Economics as a discipline would seem to be closely related to management studies. Yet the edge between these two areas of inquiry has often seemed more like a chasm than a fertile field for insight. Economists wedded to mathematical models of equilibrium look down on the “unscientific” musings of management theorists. Management writers, on the other hand, look upon economics as a theoretical inquiry that offers little insight into the real world challenges of business executives. As just one example of the latter, look at what Peter Drucker had to say about economics: "There are no slower learners than economists. There is no greater obstacle to learning than to be the prisoner of totally invalid but dogmatic theories."
Two recently published books shed light on the potential to redefine economic inquiry in ways that could help to cross this chasm. The first book, Knowledge and the Wealth of Nations, by Peter Warsh focuses on the impact of one journal article – “Endogenous Technological Change” by Paul Romer - in re-shaping the focus of economic inquiry. The second book, The Origin of Wealth by Eric Beinhocker, does a remarkable job of describing the ways in which complexity theory provides new insight into economic issues.
A warning to executives – if you are looking for easy to digest management prescriptions or parables like “Who Moved My Cheese?”, stay away from these books. They are both extremely well written, but they are much more concerned with describing new lenses for understanding the economic landscape than with offering quick tips for profitability and growth. There is enormous insight to be gained from both books, but the reader needs to be patient and willing to think carefully about the material covered.
It is certainly not the place for a blog to try to summarize the complex and nuanced perspectives offered by these books. Instead, I'll just briefly point out a few of the interesting elements in each book to try to prompt those interested to dive into the books themselves.
Both books begin by outlining some of the key limitations of 20th century mainstream economics: a deep focus on static equilibrium models and a tendency until fairly recently to view such critical factors as the extent of knowledge or tastes and preferences as “exogenous factors” that are not within the scope of economic analysis. As Warsh indicates, these exogenous factors “lay outside the model, treated as a ‘black box’ whose detailed internal workings were to be willfully ignored.”
While both books describe efforts to overcome these limitations, it is striking that these books have such little overlap. In fact, Paul Romer, who plays a central role in Warsh’s book, merits only two brief mentions in Beinhocker’s book. In contrast, the Santa Fe Institute and complexity theory, both key players in Beinhocker’s book don’t even surface in Warsh’s book.
Warsh’s book focuses on the “conceptual rearrangement in economics” precipitated by Paul Romer in his article on "Endogenous Technological Change" in the Journal of Political Economy in 1990. Paul Romer’s key insight was to describe knowledge as a “non-rival, partially excludable good” that played a central role in driving both technological change and economic growth. For the layman, this means that knowledge can be “shared equally by many persons at the same time practically without limit” but also that “access . . . can in some degree be controlled.” Among other things, this provides a foundation for increasing returns, a concept that mainstream equilibrium economics found deeply problematic.
Warsh sums up the impact of Romer’s article in the following way:
The fundamental categories of economic analysis ceased to be, as they had been for two hundred years, land, labor and material. This most elementary classification was supplanted by people, ideas and things. . . . Technical change and the growth of knowledge had become endogenous – within the vocabulary and province of economics to explain.
In the end, I fear that Warsh overstates the impact of Romer’s article, implying that it led to a fundamental shift in the economics profession, away from static, equilibrium models and towards more dynamic, growth models. While the article was certainly influential and opened up a new set of issues for economic inquiry, too much of the mainstream economics profession remains mired in the mathematical marshes that simplify away all the interesting variables of economic life.
In particular, Warsh is much too optimistic about Romer’s role in resurrecting “that long-neglected figure (at least in economics classrooms), the entrepreneur.” To really gain insight into the economic role of the entrepreneur, one still has to venture far beyond mainstream economics into the realm of Austrian economic perspectives, starting with Joseph Schumpeter and most recently developed by Israel Kirzner.
Beinhocker’s book takes on a more ambitious task. As he indicates in his preface,
. . . the field of economics is going through its most profound change in over a hundred years. I believe that this change represents a major shift in the intellectual currents of the world that will have a substantial impact on our lives and the lives of generations to come. I also believe that just as biology became a true science in the twentieth century, so too will economics come into its own as a science in the twenty-first century. . . . .
Despite the importance of economic thinking, few people outside the hushed halls of academia are aware of the fundamental changes under way in the field today. This book is the story of what I will call the Complexity Economics revolution: what it is, what it tells us about the deepest mysteries in economics, and what it means for business and for society as a whole.
This is a remarkable book (full disclosure: Eric acknowledges me as one of the people who played a substantial role in shaping the thinking in this book, so I am a bit biased). It is a wide-ranging critique of the limitations of mainstream economics, succinctly summarized by Eric in the following way:
. . . economics has historically been concerned with two great questions: how wealth is created and how wealth is allocated. Between the Classical Era of Adam Smith and the mid-twentieth century era of Samuelson and Arrow, the first question was largely overshadowed by the second. The models of Walras, Jevons and Pareto began with the assumptions that an economy already exists, producers have resources, and consumers own various commodities. . . . An important reason for this focus on allocation of finite resources was that the mathematical equations of equilibrium imported from physics were ideal for answering the allocation question, but it was more difficult to apply them to growth. Equilibrium systems by definition are in a state of rest, while growth implies change and dynamism.
But this is only a launching pad, Eric’s primary focus is on providing a rich and powerful view of the drivers of wealth creation:
This book will argue that wealth creation is the product of a simple, but profoundly powerful, three-step formula – differentiate, select, and amplify – the formula of evolution.
Eric develops this perspective and traces out its implications in a broad range of domains in language that is simple and compelling while illustrating complex concepts with examples that are accessible and entertaining. Rather than trying to summarize his arguments and inevitably doing an injustice to the richness of his book, let me instead just briefly highlight two areas that I wish he had developed more, even though his book, with a wealth of footnotes, already breaks the 500 page barrier.
First, like most of the complexity theorists that influenced him, Eric puts great emphasis on the need for adaptability. This is certainly appropriate, but it under-estimates the potential for shaping strategies. In environments undergoing rapid change and a high degree of uncertainty, players have more degrees of freedom to alter outcomes than they would have in more static environments. Shaping is of course different from dictating – we are talking about the ability to alter probabilities on the margin rather than designing and imposing outcomes. This is an enormous opportunity for companies of all sizes, yet very little is understood about what is required to be a successful shaper. This is a topic for another blog posting, but shapers have very different mindsets and practices relative to adapters, even though both types of players in the end have to be highly adaptable in the strategies they pursue.
Second, and related to the first, Eric’s rich discussion of business strategy towards the end of his book suffers from a tendency to focus solely on individual enterprises without exploring significant opportunities to pursue strategies that mobilize large networks or webs of participants. His discussion of strategy tends to assume a dichotomy of firm and market, without acknowledging the rich spectrum of relationships that exist between these two extremes. This is particularly surprising since, earlier in his book, Eric explores with great insight the role of networks in complex adaptive systems.
In the end, both books are deeply concerned with bringing the growth of knowledge and its role in wealth creation back into center of economic inquiry. This is a profound, and long overdue, development. It may finally help to close the chasm that has separated economics and management studies.
But to do more than close the chasm and generate even greater insight, it will be necessary to add another key ingredient to the mix – exploring more systematically the role of relationships in shaping opportunities for learning and the growth of knowledge. In fact, these two topics are inextricably linked in terms of understanding the potential for wealth creation and it will be difficult to generate much insight for business strategy without understanding these connections more fully.