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  • Writer's pictureDr. Richard Nelson, PhD

Economic Development From the Perspective of Evolutionary Economic Theory

Updated: May 20, 2023

Of course modern evolutionary theory has been strongly influenced by Schumpeter. It is interesting, and relevant that in his Theory of Economic Development, Schumpeter (1934) used the concept of a circular flow equilibrium, where habitual, customary, behavior sufficed, indeed was hazardous to abandon, as the vehicle to contrast with what is involved in economic development, where innovation was driving change, and the system was out of equilibrium. Schumpeter’s conception of behavior in the circular flow was his interpretation of Walrasian general equilibrium. His characterization of the circular flow is an interesting way of specifying the conditions under which modern neoclassical economics would provide a reasonable analysis of what was going on, at least if maximizing behavior is interpreted, as it was by Milton Friedman (1953), as a way of “predicting” and describing behavior that has been winnowed by learning and competition. I note that modern economic evolutionary theory becomes very similar to neoclassical theory, and generates a continuing equilibrium “circular flow” of economic activity, when innovation is shut down for an extended period of time. But Schumpeter’s basic point was that, if innovation is an important part of what is going on, this characterization of economic activity is inappropriate.

I would like to highlight a particular aspect of Schumpeter’s treatment of innovation in his Theory of Economic Development, that he carries over into his later Capitalism, Socialism, and Democracy (1950), because it is a central element of evolutionary theory. It is the presence of uncertainty.

I note here that Schumpeter’s concept of uncertainty is close to that of Frank Knight (1921); absence of sufficient relevant experience for the actor to estimate relevant probabilities reliably, or even to list in any detail the states of affairs that might materialize after an action is taken. The essence of trying something new, of innovation, is that what will happen is uncertain in this sense, with success never a sure thing. And where and when a considerable amount of innovation is going on, being done by different economic actors, the current context is particular uncertain. In such a context, considerable progress may be being made by the economy as a whole, but through a process of “creative destruction” that involves losers as well as winners. The evolutionary economic theory that Sidney Winter and I helped to develop, as an alternative to neoclassical theory, was strongly inspired by Schumpeter.

However, there is an important blind spot in Schumpeter, that I would like to flag here, that also was there to some degree in the early articulations of evolutionary economic theory. It is failure to recognize the institutional complexities of modern market economies.

Of course the same problem is there in neoclassical economic theory. Indeed, one explanation for the institutional oversimplification in Schumpeter and in early modern evolutionary theory is that, in focusing their attacks and proposals for reform on the limitations of the equilibrium concept, the writers failed to pay sufficient attention to the spare institutional assumptions of that theory. That theory contains firms, who employ inputs to produce outputs. There are households who supply primary inputs and who purchase final outputs. And there are markets that somehow work, through the adjusting of prices, to equilibrate supply and demand. That’s it!

The innovation systems strand of research is designed to enrich this overly spare institutional picture. It does so in two somewhat distinct but overlapping ways. One is to recognize the complexity of many market relationships, their embedding in broader social and institutional structures, and the elements of cooperation and trust that often are essential if markets are to work well. The other is to highlight the role of non-market institutions, like university and public research systems, scientific and technical societies, government programs, in the innovation process in many sectors. While there has been a tendency in the innovation systems literature to focus on institutions involved in the early stages of the innovation process, particularly R and D, some treatments also include in the innovation system the labor market, the education system, financial institutions, regulatory structures, and other institutions that shape economic dynamics more broadly.

Particularly the latter strand makes the research on innovation systems very much part of the recent broad movement in economics to develop a new institutional economics. While sometimes not recognized for what it is, this is a major step away from the Walrasian model. However, I think it fair to say that there are significant differences between the adherents to a richer institutional view who, in other regards, try to hold on to the basic tenets of neoclassical theory, and those coming from evolutionary economics, who thus far mostly have been associated with the innovation systems writings.

One important difference is that, in the neoclassical writings, the normative justification for structures that regulate markets and for non-market structures more generally is posed in terms of “market failures”. The evolutionary theoretic view on this, or at least my view, is that this mode of normative analysis involves a major asymmetry and often obfuscates understanding. Once one recognizes the wide range of institutions involved in economic activity and acknowledges as well that no particular institution ever works “perfectly” in any real context, the asymmetry involved in justifying non-market modes simply in terms of the inadequacy of markets stands out. It becomes apparent that normative analysis needs to be oriented to comparing imperfect alternative modes of organization and governance, and possible mixes of them.

Thus, public funding of basic research, conducted largely at public labs and universities, is a reasonable policy not so much because of “market failure”, but because well allocated basic research spending yields high expected social returns, and publicly funded research conducted at public institutions would appear to be the best way of getting certain kinds of research done and the results made available for general use.

Similarly, it makes much better sense to argue for well-designed industrial policies in terms of high expected payoffs (if in fact that can be argued) than to go through a litany of “market failures” that might justify such policies.

Another important difference between a neoclassical and an evolutionary perspective on institutions and institutional change goes back to the basic differences in the theories I discussed above. Neoclassical economists tend to see institutions as created through and operating as they do because of the maximizing behavior of economic agents, and prevailing institutions as an equilibrium configuration. In contrast, evolutionary economists tend to see the institutional structure as always evolving.

Originally Published by Richard Nelson in Economic Development From the Perspective of Evolutionary Economic Theory


About the Author

Dr. Richard Nelson, PhD, is the George Blumenthal Professor Emeritus of International and Public Affairs, Business, the director of the Program on Science, Technology and Global Development at Columbia's The Earth Institute, and a Visiting Professor at the University of Manchester. He is considered a pioneer in the field of evolutionary economics, innovation and technological paradigms.



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