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Tuesday, July 03, 2007

Innovation and Adaptation

Changing circumstances in the world both of small and large magnitude force us to adapt if we wish to thrive. Arnold Kling addressed this matter through the eyes of 1993 Economic Nobel Prize winner Douglas North.

A free market system makes better use of the inherently dispersed knowledge within the economic realm. It also makes for a more efficient allocation of scarce resources.
In textbooks, economics is often defined as the study of the allocation of scarce resources among competing ends. Douglass North says that adaptation is more important than allocation.

"It is adaptive rather than allocative efficiency which is the key to long run growth. Successful political/economic systems have evolved flexible institutional structures that can survive the shocks and changes that are a part of successful evolution. But these systems have been a product of long gestation. We do not know how to create adaptive efficiency in the short run."
-- Douglass C. North, Economic Performance Through Time, the 1993 Economics Nobel Prize lecture
These flexible institutions allowed for the creation and adoption of innovations both technological and social.
Douglass North's primary field is economic history, and his primary interest is in economic change. In fact, the word "change" appears in the title of many of his works. For North's purposes, the study of allocation mechanisms is inadequate.

[textbook] economics applied to economic development or economic history may account well for the performance of an economy at a moment of time or...contrasts in the performance of an economy over time; but it does not and cannot explain the dynamics of change. The major source of changes in an economy over time is structural change in the parameters held constant by the economist -- technology, population, property rights, and government control over resources.

-- Structure and Change in Economic History, p. 57

Some of the really interesting stuff in economics involves peoples attempts to cope with uncertainty. Frank Knight claimed that this can not be modeled.
For agriculture to work well, property rights must be defined. To reach the stage that we call modern economic development, rules need to cover trading rather than basic sharing.

In short, what is required is a shift from a status-based and coercive society that relies on mutual control, respect of ranks, and strictly enforced codes of generosity, to an open society where free entry and exit, democratic governance (including acceptance of dissent), competence criteria, and socioeconomic differentiation are used as guiding principles or expressly allowed to operate.
It seems like a shakeup of the social order has lingering effects to this day.

While market prices are necessary to enable an economy to process this information (a point stressed by Ludwig von Mises and Friedrich Hayek), they are not sufficient, according to Douglass North.

The integration of this specialized knowledge with low costs of transacting requires more than an effective price system. Institutions and organizations were necessary to supplement the price system where externalities, information asymmetries, and free rider problems had to be overcome. The increasingly dispersed knowledge of modern societies requires a complex structure of institutions and organizations to integrate and apply knowledge...The growth of knowledge is dependent on complementary institutions which will facilitate and encourage such growth and there is nothing automatic about such development.

--Understanding the Process of Economic Change, p. 99

We are still grappling with improving the institutions of intellectual property and regulation.

Douglass North calls attention to the relationship between the private rate of return on innovation and the social rate of return. The social rate of return from innovation is always high, but the private rate of return can easily be low. Innovation takes place when the private rate of return is sufficiently high. Institutional arrangements determine the private rate of return from innovation, and hence they determine a society's adaptive efficiency.

Two important institutional factors are property rights and capital markets. We have just seen how North views the development of the patent mechanism for protecting intellectual property as a cornerstone for modern economic development. On capital markets, he writes,

economic change will require continual alteration in the institutional structure in order to maintain efficiency. This is particularly critical for capital markets...The history of Japan in the 1990's is a classic instance of a capital market that initially fueled extraordinary development--that of post-World War II--only to develop the sclerosis that followed.

--Understanding the Process of Economic Change, p. 123-124

Suppression of private incentives through too heavy a tax or regulatory burden has a high social and economic cost.
One reason that institutions evolve slowly is that organizations have developed with a vested interest in existing practices. Another reason is that institutions reflect the beliefs shared by a culture. North places a heavy emphasis on the role of beliefs in shaping institutions, which in turn determine economic outcomes.
Both rent seeking special interests and the established political class can make change quite difficult. Think - eliminating agricultural subsidies.

Mancur Olson addresses uncertainty, innovation, adaptation and institutions in the conclusion of his final book, Power and Prosperity:
Because uncertainties are so pervasive and unfathomable, the most dynamic and prosperous societies are those that try many, many different things. They are societies with countless thousands of entrepreneurs who have relatively good access to credit and venture capital. There is no way that a society can predict the future, but if it has a wide enough array of mutually advantageous transactions, including those for credit and venture capital, it can cover a lot of the options - more than any single person or agency could ever think of.

At least when a society has the appropriate institutions and government policies, the overwhelming majority of the firms that make huge profits are doing a huge service to the population. In a society with the right institutions and public policies, the prevailing prices will approximate the true values and costs of marginal quantities of the goods and productive inputs. A great excess of revenues over costs means that the enterprise is almost certainly putting more value into the society than it is taking out.
Contrary to what collectivists would have us believe, effective institutions that harness private incentives provide a big payoff to us all!


Bret said...

So who's responsible for adapting these "flexible institutional structures". Sounds like a government to me. I don't have a problem with that but I'm wondering if Arnold Kling (an uberlibertarian) has thought it through to that conclusion?

Howard said...

I think "we the people" by engaging in a bit of wrestling and persuasion around various ideas can shape and reshape our beliefs. That influences what is and is not acceptable from the political class, ordinary citizens and leaders of other public entities. It's a long, messy and largely uncontrolled process.

Kling has his uberlibertarian moments but there are many more extreme libertarians. They just marginalize themselves unless they can persuade other people as to the next incremental step in a preferred direction.

Bret said...

I agree that there are more extreme uberlibertarians than Kling. The folks (especially the commenters) at cafe hayek, for example.

I like Kling and North. I was just surprised that Kling didn't even touch on the fact that government has to be signficantly involved (even as "we the people") for the institutions to evolve.

Bret said...

Kling wrote that North stated: "The social rate of return from innovation is always high, but the private rate of return can easily be low."

Not really. The invention of the "pet rock" probably didn't have a high social rate of return.

But seriously, an important qualifier is "sufficiently" when applied to high. Once the threshold is reached, increasing via institutions the private rate of return is counterproductive, perhaps very counterproductive.

Howard said...

Bret said, "Once the threshold is reached, increasing via institutions the private rate of return is counterproductive, perhaps very counterproductive."

Well there you go. This is a good example of being trapped by a poor use of words which I usually prefer to avoid. The word
"incentive" as used in your comment does imply the possibility of going too far. Incentives also has a positivist tone which only encourages central planning and control types to pursue their grand visions. My preferred usage is the more passive "barriers to exchange." Let's view taxes as a means of revenue generation and regulations as a means for reducing negative externalities rather than means of control. This provides the possibility of finding paths of improvement. Then it is overtaxation and overregulation which are to be avoided as excessive barriers to exchange.

Harry Eagar said...

'A free market system makes better use of the inherently dispersed knowledge within in the economic realm.'

I dare you to read Nick Leeson's 'Rogue Trader' and then say that again.

Hey Skipper said...

All the cites sound like an excellent argument for restoring states' rights.


The important words are "... better use ..."

As in, better than all the other options on offer.

Harry Eagar said...

I don't know who Dan Stanford is or was, but he said words to live by:

'Experience is what you get when you don't get what you want.'

Free-marketers get a hell of a lot of experience.

Bret said...

I suppose Howard didn't specify what the free market makes "better use" of dispersed knowledge, but what alternative do you think makes better use of information than the free market?

Harry Eagar said...

Well, a thoughtfully considered regulatory system can do.

Or do you test each tube of toothpaste yourself for poison?

The free market in toothpaste isn't working out so well, is it?

Bret said...

I suspect that if we looked at dental records for the Soviet Union and the United States, we'd find that the free market approach to toothpaste works better. Note that no-one in the US has actually been harmed by the Chinese toothpaste.

Harry Eagar said...

No, but 100 Panamanians died of it.

What kind of a globalist are you if you don't count the Panamanians?

And you haven't said whether you test your own toothpaste. Somebody is testing it (now), but that somebody is not the free market.

Bret said...

No, the free market is not testing toothpaste (other than Consumers Reports), that's true. That doesn't mean that if the government didn't do it, there wouldn't be adequate demand to get the free market to do it. For example, an extension of something like Consumers Reports).

Harry Eagar said...

I very much doubt that Consumer Reports, or anything like it, could screen imports the way Customs can.

Your argument, though not as extreme, reminds me of the Minutemen in Idaho and Montana who damn all the works of government while driving down paved highways.

The problem with worshipping the freedom of the market is that you agree, willynilly, to accept anything the market throws up. This naive belief that the market cannot be wrong has been disproven enough times that, you would think, people would stop believing it.

Bret said...


I'm not saying the market can't be wrong. I agree that it can, and the way I get skewered at Cafe Hayek, I'm clearly no strict libertarian.

However, the USSR showed there are limits to what government can achieve as well. Also, there are often market alternatives to government. Was our government testing toothpaste prior to the Panamanian incident? I don't think so, which means that it didn't really protect us in this case either. Government can't do everything. Customs can't do everything - they inspect less than 5% of containers coming into the country.

Howard said...


I state my views based on the impression that most people: vastly underestimate the abundance produced by a free market system, are correct in pointing out some of the negatives but without an appreciation for some of the self-correcting aspects (especially with rapid communication) and fail to realize how far we are from the thoughtfully considered regulatory system which you and I would like to see.

A free society and free markets are founded on principles of liberty which require rules to work. An ethic of "anything goes" is not part of liberty, it's called license.

Let me offer a few examples of where regulatory systems miss the mark. Most antitrust cases involve business seeking protection from competitors and not the protection of the public. (see also article linked to in above link) The CAFE standards for fuel efficiency were not only detrimental in an economic sense, but very likely cost many lives in highway fatalities. The public and industry got around the safety problem by building and buying suvs built on truck chassis thereby working around the regulation. Finally, the ban on DDT was ill conceived and likely resulted in many millions of deaths and cases of illness from malaria.

The institutions in support of a market system which delivers large benefits are ok, but the warts on the regulatory system are significant and underappreciated. This is why I prioritize points of emphasis as I do. There are often tradeoffs. Wise choices are difficult enough to make. Blind allegiance to good intentions or hysterical pronouncements do not help.

Harry Eagar said...

Well, DDT was not economic regulation. Let's say, for the sake of argument, that it should have been banned.

I don't see how that ever happens in a free market. In the analogous case of toothpaste, it may be that the free market would catch up to the harm eventually, but why wouldn't it have been better to have avoided the harm through regulation in the first place?

To take an purely economic case: In a free market, it will ALWAYS pay somebody to sell a terrorist a working A-bomb. Or, as Lenin put it, capitalism will sell the rope used to hang it.

Or to take another example, one that worries me a good deal these days: the free-market attack on intellectual property.

It is empirically true that where there is no regulation (copyright, patent) in favor of intellectual property, there is no intellectual property to protect. The regulaton creates the economic good, which cannot exist in the absence of regulation.