Ormerod’s Why Most Things Fail

28 July 2012 by Leave a Comment

After sitting on my reading list for a few years, I have finally read Paul Ormerod’s Why Most Things Fail. Ormerod’s basic argument is that failure is all around us and given the complexity of the world, there are limits to how much corporations can control their fate or governments can control the success of their policies. Governments, firms and households lack complete information. They do not have the cognitive power to process the available information to determine the optimal choice. As a result, when you look at their success, the outcomes look more like the result of chance than of rational strategic decisions.

Ormerod’s argument is built upon some interesting work done by himself and others in which the extinction rate of United States firms (and ultimately a wider suite of global firms) was examined. Firm death tends to follow a power law distribution, and when mapped against the historical extinction of species, which we know is built upon chance events, the pattern looks similar. In models of firm extinction involving networks of interconnected firms, if firms are given much more than 10 per cent of the available information about their relationships with other firms and are able to affect those relationships, the patterns of firm death cease to mirror those which we see. This suggests that firms act with little control over their success or failure.

While this is an interesting argument and I would suggest an important observation, is the mapping of firms to species the right mapping for the analogy? For example, a species is defined (roughly) as a group of organisms that are capable of interbreeding and producing viable offspring. Thus, the units of selection, the genes, are limited to within that species. In the case of a firm, if we consider the unit of selection to be a strategy, these are able to spread to any firm. All firms are capable of interbreeding and producing fertile offspring. So are firms more akin to members of a species than to each being a species on their own? And if so, what implications does this have for the model? If individual organisms within species have similar patterns of death without reproduction to that observed for the extinction of species (which I expect is roughly the case), then the implications may be small. However, without exploring these types of questions, Ormerod was some way from having me fully convinced that his comparison is the right one.

Ormerod takes some time to build to his exploration of firm extinction and some detours of varying interest along the way. One of his building blocks is an exploration of Schelling’s models of segregation, which Ormerod uses to show that simple rules can result in surprising and complex phenomena. This example forms ones of the pillars of Ormerod’s case about the complexity of the world, but I wondered at times if this was the most convincing example available. Despite the complex behaviour in Schelling’s models and the difficulty of predicting which person will end up living where, the model does allow some prediction at the macro level. It is also the case for other models explored in this area, whether that being the first-order difference equations investigated by Robert May or Brian Arthur’s El Farol bar. Predicting specific results is near impossible, but picking the pattern and the effect of parameter changes on that pattern is possible.

The detours also includes some bashing of the neoclassical economics straw man, which rarely moves beyond attacks on the most basic of assumptions. Ormerod’s choice of supporting evidence is interesting, but the omissions are often obvious. Take his quoting of Vernon Smith on the flaws with existing models of the operation of markets, but no mention of Smith’s experimental work which suggests how well markets seem to find an equilibrium despite the knowledge shortfalls and bounded rationality. Similarly, when discussing bounded rationality, Ormerod does not explore the success or failure of heuristics (Also strange was the crediting of bounded rationality to Akerlof and Stiglitz with no mention of Herbert Simon). Ormerod could still have made his case with a more in-depth discussion, and then it might have felt more convincing.

Ultimately, however, it was the closing that was most disappointing. Once Ormerod has established that companies have little control over their fate, and that the world is too complicated for governments to make decisions (both arguments I am sympathetic to), he then takes little effort to ask what this means. In the company case, it comes with a call to innovation and flexibility. But given that strategic choice has little to no effect on the probability of firm survival, as Ormerod told us, why will that particular approach work? Why is Ormerod’s suggestion immune to this problem? Compared to Tim Harford’s examination in Adapt (whether you agree Harford’s recommendations or not), Ormerod’s examination of the practical implications is very thin.

When it comes to government, again the questions left unanswered are more interesting than those addressed. If governments are likely to achieve success only by chance and cannot possibly achieve success through detailed planning, what should they do? We have a host of government interventions ranging from legislation to enable joint stock companies to protection of property rights that could be argued to be important in affecting our wellbeing. How would these be facilitated in a world where we otherwise throw up our hands in despair? Ormerod’s hints at some ideas but instead of exploring them, he sticks to blanket denouncements of governments acting as though Soviet Russia was a success. Fair enough, but it’s not a very deep argument and I sense the book sells Ormerod’s thoughts on this question short.

Filed Under: Economics, Evolution Tagged With: , , , ,

Some perspectives on Elinor Ostrom

13 June 2012 by Leave a Comment

Below are three passages that capture a small part of the evolutionary flavour of the now late Elinor Ostrom’s work.

From David Sloan Wilson:

Lin’s work was like a breath of fresh air compared to the forbidding world of neoclassical economics, which was top-heavy with theory and required assumptions about human preferences and abilities that were manifestly unrealistic. In contrast, Lin’s work was empirically well grounded and her eight design principles were highly congruent with the evolutionary dynamics of cooperation in all species and the biocultural evolution of our own species. Her work might have originated within the field of political science and been applied primarily to common-pool resource groups, but I realized that it could be generalized in two senses. First, it could be placed on a more general theoretical foundation suitable for all human-related disciplines. Second, it could be applied in a practical sense to most human endeavors that involve working in groups to achieve common goals—which means most human endeavors.

From Henry Farrell’s response to Ostrom’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel:

Her work implies that both pure marketization and top-down government control can have badly adverse consequences for resource management, because they rob individuals of the capacity to govern themselves, and because they both lead to the depletion of important forms of local collective knowledge. Alex Tabarrok is right to see something Hayekian in Ostrom’s arguments – but it is Hayek against Hayek. Ostrom stresses repeatedly that even the best functioning markets are undergirded by an array of collective institutions which order people’s market interactions, and that in the absence of such rules, self interested behaviour will have highly adverse consequences.

From Ostrom’s How do Institutions for Collective Action Evolve (pdf):

It would be naive to assume that any evolutionary process will always lead to better outcomes. In biological systems, competition among populations of diverse species did lead to the weeding out of many individuals over time that were out-competed for mates and food in a given environment. Evolutionary processes can also lead to equilibria imposing higher costs on some species and eliminating others. The huge investment made by peacocks in their tails is one example. Thus, one should not expect that all locally governed systems will eventually find effective rule configurations. Some will experiment with rule configurations that are far from optimal. And, if the leaders of these systems are somehow advantaged by these rules, they may resist any effort to change.

Filed Under: Economics, Evolution Tagged With: ,

Beinhocker’s The Origin of Wealth

11 April 2012 by 1 Comment

In The Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics, Eric Beinhocker argues that the economy should be studied as a complex adaptive system made up of adaptive agents, with the economy emerging from the interactions of those agents. It is an excellent book and possibly the best discussion of why the economy should be studied as a complex adaptive system, but as for other explorations of this area, it does not take the step of bringing complexity economics to life as an applied science.

Complex adaptive systems are open, dynamic and modelled individually, with macroeconomic outcomes reflective of microeconomic behaviour. The units of selection – which for Beinhocker are the modules of business plans – undergo an evolutionary process of differentiation, selection and amplification. This contrasts with the “traditional economic” approach of closed, static systems that are in equilibrium and modelled collectively with no mechanisms for endogenous novelty.

Beinhocker’s critique of neo-classical economics and its foundations does not completely avoid caricature, but his argument that an economy is a complex adaptive system is strong. This naturally leads to observations about the importance of path dependence in outcomes, the possibility of markets failing, the existence of bubbles and so on. For someone who has read much on complexity theory, the usual pieces of work and suspects are wheeled out, from Brian Arthur’s El Farol bar problem to Doyne Farmer’s trading markets. It is interesting, but it is also a sign of a field struggling to gain traction when the same examples are wheeled out repeatedly.

Beinhocker generally stays at Stage 2 of the stages of evolutionary economics, whereby evolutionary biology is not directly incorporated into the analysis. At times, this results in some laboured explanations. For example, in attempting to find the appropriate unit of selection, Beinhocker argues that the definition of a gene is fuzzy and changes depending on whether it is undergoing selection. By attempting to cast uncertainty over the biology, the difficulty in defining the units of selection in the economy might seem less so.

Similarly, gaps can be seen when Beinhocker suggests that the economy has shifted from being a “Big Man” economy, in which someone at the top of a hierarchy directs economic activity and obtains the economic surplus, to a market economy. This results in a shift from survival selection to what Beinhocker calls social selection. Technologies in Big Man economies spread with the survival of their carriers, but now that link is divorced. However, this has not changed to the extent that Beinhocker suggests. Human genes are still under selection, regardless of the form of economic system, although the favoured traits may vary. Survival and reproduction still matter, and the transmission of technologies and ideas remain linked to this. An approach that ignores biological motivations also provides limited insight into the formation of the Big Man or market economies. They too are endogenous to the biological actors.

At times Beinhocker heads towards a stronger evolutionary basis, such as in his suggestion that evolutionary psychology should be used to understand human preferences. However, this ultimately short-changes what evolution can offer. Beinhocker notes its central role when he writes:

Economic wealth and biological wealth are thermodynamically the same sort of phenomena, and not just metaphorically. Both are systems of locally low entropy, patterns of order that evolved over time under the constraint of fitness functions. Both are forms of fit order. And the fitness function of the economy – our tastes and preferences – is fundamentally linked to the fitness function of the biological world – the replication of genes. The economy is ultimately a genetic replication strategy.

The book closes with a discussion of what the lessons are from a complexity framework. Beinhocker warns at the beginning of the book that he does not give concrete answers, but he does offer suggestions.

For businesses, Beinhocker’s analysis is similar to (but predates) the argument by Tim Harford in Adapt. Beinhocker encourages experimentation within companies, with greater tolerance for failure and appropriate feedback mechanisms to tell the business when it is time to drop a particular strategy. Unfortunately, Beinhocker then turns to a discussion of whether companies should pursue narrow shareholder value or long-term growth, at which point the argument becomes weak.

Beinhocker also claims to overcome the left-right continuum through his complexity approach, which acknowledges the emergent and useful behaviour of markets but the possibility of market failure. However, after making this claim, he then suggests a group of policy prescriptions that place him on the continuum and that are only weakly derived the complexity approach that forms the bulk of the book. For example, he adopts arguments concerning the lack of intergenerational mobility in the United States and the importance of parental influences on children, despite the dearth of any evidence for parental influence, yet he fails to mention the argument about path dependence provided by complexity theory (nor the implications of heritable traits). Instead, he falls back on Rawlsian arguments for justice.

One interesting observation by Beinhocker is his description of the role of government as a fitness function shaper. By introducing market based regulations (such as an emissions trading scheme), government shapes the landscape of what strategies will have highest fitness, without prescribing which particular strategies should be used. In such a case, it is not clear that the change in landscape will be efficiency destroying, although Beinhocker does note the potential for what Hayek would term the fatal conceit.

Overall, Beinhocker’s book is a great synopsis of the area, but it confirms that since the formation of the Santa Fe Institute 30 years ago, the field of complexity economics has moved slowly. Beinhocker suggests it takes some time for changes in frameworks to be absorbed. There is no sign of change coming for complexity economics yet.

Filed Under: Economics, Evolution Tagged With: , ,

The three stages of evolutionary economics

9 April 2012 by 4 Comments

Many of the suggested additions to my reading list in evolution and economics came from the fields of evolutionary economics and complexity theory.

While my area of interest is sometimes described as “evolutionary economics”, evolutionary economics is a label generally applied to the study of the interactions of firms, institutions and agents in the economy using an evolutionary methodology. Businesses search the landscape for technology and other sources of competitive advantage, and those business modules (technologies, plans) with higher fitness are replicated and spread. Much research in evolutionary economics also has strong links to complexity theory. However, evolutionary economics it is not directly concerned with evolutionary biology.

I tend to argue for the intersection of evolution and economics at a deeper level than that generally examined in evolutionary economics. I suggest there are three stages of evolutionary economics.

1. The metaphor: Economies are like evolutionary systems. The metaphor is the domain of popular books, magazine articles and conversation at the pub.

2. Economies and biological systems are both complex adaptive systems. This is where the field of evolutionary economics tends to operate. Economic activity occurs in an evolutionary system, as opposed to being just like one in Stage 1. Selection in the system is often at the level of businesses and the modules of their business plans.

3. Economies and biological systems are the same system. Economic activity is undertaken by evolved (and evolving) people, with traits and preferences reflecting their evolutionary past. As an extension to Stage 2, businesses are made up of parties with biological interests (shareholders, creditors, employees) and interact in social orders that emerged from interactions between those parties.

There is much useful research being undertaken at Stage 2, and in many cases it is the most useful level of analysis, but economics will only be an evolutionary science when it incorporates Stage 3.

Following the feedback, I have added a couple of evolutionary economics and complexity theory books and articles to the reading list.

Filed Under: Economics, Evolution Tagged With: , ,

Galbraith on evolution and the invisible hand

1 July 2011 by

Paul Krugman’s oft-quoted critique of Stephen Jay Gould is one of the more brutal dismissals of his work (it is from a 1996 speech on what economists can learn from evolutionary theorists):

Now it is not very hard to find out, if you spend a little while reading in evolution, that Gould is the John Kenneth Galbraith of his subject. That is, he is a wonderful writer who is beloved by literary intellectuals and lionized by the media because he does not use algebra or difficult jargon. Unfortunately, it appears that he avoids these sins not because he has transcended his colleagues but because he does not seem to understand what they have to say; and his own descriptions of what the field is about – not just the answers, but even the questions – are consistently misleading.

While this statement is usually quoted in reference to Gould, it is also a blunt assessment of John Kenneth Galbraith’s work. I have not read much Galbraith, despite having The Affluent Society on my reading list for a while, so I am not in a position to judge Krugman’s comparison. However, I recently came across an article written by Galbraith in which he considered the invisible hand metaphor from the perspective of Darwinism. He stated that belief in the invisible hand was like belief in intelligent design, under which evolution is guided by an intelligent designer and is not the result of unguided natural selection. Galbraith writes:

Smith’s Creator did not interfere. He simply wrote the laws and left them for events to demonstrate and man to discover. The greatest American economist, Thorstein Veblen, observed that “the guidance of…the invisible hand takes place…through a comprehensive scheme of contrivances established from the beginning.” What is this if not Intelligent Design?

But to Veblen this was, precisely, unscientific. And so he made a mighty effort back in 1898 to move economics into the Darwinian age. In a magnificent essay entitled “Why Is Economics Not an Evolutionary Science?” Veblen pointed out the problems of classical economics: too much preoccupied with classification schemes and higher purposes, too little with material process and “cumulative or unfolding sequence.” Economics could become a science, but only if it detached itself from the idea that change intrinsically led to improvement.

It is an interesting comparison but  Galbraith has lined up the wrong target. He is right that evolution provides a critique of the interpretation of the invisible hand that voluntary interactions between people always result in the optimal social outcome. While voluntary exchange is beneficial for the individual participants, evolution shows us that there is no mechanism to make sure societal benefit is maximised – there is no intelligent designer. With wasteful signalling, winner takes all contests and the potential for sub-optimal equilibria, an emergent economy might be full of waste and inefficient competition.

However, Smith did not state that emergent outcomes were always positive and he recognised a score of ways in which market interactions could lead to sub-optimal outcomes. The invisible hand is an excellent metaphor for the emergent phenomena whereby “selfish” actions by individuals lead to outcomes that they do not intend. They are generally welfare enhancing (which is one reason I lean libertarian) but not necessarily so. Instead of criticizing the invisible hand metaphor, Galbraith should have used the intelligent design comparison to argue that there is no mechanism to make sure that emergent economic outcomes are positive. (Of course, this does not mean government should step in – you still need to show that government can fix the problem without creating other worse problems.)

In attacking neo-classical economics, Galbraith also raises the important issue of variation:

Economists still don’t understand variation; instead they write maddeningly about “representative agents” and “rational economic man.” They still teach the “marginal product theory of wages,” which excuses every gross inequality faced by the laboring poor. Alan Greenspan even recently resurrected the idea of a “natural rate of interest” to justify raising rates, though that doctrine had been extinct for 70 years. Economists still ignore the diversity of actual economic and social life.

Ignoring the specific examples that Galbraith has used (I don’t understand how they line up with his points), natural selection operates on variation. If every firm or agent is the same, you cannot have firm failure or creative destruction. There cannot be comparative advantage and the benefits of specialisation are diminished. Outside of evolutionary economics, few economic models try to capture this. Despite having some trouble getting to grips with Arnold Kling’s “patterns of sustainable specialisation and trade” (I’m still short on details, and am not convinced by many of his examples), I appreciate how it introduces the ideas of variation, exploration and failure. Entrepreneurs vary in their ideas and how they search for them.

Filed Under: Economics, Evolution Tagged With: , ,

Kling on patterns of sustainable specialisation and trade

15 February 2011 by Leave a Comment

I have just listened to the recent Econtalk podcast with Arnold Kling on his new “paradigm”, Patterns of Sustainable Specialisation and Trade (PSST). On first thoughts, I am not convinced about the idea. If anything, the paradigm appears to need a lot more development – although reading Kling’s blog posts, he may agree. I felt that many of the stories involved too much hand-waving and not enough empirical backbone to be convincing.

I won’t go into the details of Kling’s paradigm – I suggest listening to the podcast or tracking through Kling’s posts at Econlog for background. His most recent one on PSST is here. But, I had a couple of initial thoughts.

First, this paradigm has many similarities to evolutionary economics. Nelson and Winter’s An Evolutionary Theory of Economic Change contains a lot of material on search, competition and organisation is along the same lines as that discussed by Kling. Naturally flowing from this, would agent based modelling or other evolutionary economic modelling techniques be useful in developing working models of Kling’s theory?

Second, and given that I am far from convinced as to whether this paradigm is correct (for example, can PSST explain the current high levels of unemployment), I was wondering what empirical evidence would sway me towards it. If we track workers who have become unemployed during this recession, the PSST paradigm would predict that a sizeable chunk of this group will go to new jobs created by entrepreneurs looking to take advantage of this cheap resource. Will this be the case? How many construction or manufacturing workers will end up in jobs in which they have a new comparative advantage, and how many will get employment doing almost the same thing they were doing before? We could apply a similar test to the employer side. Do firms hire back workers for positions that they previously dumped workers from, or is the hiring in new positions in new firms?

Update: A quick additional thought – what does this paradigm say about immigration? If the gates are opened and immigration levels jump, how long is the period of adjustment for entrepreneurs to be able to take advantage of this huge resource of presumably low-skilled labour?

Filed Under: Economics Tagged With: ,

Evolutionary economics and group selection

7 February 2011 by Leave a Comment

As my research intersects economics and evolution, I have found it inconvenient that the term “evolutionary economics” is already taken. Evolutionary economics is an area of economics inspired by biological processes, with interactions between firms, industries and institutions examined using evolutionary methods. The economics is evolutionary by analogy.

I find the ideas in evolutionary economics attractive, which is natural given my interest in complex systems, out-of-equilibrium processes and the dynamic, emergent properties of economies. However, each time I read an evolutionary economics paper or book, I wonder if they are looking at the right level of selection. Should the agents in the models be firms or should they be the employees or managers of those firms (or their genes)? Putting it more bluntly, is evolutionary economics based on an inappropriate use of group selection?

The actions of firms in the lead up to the financial crisis provides an illustration. Could the web of financial firms and their interactions be usefully modelled without consideration of the range of incentives faced by employees and managers? Think Dick Fuld, his brinkmanship around saving Lehman brothers and the half a billion he was left with after it all went bad. An evolutionary economic model of this sector at the firm level might miss the major incentives (this could lead us to my previous question of what the objectives of these agents are).

So why we don’t start from a biological basis to begin with and then work up? Evolutionary economics would then become evolutionary in the truest sense. The flip side is that it is already difficult to model the interactions between firms. Adding more layers of employees, managers, creditors and shareholders may make the model more opaque, need a more complex set of assumptions and be more difficult to interpret. After all, the purpose of a model is to offer a set-up simple enough for analysis.

To assess what is the right balance, a fair starting point for analysis of an evolutionary economics paper is to ask whether the model would give the same predictions if an alternative, lower level of selection was examined? If not, it may be time for that evolutionary economic model to be evolutionary in fact and not by analogy.

Filed Under: Economics, Evolution Tagged With: ,