Evolutionary Economic Principles
Why are some economies rich & some poor?
Economic Principle No. 1 - Wealth
Creation.
Wealth creation is not luck, nor providence, but a process of evolution ... a process of technological & institutional innovation involving the generating & testing a diversity of ideas which discover & accumulate more survival value for the costs incurred than competing alternatives.
Economics is the science of choices ... the natural selection of the choices we make results in survival 'know how'.
Why is evidence so important?
Economic
Principle No. 2 - Empirical Science.
Empirical scientific methodology, not a priori reasoning, provides the supporting evidence for the process of evolution –
observation - evidence of the senses, everything else is a woven web of guesses
mathematical theory - precise imaginative description, a verifiable system of assumptions and rules in the mind which explain a wide variety of interconnected phenomena in physical reality, in general terms
testable hypotheses - convincing prediction, suggested explanations as a basis for verification and further reasoning without an assumption of truth
experimental validation - repeatable evidence, convincing the jury
peer review - the triumph of science over the whims of Bishops, Princes, Generals and bureaucratic majorities
Over generations scientific methodology accumulates knowledge and understanding of the world by a relentless process of generating & testing ideas. Science discovers models of reality ever closer to the truth. The key to understanding complex economic systems is the differential survival of alternative ideas.
Stephen Hawkins, 'some individuals are better than others at drawing the ‘right’ conclusions about the world around them & act accordingly. These individuals will be more likely to survive & reproduce & so their pattern of behaviour & thought will become dominant'.
Why is differential survival so counter intuitive?
Economic Principle No. 3 - Natural
Selection.
The penny has to drop, economic systems not the result of plausible top down intelligent design but rather counter intuitive bottom up differential survival.
Darwin delayed the publication of 'Origin of Species' for 20 years because of his concern about the adverse reaction as he confronted the conventional wisdom of intelligent design.
Daniel Dennett of Tufts University, Boston, USA, came up with one of the most succinct aids to understanding evolution - ‘the giraffes long neck is undoubtedly caused by some complex chemistry but a more meaningful explanation is that short necked giraffes died out’.
But the truth is often counter intuitive ...remember the flat earth & moving sun, the beautifully ‘designed’ lily ... and the homunculus in the brain …
Can random mutations create wealth?
Economic
Principle No. 4 - Adaptation of Behaviour.
Genes evolve but so too does economic behaviour ... survival 'know how'. This is not useful biological analogy, it is ontology.
Survival value emerges from Darwin's process of adaptation to a local environment by natural selection -
copy = a new innovation cycle starts from an inherited population of diverse replicating survival ideas, or 'know how'
vary = a random diversity of innovative ideas are generated for testing, a diminutive few will have small advantages, but nobody knows which? when? where? or how?
select = successful innovative ideas spread by differential survival in changing populations, winners tend to monopolise local profit as few survive as second best, close associates imitate, competitors adopt & new comers embrace the new 'know how' which spreads throughout the population as the old 'know how' dies out
Future outcomes are unknowable and complexity makes interpretation of the past difficult even with hindsight. Nevertheless statistical uniformities and patterns emerge from diversity & choice.
Economic efficiency can be defined as adaptive efficiency - a trial & error process of discovering & accumulating survival value.
Can genes do cost/benefit analysis?
Economic Principle No. 5 - Changes over
Deep Time.
A continuity from replicating genes to human culture & complex economic interactions has evolved via a series of emergent systems over deep time.
Given the basic copy/vary/select process and a long long time ... 'miracles' happen.
Richard Dawkins’ ‘the long reach of the gene’, 'the extended phenotype' & the mechanisms of change –
genetic drift - random genetic variation can change neutral (non-adaptive) traits.
adaptation - genetic variation + natural selection.
responsive adaptation - adaptation + environmental change that favours natural selection of previously neutral genetic variations (spandrels) or previously differently functional (exaptations).
Baldwin Effect - responsive adaptation + behaviour (niche construction) ...
something happens - individuals change their behaviour by trial & error and a survival enhancing learned behaviour proliferates – a pre-existing genetic variation helps the new behavioural skill, enabling the the solution to be learned more easily - this genetic variety is then naturally selected - assimilated behaviour can become an instinct.
Did the Boeing 747 evolve?
Economic Principle No. 6 -
The Baldwin Effect.
Economic systems are a whole evolving complex hierarchical interactive interconnected shebang.
The Baldwin Effect further justifies the move from biological evolution to the reality of an evolving whole which includes everything we see in the universe. This is not Lamark's inheritance of acquired traits where there is no direct alteration of the genotype, based on the experience of the phenotype. Rather Baldwin established the mechanisms directly linking behaviour to the gene. We can pass on an inherited tendency to acquire certain behavioural traits. A pre-existing tendency to make survival easier can eventually become genetically hard wired deep down in the skull.
Universal Darwinism is an idea powerful enough to explain
everything - understanding ontology comes from the whole interactive
shebang, layer upon layer of hierarchical interactivity & emergence - energy, matter, chemistry, biology, immune systems, neural
networks & circuits, instincts, language, social behaviour and culture -
choices at one level are always tested against alternatives at other levels.
Self consistency is guaranteed as everything
effects everything else ... economics is embedded in an historical
trajectory of a nested set of sets ...
Supernatural intelligent design or natural selection?
Economic
Principle No. 7 - Emergence of Economic Institutions.
Local economic activity leads to the emergence of economic institutions.
The necessary knowledge does not exist for the intelligent design of economic activities in an environment rampant with problems of -
complexity
scarcity
change
conflict
Rational calculating economic man of neo-classical equilibrium economics is a myth! But isn't it blindingly obvious that the ingenuity of the human brain is continually creating wealth and designing the most complex of machines like the Boeing 747?
Yes ... but ... intelligent design suggests –
evidence is evaluated, weighed and balanced
future consequences are thought through
appropriate decisions are taken
necessary actions to deliver the desired result are implemented
Progress seems to result from a plausible process of logical cause and effect, an imagined outcome is implemented by design.
But if this is so the economic plight of Burundi becomes a stupendous puzzle, why can't they design economic efficiency?
The alternative of universal Darwinism suggests that ideas evolve just like everything else, and intelligent design is just an experiment in the imagination and only a part of a complex dynamic –
evidence is incomplete, dispersed, diverse and complex
future consequences and responses of others are unpredictable and unknowable
decisions are experiments in the imagination and there will be better alternatives
successful outcomes differentially survive
Better behavioural & institutional alternatives emerge from bottom up social interactions!
Can survival know how be communicated across the generations?
Economic
Principle No. 8 - Cultural Accumulation.
Valuable survival synergies are discovered by individual creative interactions but 'know how' is accumulated in larger groups, in economic institutions by cultural learning.
The long hard slog from the foothills of Richard Dawkins' 'Mount Improbable' may explain why so few economies have reached a rising pinnacle of complexity where we find complex social institutions like freedom & democracy.
But this is evolution ... the pinnacle is transient ... not the best just better than some of the competing alternatives at a particular time and place ... the future is unknowable ...
We are dwarfs standing on the shoulders of giants!
Why economic Growth?
Economic
Principle No. 9 - Synergies of Economic Interactions.
Economic growth emerges when survival synergies are discovered in complex social interactions associated with -
specialisation - time consuming acquisition of skills & complex cooperation & exchange
scale - conflict resolution in large groups of different individuals involving trust in strangers
science - high fixed costs of education & disciplined methodology
imitation - inspired transmission & reliable reception
innovation - uncertain risky change & hitherto unconnected connections
investment - scare delayed individual consumption as the magic of property & compound interest benefits more people in the long term
Wealth creating productivity, more value for less cost, is a 2 + 2 = 5 process.
How do we decide the who, what, when & which?
Economic
Principle No. 10 - Decision Making Behaviour.
Economic behaviour emerges 'as if' to speed up adaptation, Herbert Simon’s ‘satisficing’ describes instinctive cultural 'rules of thumb' –
build on proven inherited success, chase profits/cut losses by hard work & mediating moral urgency
choose freely between options available here & now, unhindered by Bishops, Princes, Generals & Bureaucratic majorities
experiment to generate diversity & increase the chances of discovering new tricks unhindered by risk averse rent seekers
cooperate to discover better tricks from synergies which are not available to individuals
retaliate to protect value from inevitable parasites & predators, growing trust & accumulating colonisation benefits
learn from emergent outcomes of differential survival & start again
Inheritance with modification, generating experimental ideas in the imagination and then testing out promising options in reality, and learning.
Continuous improvement!
Who's in control of the wealth creating process?
Economic
Principle No. 11 - Market Coordination.
Order tends to emerge from economic behaviour as markets coordinate activities 'as if' a control loop -
sensors - inherited price information from millions of trades in technological 'know how' are compared to
set points - diverse innovative alternatives generated by competing entrepreneurs by
algorithms - as customers select and test by sifting value & cost resulting in
actuators - responding as some investments differentially survive and change the population frequency of successful 'know how'
Order, like 'an invisible hand' is an unintended consequence of free market activity!
Who does the calculations?
Economic
Principle No. 12 - Opportunity Costs & Marginal Utility.
Deals are done, decisions are taken by many individual value judgements about the costs of alternatives & the added value.
'Equilibrium' prices are dynamic and are tendencies which emerge from economic activity as inefficient prices are continually adjusted by consumers and suppliers who want to avoid unnecessary waste for their own survival.
Nothing supernatural just a process of adaptation, inefficient prices don't survive! Same as short necked giraffes!
Richard Dawkins suggested in the 'Selfish Gene' that genes act 'as if' they do cost/benefit analysis. It is 'as if' marginal utility and opportunity costs were calculated ... but it is not a rational process rather a statistical tendency resulting from adaptation - 'he intends only his own gain, but he is led by an invisible hand to promote an end which was no part of his intention'.
Normal behavioural 'rules of thumb' tend to produce economic results otherwise they wouldn't survive to become normal behaviour … think about it … ?
Who fixes the prices?
Economic
Principle No. 13 - Supply & Demand.
Markets tend to balance the prices and quantities of desired goods and services sold and produced at minimum cost -
demand curves sloping down to the right reflect the decreasing marginal utility of consuming increasing quantities and
supply curves sloping up to the right reflect the increasing opportunity costs of producing increasing quantities
producing a market clearing price where gluts and surpluses from high prices and queues and shortages from low prices disappear 'as if' by magic.
Leon Walrus used mathematical models to demonstrate a supply & demand equilibrium but it isn't a stable equilibrium! His maths required unrealistic assumptions about rational calculation, static equilibrium, perfect information and perfect competition and a strange method of price fixing my a mythical 'auctioneer', he called it 'tatonnement'? Groping!
Can you specialise without trade or trade without trust?
Economic
Principle No. 14 - Division of Labour.
Economic activity, doing deals, emerges from trading different individual aptitudes and skills, different opportunity costs, different specialisations.
Adam Smith identified the necessary behavioural traits present in human nature -
moral urgency - an innate sense mediating the decisions and necessary trust for different social economic interactions, trades in rights & reciprocal obligations, a 'propensity to truck, barter and exchange' - Theory of Moral Sentiments 1759.
markets & division of labour - individual striving to discover & accumulate 'survival tricks', 'it's not from the benevolence of the butcher that we expect our dinner but from his regard to his own interest' - Wealth of Nations 1776.
Individual freedom is a vital element in learning and creativity. The economics of the pecking order and the top down exercise of power is an irrelevance for modern industrialised economies where synergies emerge from social interactions.
The division of labour is limited by the extent of the market!
Is democracy an idea pregnant with economic significance?
Economic
Principle No. 15 - Economies of Scale.
A larger group involves more differences, more specialisation, more interactions and more synergies.
Francis Fukuyama has recently suggested that the cultural evolution of trust in democratic institutions has helped the cohesiveness of larger social groups.
The democratic ideal of free participation is geared by the scale economies from wider participation - the more the merrier. Over deep evolutionary time there is a clear tendency for larger and larger interactive groups exploiting increasing specialisation and scale.
Democratic ideas play an important role in intensifying economic interactions in larger groups ... genes, phenotypes, families, tribes, religions, cities, nation states, democracies, globalisation ...
Economics is the science of decision making in an environment of scarcity, risk and uncertainty. Democratic decision making is self determination by 'we the people', freedom under the law.
Democracy widens and deepens participation thus increasing the chances of discovering harmless survival value. More activity in larger groups!
Some authoritarian decisions which make some people worse off will tend to be resisted by those people, destroying the benefits of co-operation.
In 1789 Jeremy Bentham’s ‘greatest happiness’ principle defined Democracy as maximising the sum total of the happiness of the all individuals who compose society.
However, self determination cannot be based on majority voting because this outlaws the aspirations of the minorities who voted the other way …
Plato’s conundrum was debated at the birth of the democratic idea - 'mob rule and emasculation of the wise …'
Can you avoid fighting over the spoils?
Economic
Principle No. 16 - Pareto Optimal.
Economic efficiency results from synergies which avoid harm to others.
In 1906 Vilfredo Pareto illuminated the issue of Democratic progress by defining as Pareto Optimal any decision which results in perceived betterment but does not result in anybody else being worse off, in their own estimation and after compensation where appropriate.
All Democratic institutions tend to exploit this optimal through decisions which avoid harm to others. For Nigel and Joe the Pareto efficient improvements from initial conditions X is to anywhere on the production possibilities curve from N1 to J1.
The initial conditions X grossly favour Nigel but the economic significance of the idea is that Joe’s position can be dramatically improved without harm to Nigel by pushing the ppf1 to ppf2 through the process of economic education, imitation and technological innovation.
Pareto's analysis is criticised as –
involving unrealistic assumptions about perfect competition and clear legal property rights
static and tending to protect the status quo and inhibit progress because most economic activity in the real world hurts somebody
dependent on inequitable initial wealth distributions
requiring all markets to be distortion free; ‘The Theory of 2nd Best’ suggests imposed uniform distortions maybe better than some free market distortions
However an evolutionary analysis of Pareto decision making suggests the criticisms have no foundation. Remember evolution involves –
a scientific theory of reality and avoids all unrealistic assumptions
a dynamic process suggesting decisions will tend statistically to be driven in a Pareto optimal direction because of synergies of cooperation and retaliation against parasites & predators
current initial conditions which are themselves the result of evolution (both cooperative and predatory) and the only starting point for all innovative improvements
interactions with all 'harmed' counter parties and ongoing refinements from 'compensation contracts' will tend to drive decisions towards economic efficiency, ‘The Theory of 2nd Best’ is not ‘Evolutionarily Stable’ it harbours inefficiencies, all distortions will tend to be eliminated as niches are filled and opportunities seized to -
make somebody better off without harming others
retaliate against parasites & predators who inhibit Pareto improvements
Hence the institutions of civil society which always spontaneously emerge in liberal democracies – churches, clubs, societies, associations, co-ops, partnerships and public limited companies … produce diversity & choice for Pareto optimal decisions, the successful institutions will increase in frequency and size provided they are protected from parasites & predators.
Is the public interest served by private greed?
Economic
Principle No. 17 - Tort Law & the Universal Declaration of
Human Rights.
The protection of individual rights & obligations in law is a cost effective way of resolving conflict and avoiding expensive violence.
The rule of law is not the elitist whim of powerful Bishops, Princes, Generals nor Bureaucratic majorities!
Robert Axelrod (1983) suggested how cooperation could evolve and develop immunity from cheats but it was Thorstein Veblen (1898) who had earlier reminded us of the age old problem of parasite & predator theft. Thorstein Veblen's ceremonial/instrumental dichotomy described how the 'instrumental' necessity for survival value creates the opportunity for theft and the 'ceremonial' 'conspicuous consumption' of the pecking order.
Evolutionary economics recognises the importance of the long evolution of Tort Law and protections for individual freedoms culminating in the Universal Declaration of Human Rights and explores how the survival benefits of cooperation always involve a defence cost -
a tit evolves for every tat
the solution to Plato's democratic conundrum 'mob rule and emasculation of the wise' involves constraints on the mob
the 'democratic trap' is avoided by institutional checks and balances which outlaw 51% majorities voting to tax 49% minorities
As men become domesticated in social groups interactions intensify and systems of conflict resolution must co-evolve if economic benefits are to emerge. Evolved laws push the incentive system towards productive positive sum synergies and away from zero sum 'rent seeking'. It is the rule of law that is much cheaper than violence in resolving conflict.
Douglass North has emphasised the institutional innovations which enable larger and larger groups to secure the rewards for cooperation while at the same time providing 'free rider' sanctions.
The institutions of property rights, contract and low transaction costs embedded in Common Law and enlightened behaviour provided the cohesive incentives and sanctions.
North describes the economic change as 'adaptive efficiency' - a society's effectiveness in creating institutions that are productive, stable, fair, and broadly accepted and flexible enough to respond to political, economic and predator feedback.
Douglas North - 'adaptive efficiency copes with novel uncertainty in a non-ergodic world, the best recipe is the maintenance of institutions which enable trial and error experiment to occur, and an effective means of eliminating unsuccessful solutions'.
Some evidence from English history traces the evolution of Tort Law, from Magna Carta to UDHR. A continuous 'golden thread' of survival incentives and sanctions as the rule of law emerges to resolve conflicts enabling larger and larger groups to specialise and trade unhindered by Bishops, Princes, Generals and Bureaucratic majorities by -
identifying property rights
lowering transaction costs
and constraining parasite and predators
Is it profitable to cooperate?
Economic
Principle No. 18 - Cooperation.
Cooperative moral order tends to emerge naturally from evolved systems without intelligent design.
In 1983 Robert Axelrod explored computer models of the iterated ‘Prisoner’s Dilemma’ game and formalised the risks and payoffs associated with ‘evolutionary tit for tat’ strategy and with William Hamilton published ‘The Evolution of Cooperation’. There are no expensive prerequisites, the strategy is applied ‘blindly’, everybody can participate, long term co-operation becomes understandable. The key is that economics is not a one off zero sum game!
Downward spirals of ‘tit for tat’ are not ‘Evolutionary Stable Strategies’ because -
genes/memes act ‘as if’ calculating cost/benefit, the development of the Peacock’s tail and ‘arms races’ always end
random events always offer alternative options to avoid local cul-de-sacs.
This breakthrough in understanding has important implications for evolutionary economics and illuminates all decision making.
Richard Dawkins – ‘wherever there are suckers there will be cheats but genes/memes act ‘as if’ calculating costs/benefits and all the optimistic conclusions about cooperation apply in the world of nature’.
Matt Ridley – ‘Game Theory is an esoteric branch of mathematics but provides the bridge between biology and economics whenever there is an apparent conflict between self interest and the common good’.
Must profits be protected by property rights?
Economic
Principle No. 19 - Evolutionary Stable Strategies.
An ‘evolutionary tit for tat’ behavioural strategy grows the synergies of cooperation over time and protects them from parasites & predators –
cooperate & trust - discover synergies, be nice, don’t try to win at the expense of others, share benefits
peace & defence - avoid costly violence but retaliate if attacked to protect benefits from parasites & predators
social communication - respond clearly, simply, timely and emphatically to avoid misunderstandings and develop trust – cooperation is the rule but there will be a proportionate defensive response to all attacks
forgive & recruit – intensify interactions for scale economies and opportunity for cooperation next time round
persevere & learn from outcomes – cooperate with cooperators
Selfish maximising animals 'red in tooth and claw' is not an accurate description of social human beings. Evolution will tend to drive decision making towards cooperation whenever 2 + 2 = 5 type synergies exist. Cooperation will not be universal, parasites will evolve, however cooperation will tend to differentially survive and institutions exploiting these synergy advantages will tend to proliferate.
The 1994 Nobel Prize for economics went to John Nash for a concept of equilibrium where there is an optimal response to any position adopted by other people. A strategy that always works whatever other people do.
John Maynard Smith called the Nash equilibrium an ‘Evolutionary Stable Strategy’, such strategies emerge from evolution and require no human intervention.
Why pay transport costs to import Barbie dolls from China?
Economic
Principle No. 20 - Comparative Advantage.
Trade takes place because of different opportunity costs, for different people and different countries, comparative advantage not because of absolute advantage.
In 1817 David Ricardo identified the principle of comparative advantage when confronting protectionism and the Corn Laws. Trade is at the heart of economics so it is well worth while going through the mathematics –
Nigel, a world beater, is an excellent bricklayer and a very good typist.
In 8 hours he can lay 100 bricks OR type 1000 words …
NB = 1 brick barters for 10 words.
Joe, an incompetent, is a terrible brick
layer and he is a barely adequate typist.
In 8 hours he can lay 20 bricks OR type 400 words …
NB = 1 brick barters for 20 words.
Nigel has an absolute advantage in both activities (his 8 hours is more productive in both activities) but he has a comparative advantage in bricklaying (his brick will barter for 20 of Joe’s words but only 10 of his own)
Joe has a comparative advantage in typing (20 of his words will barter for 2 of Nigel’s bricks but only 1 of his own) specialisation and trade will tend to evolve (unless there is intervention) because of mutual benefits.
Nigel will tend to do more bricklaying and Joe more typing increasing total output.
With no trade both have to be self sufficient in both bricks and words …
Say in 8 hours Nigel lays 50 bricks and types 500 words.
Say in 8 hours Joe lays 10 bricks and types 200 words.
Combined output 60 bricks 700 words.
With specialisation & trade …
Say Nigel lays 60 bricks types 400 words and trades 5 to 10 bricks to Joe for the 100 words he needs (NB = I brick barters for 20 words) he has up to 5 bricks EXTRA to share with Joe.
Say Joe lays only 5 bricks but types 300 words and trades 100 words with Nigel for the 5 bricks he needs plus a share of the 5 brick SURPLUS (NB = 1 brick barters for 10 words).
Combined output 65 bricks 700 words = 5 EXTRA bricks.
The counterintuitive conclusions are –
both gain from specialisation and trade even though Nigel is better at both activities.
the principle explains trade at individual and national level, with money or barter.
specialisation and trade will evolve because extra 'value' is created, it does not require the intervention of a government 'designer'.
every person (and country) has a comparative advantage in something (even inadequates like Joe) and will benefit from trade.
The Open University summary – "The principles of comparative advantage and gains from trade are the most important results in the whole of economics. They apply at national, and also individual level. It maybe that a doctor is better than a farmer both at practising medicine and growing potatoes. It does not follow that the doctor should do both. If each specialises in the activity in which they have comparative advantage and engage in trade they are both better off than if each tries to be self sufficient".
Nobel laureate Paul Samuelson – "Thousands of important and intelligent men have never been able to grasp it or believe it even after it was explained to them'.
A mathematical model can easily be constructed to introduce money, transport costs, wage costs, market prices, exchange rates … confirming this wealth creation principle.
NB. understand -
real wages are determined by the value of output
real prices are determined by supply & demand
prices & exchange rates don’t determine trade, they result from trade, they are measurements of opportunity costs ... and if everyone specialises on what he does best and everyone is included in for economies of scale then everyone benefits … but innovators benefit most … ??
Ricardo's principle of comparative advantage was an explanatory breakthrough building on Adam Smith's earlier insight in his descriptive account of specialisation and trade in his pin factory.
Adam Smith has an ongoing influence on economics, guiding us from an innate moral sense to the increasing returns of the industrial revolution, as he and his friends in the Scottish Enlightenment explained what was happening in a complex free and individualistic English culture.
Why are land, labour & capital red herrings?
Economic
Principle No. 21 - Total Factor Productivity.
Economic growth overwhelmingly results from technological and organisational innovation and not natural resources, hard labour nor investment capital.
In 1957 Robert Solow used 'growth accounting' mathematics to analyse historical GDP data and identified the importance of a residual, ‘total factor productivity’, growth tended to be relatively independent of the neo-classical endogenous inputs variables, capital (resources) and labour (effort).
Solow defined ‘total factor productivity’ as technological innovation, 'know how' or understanding and practice.
Paul Romer dramatically extended Solow's insight and integrated economic growth into evolutionary theory with his Endogenous Grow Theory' in 1990.
Why has Paul Romer not been awarded a Nobel Prize?
Economic
Principle No. 22 - Endogenous Growth.
Productive output growth results from 'know how', not physical factors of production, and 'know how' is -
nonrival, used over and over without depletion to the extent of the market resulting in increasing returns
lumpy because it involves fixed costs and clusters associated with specialisation & scale generated by monopolistic competition in commercial R&D
discovered, therefore risky & uncertain, making government design and entrepreneurial incentives a problem
partly appropriable as intellectual property, making investment in commercial R&D rewarding
temporary and dissipates as people learn
Goods and services are welfare spread by trade (comparative advantage) but 'know how' is spread by cultural learning -.
Human Capital -
- Tort Law, Trade, Technology.
- Education, Health, transport/planning interactions.
- Specialisation. Scale. Science. Investment. Imitation. Innovation.
Market Coordination -
- free trade – free capital movement – competition – property rights – free
wages & prices – low tax – low intervention – low inflation – trust for
investment and saving
The production of 'know how' makes growth endogenous and monopolistic competition keeps growth rolling, a constant stream of innovation is necessary to secure temporary monopoly profits.
Can property rights confront the tragedy of the commons?
Economic
Principle No. 23 - Social Costs.
Externalities, law and the problem of social costs can be understood by economic analysis.
Two parties are always involved in troublesome externalities - the polluters and the polluted. The polluters can stop polluting and the polluted can move elsewhere but there is a cost - who pays? - how much? Markets resolve the problem efficiently by bargaining between the antagonists, the higher cost avoider paying the lower cost avoided market determined 'compensation'. When transaction costs are low and property rights are defined contracts will be negotiated to satisfy both parties. But transaction costs are the problem not externalities. Transaction costs make some markets prohibitively expensive.
With zero transaction costs the allocation of resources remains the same whatever the legal position, however, with positive transaction costs, the law plays a crucial role in determining how resources are used ... the marginal productivity of capital.
Proposed solutions -
regulation = no incentive for technological innovation ... output declines. Restricts new competition. Adds administrative and compliance costs which customers and shareholders have to pay. Some win some lose and regulation becomes impossible to implement in a democracy where economic growth reduced from 2.5% to 2.4% over the 21st century = total 2000 global income!
Pigouvian Taxes = a one-size-fits-all theory does not distinguish between high and low cost avoiders. Pigouvian taxes are inefficient if they tax the highest cost avoider. Tax is used as a revenue raising device in excess of the 'unknown' social cost ... and output suffers.
rights trading = define property rights then freely bargain. Social costs are paid by the lowest cost avoider. If the legal rule chosen is inefficient, parties will bargain around it. Rights will be acquired by those who value them most highly, which creates an incentive to discover and implement transaction cost minimizing governance forms. Don't build houses near polluters build other polluters thus confining cleanup costs to the periphery. Which costs less you stopping or me moving? Pareto efficient, nobody loses, but property rights are required to measure the costs.
Example - the Kyoto objectives are admirable apple pie but solutions will be technological alternatives driven by the high social costs - piecemeal, tentative and adaptive.
1. Throwing filth at other people harms them, it is an illegal nuisance.
2. The polluter must pay the cost but how much? Who is the least cost avoider? Polluters could pay the costs of 'know how' for fuel cells, flood relief and relocation?
Competitive Property rights with tradable permits -
Process A emits 100 tons of obnoxion p.a. costs £100 per ton to reduce
(this process could be new technology in industrialised countries).
Process B emits 100 tons of obnoxion p.a. costs £1 per ton to reduce
(this process could be old technology in developing countries).
Competitive Property rights with tradable permits, reduction in obnoxion costs £2 per ton + transaction costs = £99 cheaper than regulation!!
Can market prices eliminate the costs of gluts & queues?
Economic
Principle No. 24 - Adverse Selection & Moral Hazard.
Adverse Selection - ‘Would you buy a 2nd hand car from this
man?’
Asymmetric information results in price fixing & a glut of lemons ...
unless confidence & trust can be established ...
NB Deal transparency increases with advertising quality reputation,
convincing innovations, brand loyalty & credible endorsements...
Moral Hazard - ‘If it’s free put me down for two please!’
Tax funding & insurance jobs result in queues for ‘freebies’ ...
unless costs can be aligned to products ...
NB In return for their votes poor folk are bribed with their own taxes into
excess debt to pay for a dream of affordable housing ...
Who controls the money supply & interest rates?
Economic
Principle No. 25 - Commercial Bank Balance Sheets.
The money supply & interest rates are endogenously determined as credit growth and GNP growth are 'matched' by loans & deposits on the Balance Sheets of commercial banks.
Money is a vital tool for lubricating economic activity having intrinsic value as a -
unit of measurement - money x velocity = price x output
medium of exchange avoiding the double coincidence of wants in barter - caveat emptor and moral sentiments
store of value over time if inflation is avoided - marginal utility and opportunity cost
In the past Cowry shells, stones, gold, cigarettes, LETS (Local Exchange Trading Systems) and paper IOUs promising to pay 'the bearer' have been generally acceptable as ‘money’ but in modern economies money is overwhelmingly credit and its many innovative variants.
Banks produce money by creating credit for sale, credit has a price - the interest rate - which is determined by supply & demand -
supply is determined by the interest rate cost necessary to induce saving after satisfying liquidity preferences. Claims on the bank for repayment of deposits in the shorter term.
demand is determined by the opportunities for profitable investment. Promises to the bank to repay in the longer term.
Profitable economic activity is funded by banks selling credit and a Banking Institution Balance Sheet will reveal -
A liability of a $10,000 deposit becomes an asset of $10,000 cash and (after maintaining a prudent loan/cash ratio of 10/1) is put to work to fund other assets - a series of loans - these loans will result in further deposits and interest payments which will be available to finance further loans ... etc ...
$10,000 of initial savings generate $90,000 of growth. The growth of the system is dependent on a series of profitable economic activities. Without profit, the interest could not be paid and the loans could not be repaid.
Banks make their own profit by maintaining a loan portfolio whilst minimising bad debts. The 363 interest rule - pay 3%, receive 6% & be on the golf course at 3pm! But such earning potential requires trust and confidence built over years as reputations must be earned for repayment on demand, and identification of profitable projects. Reputation, risk, reward!
Such skills require central banks, prudent risks and sound money, institutions which have proved remarkably difficult to nurture, as democratic politicians, by definition take popular decision not economic decisions.
Not only is this an 'Evolutionarily Stable Strategy' for funding those with the ideas by those with the money. But we can make growth endogenous to the system and see how the 2 + 2 = 5 profitable investments produce a surplus to pay interest to banks and depositors.
Economic growth will feed back and real economic output of goods and services will determine the ‘value’ of the $10,000 initial ‘money’ deposit.
The system has its own in built control systems. The money supply is determined endogenously by interest rates as a function of national income. The balance sheets of profitable commercial banks will ensure the credit base does not increase at a rate faster than GNP and cause inflation. Government interference in ‘interest rate control’ is an irrelevant and inefficient distraction -
'in a market economy where money includes deposits with private sector banks, monetary policy can never be simply a question of the 'authorities' deciding on the quantity of money it will 'allow' to circulate in the economy'. Economic Briefing No.5 August 1993
NB as a lender of last resort the Bank of England can influence interest rates ... but then so too can India, China and America ... ...
NB usury is not immoral after all!
Can a poll tax avoid the XS burden on society?
Economic
Principle No. 26 - Tax Distortions.
The dead weight loss or the XS burden is an irrecoverable
loss of welfare to the community. Discriminatory taxes are not Pareto
optimal not only inefficient but also unfair. Equity and efficiency don’t
conflict.
Pareto improvement implies no one loses but all economic and evolutionary
activities involve choices and the rejected are hurt? But there is a
difference between a ‘hard' and a 'harm’. An allele ‘not selected’ is a hard
but it is an essential part of cooperative evolutionary progress, stealing
is a harm and is parasitic.
Morality evolves, making the distinction between a normative & an
evolutionary criteria meaningless?
The only non discriminatory tax is a poll tax.
Can tax rates determine tax revenue?
Economic
Principle No. 27 - Tax Rates & Tax Revenue.
The Art Laffer curve – average tax rates v. tax revenue.
Flat rate tax - more income = more tax. Rich people pay the most tax.
Average tax rates.
People don’t pay high marginal tax rates and never have. They change their
behaviour. Hard work, honesty & thrift are discouraged by high marginal tax
rates.
Why not ban 'animal spirits'?
Economic
Principle No. 28 - Business Cycles.
A cycle of flip flopping human emotions drive the generating & testing, the diversity & choice which feed the evolution of business 'know how' - Optimism - Excitement - Thrill - Euphoria - Suspicion - Anxiety - Denial - Fear - Desperation - Panic - Capitulation - Despondency - Depression - Hope - Relief - Optimism ...
Joe Schumpeter described this discovery process as 'creative destruction'.
Are rational purposeful intentional plans a mirage?
Economic
Principle No. 29 - The evolution of evolvability.
In order for a biological organism to evolve by natural selection,
There must be a minimum probability that new variants are beneficial. Random mutations are expected to be mostly detrimental, but they seem to be beneficial more often than randomness dictates. This suggests that the process structures make beneficial changes more likely than they would otherwise be. Evolution has created not just fitter organisms, but populations that are better able to evolve.
Path dependency prunes out vast swathes of randomness, and when supplemented by increasing diversity of 'likely' candidates, evolvability will increase. Sex, immune systems and brain activity are examples of adaptive mechanisms generating path dependent diversity.
The brain generates a diversity of ideas and sifts them for testing with flip flopping emotional and reasoned criteria. The suggestion that the evolutionary function of the brain is the generation of diversity for further evolution of more basic functions is an affront to the more plausible idea as self consciousness and rational purposeful intentional planning ... but self consciousness appeared very late in the evolution of the brain ...
Does economic growth result in the urban trek?
Economic
Principle No. 30 - Economic Intensification in Cities.
Economic interactions are intensified in cities generating more synergies.
Once the rule of law is established, a process of dynamic economic change emerges spontaneously in regions - not a 'homogeneous society' but a tapestry of different individuals who group together in cooperating families, tribes, religions and states but above all in towns and cities.
Jane Jacobs has described a process of institutional adaptation enabling the intensification of economic interactions in cities. The explosion of the industrial revolution was in the cities and such intensification of activity was inconceivable without the rule of law.
Six regions are usually involved in interconnected economic activity -
innovative heart (high density interactions & immigration) - low tax?
resource supply (food & raw materials) - low prices?
clearance (labour saving investment & emigration) - job mobility?
transplants (low density mature technology & routine) - planning freedom?
obsolete (abandoned technology & the rust belt) - no subsidies?
subsistence (non-participants & bypassed) - skill acquisition?
The delicate dynamic is easily destroyed by 'breaking the rules' of property rights, low transaction costs and parasite/predator constraint, by misunderstanding the integrity of the whole system and separating the political from the economic.
The political evolutionary process is part of the game, but politics does not write the rules of the game, 'know how' is institutionalised.
Why is the joint stock company the growth miracle of capitalism?
Economic
Principle No. 31 - Accounting for Growth.
Economic growth is measured in The Balance Sheets of joint stock companies.
It is usual to be in awe of the great individual achievements of Charles Darwin and Isaac Newton but the overwhelming success of wealth creating cooperative institutions is less easily grasped and often denied.
Definition - the jsc is an economic institution, a complex system built by evolutionary processes 'as if' to cope with the age old problems of scarcity, conflict, complexity & change.
Evolutionary Success - a neat survival trick evolved, an incentive system for rewarding individuals who satisfy customers. A self-policing system based on private property where competing alternatives to vie for customer sales, encouraging the preservation and enhancement of assets and contracts for employment and supplies. Evolution inevitably produces a diversity of competing institutions, some of which differentially survive. Innovations are not 'a best way' which is known in advance, but more simply those institutions which produce more survival value for the cost incurred than competing alternatives survive -
wealth creation - understand the jsc as a wealth creating institution it has proved remarkably successful. The jsc has cemented the survival of western civilisation, the international jsc is the driving force of the global economy, this success is exposing the inability of national governments to control their own economies
robustness - immune from internal and external treachery and responsive, able to learn from past outcomes and exploit future innovations.
NB The jsc suffers from inefficiencies -
hierarchical organisations like the jsc are less efficient than perfectly competitive markets - new institutional economists describe how the jsc exists only because market transaction costs can be prohibitive
managers cannot always be relied upon to act in the interests of the shareholders - the moral hazard and the principal / agent problem.
The evidence of history - a mix of elements contribute to the success and robustness of the jsc.
The elements did not evolve sequentially but gelled into a coherent whole displaying all the characteristics of a complex system.
The emergence of these elements was not an accident but the result of a selection process from the trial and errors of experiment.
The jsc emerged in a modern form in England - some significant landmarks in the evolution of the jsc -
Origins - economic activity grows and prospers when folks co-operate to benefit from synergies associated with scale, specialisation, science, imitation, investment and innovation. Groups of people associating together and sharing resources, in order to pursue a common purpose. Historically economic interactions intensified initially in towns and cities and then further intensified in institutions within the cities -
as money replaced payment in kind there were more opportunities to save and accumulate capital
as trade in the cities grew there were opportunities for profit from risky trading ventures, particularly far away and overseas
in England in the 17th century there was an increasing opportunity for free men to choose the form of their co-operative endeavours. The jsc was the result of voluntary co-operation between merchants who copied earlier Italian practice and pooled their resources in return for a pro rata share in any profits. The prizes these merchant sought were - property ownership - limited liability - succession and continuity - legal remedy for debts
in mercantilist times a tempting source of state revenue was the granting of licences to trade as joint stock companies. State sponsorship was common when ventures were unsupportable by taxation - East India Company, Hudson Bay Company, Virginia Company - many of the first companies were privileged state monopolies
1624 Repeal of ‘The 1571 Act of Usury’ - confirming a change of moral attitude to investment returns, rewarding risk taking became legitimate. Risk was uncomfortable and discouraged investment - ‘a glimpse of risk made the crowd shrink’ -
risk associated with saving, why delaying consumption today when tomorrow is unknowable?
risk associated with lending your savings to others, do you trust him?
communities which evolved the new morality started creating more wealth as more people took more risks. Those with the money have no ideas, those with the ideas have no money
those seeking investment opportunities realised that trust was essential not only because of some inner driven ethic but because honesty was seen to be profitable
1773 Securities Exchange - traders started to deal in utility and industrial stocks as future income streams were bought and sold -
risk was reduced as information became more transparent, investment choice started to become an important indication of value
value was enhanced as resources were allocated to the more profitable ventures, private commercial decentralised decisions start to provide an alternative to central taxation
1825 Repeal of ‘The 1720 Bubble Act’ - for 100 years the jsc was indictable as a common nuisance and, although fraud remained illegal, at a stroke regulation could no longer inhibit legitimate creativity and innovation -
investment scale increased as savings from larger numbers of smaller folk were mobilised
investment flexibility increased as investments could be freely transferred to others
* 1834 Legal Entity - opportunities for legal remedies -
companies could sue for the recovery of debts through the courts
companies could be sued for the recovery of debts through the courts, honesty was the best policy
1844 Board of Trade Registration - a specific act of Parliament was no longer necessary to form a company -
companies could be readily formed by anyone, for any legitimate activity quickly and easily with minimal cost and red tape
profitable trading no longer depended on political influence, vested interests and monopoly power
1856 Limited liability - savings capital could be mobilised to exploit profitable opportunities with a minimised personal risk, innovation took off! -
investors liability for debts was limited to the amount of the investment
rewards for choosing profitable investments correctly were going directly to substantial numbers of people who could not prevent others from proving them wrong! Investors had only themselves to blame if they burnt their fingers. A restatement of an old principle of Caveat Emptor?
1890 Stock markets - business finance became readily available as small packets of risk were freely valued and exchanged -
information flows around the world as folk were able to quickly and flexibly move funds into wealth creating activities
mass participation becomes possible.
1989 Fall of the Berlin Wall and abandonment of Clause 4 - the success of the jsc is more generally accepted -
privatisation is embraced
massive populations in China and India join the globalisation gravy train.
The line of causation runs from economics (survival necessity) to an
institutional and legal response. There was a competitive economic necessity
for investors to share the risks associated with business innovation in
co-operative ventures. Specifically the trading rivalry between England and
the Netherlands.
The Wealth Machine - here is a 'PowerPoint' presentation describing how the
machine works and why it works ... this material was put together for a
business appreciation course for first line managers ...