriticismfocuses insteadontheassumptionthatallpossiblecontingenciescanbe foreseenandtheir consequencesweighed.Thus,althoughit isnot literally appropriate tostigmatize orthodoxy asconcerned only with hypothetical situations of perfect information and static equilibrium, the prevalenceofanalogousrestrictionsinadvancedworklendsa metaphorical validitytothe complaint. Last,thereisonekeyassumptioninthestructureoforthodox thoughtthatdoesnotgetsignificantlyrelaxedorqualifiedasone passes fromintermediate to advanced theory;on the contrary, it becomesstronger tosupport agreater weight.Thisistheassumption that economic actorsarerational in the sensethat they optimize.In elementary instruction or in popular exposition,thisassumption of economic rationality may be presented as a conceptual expedient justifiedby the realistic observation that people have objectives which theypursuewithacertainamountofconsistency,skill,andforethought.Attheintermediate level,the assumption takeson astark appearancethatstrainscredulity,butthenintermediatetheoryis pretty stark overall.Inadvanced formsof orthodoxy, while recognitionof informationalandother "imperfections"softensthegeneral theoretical picture regarding what the actor knows, no such compromisewithrealityaffectsthetreatmentofeconomicrationality.As theoretical representations of the problems facedby economic actors increaseinrealisticcomplexityandrecognitionofuncertainty regarding values of the variables,there is a matching increase in the featsofanticipationandcalculationandintheclarityofthestakes imputedtothoseactors.Neverissuchatheoreticalactorconfused aboutthesituationordistractedbypettyconcerns;neverishe trapped in a systematically erroneous view of the problem; never is a plain old mistake made.It is acentral tenet of orthodoxy that this is the onlysound way toproceed;recognition of greater complexity in theproblem obligatesthetheoristtoimputeasubtlerrationalityto 9INTRODUCTION theactors.Thus,withregardtorationalityassumptions,toallow orthodox theorytobe championed by itselementary and intermediateversionsistowaiveasetofobjectionsthatbecomeparticularly tellingat theadvancedlevel. Theforegoingdiscussionshouldmakeclearthesourcesofa problem that willarise repeatedly in the analysisthat follows.Theoreticalorthodoxyismanifested atavariety of levels,and displaysa variablemixof strengthsandshortcomings.Someoftheshortcomingsofelementaryversionsarecorrectedinadvancedtreatments; othersaremerelypapered over.Sometimesadeficiencyundergoes mutation toa new but analogous form,and some deep problems get exacerbated asthe theory gets "better." We attempt to cope with this complexsituationbymodifyingourreferencestoorthodoxywith clarifyingphrases-"textbook"or"simple"orthodoxyversus"advanced" or "recent developments," and so forth. We also distinguish between"formal"orthodoxy,displayedinlogicallystructured theorizing,andthe"appreciative"versionwhichismoreintuitive andmodifiedby judgmentand commonsense.(Thisdistinctionis discussed further in the following chapter.) These devices are not entirelyadequate tothe task,but it doesnot seem reasonableto interruptourdiscussionrepeatedlyforthesakeofclarifyinganddocumentingeachcriticismof orthodoxy.Wehopethatwehavehere providedanadequateguide,atleastforthosefamiliarwitheconomic theory Itothe way in which such detailed indictmentsmight bedeveloped. Our use of the term "evolutionary theory" todescribe our alternativetoorthodoxyalsorequiressomediscussion.Itisabovealla signalthatwehaveborrowedbasicideasfrombiology,thusexercisinganoptiontowhicheconomistsareentitledinperpetuityby virtue of the stimulus our predecessor 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." Market environments provide a definition of success for business firms, and thatdefinitionisverycloselyrelatedtotheir abilitytosurviveand grow.Patterns of differential survival and growth in a population of firms can produce change in economic aggregates characterizing that population,evenifthecorrespondingcharacteristicsofindividual firmsareconstant.Supporting our analyticalemphasisonthissort ofevolutionbynaturalselectionisaviewof1/ organizational genetics"-the processes by which traits of organizations, including those traits underlying the ability toproduce output and make profits,are transmitted through time. We think of organizations as being typicallymuchbetter atthetasksofself-maintenanceinaconstant environmentthantheyareatmajorchange,andmuchbetterat 10OVERVIEWANDMOTIVATION changing in the direction of "more of the same" than they are at any other kind of change. This appraisal of organizational functioning as relativelyrigidobviouslyenhancesinterestinthequestionof how muchaggregatechangecanbebroughtaboutbyselectionforces alone. Thebroaderconnotationsof"evolutionary"includeaconcern with processes of long-term and progressive change. The regularities observableinpresentrealityareinterpretednotasasolutiontoa staticproblem,butastheresultthatunderstandabledynamicprocesseshaveproducedfromknownorplausiblyconjecturedconditionsinthepast-andalsoasfeaturesofthestagefromwhicha quite different futurewill emerge by those same dynamic processes. In this sense, all of the natural sciences are today evolutionary in fundamentalrespects.Perhapsthemostdramaticillustrationof this point istheincreasingacceptanceof thecosmologicaltheoryof the Big Bang, a conception that regards all of known reality as the continuously evolving consequence of one great antecedent event. At a less cosmic level,science has come tosee the continents asshifting with sporadic violence beneath our feet,the changing behavior of the Sun asapossiblefactorinhumanhistory,andtheworld'sclimateas threatenedwithmajorandperhapsirreversiblechangeasaconsequenceofindustrialization.Againstthisintellectualbackground, muchof contemporary economic theory appears faintlyanachronistic,itsharmonious equilibria areminder of an agethat wasat least moreoptimistic,if notactuallymoretranqUil.It isasif economics hasnever really transcended the experiences of its childhood, when Newtonianphysics wasthe only science worth imitating and celestialmechanicsitsmost notable achievement.2 Thereareotherconnotationsthathaveatmostaqualifiedrelevancetoour own evolutionaryapproach.For example,thereisthe ideaofgradualdevelopment,ofteninvokedbyanopposition between"evolutionary"and"revolutionary,"Althoughwestress theimportanceofcertainelementsofcontinuityintheeconomic process, we do not deny (nor doescontemporary biology deny)that change is sometimes very rapid.Also,some people who are particularlyalerttoteleologicalfallaciesintheinterpretationofbiological evolution seem to insist on a sharp distinction between explanations that feature the processes of "blind" evolution and those that feature "deliberate" goal-seeking.Whatever themerit of this distinction in 2.In his Dynamic Economics(1977)Burton Klein discusses at some length this failure of economics torecognize the profound changes in the view of "what science is" that have occurredin the natural sciences,principally physics.His perceptions of the problemswithcontemporaryorthodoxeconomicsare consonantwithoursinmany respects. I INTRODUCTION11 thecontext of thetheoryofbiologicalevolution,itisunhelpful and distractinginthecontextofourtheoryofthebusinessfirm.Itis neither difficult nor implausible todevelopmodels of firmbehavior thatinterweave"blind"and"deliberate"processes.Indeed,in human problem solving itself,both elements areinvolved and difficulttodisentangle.Relatedly,ourtheoryisunabashedlyLamarckian:it contemplates both the "inheritance" of acquired characteristics and the timely appearance of variation under the stimulus of adversity. Weemphatically disavow any intention to pursue biological analogiesfortheir own sake,or even forthesake of progress toward an abstract,higher-levelevolutionarytheorythatwouldincorporatea rangeof existingtheories.Wearepleasedtoexploitanyideafrom biologythatseemshelpfulintheunderstandingofeconomic problems,but weareequallypreparedtopassoveranythingthat seemsawkward,or tomodifyacceptedbiologicaltheoriesradically in the interest of getting better economictheory (witness our espousal of Lamarckianism).Wealsomakenoefforttobaseourtheoryon a viewofhumannatureastheproductofbiologicalevolution, although we consider recent work in that direction to be a promising departurefromthetraditional conceptionof Economic Man. 2.EVOLUTIONARYMODELING Itisnotaneasymattertostatepreciselywhat orthodoxtheoryentails.Our evolutionary theory, as we shall develop it in this volume, isSimilarly flexibleand will take on diverse formsdepending on the purpose of the particular inquiry. There is, nevertheless, a characteristicmodelingstyleassociatedwitheachtheoryIastylethatisdefinedbythefeaturesthatdiversemodelshaveincommon.The principalpurposeofthissedionistodescribethegeneralstyleof evolutionarymodeling.Beforeproceedingtothattask,webriefly set forth an analogous characterization of orthodox modeling, for the sake of the contrast provided. The Structure of Orthodox Models There are some readily identifiable building blocks and analytic tools employedinvirtuallyallmodelswithincontemporaryorthodox theoryofthebehavioroffirmsandindustries.3 Thesesamestruc3.Weareconcernedhereonlywithdescribingingeneraltermsthestructureof orthodoxmodels;inthenexttwochapterswediscusstheadequacyofoforthodox modeling of economic change and offera critique ofthebasic orthodox concepts. 12OVERVIEWANDMOTIVATION turesarevisibleinmodelsspanningaverydiversesetofspecific inquiries. While our discussion of the orthodox art form will be quite general,it might be useful forthe reader to keepin mind the central and best-known example of orthodox modeling of firmand industry behavior:thestandardtextbookmodelofthedeterminationof firm and industry inputs and outputs,andprices. Inorthodoxtheory,firmsareviewedasoperating accordingtoa set of decision rulesthat determine what they do as a functionof external(market)andinternal(suchasavailablecapitalstock)conditions.The theory containsasharp answer tothe question"Why are the rulesthe way they are?/I- ananswer that also yieldspredictions about the scope or characteristics of the rules.The rulesreflect maximizingbehavior onthepartoffirms.Thisisonestructuralpillar of orthodox models. Amaximizationmodeloffirmbehaviorusuallycontainsthree separable components.First,thereisaspecification of what it isthe firmsintheindustryareseekingtomaximize-usuallyprofitor present value,but in some cases the objective is something different ormorecomplex.Second,thereisaspecificationof asetof things that the firms know how to do. Where the focusis on production in a traditionalsense,thesethingsmightbespecifiedasactivitiesor techniques,assumptions made about the characteristics of activities and their mixability and about the properties of the "production set" thus determined.But in models concerned with other questions, the set of things a firm knows how todo might comprise advertising policiesorfinancialassetportfolios.Thethirdcomponentofamaximizing model isthe presumption that afirm'saction can be viewed astheresultofchoiceoftheactionthatmaximizesthedegreeto which its objective is achieved, given its set of known alternative actions,marketconstraints,andperhapsotherinternalconstraints (like the available quantities of factorsthat are fixedin the short run). Insomemodels,therepresentationofmaximizingbehaviortakes intoaccountinformationimperfections,costs,andconstraints. Themaximizationapproachpermitsthedeductionof adecision rule or set of rulesemployed by a firm-a rule or rulesthat specify a firm'sactionsasafunctionof marketconditions,givenitscapabilitiesand objectives.It attempts atheoretical explanationof firmdecision rules in the sense that it traces their origin and accounts for their characteristicsbyreferencetotheseunderlyingconsiderations, together with the maximization procedure. The decision rules themselves are the operational part of the theory. In some cases amaximizationmodelgeneratespredictionsabouttheformofthedecision rules.For example,if the production set isstrictlyconvex and firms treat prices as parameters,the "output supply rule" relating producINTRODUCTION13 tiontoproductpriceiscontinuousandapriceincreasenever decreases the output supplied. More generally, the maximization hypothesis leads analysts totry tofigureout why a firmis doing something, or what it would do differently under different conditions, on thebasisof anassessmentof itsobjectivesanditschoiceset. The other major structural pillar of orthodox models is the concept of equilibrium.Thisisanextremely powerfulandflexibleconcept;a fullequilibrium in an orthodox model may be an equilibrium in two or three distinguishable senses relating to a number of different componentsorvariableswithinthemodel'soverallstructure.Therole andresultofalltheseequilibriumconditionsistogeneratewithin thelogicofthemodelconclusionsabouteconomicbehavior itself-asdistinguishedfromtheconclusionsabouttherulesof behaviorthataregeneratedbythemaximizationanalysis.Inthe mostbasicexample,the supply anddemand curvesinamarket are simplyaggregationsofbehavioralrulesofindividualsellersand buyers,whichforeachactordescribethetransactionquantitythat would bemostdesirableat eachpossiblevalueof themarket price.. The actualvalueoftheprice-and hencetheactualbehavior of the actors-isdeterminedbythesupply-demandequilibriumcondition,whichpicksoutthespecificpriceforwhichtheaggregatedesired purchase quantity precisely equalsthe aggregatequantity sellerswishtosell.Althoughthedetailsmaybedifferentandmuch more complex,thespirit of equilibrium analysisin economicsisalmost always the same as in this basic example:to impose an equilibriumconditionistoaddanequationtothemathematicalsystem characterizing themodel and thustoprovide forthe determination, withinthemodel,of thevalueofanother variable. Formalmodels embodying the central orthodox concepts of maximizationandequilibriumhavebeenbuilt with avarietyof mathe. matical tools. Indeed, the range and rate of change of the set of mathematicaldevicesemployedtoexploreanessentiallyconstantsetof theoreticalconceptsissuchastomakeonesuspectthatthekey mechanismsintheprocessinvolvethelevelsofmathematicalsophistication attained by researchers and their audiences, and not any deepaffinitiesbetweenthemathematicaltoolsandthesubject matter.Calculus techniques are,however, increasingly central in the intermediate andadvancedpedagogyof thesubject,andtheyhave long been an important research tool.They do seem to provide a natural and efficientway of expressing someof thekey ideasof orthodoxy,particularlythoserelatingtomaximizingbehavior.Given someancillaryassumptionsabout theshape and smoothness of the frontiers of the choice set and other constraints, maximizing choices can be deduced by setting the appropriate derivatives equal tozero. 14OVERVIEWANDMOTIVATION Lagrangian multipliers associated with the constraints have a natural connectiontotheoreticalunderstandingofpricing.Equilibriumof the set of firmsin question implies that the equations characterizing theirmaximizingbehavior mustbe simultaneouslysatisfied.These mathematicalideasseemtofitthesubjectmatterextremelywell; undoubtedly,thatisatleastpartlybecausetheyhavesignificantly influencedthedevelopment of thinkingabout the subjectmatter. The Structure of EvolutionaryModels The decisionrulesemployedby firmsformabasic operationalconceptofourproposedevolutionarytheoryaswellascontemporary orthodoxy. However, we reject the notion of maximizing behavior as anexplanationof why decisionrulesarewhat theyare;indeed, we dispense with allthree components of the maximization model-the global objective function,the well-defined choice set,and the maximizing choice rationalization of firms'actions.And we see "decision rules" as very close conceptual relatives of production "techniques," whereasorthodoxyseesthesethingsasverydifferent. Ourgeneraltermforallregularandpredictablebehavioralpatterns of firms is "routine." We use this term to include characteristics offirmsthatrangefromwell-specifiedtechnicalroutinesforproducingthings,throughproceduresforhiringandfiring,ordering new inventory,or stepping up production of items in high demand, topoliciesregarding investment,researchand development (R&D), or advertising, and business strategies about product diversification and overseas investment.Inour evolutionary theory,these routines play the rolethat genes play in biological evolutionary theory.They areapersistentfeatureoftheorganismanddetermineitspossible behavior (though actualbehavior isdetermined alsoby the environment);theyareheritableinthesensethattomorrow'sorganisms generated fromtoday's (for example,by building anew plant)have many of the same characteristics, and they are selectable in the sense that organisms with certain routines may do better than others, and, ifso,theirrelativeimportanceinthepopulation(industry)isaugmented over time. Undoubtedly, there is a great deal of business behavior that is not, within the ordinary meaning of the term, "routine." Equally clearly, much ofthebusinessdecision makingthatisof the highest importance,bothfromthepoint of viewofthe individual firmand from that of society, is nonroutine. High-level business executives do not, inthemodernworld,spendhumdrumdaysattheofficeapplying the same solutions to the same problems that they were dealing with fiveyearsbefore.Wedonotintendtoimplyanydenialofthese INTRODUCTION15 propositions in building our theory of business behavior on the notionofroutine.Forthepurposesofeconomictheorizing,thekey point is somewhat different. It is that most of what is regular and predictableaboutbusinessbehaviorisplausiblysubsumedunderthe heading "routine," especiallyif weunderstandthat termtoinclude therelativelyconstantdispositionsandstrategicheuristicsthat shape the approach of a firm to the nonroutine problems it faces.The factthatnotallbusinessbehaviorfollowsregularandpredictable patterns is accommodated in evolutionary theory by recognizing that thereare stochastic elementsbothinthedeterminationof decisions and of decision outcomes.From the point of view of a participant in businessdecisionmaking,thesestochastic elementsmay reflectthe resultoftumultuousmeetingsorofconfrontationswithcomplex problemsunder crisisconditions;but fromtheviewpoint of anexternalobserverseekingtounderstandthedynamicsofthelarger system, the significant point about these phenomena is that they are hard topredict.Conversely, if they were nothard topredict, the observerwouldbeinclinedtointerpretthetumultandthesenseof crisisassome sort of organizational ritual-a part of theroutine. Our use of several different terms for different types of routines is meant toconvey our appreciationthat,forsome purposes,it isimportant to distinguish between a production technique whose operation is tightly constrained by machinery or chemistry and procedures forchoosingwhattechniquetoemployatacertaintime,andalso betweenarelativelylow-orderprocedureordecisionrule(forexample, the way a new order is handled or an inventory decline recognizedandrespondedto)andahigher-order decisionruleor policy (forexample,aruletoswitch fromuseof oiltonaturalgasasfuel whentherelativepriceratiohitsacertainlevel,orthecustomof keepingadvertisingexpendituresroughlyinproportiontosales). But,astheuseof the common term "routine" indicates, webelieve thatthesedistinctionsaresubtleandcontinuous,notclearand sharp.Orthodoxtheorymakesasharpdistinctionbetweenthe choicesetandchoosing-between whatisinvolvedin operatinga particulartechniqueandwhatisinvolvedindecidingwhattechnique to use. In our evolutionary theory we see strong similarities in these.Inmixingupbatchesofrawmaterials,decisionshavetobe madeastowhetherthecompositionandtemperaturearerightor not, and, if not, what to do. If there is a rationale for orthodoxy'S policyofdenyingtheoreticalrecognitiontothiselementofchoicein firmbehavior by including it in thedescription of technique, it presumably has todo with the fact that the choices are made in a routinized manner, and perhaps also that they arenot an important source ofvariabilityinthefirm'sprofits.Butempiricalstudiesofpricing 16OVERVIEWANDMOTIVATION behavior,inventory management,andevenadvertisingpoliciesrevealasimilar"by-the-rule"characteroffirmdecisionmakingin thesearenas.Insomecases,thoughnotinall,routinizationholds sway in particular decision-making arenas because the important actioniselsewhere-perhaps infinance,R&Dpolicy,or copingwith regulation.4 Thus,orthodoxy'sunwillingnesstogiveparalleltreatment to the similar forms of routinized behavior involved in "doing" and"choosing"remainsapuzzleandwillbearecurringthemein thisbook. Inanycase,evolutionarymodelinghighlightsthesimilarities among differentsortsof routines.At anytime,afirm'sroutinesdefinea list of functionsthat determine (perhaps stochastically) what a firmdoesasafunctionofvariousexternalvariables(principally marketconditions)andinternalstatevariables(forexample,the firm'sprevailing stock of machinery,or the average profit rate it has earnedinrecentperiods).Amongthe functionsthusdefinedmight be one that relates inputs required to output produced (reflecting the firm'stechnique),onethat relatesthe outputproducedby afirmto marketconditions(thesupplycurveoforthodoxtheory),andone that relatesvariable input proportions totheir prices and other variables.But whereas in orthodox theory the available techniques are a constantdatum,anddecisionrulesareassumedtobetheconsequenceofmaximization,inevolutionarytheorytheyaretreatedas simplyreflectingatanymomentoftimethehistoricallygivenroutinesgoverningtheactionsof abusiness firm. Although the routines that governbehavior at any particular time are,at that time, given data, the characteristics of prevailing routines may be understood by reference tothe evolutionary processthat has moldedthem.For the purposes of analyzing that process,we findit convenienttodistinguishamongthree classesof routines. One of these relates to what a firmdoes at any time, given its prevailingstockofplant,equipment,andotherfactorsofproduction that are not readily augmented in the short run. (In effect here we are definingthebasicunit "period" inour evolutionary modeling,asa counterparttoMarshall's"shortrun.")Theseroutinesthatgovern short-run behavior maybe called"operating characteristics." Asecond set of routines determine the period-by-period augmentation or diminution of the firm'scapitalstock (those factorsof pro4.Amajorthemeof R.A.Gordon'sclassicstudyofcorporatedecisionmaking (Gordon, 1945) is that many of the decisions with which economic theory is concerned (suchaspriceandoutput determination)aremadebyroutinizedprocedures,while corporateexecutivesactuallyspendtheirtimeonmattersofgreaterimportancewhich alsohappentobe mattersthatresist orthodox modeling. INTRODUCTION17 duction that are fixedin the short run). The extent to which actual investmentbehaviorfollowspredictablepatternsprobablyvariesa gooddealfromone situationtoanother.Insome casesthe decision makingsurroundingthequestionofwhethertobuildanew plant maynotbemuchdifferentinkindfromthedecisionmaking regarding whether or not to continue to run a particular machine that has been operating roughly, or tostop it and callin the maintenance crew.In other cases, the new plant decision may be more like a decisiontoundertakeamajor R&Dprogramonarecently opened technological frontier, a problem without real precedent that is dealt with throughimprovisedprocedures.Whichof thetwopatternsobtains probablydependsimportantly onthesizeof theinvestment project relative to the existing activity of the firm.Assuggested above,this spectrum of realistic possibilities corresponds in evolutionary theory toarange of differingrolesforstochastic elementsintherepresentationofinvestmentdecisionmaking.Intheparticularmodelswe shall develop later in this volume, the investment rule used by firms willbekeyedtothefirm'sprofitability,andperhapstoother variables.Thus,profitablefirmswillgrowandunprofitableoneswill contract,andtheoperatingcharacteristicsofthemoreprofitable firmsthereforewillaccountforagrowingshareoftheindustry's activity. Theselectionmechanism here clearlyisanalogoustothenatural selection of genotypes with differential net reproduction rates in biological evolutionary theory.And, asin biological theory,in our economic evolutionarytheorythesensitivity of afirm'sgrowthrateto prosperityor adversity isitself areflectionof its"genes." Finally,weviewfirmsaspossessingroutineswhichoperateto modify over time various aspects of their operating characteristics. In a sense,the model firmsof evolutionary theory can be thought of as possessing market analysisdepartments, operations researchshops, and research and development laboratories.Or there may be none of these organizationaldevicesbuilt into a firm,but at least fromtime to time some people within the firmmay engage in scrutiny of what the firmis doing and why it is doing it, with the thought of revision or evenradicalchange.Weproposethatthese processes,likeother ones,are "'ruleguided." Thatis,we assume ahierarchy of decision ruleswithhigher-orderprocedures(forexample,scrutinyofthe currentlyemployedproductiontechnique,ortheundertakingofa studyofarangeofpossiblemodificationsinadvertisingpolicy) whichactoccasionallytomodifylower-orderones(thetechniques used to make a particular part, or the procedure determining the mix of rawmaterialsemployed,orcurrentdecisionrulesregardingadvertising expenditure).And theremay even be proceduresof astill 18OVERVIEWANDMOTIVATION higherorder,suchasoccasionaldeliberationsregardingtheadequacy of present research and development policy, or of the methodologicalsoundness of the marketing studiesbeing usedtoguide advertisingpolicy. 5 These routine-guided, routine-changing processes are modeled as "searches" inthe following sense. There will be a characterization of apopulationofroutinemodificationsornewroutinesthatcanbe found by search. A firm's search policy will be characterized asdeterminingtheprobabilitydistributionof whatwillbefoundthrough search,asafunctionofthenumberofvariables-forexample,a firm'sR,&Dspending,whichinturnmaybeafunctionofitssize. Firms will be regarded as having certain criteria by which to evaluate proposed changesinroutines:invirtuallyallour modelsthecriterion will be anticipated profit.The particular modelwe shall employ forsearch willdepend onthe questionweareprobing. Our concept of search obviously is the counterpart of that of mutation in biological evolutionary theory.And our treatment of search as partly determined by the routines of the firmparallels thetreatment in biologicaltheory of mutation asbeing determined in partby the geneticmakeupof theorganism. As in orthodoxy,the characterization of individual firmsin evolutionarytheoryisprimarilyasteptowardanalyzingthebehavior of industriesor other large-scaleunitsof economicorganization.The modelsin this book are of "industries"-that is,situations in which anumberofbroadlysimilarfirmsinteractwithoneanotherina marketcontextcharacterizedbyproductdemandandinputsupply curves.Inmodelingthesesituationsweoftenfindit convenientto assume that "temporary equilibrium" isachieved-to abstract from suchshort-rundynamicprocessesasthosethatestablishasingle price in the market in asingle period.However, we emphatically do notassumethatour modelindustriesareinlong-runequilibrium, or focusundueattentionupon thecharacteristics of long-runequilibria. Thecoreconcernofevolutionarytheoryiswiththedynamic processbywhichfirmbehaviorpatternsandmarketoutcomesare jointly determined over time.The typical logic of these evolutionary processesisasfollows.Ateachpoint oftime,the current operating characteristicsoffinns,andthemagnitudesoftheircapitalstocks andotherstatevariables,determineinputandoutputlevels. Togetherwithmarketsupplyanddemandconditionsthatareex5.This image of a hierarchical structure of rules,with higher-level rules governing the modification of lower-level ones, is essentially that presented by Cyert and March (1963,ch.6). INTRODUCTION19 ogenoustothefirmsinquestion,thesefirmdecisionsdetermine marketpricesof inputs andoutputs.6 Theprofitability of eachindividualfirmisthusdetermined.Profitabilityoperates,throughfirm investment rules, as one major determinant of rates of expansion and contractionofindividualfirms.Withfirmsizesthusaltered,the sameoperating characteristicswouldyielddifferentinputandoutput levels, hence different prices and profitability signals, and so on. . Bythisselectionprocess,clearly,aggregateinputandoutputand pricelevelsfortheindustrywouldundergodynamicchangeeven ifindividualfirmoperatingcharacteristicswereconstant.But operatingcharacteristics,too,aresubjecttochange,throughthe workings of the search rules of firms.Search and selection are simultaneous,interactingaspectsoftheevolutionaryprocess:thesame prices that provide selection feedback also influence the directions of search.Throughthejointactionofsearchandselection,thefirms evolveover time,withtheconditionoftheindustry ineach period bearingtheseedsof itsconditioninthe followingperiod. Just as some orthodox ideas seem to find their most natural mathematicalexpressioninthecalculus,theforegoingverbalaccountof economic evolution seems totranslate naturally into adescription of aMarkovprocess-though oneinarather complicatedstatespace. The key idea is inthe finalsentence of the preceding paragraph:the conditionof theindustry ineachtimeperiodbearstheseedsof its conditioninthefollowingperiod.Itispreciselyinthecharacterizationofthetransitionfromoneperiodtothenextthatthemain theoreticalcommitments of evolutionary theory have directapplication.However,those commitments include the idea that the process isnotdeterministic;searchoutcomes,inparticular,arepartlystochastic.Thus,whattheindustryconditionofaparticularperiod really determinesis the probability distribution of its condition in the following period. If we add the important proviso that the condition of theindustry inperiodsprior toperiod thasnoinfluenceonthe transitionprobabilitiesbetweent andt+ I,we have assumed preciselythatthevariationovertimeoftheindustry'scondition-or "state"-is aMarkovprocess. Ofcourse,avastarrayofparticularmodelscanbeconstructed within thebroad limitsof thetheoreticalschema just defined.Each particular model defines a particular Markov process,whichmay be analyzedwiththeaidofthemathematicalpropositionsrelatingto Markov processesin general.For such analysistoreach conclusions ofeconomicinterest,however,theremustbealotofspecificeco6.Alternatively,firmdecisionsandmarketpricesmaybejointlydeterminedin eachtimeperiod. 20OVERVIEWANDMOTIVATION nomiccontentinthemodel.GeneraltheoremsaboutMarkovprocesses are not themselves of economic interest; they are just tools that are useful in attempting to extract the conclusions that have been introducedintothemodelthroughitsspecificassumptions.Forexample,itmaybepossibletoshowthattheindustryapproachesa "long-run equilibrium/' whichmaybe either a static condition or a probabilitydistributionof theindustrystatethatapplies(approximately)toalldatesin theremote future.And if an approachto such an equilibrium isin factimplied in the model'sassumptions,it will ordinarilybepossibletodescribesomepropertiesofsuchan equilibrium-for example,todescribetheoperating characteristics of firmsthat. survive. Animportant determinant of the success of effortsto extract such conclusionsisthe complexity of the model.Thisbrings usto an importantpoint regardingthescopeof evolutionary theoryand,more particularly, of the class of Markov models of industry evolution.At an abstract level,this modeling schema has enormous generality. We maythinkofa"firm state"ascomprising descriptionsof the firm's physicalstate(plantand equipment),informationstate(contents of filedrawers and human memories), operating characteristics, investmentrules(affectingtransitionsofphysicalstate),recordingrules (affectingtransitionsofinformationstates),andsearchrules(affectingtransitions of operatingcharacteristics,recordingrules,and searchrules).Allof thesedescriptionscouldinprinciplebehighly detailed.Wecanthinkofan"industrystate"descriptionasinvolving the list of all firm state descriptions, for all firms in being and alsoforpotentialor deceasedfirms,togetherwithalist of environmental variablesthatmaybedeterminedasgiven functionsof time and/orasfunctionsof thefirmstates.Thetransitionrulesforthis complex industry state description are largely implicit in the descriptionitself.Operatingcharacteristicsmapphysicalandinformation statesintocurrentactions.Currentactionsandthedatedetermine the environmental variables.Firm by firm,the current firmstate and valuesof environmental variablesaremapped intoanew firmstate byapplicationofinvestment,recording,andsearchrules.Andthe processcontinues. Thereisnothing wrong with the foregoingasan abstract conceptualization.However,thepointofamodelingeffortisnotjustto describe asystem,but todescribe it in such away that its behavior mayinsomedegreebeunderstood.Itisforthisreasonthatthe modelsthatappearlaterinthisbookareverysimpleexamples within the abstract scheme just described.Like most of our orthodox colleagues,we distinguishsharply betweenthepower and general21INTRODUCTION ity of the theoretical ideas we employ and the much more limited resultsthat our specificmodelingeffortshaveyieldedthus far. 3.PLANOFTHEVOLUME Inthe followingchapter,weexamineanddiagnosesomekeydeficiencies of orthodox theory.Our own response tothose deficiencies isplacedagainstthebackdropprovidedby past criticisms of orthodoxyandbythebroadertraditionofeconomic thought. Attheendof PartI,weofferanoption.Mostreaders,wehope, willbeinterestedin our attempt tooffer a plausible cure forcertain deep-seatedinadequaciesofeconomictheory.Theseinadequacies involve,ofcourse,theflagrantdistortionofrealityrepresentedby economists'basicassumptionsaboutindividualandorganizational capabilitiesandbehavior.Part IIsetsforththisattempt.It contains no formalmodelsitself,but rather developsthe image of individual and organizational functioningthat underlies and guides the subsequentmodeling.Wefirstscrutinizewithsomecaretheconceptual foundationsoforthodoxy'Streatmentofthesetopics.Wethenset forthanalternativeviewfocusedonsequencesofcoordinated behavior-individualskillsandorganizationalroutines.Among otherthings,thisanalysismakesclearthatthereisnosharpline separating theperformance of actionsfromthechoosing of actions. Most important,Chapter 5 seeks to establish that the formalmodels that appear later in the volume are well founded in a realistic account oforganizationalcapabilitiesandbehaviorgenerally,andofthe sourcesofcontinuitythereininparticular.Theassumptionsof the formalmodelsseektocapturesomeofthemaintendenciesthat emerge fromthedetailedmechanismsdescribedin Part II. Somereaderswillbeinterestedaboveallinthestyleofformal theorizing that characterizes evolutionary theory, in the answers that evolutionary models give to standard analytical questions, and in the new linesof attackdeveloped forthemorerecalcitrantproblemsof economicanalysis.WesuggestthatthesereadersskipPartIIand proceedtoPartIII,inwhichwe dealwithtwoofthecentralquestionsexplored in thepositive theory of firmand industry behavior: the characteristics of industry equilibrium and the response of firms and the entireindustrytochanged market conditions.Byexploring thesetraditionalquestionswiththeconceptsandtoolsofevolutionary theory, we develop the basis for comparisons with orthodoxy bothintermsofmethodsandofresults.Itbecomesclearthata 22OVERVIEWANDMOTIVATION number of familiar theoretical conclusions can survive a shift to new foundations-butnew interpretationsand caveatssurroundthem. Part IV is concerned with developing and exploring several evolutionarymodelsof long-runeconomicgrowth.It willbearguedthat the treatment of innovation within an evolutionary model provides a farbetterbasisformodelingeconomicgrowthfueledbytechnical advancethan does the neoclassicalmodel amended bythe introductionof variablesthatrepresenttechnicaladvance.Inparticular,we shall develop the point that an evolutionary theory of growth offers a frameworkthatisfarmorecapableof integratingmicroandmacro aspectsof technicaladvancethanisthemoreorthodox,formalapproach. InPartV,weturntoaproblemthathasresistedeffectiveattack with conventional theoretical tools:analysis of the processes of competitionthrough innovation describedby Joseph Schumpeter (1934, 1950).Wedevelopmodelscapableofexploringandidentifying strandsoftherichwebofrelationshipsbetweenmarketstructure andinnovationthatsuchprocessesinvolve.One of theaspectsexplored willbethelineof causation that connectssuccessfulinnovation tofirmgrowthtochange inmarket structure.But we shall consider,aswell,themoretraditionallyconceivedSchumpeterian "tradeoffs"and some of the associatedpolicyissues. TheanalysisrevertstoalessformalstyleinPartVt wherewe discussnormativeeconomicsfromtheperspectiveprovidedbythe evolutionaryviewofpositiveeconomics.Manyofthetraditional questions of normative theory will be dismissed as too artificial to be helpfulsurrogatesforrealissues,otherswillreceivesomewhatdifferentanswers,andanumberofpolicyquestionsthatarenot brought into view with orthodox lenses will be observed and considered.Inparticular,the issue of the strengths and weaknesses of free enterpriseasameansof organizingsupplywillbeseeninalight quite different from that provided by contemporary welfare economicstheory. A final chapter reviews the progress made and points tothe much larger agenda of tasksnotyetundertaken. TheNeed foranEvolutionary Theory ITISINCUMBENTupon those who propose amajor shift of theoreticalorientationtopoint out in some detailthe deficienciesof the prevailing theory or the advantages of the prevailing alternative-or preferablyboth.Ourcasefortheadvantagesofanevolutionary theoryispresentedthroughoutthisvolumeinthecourseofour development and illustrativeapplicationof thetheoryitself.Inthis chapter we introduce our critique of orthodoxy and attempt toplace it in the context of other work that has broken with the orthodox tradition. Therearenumerousrespectsinwhichorthodoxtheoryseemsto us erroneous or inadequate.Accordingly,acritique might plausibly be initiated from any of a number of different perspectives. One possibleemphasiswouldbemethodological,sincehighlydisputable questionsof scientificmethodology areraisedby thedefensivedevices that shield orthodoxy from the factsof individual and organizationalbehavior.Asurvey of some of themoresalient of thosefacts would provide an alternative perspective. Yet another might emphasize a critical appraisal of the sort of evidence that is typically put forward in supportof the orthodox explanatory scheme.All of these approacheswillbetakenatonepoint or anotherinthisbook.Butit seems appropriate to begin with an examination of orthodoxy's difficultiesintheanalysisofvariousfacetsofeconomicchange-the same important theoreticaltaskswith which our evolutionary alternativeisprincipally concerned. 24OVERVIEWANDMOTIVATION 1.THEAWKWARDTREATMENTOFECONOMICCHANGE BYORTHODOXTHEORY Much of economic analysis is concerned wi th predicting, explaining, evaluating,or prescribingchange.Presumably,then,theadequacy of atheory of firmand industry behavior should be assessed in good part in terms of the light it sheds on such phenomena asthe response of firmsand the industry asa wholetoexogenous change inmarket conditions, or how it illuminates the sources and consequences of innovation.We are not the first to point out that orthodox theory tends todeal in an adhocway with the firstproblem, and ignores or deals mechanicallywi ththe second. Thetheoryoffirmandindustrybehaviorputforthincontemporary textbooksand certainadvanced treatisescertainly appears to addressthefirstproblemdirectly;indeed,thisiswhatpositive theory seems to be mostly about.Formal orthodox theory purports to explain the determination of equilibrium prices,inputs, and outputs under variousunderlying product demand and factor supply conditions.Inthe context of partial equilibrium industry analysis,for example,the heart of the theoretical exercise involves the derivation of output supplyfunctions(firmandindustry output asafunctionof factorandproductprices),functionsrelatinginputproportionsof firmstorelativefactorprices(presumingmovementsalongisoquants),andsoon.But,despiteappearancestothecontrary,the theorydoesnotdirectlyaddressthequestion:Whathappensif the demand for the product of the industry increases,or if the price of a particular factor of production rises?That is,it doesnot addressthe questionunlessoneassumesboththatbehavioraladjustmentsare instantaneousandthatthesechangesin market conditions andthe resultingequilibriumpricesareperfectlyforecastinadvanceby everybody.Morerealistically,firmsmust beunderstoodasmaking time-consumingresponsestochangedmarketconditionstheyhad not anticipated on the basis of incomplete information astohow the market willsettledown.1 Onthisplausibleinterpretation,firmbehavior intheimmediate aftermath of achange in market conditions cannot be understood as "maximizing,"inthesimplesenseofthattermembracedbythe theoryinquestion,andtheindustrymustbeunderstoodasbeing 1.In his Foundations(1947)Samuelson dearly articulatesthe "out of equilibrium" character of actualfinnand industry responsestoshocks.Since that time the profession has grown somewhat casual aboutthe problem, in the context of partial equilibriumanalysis.See,forexample,thetreatmentof dynamics,introducedalmostasan afterthought,in Henderson andQuandt (1980,pp.159-169). THENEEDFORANEVOLUTIONARYTHEORY25 outofequilibriumatleastforatimeaftertheshock.Absentthe perfect-foresightassumptionorsomethingveryclose,onemust admit that changes in market conditions may come as a surprise to at leastsomefirmsintheindustry.Oncetheunanticipatedchange comes, firms' prevailing policies, keyed to incorrect expectations, are not profit maximizing in the actual regime.Explicit models that recognizetheproblemtendtoincorporatetheassumptionthat,faced with ashockthat makesoldpoliciessuboptimal,firmsadapt tothe changedconditionsbychangingtheirpoliciesinanappropriate direction.2 Seldomdothesemodelsassumethatthechangesare madeinstantlyoronceandforall.Positingadaptive(ratherthan maximizing)responsestounforeseenshocksispartiallyanimplicit or explicitconcessiontotheexistenceofsomeadjustmentcostsor "friction" in economic adjustment; friction,however,is a phenomenon that is not generally considered in the textbook accounts of optimizing behavior. Somerecentpapershaverecognizedexplicitlytheadjustment cost/frictionphenomenon,andhaveattemptedtodealwithitby treating the time path of response to an unforeseen shock as optimal, given adjustmentcostS.3Butsuchanapproachfoundersif it isadmitted that the response of firmsinthe industry totheinitial set of disequilibriumpriceswilllikelychangethosepricesinwaysthat cannotbeforeseeninadvance,unlessonegoesbacktotheinitial perfect-forecastingassumption.Indeed,itisaratherdelicateand complicatedtheoreticalmattereventodefineanoptimumadjustment strategy in acontext where thereare many firms,unlesssome very stringent assumptions aremade. Thus,contrary tothe apparentimpressionsof manyeconomists, theoperativetheory(ifonecancallitthat)offirmandindustry responsetochangedmarketconditionsisnotderivablefromthe textbookformalismaboutprofitmaximizingandequilibriumconstellations.Rather,thetheoryactuallyappliedin theinterpretation of real economic events is one that posits adaptive change (specified in any of several plausible ways) and typically involves two key pre2.Inparticular,notionsofadaptivebehaviorhaveoftenbeentheimplicitor explicit rationalefortheuseofdistributed lagsin appliedeconometrics.For discussions emphasizing that this sort of statistical specification isincompatible with strict orthodoxtheoreticalprinciples,see Griliches(1967)and Nerlove(1972). 3.Formalanalysisoftheeffectsofvariousformsof economicfrictionhasbeen undertakeninanumberofadvancedtheoreticalpapersdealingwithinvestment behaviorandmarketfunctioning.See,forexample,Gould(1968),Lucas(1967b), Treadway (1970), and a number of the papers in the volume by Phelps et al.(1970).For anempiricalapproachthatemphasizescontinuingoptimaladjustmenttochanging market conditions, see Nadiri and Rosen(1973). 26OVERVIEWANDMOTIVATION sumptions.One of theseisthatthe directionof adaptiveresponseis thesameasthedirectionofthechangeinprofitmaximizationconstellations.The secondisthatthe adaptive processes ultimately convergetothenew equilibriumconstellation. Atbestthistheoryisanadhocmixofmaximizingandadaptive models of behavior, and isnot at all consistent with orthodoxy's rhetorical emphasis on the unique validity of the maximizing approach. At worst,therearesome serious analytic stumbling points along the road.If decisionsaretakenatdiscretetimeintervals,adaptiveadjustmentinlitherightdirection"mayovershootthegoal-the well-knowncobwebproblem.Evenintheabsenceofdiscreteness, differencesinthepresumednatureofadaptiveresponse(forexample,whetheroutputincreasesorpriceincreasesinresponseto excessdemand)canaffectthestability conditions.Adaptivemodels mayor maynotgeneratetimepathsthatconvergetoequilibrium. Andwhether theydoor donotinaparticular case,iftheadaptive behaviormodelisacceptedascharacterizinghowfirmsrespondto unanticipated events,it shouldbe recognized that itsaccount of the processisnottheformalmodelexpoundedinm o ~ ttext booksand treatises.Verbal descriptions of adjustment, especially in elementary texts,do carry an adaptive flavor.This sort of discrepancy isnot uncommonintheoreticaldiscussion. In general equilibrium theory,the same basic problem appears in another form.The objectives of the analysis are,of course, less pragmaticandapplied,andmoreconcernedwiththefunctioningof highlyidealizedsystems.F.H.Hahn(1970),inhispresidential addresstotheEconometricSociety,surveyedtheaccomplishments of themathematicaltheory of general equilibrium,and calledattention tothe factthat economists had made little progress in modeling plausibleprocessesofdisequilibriumadjustmentthatconvergeto generalcompetitiveequilibrium.Henotedthat the institutional assumptionsonwhichmostoftheextantstabilitytheoremsdepend (Walrasiantatonnement)areplainlyartificial,whilemodelsslightly closertorealityfailtoyieldthedesiredresultin realisticcases.He concludedthat,absentunderstandingofdynamicadjustmentprocessesoutof equilibrium,lithestudyofequilibriumaloneisof no helpinpositiveeconomics.Yetit isnoexaggerationtosaythatthe technically best work in the last twenty years has been precisely that. Itisgoodtohaveit,butperhapsthetimehasnowcometosee whether itcanserveinananalysisof howeconomiesbehave.The most intellectually exciting question on our subject remains: Is it true thatthepursuitofprivateinterestsproducesnotchaosbutcoherence,andifso,how isit done?"(Hahn,1970,pp.11-12). Inspiteof Hahn'ssuggestionthat lithetimehasnow come,"the THENEEDFORANEVOLUTIONARYTHEORY27 yearsthathavepassedsincehewrotehaveyieldednosignificant progressontheproblemsheidentified.Thereasonissimplythat thoroughgoing commitment tomaximization and equilibrium analysis puts fundamental obstacles in the way of any realistic modeling of economicadjustment.Eitherthecommitmenttomaximizationis qualified in the attempt toexplain how equilibrium arises fromdisequilibrium,orelsethetheoreticalpossibilityofdisequilibrium behavior isdispatchedby someextremeaffront torealism.Applied work has tended totake the former path, and more abstract theoreticalworkthelatter. Muchthesamestrainshavedistortedorthodoxattemptstoanalyzeinnovationandtechnicalchange.Tobeginwith,itisnoteworthy that such analyses constitute a specialized literature,ignored not only in most of the theory textbooks, but also in the rest of the research literature.This segregation certainly doesnot reflectany correspondingisolation of technicalchangeandinnovation fromother phenomena of economic reality.Rather,it is implicit testimony that theorthodoxtheoreticalenginesoperatemoresmoothlyin(hypothetical)environments fromwhich these change phenomena are absent.Thetaskof copingwiththecomplicationsthey introducehas been facedup to only when the particular characteristics of a specific subjectmatterhaveplainlyleftnootherchoiceopen-and sometimesnot eventhen. Technicaladvanceisnowacknowledgedbyeconomiststobea centralforcebehindawidevarietyofeconomicphenomena:productivitygrowth,competitionamongfirmsinindustrieslikeelec:tronics and pharmaceuticals, patterns of international trade in manu.., factured goods, and many more.But recognition of its importance in thesecontextslongpredatedtheattemptstorepresentitsrolein formalmodeling.Such attempts have often reflected agrudging recognition that the data would continue to rebuff any theoretical structurefromwhichtechnicaladvanceisexcluded.Andtheresulting models havetypicallygrafted variables relating totechnical advance onto orthodox theoryin waysthat aimtopreserveasmuchaspossibleofthestandardtheoreticalstructure.Inourview,these responseshavebeen inadequate. Thisintellectualsyndromesurelymarksthepost-WorldWarII theorizing about long-run economic growth.Empirical studies in the 1950s established that the historical growth of gross national product (GNP)per worker in the United States could not be accounted forby . increases in complementary inputs per worker:there was a large unexplainedresidual.Whenmodelsappearedthat"predicted"the appearance of such aresidualasaresult of something called iltechnical advance," they preserved most other aspects of orthodox static 28OVERVIEWANDMOTIVATION theory.In particular,they maintainedthe basic assumptions that the firmsin the economy maximize profit faultlessly and that the system asawholeisin (moving)equilibrium.4 Itis,however,aninstitutionalfactoflifethatintheWestern marketeconomies-theeconomiesthatgrowththeorypurportsto model-much technicaladvance resultsfromprofit-orientedinvestment on the part of business firms.The profits fromsuccessfulinnovationaredisequilibriumphenomena,atleastbythestandardof equilibriumproposedinthemodelsin question.They stem largely fromthe lead over competitors that innovation affords.And it is also afactof lifethatthe successofinnovationisvery hardtopredict in anydetail:differentdecisionmakersandfirmsmakedifferentbets even whileunderthesamebroadeconomicinfluences,and expost some prove right and others wrong.Giventhesefacts,the retention in growth theory of a static conception of profit maximization tended to hinder understanding of economic growth rather than facilitate it. Paradoxically,it had this effect because it underemphasized and obscured the part that the pursuit of profit plays in the growth process. Forthesakeofaformaladherencetotheorthodoxcanon,growth theoryabstractedfromtheuncertainty,thetransientgainsand losses,theuneven,groping character of technicaladvance,andthe diversity of firmcharacteristics and strategies-that is,fromthe key featuresof the capitalistdynamic. Inprinciple,thesefeaturescouldhavebeen muchbetter accommodated in amore sophisticatedtheory embodying subtler applicationsof orthodoxtheoreticalprinciples.Indeed,the factthat sucha theory does not exist today must be attributed largely to the difficulty of constructing it rather than to a failure to appreciate the desirability of doing so.But whilethe difficultiesimposed bythe complexity of thesubjectmatterarecertainlysubstantial,it isimportanttonote thatorthodoxtheoristsoperateunderadditionalsevereconstraints thatareself-imposed.Whenproperlyinvoked(byorthodoxstandards),thenotionsofmaximizationandequilibriumthatarerequiredtomodeluncertaintyIdiversity,and change aredelicateand intricateintellectualdevices.Extremelystringentcriteriaof consistencymustbesatisfiedinmodelsproperlybuiltaroundthese notions-so stringent that their effect is to make situations that have beensimplifiedandstylizedtothepoint of absurdityblossominto challenging puzzles. 5There is no gainsaying the intellectual achieve4.We discusstheseissues inconsiderabledetailinPart IV. 5.Thegeneraltheoreticalapproachidentifiedwiththeterm"rationalexpectations"issupremelyorthodoxinthesensethattheconsistencyrequirementsassociated with a rational expectations equilibrium are supremely stringent. What is noteTHENEEDFORANEVOLUTIONARYTHEORY29 ment representedbythesolutionof suchpuzzles,but theachievementwouldbemoreinterestingifonlythereweresomereasonto thinkthat reality actually displaysthe consistency that the orthodox theorist strugglessovaliantlytorepresent. It isnotsurprisingthatgrowththeoristsgenerallychosetorely uponsimpleconceptionsofmaximizationandequilibrium,rather thanattemptingtocarrytheweightofthecombineddifficulties (inevitable and self-imposed) that the phenomena of growth present toorthodoxtheorizing.Whatissignificant isthat therewassolittle willingnesstocompromisefurther,thatmaximizationandequilibrium retained the honored place inthe theory while the key substantivephenomena wereejected. A different response to the same problem has dominated the literature concerned with the nature of competition in industries marked by highratesof innovation.Schumpeter'sbasiccontributionshave beenwidelyinvokedbyeconomistsintheirverbalaccountsof behavior intheseindustries,but have receivedonly afewattempts atformalization.Economictheorists,workingwithideasofprofit maximizationandequilibrium,haveknownintheirbonesthatit would be extremely difficult to build a model of Schumpeterian competition out of such components.Asaresult,untilrecentlyat least, economistswhosemotivationistodescribeandexplainecononlic phenomena asthey see theIn,rather than totest or calibrate a particular body of theory against data,have had to work with verbal theoreticalstatementsforwhichthereisnoestablishedformalcounterpart.Sometimes,in obeisance tothe canonsof acceptableeconomic argument associated with prevailing formal theory, these economists point toprofit-seeking behavior and callit profit maximization,and totendenciesof dynamiccompetitiontowipeout quasi-rentsgeneratedbypastinnovativesuccessandcallthisequilibrium.However,it shouldberecognizedthat theseconceptionsof profitmaximizationandequilibriumareafarcryfromthoseof contemporary formal theory, whether at textbook or advanced levels.Moreover, the intellectualcoherenceandpower ofthinkingaboutSchumpeterian competition have been quite low, as one would expect in the absence ofawell-articulatedtheoreticalstructuretoguideandconnectresearch. Therehavebeenanumber of attemptsinrecentyearstomodel Schumpeterian competition. Most of these have employed the orthoworthy about this approach, aside fromits indifference todescriptive accuracyat the individualactorlevel,isthatitstotaldedicationtotheconsistencyaestheticoften forcestheuseofthemost extremesimplifyingassumptionsinthestatementofthe model. 30OVERVIEWANDMOTIVATION doxbuildingblocksof maximizationand equilibrium.Severalhave been quite ingenious.They have managed to callattention to certain phenomenathatmightobtainintherealworldofSchumpeterian competition,andtoprovideatleastpieces of plausibleexplanation forthese.However,invariablytheyhavetwolimitations.First,the requirement that the model adhere rigorously to the concepts of maximization and equilibrium has forced the theorists to greatly simplify andstylizetheprocessesofR&D,industrialstructure,theinstitutionalenvironment,andsoforth.Second,thesimplifyingassumptionsemployedobscurewhatseemstoustobeessentialaspectsof Schumpeteriancompetition-thediversityoffirmcharacteristics and experience and the cumulative interaction of that diversity with industry structure. 2.DIAGNOSISANDPRESCRIPTION Manyofour criticismsof orthodoxanalysisarefamiliarenough,at leastwithintheindividualtheoreticalcontextstowhichtheyrefer. Less familiar,and morecontroversial,is our suggestion that the difficultiesof such analysis are largely areflection of fundamentallimitationsarisingfromorthodoxy'scanonicalassumptionsofprofit maximizationandequilibrium.Ifthissuggestioniscorrect,the problemsarenotfullyinherentinthesubjectmatter,butonthe other handthereisno reasontothinkthat orthodoxtheorizing will ultimately overcomethem.They willpersist,thoughperhapsin alteredform,untiltheoreticaltoolsofquitedifferentdesignare directedatthem. Ineconomictheory,asin other spheres,novel designsarenever innovativein allrespects;theyborrowheavily fromwhathasgone before. This is certainly the case wi th our own proposal. Following is a concise statement of our key differences with orthodoxy-and also of themainpointsofagreement. First,webelieve jt isapowerfultheoreticalhypothesisthateconomicactors-particularlybusinessfirms-haveobjectivesthat they pursue. Profit is an important one of these 0 bjectives. Indeed, in the specific models we present in this volume, profit is the only businessobjectiveexplicitlyrecognized.Andthisassumedobjective operatesinourmodelsofbusinessbehaviorinthestandard way-that is,asacriterion forchoiceamong contemplatedalternativecoursesof action.If thismuchwereallthat"profitmaximization"implied,ourmodelswouldbemodelsofprofit-maximizing behavior. The profit maximization assumption of formal orthodox theory is, 31THENEEDFORANEVOLUTIONARYTHEORY however,muchstrongerthantheviewwithwhichwehaveexpressed agreement. It involves very definite commitments on the natureofthealternativescomparedandthecomparisonprocess.We explore these commitments in detail in Chapter 3.Here we make the point concisely and a bit too starkly:the orthodox assumption is that there isa global, faultless,once-and-for-all optimization over a given choicesetcomprisingallobjectivelyavailablealternatives.6 This clearlyconflictswith,forexample,anassumptionthatthefirm operatesatalltimeswithastatusquopolicy,theprofitabilityof whichitinexactlycompares,fromtimetotime,withindividual alternativesthat present themselves by processesnot entirelyunder its control-changing policies whenthe comparison favorsthepresented alternative over the current status quo. This latter assumption ismoreinthespiritofevolutionarythe