Economics needs to evolve beyond Euqilibrium says TheEconomist 2021

24/6/2021 Economics needs to evolve – There has been too much focus on equilibrium

Not for the first time this century, the global economy is rebounding from crisis. The new normal will differ from the old one. The pandemic shifted resources around, destroyed firms, and subtly adjusted habits. The economy has evolved, in other words. Strangely, most economic models do not treat the economy as an evolving thing, undergoing constant change. They instead describe it in terms of its equilibrium: a stable state in which prices balance supply and demand, or the path the economy follows back to stability when a shock disturbs its rest. Though such strategies have sometimes proved useful, economics is the poorer for its neglect of the economy’s evolutionary nature.

Indeed, social-science thinking informed the views of naturalists such as Charles Darwin. The Reverend Thomas Malthus, who explained how population growth must lead to a life-and-death competition for resources, influenced Darwin as he sketched out how natural selection might lead to the emergence of new species. And while Alfred Marshall—among the figures most responsible for setting economics on its modern, mathematised course—analysed economic behaviour using systems of equations which could be solved for an “equilibrium”, he did so as a necessary expedient. “Mechanical analogies” were useful, he reckoned, but, “[t]he Mecca of the economist lies in economic biology.”

Such models shared a mathematical rigour and elegance with high-prestige fields like physics, and lent themselves more readily to making the forecasts governments required. Milton Friedman argued that it did not matter if the models made unrealistic assumptions about the behaviour of people and institutions. So long as the economy looked, in aggregate, “as if” individuals made rational decisions, and models thus yielded accurate predictions, that was good enough.

Because they very often did not do so, an evolutionary approach crept back into the profession. One important contribution came in 1982, when Richard Nelson, now of Columbia University, and Sidney Winter, now of the University of Pennsylvania, published “An Evolutionary Theory of Economic Change”. Neoclassical models of economic growth failed to capture the forces—like Schumpeterian creative destruction—which played an essential role in generating technological change, they thought. Theories often supposed, for instance, that executives knew and would immediately adopt profit-maximising strategies. In reality, practices might differ widely across an industry, reflecting distinct beliefs and the persistence of firms’ unique cultures and habits. As these approaches competed, some ways of doing things became more widespread across an economy—until some other “industrial mutation” changed the competitive dynamic again.

Messrs Nelson and Winter inspired an entire literature on corporate structures and competition across industries. Empirical work across other parts of economics seems increasingly to reflect an evolutionary influence. Recent, influential studies of innovation, for example, focus on things like exposure to inventors in childhood or the beliefs imparted by academic mentors, as contributors to individuals’ creative output (in addition to factors which have previously received more attention, such as educational attainment and the financial incentive to innovate).

Modification with dissent
Perhaps most intriguing is recent work on culture’s role in shaping economic outcomes. To accept that culture influences behaviour is to allow that people are not foresighted utility calculators, but rather social creatures who rely on norms and traditions when taking decisions. But culture—which changes slowly and is often transmitted across generations—cannot be understood outside an evolutionary framework. Evolutionary economics, having got a foot in the door, may prove difficult to push back out.

This is all to the good. Theory built on unrealistic assumptions has proved less illuminating than economists a century ago might have hoped. Trying to understand the world as it is could yield insights and perhaps, eventually, better predictions. Economists still working with equilibrium models out of habit should consider the disruptive potential of a new, yet old, approach.