EVOLUTIONARY PERSPECTIVES IN ECONOMICS Luigi Orsenigo University of Brescia KITeS – CESPRI, Bocconi University Open University L. Orsenigo, Seoul, April 2008

Outline Basic concepts and inspirations of evolutionary economics Methodology and the essence of the evolutionary approach Evolutionary Models of industrial dynamics, innovation and technical change Developments in Evolutionary Modelling L. Orsenigo, Seoul, April 2008

BASIC CONCEPTS AND INSPIRATIONS Antecedents: Marshall, Schumpeter, Alchian, etc.. The invisible hand and the natural selection metaphor: competition like natural selection (survival of the fittest)? (Milton Friedman) Institutionalism: Veblen, Hodgson L. Orsenigo, Seoul, April 2008

The “new” evolutionary economics Nelson and Winter 1982 Innovation, technical change Dynamics Bounded Rationality Organizations Institutions Schumpeterian competition Economic growth How is it that some kind of “order” emerges out of the actions of heterogeneous agents, who do not understand very well the constantly and endogenously changing environment in which they live? Dynamics first Bounded rationality Disequilibrium L. Orsenigo, Seoul, April 2008

The Principles (from S. Winter) 1. Realism! It may not be a necessity for good theory, but it is often a virtue at least at the prevailing margin. There is no need to take off one head and put on another one when you step reading the business page and start doing economics 2. Dynamics first! To impose on dynamic theory the burden of supporting a pre-existing static equilibrium analysis, is essentially to put on blinders, making it inevitable that obviously significant issues will be overlooked 3. No free calculation! It is an abiding scandal that the self-proclaimed science of scarcity routinely treats all forms of deliberation and information processing as free. This scandal reaches Monica-gate proportions in rational expectations and other sophisticated equilibrium concepts that implicitly endow each actor with the ability solve every actor’s problem many times over. 4. Firms are profit seeking! It is a true fact of nature that firms are typically profit seeking, but it is not a true fact of nature that they are typically profit maximizing. Profit maximization is a theorist’s crutch and ought to be abandoned when it is too stark to capture the reality of profit seeking or too cumbersome to permit analysis of any but the most extremely stylized models L. Orsenigo, Seoul, April 2008

.5. Innovation is always an option! One thing a profit-seeking firm can do rather than optimize over a given set of possibilities is to think of some new possibilities. Hence, every analysis of such optimizing behavior deserves an asterisk leading to a footnote that says: unless, of course, there is a better idea. 6. Firms are historical entities! They typically display pronounced inertial or quasi-genetic traits (e.g. scale/ routines) that are clearly persistent enough to shape their actions over interesting prediction periods. They ought to be represented that way in theory, positioned in model history the way real firms are positioned in real history. 7. Firms are repositories of productive knowledge! In most contemporary societies they are in fact the key repositories of technological and organizational knowledge and among the key agents of historical change. The storage and advance of knowledge, the maintenance and improvement of organizational capabilities, are complementary roles. L. Orsenigo, Seoul, April 2008

8. Progress is co-evolutionary! Technological and organizational innovation is generated by a variety of firm- level search processes. But firms do not search independently, they look to rivals, suppliers and customers for ideas, technologies and practices. And these firm and industry processes go forward in the context of a variety of public and private institutions and programs, which in turn are shaped by the firms. I could tell you that itís really simpler than that, but That Would be Wrong. 9. Anything can happen for a while! As Schumpeter said, only when things have had time to hammer logic into men is it safe to assume that some level of rationality will characterize economic outcomes. Market discipline and economic natural selection constrain outcomes over time, but in the short run anything can happen. L. Orsenigo, Seoul, April 2008

The Evolutionary Approach Analysis of changing systems Change is partly exogenous, but partly endogenous Change is partly stochastic and partly deterministic Agents are different, do not understand perfectly the world and cannot look too far ahead Selection Learning Institutions Methodological commitments: start from stylized facts empirically-based assumptions appreciative theorizing models L. Orsenigo, Seoul, April 2008

The Evolutionary Metaphor Heterogeneous Populations (agents, routines, technologies, etc) Selection: define fitness and how fitness selects among “things”. But fitness can be multidimensional, may change over time (Hyper-selection, co- evolution) and may be partly endogenously determined. Units of selection: genotypes and phenotypes Mechanisms of selection Adaptation and variation: bounded rationality, learning and discovery Does selection optimize? L. Orsenigo, Seoul, April 2008

Applications Economic History and History of Technology (Rosenberg, Chandler, Galambos, Mokyr, Vincenti, Basalla, Freeman…): technology and organizational institutional forms co-evolve over time Business and Management: (Teece, Utterback, Rosenbloom, Pisano, Henderson, Winter…..): competence-based theories of the firm Individual and Organizational Learning (Dosi, Marengo, Malerba…) Consumer Behaviour (Dosi) Industrial Organization: (Dosi, Malerba, Klepper, Metcalfe…..): - empirical studies of the evolution of particular industries Innovation studies (Freeman, Pavitt, Cantwell, Archibugi,….) Industrial dynamics L. Orsenigo, Seoul, April 2008

Applications (ctd.) Growth: (Dosi, Silverberg, Verspagen…) Trade: (Dosi, Verspagen, Cantwell..) Policy: (Metcalfe, Winter,….) Methodologies: Case Studies Experimental Economics Econometrics L. Orsenigo, Seoul, April 2008

Evolutionary Models of Industrial Change Build a formal argument to reproduce and “explain” specific stylized facts The argument is derived from appreciative theorizing Dynamic stochastic systems: when analytic treatment is impossible, simulate the model Derive simplified, compact versions of the model and solve it analytically L. Orsenigo, Seoul, April 2008

Simulation Heuristic technique, widely used in other sciences Inductive approach Theory-driven and disciplined Problems of validation: robustness, sensitivity analysis, ability to reproduce facts, calibration L. Orsenigo, Seoul, April 2008

Nelson and Winter 1982, Winter 1984: Schumpeterian competition Heterogeneous firms, characterized by capital stock and routines, produce, invest and search for new techniques Invest in R&D or imitation a fraction of turnover Double draw scheme: first draw from a distribution to determine whether the effort was successful or not; if yes, draw from another distribution to determine the extent of the improvement Produce and sell with the new technique, determine profits More profitable firms, invest more in capital stock and R&D and grow (success breeds success) Markov process In Winter 1984: entry, exit L. Orsenigo, Seoul, April 2008

Applications and results Emergence of concentration in industries undergoing technical change Endogenous market structure: concentration increases with conditions of opportunity, appropriability and cumulativeness (technological regimes) - Technical change is higher in concentrated industries L. Orsenigo, Seoul, April 2008

History Friendly Models CLOSER RELATIONSHIP WITH HISTORICAL AND EMPIRICAL ANALYSIS INDUSTRY-SPECIFICITIES PUT MORE RESTRICTIONS ON MODELS DERIVE TIME-PATHS, NOT “SIMPLY” LIMIT PROPERTIES FORMALIZE AN APPRECIATIVE ARGUMENT (Sources of industrial advantages) L. Orsenigo, Seoul, April 2008

The Evolution of the Computer Industry Four eras: early experimentation and mainframes (transistors) introduction of integrated circuits and subsequent development of minicomputers. personal computer, made possible by the invention of the microprocessor. networked PCs and the Internet. Discontinuities concerning both components technology (transistors, integrated circuits, and microprocessors) and the opening of new markets (minicomputers, PCs). One firm - IBM - emerges as a leader in the first era and keeps its leadership also in the successive ones, surviving every potential "competence-destroying" technological discontinuity. In each era, however, new firms have been the vehicles through which new technologies opened up new market segments. The old established leaders have been able to adopt the new technologies and - not always and often facing some difficulties - to enter in the new market segments, where they gained significant market shares but did not acquired the dominant position they previously had. L. Orsenigo, Seoul, April 2008

Questions What determines the emergence of a dominant leader in the mainframe segment? What are the conditions that explain the persistence of one firm's leadership in mainframe computer, despite a series of big technological "shocks"? What allowed IBM to enter profitably into new markets (PCs) but not to achieve dominance? L. Orsenigo, Seoul, April 2008

The era of transistors, entry and the mainframe industry At the beginning, the only available technology for computer designs is transistors. N firms engage in efforts to design a computer, using funds provided by "venture capitalists" to finance their R&D expenditures. Some firms succeed in achieving a computer that meets a positive demand and begin to sell. This way they first break into the mainframe market. Some other firms exhaust their capital endowment and fail. Firms with positive sales uses their profits to pay back their initial debt, to invest in R&D and in marketing. With R&D activity firms acquire technological competencies and become able to design better computers. Different firms gain different market shares, according to their profits and their decision rules concerning pricing, R&D and advertising expenditure. Over time firms come closer to the technological frontier defined by transistor technology, and technical advance becomes slower. L. Orsenigo, Seoul, April 2008

The introduction of microprocessors After a period t', microprocessors become exogenously available. This shifts the technological frontier, so that it is possible to achieve better computer designs. A new group of firms tries to design new computers exploiting the new technology, in the same way it happened for transistors. Some of these firms fail. Some enter the mainframe market and compete with the incumbents. Some others open up the PC market. Incumbents may choose to adopt the new technology to achieve more powerful mainframe computers. Diversification in the PC market L. Orsenigo, Seoul, April 2008

Computers in the space of characteristics L. Orsenigo, Seoul, April 2008

Customers and Markets Computers are offered to two quite separate groups of potential customers:. "large firms", greatly values performance and wants to buy mainframes. "individuals", or "small users", has less need for high performance but values cheapness. It provides a potential market for personal computers. Each of the two user groups requires a minimum level" of performance and cheapness before they are enticed to buy any computer at all. Then, the value that customers place on a computer design is an increasing function of its performance and its cheapness.

Demand The probability, Pi, that a particular submarket will buy a computer i is: c0 is specified so that the sum of the probabilities adds to one. Mi denotes the "value" of computer i. "mi" is the market share of the firm who produces computer i the market share variable can be interpreted either in terms of a "bandwagon" effect, or a (probabilistical) lock-in of consumers who previously had bought products of a particular brand. The constant parameter d1 assures that even computers that have just broken into the market, and have no previous sales, can attract some sales. "A" is the advertising expenditure of a firm. The constant parameter d2 performs here a similar role to d1 for firms who have just broken into the market and have not yet invested in advertising. If consumers in a particular submarket decide to buy computer i, then M is the number of machines they buy. L. Orsenigo, Seoul, April 2008

Innovation In every period the "merit " of the computer each firm is able to achieve along its technological trajectory -- performance and cheapness— improves according to: R, is the firm's R&D expenditure, where i=1 is performance and i=2 is cheapness. T represents the number of periods that a firm has been working with a particular technology. Li-Xi, measures the distance of the achieved design from the technological frontier. The closer one gets to the frontier, the more technological progress slows down, for every given level of R&D expenditure. There is also a random element to what firm achieves, given by e. L. Orsenigo, Seoul, April 2008

Profits, prices, R&D Profits:  t = M*p – M*k, Price: p t = k * (1+  t ) Mark-up:  t = 0.9*  t *(m i /(  - m i ), Where  is demand elasticity R&D expenditures: R t, =  *  t (1-  ) Advertising: L. Orsenigo, Seoul, April 2008

The dynamics of concentration L. Orsenigo, Seoul, April 2008

Counterfactuals L. Orsenigo, Seoul, April 2008

Counterfactuals 2 L. Orsenigo, Seoul, April 2008

Policy experiments L. Orsenigo, Seoul, April 2008

Theoretical experiments: failed adoption L. Orsenigo, Seoul, April 2008

Experimental Users L. Orsenigo, Seoul, April 2008

Pharmaceuticals Innovation as a quasi random process Innovation and imitation Market fragmentation Low concentration, despite high R&D and marketing L. Orsenigo, Seoul, April 2008

Pharmaceuticals L. Orsenigo, Seoul, April 2008

Random search, patent Development Product launch and marketing Imitation L. Orsenigo, Seoul, April 2008

Counterfactuals Costs and economies of scale Market size and demand growth Market fragmentation Innovative opportunities Patent protection L. Orsenigo, Seoul, April 2008

CHANGING VERTICAL SCOPE OF FIRMS IN OF THE COMPUTER AND SEMICONDUCTOR INDUSTRIES L. Orsenigo, Seoul, April 2008

Understanding the determinants of specialization and vertical integration in related industries in uncertain and dynamic environments, characterized by technological discontinuities. Major factors: capabilities, technical change and market size Co-evolutionary processes L. Orsenigo, Seoul, April 2008

A capability-based, dynamic theory of vertical integration and specialization Competence accumulation in specific technological and market domains Competence destroying technological change Coordination and integration capabilities Capabilities take time to develop Decisions to specialize and vertically integrate are not symmetrical The distribution of capabilities among all industry participants are relevant Market selection amplifies the effects of capabilities on the vertical scope of firms The identity of firms affects the development of capabilities L. Orsenigo, Seoul, April 2008

SPECIALIZATION AND INTEGRATION DECISIONS VERTICAL INTEGRATION decision is led by: - the relative size of the computer firm compared to the largest SC component producer (capabilities, R&D, innovation) - the age of the SC component technology SPECIALIZATION decision is led by: Comparison between the quality of SC components produced in-house and the quality of SC components available on the market L. Orsenigo, Seoul, April 2008

History Friendly Simulation L. Orsenigo, Seoul, April 2008

TESTING THE MODEL:COUNTERFACTUALS 1.Does lack of external markets lead to more vertical integration? 2.Do no demand lock-ins in mainframes lead to more specialization ? 3.Do no demand lock-ins in semiconductors lead to more vertical integration ? 4.Does a minor technological discontinuity in microprocessors lead to more vertical integration? L. Orsenigo, Seoul, April 2008

No external market for SC L. Orsenigo, Seoul, April 2008

Policy exercises Antitrust Public procurement Investment in basic research Unintended consequences - The creation of open standards in computers may lead to the emergence of concentration in components - Antitrust policy in computers may lead to the emergence of a monopolist in the PC market and the disappearance of a the merchant component industry. -Open standards in systems may lead to the emergence of a merchant component industry L. Orsenigo, Seoul, April 2008

User- Produce relations Dynamic matching Specific and generic bonus Contact length Exclusive contracts Lead users L. Orsenigo, Seoul, April 2008