CLASS 3 OUTLINE The Economics of Business Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe.

CLASS 3 OUTLINE

The Economics of Business

Harvard Extension SchoolInstructor: Bob WaylandTeaching Assistant: Natasha Wambebe

Incomplete without oral accompaniment

2

Revisit Class Two

Alchian and Demsetz, “Production, InformationCosts, and Economic Organization”How do Alchian and Demsetz differ from

Coase in explaining the origin of firms?What is a cooperative team, what are its

important characteristics?What do Alchian and Demsetz view as the

fundamental distinguishing characteristic of firms?


3

Revisit Class Two…

Alchian and Demsetz, continuedWhat role does shirking play? Why do people tend to shirk?Who meters and monitors the managers?How is management shirking discouraged?What compensation characteristic can be used

to distinguish types of firms?


4

Revisit Class Two continued…

Stigler, “The Division of Labor is Limited by theExtent of the Market”What is meant by vertical integration?How does vertical integration relate to “make-or-buy”What factor does Stigler focus on in

explaining the degree of vertical integration?How does the degree of vertical integration

sometimes change over the life of the firm? What insights into outsourcing can you derive

from Stigler’s analysis?


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Nature vs. Nurture

Marshall, “The Mecca of the economist lies in economic biology rather than in economic dynamics.”

Tension between Darwinian and Newtonian systems perspective

Role of man versus nature in determining success

Management hubris e.g., “inventing the future”

Collins et al notion of super manager and super firm


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In Search of Superfirm

Collins et al employ an exemplary firm process based on sorting databases for high performers

Statistical flaw of “selecting for the dependent variable” Leads to a very truncated distribution; no basis for

evaluating the larger population Not scientific

Does not test a hypothesis Does not examine range of variables, e.g. as in regression No dynamic model, no “if-then” capacity

Firm is not directly the unit of competition or selection


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Uncertainty and Survival

Knight’s distinction between measurable risk and unmeasurable uncertainty

We cannot see the future but must still make decisions Uncertainty necessary for existence of economic profit* (No

profit if all can see the future.) Entrepreneur makes decisions under uncertainty and reaps the

rewards or losses (e.g. pays factors at current value, receives future value)

Eventually limits of survival are reached Entrepreneurial capacity is the ultimate fixed factor and he is not omniscient

Environment moves in unanticipated manner Prior adaptations inhibit reaction Others are found more fit and selected or adopted by the environment

* Profit or residual over and above the opportunity cost of capital necessary to attract it to the endeavor


8

Models and Judgment

Models are a way to capture and apply knowledge and experience May be informal or formal Seek to reduce the degree of uncertainty If system modeled is completely deterministic (“if-then”), quality of

prediction depends on knowledge of initial conditions and the continuity of system characteristics. E.g. Physics as expressed by LaPlace If system’s dynamics are very sensitive to initial conditions and those are

difficult to precisely measure, results are effectively uncertain (complexity) If a system produces emergent phenomena which are different from the

initial set, the outcome is not predictable But models also create an intellectual feedback loop and influence our

view of the world. Most applied models used in decision making under uncertainty implicitly

assume way too much certainty and a strict notion of equilibrium


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Achieving Equilibriums vs. Tendencies

Simple physical systems tend to reach equilibrium quicklyComplex physical systems may take a long time, e.g. the

expansion of the universe. But, so far as we know, it will get to some sort of cold death equilibrium one day

Economics generally conceived as a quickly equilibrating system that is normally in equilibrium until disturbed whereupon it quickly finds a new equilibrium as illustrated by comparative statics

Austrian school didn’t accept the notion of a normal state of equilibrium and argued that there was only a tendency toward equilibrium

Evolutionary economics views the economy as having a tendency to equilibrium but there is no reason to believe it necessary to get there and the trip itself is very interesting


10

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory”

Alchian sets out an evolutionary approach todescribing firm behavior: Embodies principles of biological evolution and natural

selection (recall Marshall) Economic system is an adoptive mechanism that selects

from “exploratory” actions generated by adaptive pursuit of profits or success

Alchian establishes his notion of environmental adoption and then combines it with a notion of behavior under uncertainty and incomplete information

Under these conditions, people engage in adaptive, trial and error, imitative, innovative behavior

This contrasts starkly with the typical picture of foresight and perfect rationality often ascribed to economic actors


11

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” continued

“Profit Maximization” Not a Guide to ActionUnder Uncertainty:Economic behavior was often modeled as being

undertaken by highly rational creatures with perfect foresight seeking optimum outcomes

Gerhard Tintner, a pioneering econometrician, argued that under uncertainty, the notion of “profit maximization” is meaningless

Without perfect foresight, i.e. certainty, there is no basis for profit maximization as a guide to behavior (of course with perfect foresight there is no need for “profit”)


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Without perfect foresight, i.e. certainty, there is no basis for profit maximization as a guide to behavior

Without uncertainty there is no profitThe market can price risk but not uncertainty


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Frank Knight’s famous distinction betweenrisk and uncertaintyRisk; known potential and measurable

outcomes and probabilitiesUncertainty; unknown outcomes and

probabilities Judgment; the phenomena that converts

uncertainty into basis for action (probably related to entrepreneurial capacity)

People differ wrt to judgmental capability Some specialize in offering judgment


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Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” (an aside)

Complexity theory provides perspective on flawed foresight:

The study of complex dynamical systems, aka science of surprise

Insight into why we are “surprised” Models fail us in depicting reality especially in the

presence of uncertainty


15

Armen A. Alchian, “Uncertainty, Evolution and Economic Theory” resumed

“Success Is Based On Results, Not Motivation”

Realized profits (not maximum) are the mark of success and ticket to continue playing

It doesn’t matter how they came about, their existence is sufficient

Success reflects relative superiority, doesn’t require motivation and may simply reflect luck

The environment selects (adopts) from among those offered on the basis of fitness


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“Chance Or Luck Is One Method Of Achieving Success”

Conscious decision making is not necessary in a selective and adoptive environment

If a success factor is randomly acquired, e.g. an unplanned trip route that happens to include gas stations, the selection’s success is valid and can be explained


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“Chance Does Not Imply Nondirected, Random Allocation Of Resources”

Borel’s illustration of the surprising persistence of some random games precludes ascribing longevity to foresight and rationality

Random horse race bettors will produce ex post set of perfect “forecasts”

A set of people acting with some foresight and motivation may not be distinguishable from a group of random actors


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A chance-dominated model does not precludeprediction, explanation, or diagnoses: Realized requisites for survival under alternative

conditions permit statements about likely results under various situations

Economists like everyone else have 20-20 hindsight and can use their tools to explain past outcomes

It is not necessary that any particular firm change its behavior but only that the set of firms selected for the next round behave in a manner “fit” for environment

Questionnaire methods are often invalid tests of marginalist conditions. Responder may declare intentions different from marginalist behavior

but survivors will be those whose characteristics fit the new environment


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“Individual Adapting Via Imitation And Trial and Error”

Firms will imitate successful behaviors, imitation of successful actions is a justifiable reaction. Adopting standard or orthodox rules of behavior, especially those of winners makes sense when: There may be no obvious criterion for the decision-

making Environmental variability may discourage new models The problem may be very complicated Uncertainty may make the problem intractable Superiority to rivals is crucial There may be no practicable trial-and-error mechanism


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Imitation is a way to avoid making decisions and being accountable (“No one was ever fired for buying IBM”)

Much of the passion for “benchmarking” and “world-class practices” is based on avoiding a painful and risky analysis of options.

Much of innovation is accounted for by imperfect or flawed imitation resulting in unintended innovation (analogous to new characteristics emerging from DNA copying errors)


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In addition to imitation, trial-and-error is a conscious form of adaptive behavior under uncertainty

Trial-and-error does not guarantee an eventual optimum will be reached

The near-sighted grasshopper may find a local maximum but not see the distant global maximum

Trial-and-error may work when the function is continually rising, without dips, to the optimum


22


“The economic counterparts of genetic heredity, mutations, and natural selection are imitation, innovation, and positive profits”


23

Richard R. Nelson, Sidney G. Winter, “Evolutionary Theorizing in Economics”

Earlier interest in dynamics, disequilibrium, and trial-and-error searches for profitable positions was displaced by the notion of highly rational searches for optimum solutions

Interest revived with increasing interest in industries subject to technological disruption

Schumpeterian notions of continual disequilibrium and creative learning and destruction regained attention


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Nelson and Winter describe four characteristics of dynamic economic systems

Variety refers to the number of different approaches or models present at various rounds and subject to selection

Behavioral continuity is necessary to give selection validity. Selection from among randomly behaving actors is pointless.

Profit induced growth is necessary to equip the winners in one round with additional resources to contest the next

Limited path dependence rules out a powerful feed-back mechanism from quickly eliminating all but one player


25

Richard R. Nelson, Sidney G. Winter, “Evolutionary

Theorizing in Economics”

In their section on competence, learning and routines, Nelson and Winter address what they call the “competence puzzle”

Dichotomy between competence exhibited in routinized actions and poor performance in novel situations or cases where complex logical analysis is called for

Competency can be acquired by learning and training involving short term feed back

Complex and effective behavior is routinized behavior Routines persist in part because they economize on learning

related costs and reduce frictions caused by unanticipated experimentation or novel behavior

The heart of the development puzzle is how incredibly complex technologies, systems, and organizations emerge – they evolve in incremental steps


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Nelson and Wilson argue that evolutionaryapproaches are more concerned with consistencywith current science of learning (as opposed to looking for evidence of consistency with rationalityassumptions)Separate parts of the brain are involved in mastering

routines and in engaging in complex rational analysisOnce learned, routines or skills are difficult to adjust

quickly (game example)Persistence of routines and inherited practices can and

often does inhibit adaptive behavior (e.g. Polaroid)


27


Nelson and Winter describe Schumpeterian competition asevolutionary behavior:

Schumpeter was particularly interested in cases where change was driven by technological innovations

In models where internally generated innovation resulted in greater profitability and a cycle of innovation driven profitability resulted, there is a tendency toward concentration

When the technological innovations come from outside the industry, the tendency toward concentration is eliminated or greatly reduced

A distinction is drawn between “science-based” and “cumulative” innovation.

Science-based innovation tends to be external and offers no particular firm-specific advantage

Cumulative innovation tends to favor firms with well-funded and effective in-house R&D


28


The dominant design model of industry life cycles involves:

A new, unsettled technology stimulates a number of different views on how best to achieve its benefits

An early period of high levels of entry with many different models Firms continue to enter and try new approaches, failed attempts exit

(a high level of variety continues) Eventually methods and approaches converge on a dominant design Thereafter competition is less product-based and innovation efforts

shift toward process improvement As some firms become significantly more efficient, the rate of exit

increases and Finally a relatively few large firms remain The dominant design model has been tested and succeeded in

explaining industry structure and evolution in a number of sectorsNext week’s Klepper article provides a comprehensive exposition


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Incumbents are more at risk when the change is external, science-driven, and changes the architecture of the system

Incumbents can often weather change that comes from within the industry, is of the cumulative sort, and affects components of the system

The power of foresight in explaining technological innovation is surprisingly weak or absent.


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Nelson and Winter isolate some commoncharacteristics of new technology paths:A great deal of uncertainty prevails and expert

opinions have a wide varianceWinners and losers usually don’t emerge until

significant investments have been made in rival approaches

Anyone, in government or out, who believes they can pick winners among emerging technologies is ignorant of the history of technology and innovation and incredibly arrogant


31


Technological advance is a source of disruptionand growth and the process displays certainfeatures:

Most scholars view it as an evolutionary system Industry structure and technology tend to co-evolve –

rapid growth and progress, stable period, followed by concentration when the technology matures

Technology involves both artifacts (practice) and a body of understanding which, over time, tend to advance together

Current efforts to define “innovation systems”


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Evolutionary economic models are similar in manyrespects to those used in biology:

In contrast to the analytical engines of neoclassical modeling, evolutionary models often seek to replicate or explain patterns and paths

In a subject which assumes that foresight is rare and usually flawed, it is difficult to build “predictive” models

In general, evolutionary economics is more open and amenable to outside science and approaches. But it is not much more so than other new branches such as behavioral economics.

The rejection of the neoclassical assumptions of highly rational behavior and foresight accounts for most of the openness to other disciplines.


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Next Week

Steven Klepper models a dynamic process of product sector evolution through the entry-exit-concentration cycle found in many industries

Provides a rigorous explanation for commonly observed “regularities” and especially the emergence of a “dominant design”

Forges a logical connection between innovation and business success over the product life cycle

Contains calculusSome people may find the more accessible but less

economically rigorous article “Dominant Designs and the Survival of Firms” by Fernando F. Suarez and James M. Utterback in Strategic Management Journal, Vol. 16, No. 6 (Sep., 1995) helpful to read before Klepper.

CLASS 3 OUTLINE The Economics of Business Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe.

Documents

oral accompaniment2alchian

oral accompaniment3alchian

oral accompaniment4stigler

oral accompaniment5marshall

oral accompaniment8models

degree of vertical integration

oral accompaniment6collins

degree of uncertainty