Uncertainty Evolution And Economic Theory: An Overview

 

Like Ronald Coase, Armen Alchian didn’t publish many articles, but the ones he did publish are considered seminal. His papers influenced several schools of thought, ranging from New Institutional Economics, to Neoclassical Economics, to Evolutionary Economics. But unlike Coase, the breadth of Alchian’s thought is too wide to narrowly group him in one these schools. For me at least, to call him a puzzling figure in the history of economic thought is an understatement.

Despite his odd legacy, his stature in the economics profession is undeniable. After his death, economists of all stripes wrote glowing obituaries about him and how his writings influenced their way of thinking. Just consider this paragraph from Econlib’s biographical essay of Armen Alchian:

 Alchian and Allen’s textbook was truly a public good—a good that created large benefits for which its creators could not charge. And while Alchian played the role of selfish cynic in his class, some who studied under him had the feeling that he put so much care and work into his low-selling text—and into his students—because of his concern for humanity.

Reading all of these short biographies of Alchian gives you a sense of why he was such a good economist. He took the phrase “thinking like an economist” to new heights. His creativity and ability to think about economic problems in new ways set him apart from his peers. No where is this more apparent than in his famous paper, Uncertainty, Evolution, and Economic Theory. 

The Marginalist Controversy

Alchian wrote this paper near the end of the marginal pricing debates of the 1940s. In 1939, Robert Hall and Charles Hitch wrote their paper, Price Theory and Business Behavior, which argued that businesses do not set their price according to the dictates of marginal analysis (marginal cost = marginal revenue) (1). Instead, most of the entrepreneurs interviewed used what they called “full cost” pricing (2):

An overwhelming majority of the entrepreneurs thought that a price based on full average cost (including a conventional allowance for profit) was the ‘right’ price, the one which ‘ought’ to be charged.’ In some cases this meant computing the full cost of a ‘given’ commodity,and charging a price equal to cost. In others it meant working from some traditional or convenient price, which had been proved acceptable to consumers,and adjusting the quality of the article until its full cost equalled the ‘given’ price. A large majority of the entrepreneurs explained that they did actually charge the ‘full cost’ price, a few admitting that they might charge more in periods of exceptionally high demand, and a greater number that they might charge less in periods of exceptionally depressed demand. (Hall and Hitch 1939: 19)

This result, among others, caused a heated discussion in American Economic Review, which was started by Richard A. Lester and Fritz Machlup. Lester conducted an empirical analysis similar to the one that Hall and Hitch did, i.e. interviewing companies about their pricing policies. His findings included:

  1. Market demand is more important than wages rates in determining the employment levels for a firm.
  2. The firm’s actual cost structure was different that the one suggested by conventional marginal analysis
  3. When wage rates change, firms generally do not adjust their use of labor and capital.
  4. There are huge difficulties in applying marginal analysis to a real world problems. As a result, many business owners consider it impractical.

These results again put marginalism into serious question.

In his response to Lester, Machlup emphasized two points. First, he claimed that Lester misunderstood the nature of marginalism. Marginalism wasn’t designed to predict and explain the behavior of real firms. Rather, it was designed to explain changes:

Instead of giving a complete explanation of the “determination” of output, prices, and employment by the firm, marginal analysis really intends to explain the effects which certain changes in conditions may have upon the actions of the firm. What kind of changes may cause the firm to raise prices? to increase output? to reduce employment? What conditions may influence the firm to continue with the same prices, output, employment, in the face of actual or anticipated changes? Economic theory, static as well as dynamic, is essentially a theory of adjustment to change. The concept of equilibrium is a tool in this theory of change; the marginal calculus is its dominating principle. (Machlup 1946: 521)

Second, Machlup rejected Lester’s claim that marginalism had no practical use because it was difficult for firms to implement. He used the analogy of an automobile driver changing lanes:

The driver of the automobile will not “measure” the variables; he will not “calculate” the time needed for the vehicles to cover the estimated distances at the estimated rates of speed; and, of course, none of the “estimates” will be expressed in numerical values. Even so, without measurements, numerical estimates or calculations, he will in a routine way do the indicated “sizing-up” of the total situation. He will not break it down into its elements. Yet a “theory of overtaking” would have to include all these elements (and perhaps others besides) and would have to state how changes in any of the factors were likely to affect the decisions or actions of the driver. The “extreme difficulty of calculating,” the fact that “it would be utterly impractical” to attempt to work out and ascertain the exact magnitudes of the variables which the theorist alleges to be significant, show merely that the explanation of an action must often include steps of reasoning which the acting individual himself does not consciously perform (because the action has become routine) and which perhaps he would never be able to perform in scientific exactness (because such exactness is not necessary in everyday life). To call, on these grounds, the theory “invalid,” “unrealistic” or “inapplicable” is to reveal failure to understand the basic methodological constitution of most social sciences.  (Machlup 1946: 534-535)

Business owners don’t need to understand the concepts of elasticity of demand, marginal cost, and marginal revenue to implement marginalism. Rather, just like the automobile driver changing lanes, they are implicitly using these concepts in their rule-of-thumb pricing policies. So contrary to the claims of Hall, Hitch, Lester, and others, procedures that appear contrary to marginalism are actually grounded in marginalism (3).

For those familiar with the debates in economic methodology, Malchup’s arguments might look familiar. While he’s certainly not the first economist to support instrumentalism (and Machlup doesn’t explicitly embrace it in his paper), his statements started a noticeable trend in economics. From this point on, neoclassical economists would defend the unrealistic assumptions in their economic theory on the basis of instrumentalism. This would eventually culminate in Milton Friedman’s famous statement (in the context of the marginalist debates) that:

Under a wide range of circumstances individual firm behave as if they were seeking rationally to maximize their expected returns (generally if misleadingly called “profits”) and had full knowledge of the data needed to succeed in this attempt; as if, that is, they knew the relevant cost and demand functions, calculated marginal cost and marginal revenue from all actions open to them, and pushed each line of action to the point at which the relevant marginal cost and marginal revenue were equal. Now, of course, businessmen do not actually and literally solve the system of simultaneous equations in terms of which the mathematical economist finds it convenient to express this hypothesis, any more than leaves or billiard players explicitly go through complicated mathematical calculations or falling bodies decide to create a vacuum.

Alchian’s Uncertainty, Evolution, and Economic Theory

So where does Alchian fall into this? To understand this and why his paper, Uncertainty, Evolution, and Economic Theory, is important, we need to understand how the assumption of profit maximization fits into the marginalist debates. Neoclassical theory assumes that firms want to maximize profits, (which is how they make their price and output decisions) where MC = MR is the profit maximizing condition for the firm (4). Hall, Hitch, and others found was that firms and entrepreneurs don’t really think this way (5). Hall and Hitch suggested several reasons for this, e.g. tradition and fairness, but one of the main things they pointed out was lack of information:

Producers cannot know their demand or marginal revenue curves, and this for two reasons: (a) they do not know consumers’ preferences; (b) most producers are oligopolists, and do not know what the reactions of their competitors would be to a change in price. (Hall and Hitch 1939: 22)

In a world of continuous dynamic change, getting the information needed for marginal analysis is incredibly difficult, if not impossible. In this complicated, uncertain world, profit maximization as a goal doesn’t even make sense, so these firms use rule of thumb policies, e.g. “full cost” pricing, because they provide a helpful benchmark. There needn’t be any assumptions about profit maximization. So we already know how Machlup and others responded to this, i.e. by relying on implicit marginalism (6), but Alchian took a different approach.

For many years, Alchian worked at the RAND Corporation doing systems analysis and the early studies he worked on convinced him that uncertainty (7) was a central challenge to marginal analysis (8). This is immediately clear when he admits that in a world of uncertainty, profit maximization cannot be a guide to action:

In the presence of uncertainty – a necessary condition for the existence of profits – there is no meaningful criterion for selecting the decision that will “maximize profits.” The maximum profit criterion is not meaningful as a basis for selecting the action which will, in fact, result in an outcome with higher profits than any other action would, unless one assumes non-overlapping potential outcome distributions. (Alchian 1950: 212)

But Alchian had a clever way to get around this problem. Instead of focusing on the individual workings of the firm or relying on “implicit marginalism”, Alchian thought that economists should look at the “decisions and criteria dictated by the economic system” (Alchian 1950: 213). To put it differently, an economic system will have a set of “optimal conditions”. We would expect surviving firms, the ones with “positive profits”, to have characteristics closer to these “optimal conditions” (as opposed to the firms that failed). As exogenous and endogenous variables change, the economic system will change over time and the set of “optimal conditions” will be different. New firms will thrive while old firms either adjust or die out and would expect these firms to have characteristics closer to the new set of “optimal conditions”. So via some “evolutionary” process of selection, the system determines which firms will survive and which ones will not.

How specific firms survive doesn’t really matter. Surviving firms could innovate, imitate other successful firms (which would explain why the surviving firms would share many of the same characteristics), use a trial and error process, or just be lucky (9). What matters is that when the economic system changes, the economist can use his analytical tools (i.e. marginalism) to predict where the “optimal conditions” will tend to go. Therefore, the economist can make predictions that are similar to ones in the conventional model with profit maximization. Despite uncertainty, the assumption of profit maximization is still valid:

Empirical investigations via questionnaire methods, so far used, are incapable of evaluating the validity of marginal productivity analysis. This is true because productivity and demand analyses are essential in evaluating relative viability, even though uncertainty eliminates “profit maximization” and even if price and technological changes were to have no consciously redirecting effect on the firms…

…The essential point is that individual motivation and foresight, while sufficient, are not necessary. Of course, it is not argued here that therefore it is absent. All that is needed by economists is their own awareness of the survival conditions and criteria of the economic system and a group of participants who submit various combinations and organizations for the system’s selection and adoption. Both these conditions are satisfied. (Alchian 1950: 217)

This is an ingenious way to get around the problem of uncertainty. Instead of making an unconvincing appeal to instrumentalism, Alchian took a macro-based, realist approach to try and save the generality of marginalism. However, despite Alchian’s creativity, his approach wasn’t without it’s problems. His use of biological analogies, e.g. evolution and selection, has some major flaws and whether his model actually succeeds in its aims is another story all together (10). But I’ll save that for another post.


Footnotes:

1. From Hall and Hitch 1939: 18

For the above analysis to be applicable it is necessary that entrepreneurs should in fact: (a) make some estimate (even if implicitly) of the elasticity and position of their demand curves, and (b) attempt to equate estimated marginal revenue and estimated marginal cost. We tried, with very little success, to get from the entrepreneurs whom we saw, information about elasticity of demand and about the relation between price and marginal cost. Most of our informants were vague about anything so precise as elasticity, and since most of them produce a wide variety of products we did not know how much to rely on illustrative figures of cost. In addition, many, perhaps most, apparently make no effort, even implicitly, to estimate elasticities of demand or marginal (as opposed to average prime) cost; and of those who do, the majority considered the information of little or no relevance to the pricing process save perhaps in very exceptional conditions.

2. From Hall and Hitch 1939: 19

The procedure can be not unfairly generalized as follows: prime (or ‘direct’) cost per unit is taken as the base, a percentage addition is made to cover overheads (or ‘oncost’, or ‘indirect’ cost), and a further conventional addition (frequently 10 per cent.) is made for profit. Selling costs commonly and interest on capital rarely are included in overheads; when not so included they are allowed for in the addition for profits

3.Following this discussion, Machlup tried to rationalize these “anti-marginalist” procedures into a marginalist framework:

Machlup extended his critique of the “anti-marginalism” evidence to the full cost pricing evidence presented by Hall and Hitch. In his critique, he argued that even though business people may not have understood the concept of price elasticity of demand, they implicitly used it when basing their prices on average total costs, and that the use of average total costs when comparing actual and potential levels of output was simply an indirect way of using marginal revenue and marginal costs. (Lee 1984: 1115-1116)

From the Handbook of Economic Methodology:

He [Machlup] proceeded to argue that Lester’s data, exactly as Hall and Hitch’s, established only that the textbook model of short-run profit-maximization under perfect competition was inadequate, but that virtually any other model in the marginalist toolkit could be reconciled with the evidence. He clearly took Hall and Hitch’s work more seriously than Lester’s, and made some effort to explain how FCP can be reconstructed as a cartel device in some cases, and a clue to demand elasticity in other oligopolistic contexts.

4. The implications of profit maximization can be seen here. Is should also be noted that not all market structures, e.g. oligopoly, adhere to MC = MR.

5. From Hall and Hitch 1939: 18

The most striking feature of the answers was the number of firms
which apparently do not aim, in their pricing policy, at what appeared to us to be the maximization of profits by the equation of
marginal revenue and marginal cost.

6. From Winter 1964: 231-232

The Friedman position (as it relates to profit maximization) would seem to be that the theory of the firm is misnamed; it is not a theory of the firm at all in the sense of being useful for prediction of events within any particular firm. The theory of the firm is a theory of the external (market) behavior of the firm; more importantly, it is a building block in the theory of firm~, i.e., the theory of how firms in the aggregate will react to market situations. Thus, in particular, the theory of the firm does not predict the answers that decision makers in firms will give when queried about their objectives, nor does it predict how they will go about reaching their decisions. This being the case, how can evidence on these points be relevant to a judgment about the predictive power of the theory? Clearly, says Friedman, it cannot. But the theory does yield hypotheses about what will be observed in market situations; for this purpose, Friedman says, it has served well, and there are no appealing substitutes for it.

7. It should be noted that Alchian defined uncertainty as “the phenomenon that produces overlapping distributions of potential outcomes” (Alchian 1950: 212). This definition has a more statistical emphasis, which is completely different then Keynesian or Knightian uncertainty.

8. From Levallois 2009: 170-171

Alchian’s research highlighted another problem arising from the confrontation between economic models and reality, leading him to an important conclusion about the role of uncertainty in economic theory. Learning curves were used by contractors to predict the production cost of airplanes, with equations typically taking the following form:

log10 m = a + b log10 N,

with m, the direct labor per pound necessitated for the production of the Nth plane.

Alchian put this relation to the test. His conclusion stated that for a given production of 1,000 airplanes, estimated learning curves such as the above were affected by an average error of prediction of 25 percent (Alchian 1963, 679). This result did not lead him to question the robustness of the relation (“the results cast doubts on any of the alternatives being better fits than the usual progress curves”); instead, Alchian insisted on the fundamental uncertainty inherent in such an attempt to predict costs. There again, Alchian was getting close to Hitch and Hall’s objection to the postulate of rational decision making. He noted that some basic assumptions were doomed to be falsified once the actual production process was unfolding. The analyst’s role would be then to provide the decision maker with an estimate of the uncertainty of the prediction, before the decision was made. In any case, reliable decisions could not be made if alternative programs were not “disparate beyond the range of uncertainty of error of estimate of the predictive method” (692). Reached in 1949, this conclusion acknowledged uncertainty as a major obstacle to rational choice. If the difference between any two outcomes were so small that no one had an objective basis upon which to distinguish one from another, then there was no hope to reach a “rational” decision.

9. From Alchian 1950: 219

Uncertainty provides an excellent reason for imitation of observed success. Likewise, it accounts for observed uniformity among the survivors, derived from an evolutionary, adopting, competitive system employing a criterion of survival, which can operate independently of individual motivations. Adapting behavior via imitation and venturesome innovation enlarges the model. Imperfect imitators provide opportunity for innovation, and the survival criterion of the economy determines the successful, possibly because imperfect, imitators. Innovation is provided also by conscious willful action, whatever the ultimate motivation may be, since drastic action is motivated by the hope of great success as well as by the desire to avoid impending failure.

From Alchian 1950: 214

Consider, first, the simplest type of biological evolution. Plants “grow” to the sunny side of buildings not because they “want to” in awareness of the fact that optimum or better conditions prevail there but rather because the leaves that happen to have more sunlight grow faster and their feeding systems become stronger

10. For some critiques of Alchian see (Penrose 1952), (Winter 1964), and (Hodgson 2004)


Links:

  1. An Economist Who Made the Science Less Dismal by David Henderson
  2.  Armen Alchian by Alex Tabarrok
  3. The Marginalist Pricing Controversy Revisited by LK
  4. Keynesian Uncertainty by Jonathan Finegold

References:

  1. Alchian, Armen A. “Uncertainty, Evolution, and Economic Theory.” Journal of Political Economy. 58.3 (1950): 211-21.
  2. Alchian, Armen A. “Biological Analogies in the Theory of the Firm: Comment.” The American Economic Review43.4, Part 1 (1953): 600-03.
  3. Davis, John Bryan., D. Wade. Hands, and Uskali Mäki. The Handbook of Economic Methodology. Cheltenham, UK: E. Elgar, 1998. Print.
  4. Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.
  5. Lee, Frederic S. “The Marginalist Controversy and the Demise of Full Cost Pricing.” Journal of Economic Issues 18.4 (1984): 1107-132.
  6. Lester, Richard A. “Shortcomings of Marginal Analysis for Wage-Employment Problems.” The American Economic Review 36.1 (1946): 63-82.
  7. Levallois, C. “One Analogy Can Hide Another: Physics and Biology in Alchian’s “Economic Natural Selection””History of Political Economy 41.1 (2009): 163-81.
  8. Machlup, Fritz. “Marginal Analysis and Empirical Research.” The American Economic Review 36.4 (1946): 519-54.
  9. Penrose, Edith Tilton. “Biological Analogies in the Theory of the Firm.” The American Economic Review 42.5 (1952): 804-19.
  10. Penrose, Edith T. “Biological Analogies in the Theory of the Firm: Rejoinder.” The American Economic Review 43.4, Part 1 (1953): 603-09.
  11. Winter, Sidney G. “Economic ‘Natural Selection’ and the Theory of the Firm”. Yale Economic Essays, 4 (1962): 225-272
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2 Comments

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2 responses to “Uncertainty Evolution And Economic Theory: An Overview

  1. Pingback: Armen Alchian on Uncertainty and Evolutionary Economics | Gedanken zur Geschichte

  2. Pingback: Uncertainty Evolution And Economic Theory: An Overview via /r/economy | Chet Wang

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