INNOVATION, INCREASING COMPLEXITY AND
THE NEED FOR A NEW PARADIGM IN ECONOMICS.
This paper was written for a multi-disciplinary and essentially non-economists workshop on "The evolution of complexity", organised by the Principia Cybernetica Project in the framework of the "Einstein meets Magritte" conference, on the occasion of the 25th anniversary of the Free University of Brussels (29 May - 3 June, 1995).
This paper is not intended to explore new domains in economics. Rather, it re-interprets some recent developments in economic theory from the point of view of self-generating systems theories and shows how this requires a re-formulation of the mainstream economics competitive general equilibrium paradigm. This paradigm has been challenged recently by endogenous economic growth theories and their emphasis on ideas or innovation as the driving force behind economic activity. Innovation prevents an economy from collapsing into general equilibrium and entropy death and should thus be seen as an essential ingredient to ensure sustainability of economic systems. On the other hand, innovation is incompatible with competitive equilibrium because it introduces non-convexities. The trajectory of embodiment of ideas and their role as separators (constraints) is explored through hierarchical levels in an economy, thereby enabling transactions to take place and laying the basis for the self-generating capacity (autopoiesis) of economic systems.
1. Neo-classical economics: economic activity as an entropy maximising process
Present-day mainstream micro-economics is almost entirely build on neo-classical theories of consumer and producer behaviour that emerged in the late 19th century when the so-called "marginalist school" introduced the concept of market equilibrium. This can be summarised, in a nutshell, as follows. Producers, who aim at maximising profits, reach an equilibrium situation when the marginal cost of their production (the additional cost of the last unit produced) equals the market price of the product. Consumers aim at maximising utility which they derive from a given income. They reach equilibrium when the ratio of marginal utility (the additional utility of an extra unit of a good) of any pair of goods in their consumer basket equals the ratio of the corresponding market prices. These fundamental concepts have been further developed in the first half of the 20th century and resulted in a general theory of competitive equilibrium - a situation whereby all producers and consumers reach equilibrium through voluntary transactions in a competitive market. This theory constitutes the basic framework of analysis used nowadays in most economic models and research.
Neo-classical economics does not only provide a framework for the analysis of competitive economic behaviour of producers and consumers and the resulting system equilibrium or steady-state economic situation. It also contains a basic guideline for economic policy and, at least implicitly, for the organisation of society. This could be summarised as follows: perfectly competitive markets are the most optimal instrument for the allocation of production factors and outputs across economic agents and produce the highest reachable point of welfare for an economy. Society (and the State as the regulator of society) should thus maximise the possibilities for competitive behaviour among its citizens in order to reach the highest point of welfare, called "bliss point" in general equilibrium theory jargon.
Very substantial amounts of economic research resources have been invested in the further sophistication of competitive equilibrium models to prove that competition does indeed maximise welfare, provided certain market conditions are met. The State's role is thereby largely confined to creating an enabling environment for competitive economic actors and correcting the functioning of the market only in cases where the conditions for perfect competition are not met (mainly monopolies and externalities).
From a systems theory point of view, it should be clear from the above brief description that general equilibrium theory is fundamentally an entropy-maximising model, driven by voluntary transactions in a perfectly competitive market that will iron out all differentiation in the system. Competition drives the economy towards and locks it into a steady-state equilibrium where all price differences are eliminated in homogenous markets and all marginal costs equal the corresponding marginal benefits. Producers have no incentive anymore to modify the quantity of production and consumers have no incentive to modify their consumption basket. Once general equilibrium is reached, entropy is maximised and the economic system basically dies an entropy death. It can, of course, continue to run in "reproductive mode", whereby economic agents endlessly exchange the same quantities of the same goods and production factors at the same prices, but without endogenous incentives for change. Clearly, this is not a very realistic approach to economic systems. In reality, producers and consumers constantly modify quantities produced and consumed. What is missing in neo-classical competitive general equilibrium theory is a differentiation force that counterbalances the trend towards market equilibrium - the force of life that keeps the system away from entropy death.
Competitive equilibrium theories have been challenged by recent developments in macro-economic theories. While micro-economics describes the economic behaviour of individual producers and consumers, macro-economics deals with the behaviour of aggregates of producers and consumers - sectors, countries, regions, the world. Despite many attempts, the theoretical foundations of macro-economics are not as clear as those of micro-economics. It could best be described as a mixture of various aggregate (national) accounting frameworks with some price (market) mechanisms thrown in to make the accounts balance.
Macro-economics is basically focused on economic growth: how do we make a country and its citizens better off in terms of income per capita ? Most approaches to economic growth in mainstream economics found their origin in the neo-classical Solow-model (Solow 1956), or variants thereof. In this model, economic output is a function of available capital and labour stocks. Investments, financed through savings or non-consumed income, increase the capital stock and thus production capacity. The size of the labour force is largely, although not necessarily entirely, determined by non-economic demographic variables. Economic growth is simply a function of growth in capital and labour stocks.
Empirical tests of this model, by Solow himself and others, showed that its capacity to explain economic growth was limited and an unexplained growth residual remained - the so-called Solow-residual - that could only be explained in terms of productivity growth. This weakness of the model was easily remedied by the introduction of external technological change that increases the productivity of capital and labour, and thus increases output while input levels remain constant. Investments in new equipment (capital stock) are assumed to be more productive because they embody improved technologies. An electronic word processor is clearly a more productive secretarial tool than a mechanical typewriter. Labour productivity also increases, either through on-the-job learning or through a gradual increase in education levels and skills in the labour force. But these improvements in technology and skills that made their way into production processes were still considered to be "external" injections, from outside the economic system proper. They were assumed to be pure public goods, freely available to everybody at zero cost. The economic production process itself was still looked at as a pure reproductive process, based on external material and technology inputs.
Towards the end of the 1980s, economists took a fresh look at the mechanics of productivity-driven economic growth, as opposed to economic growth driven by a simple increase in the quantities of inputs. The work of Lucas (1988) and Romer (1986 and 1990) led to a new generation of "endogenous growth" models - models that generate economic growth without increases in exogenous resource inputs. In stead, the production of better equipment and better skilled labour became endogenised and part of the economic process itself. The economic system produces "innovation" on its own: it produces new ideas and incorporates them into goods (technical progress) and human beings (education). Because innovation becomes endogenously generated in the economic system, it also becomes the object of economic transactions.
In the initial stages, the new approach remained consistent with neo-classical general competitive equilibrium theories. The models still assumed perfectly competitive markets for production factors and outputs. Some economists actually started to wonder whether there was anything new at all in this approach (Stern, 1993). The embodiment of technological progress into capital goods and labour (human capital) had already been described in earlier work, for instance by Arrow (1962) and Hicks. However, the merit of the new approach is that it focused attention on innovation - new ideas - as a key variable in the functioning of an economic system. What most economists did not realise at the time, even not the principal protagonists (Romer, 1994), was that together with the concept of innovation, differentiation and complexity slipped into economics and would create problems of incompatibility with competitive general equilibrium.
2. Enter innovations: economic activity as a differentiation process
Formally endogenising "innovation" still did not explain the economic properties of innovation, of new ideas. Romer (1990, 1994) was the first to point out the crucial importance of this cognitive concept and showed that it is fundamentally inconsistent with neo-classical competitive equilibrium.
To reach general equilibrium in a competitive market economy, the behavioural functions of producers and consumers should be convex. That is, their behaviour should converge to a single equilibrium point which is their best position that can not be improved in the given circumstances. Convergence towards equilibrium will occur if and only if returns to scale are diminishing, that is if costs are increasing and benefits diminishing with increasing quantities. Consumers will not endlessly increase the quantity consumed of a particular good. Additional utility from more consumption will diminish and could even become negative beyond a certain amount of consumption. Similarly, producers will not endlessly increase output because the cost of producing more of the same good will become too high, for a given investment. Equilibrium is the point where marginal costs equal marginal benefits.
However, Romer showed that ideas are not subject to diminishing returns and thus constitute non-convexities in an economic system. Ideas are non-rival: an endless number of users can use the same idea without any additional cost or loss of benefits for the next user. Ideas may require a high initial investment cost in research and development but they can be applied endlessly at zero marginal cost thereafter. The micro-economic principle of diminishing returns does not apply anymore and competitive equilibrium can not be reached.
Non-rivalry has profound economic implications. In the case of conventional rival "goods", the production function is homogenous in the first degree (doubling of inputs results in a doubling of output) and returns to scale are constant. This mathematical property allows the application of Euler's Theorem (the value of output is entirely used to remunerate production factors according to their marginal productivity) and thus the existence of a competitive equilibrium situation in the markets for production factors, labour and capital.
However, the situation is quite different for non-rival ideas. A single idea, produced by a one-off investment in research, can change overall output totally disproportionate to the investment in that idea. Romer (1990) illustrates this with an example in the personal computer industry. Output of information throughput capacity can be doubled by doubling all physical inputs in the computer manufacturing process and thereby produce twice as many PC's. However, the invention of a new microprocessor with twice the throughput capacity of previous models produces the same result, without increasing physical inputs. Consequently, returns to scale are increasing (the degree of homogeneity exceeds 1). Euler's Theorem does not hold anymore and competitive equilibrium can not be reached.
Furthermore, in terms of effective property rights, ideas are somewhere in between pure public goods (for instance, national defence, the legal system) which are not excludable at all (every citizen enjoys the benefits; it is impossible to exclude some from enjoying them) and conventional private goods which are totally excludable (only the owner enjoys the benefits; others are excluded by law). Ideas are only partially excludable, to the extent that exclusive property rights can be effectively enforced (through intellectual property rights, patents or simply secrecy). In other words, ideas are excludable when the owner of the idea has the effective monopoly over its use. If others have not independently come up with the same idea or do not have the right to use an existing idea, than there can be no competition to establish an equilibrium price for that idea in the market. The idea-monopolist can set a price above the marginal cost of production of the idea (which is zero, once the idea has been produced) and thus earn a monopoly profit, exceeding market equilibrium profit.
Excludability is a property that permits the effective exploitation of increasing returns to scale, caused by non-rivalry. It introduces a constraint in the market (a de facto or a legal property right) that prevents the immediate diffusion of an idea throughout the system. Without excludability, there would be no need to go through a transaction to acquire the idea: it would be freely available to everybody. Excludability ensures marketable value and monopoly rents for ideas.
Fire, the wheel and the recipe to make French fries are ideas that are clearly non-rival: they can be used as often as one wants without diminishing the benefits derived from each application and without any additional cost at each application. Unfortunately for the inventors, there are no exclusive property rights attached to these ideas and they are thus not excludable. The Microsoft Windows operating system on my computer is also a non-rival idea: millions of people all over the world are using it at this very moment without any loss of benefit for myself or without any additional cost to the inventor. Moreover, it has acquired excludability through intellectual property rights. Although these may not always be effectively enforced by the inventor, they still generate a handsome revenue for him and constitute his monopoly rent - until, one day, he or his competitors will invent a better operating system.
All ideas are non-rival and thus subject to non-diminishing returns and non-convexity. Some ideas are also effectively excludable and thus constitute a monopoly right that prevents the market for this idea from reaching competitive equilibrium. Because of these two properties, ideas can not be reconciled with competitive general equilibrium theory.
It would not be exaggerated to say that economics is about to change its basic paradigm. The strong emphasis on perfect competition to reach general equilibrium, supposedly the ultimate economic bliss point, has been waning. In stead, the dual nature of the economic process, with innovation as the differentiation (entropy reducing) force, driving the economy towards increasing complexity, and market competition as the integration (entropy increasing) force that erodes away monopolies, is turning economics into a truly evolutionary systems science with a build-in mechanism that eliminates obsolete behaviour and generates new variety to replace it. Economics is moving away from the pure perfect competition paradigm towards a dualist competition-innovation paradigm. Under the old paradigm, competition was the rule and monopolistic behaviour the exception. The new paradigm suggest that the reverse is true: economic agents strive for differentiation to strengthen their monopolistic positions and try to avert perfect competition that is a rather exceptional situation.
Neo-classical analysis could be considered as describing only one side of the coin of economics: the convex side. The underlying key principle in the neo-classical world is that the universe of options available to economic agents (producers and consumers) is convex. The law of diminishing returns applies and the cost of a particular choice will inevitably increase the further that choice is pursued. This marginalist universe is a very natural world. Krugman (1994) pointed out that it can be compared to a natural landscape with hills and valleys. Wherever you throw in a ball, it will always roll to the lowest reachable point and stay there "in equilibrium". Fortunately, the world of economics, both in theory and in practice, is much more alive and kicking than neo-classical equilibrium analysis suggests. The other side of the coin of economics, non-convexity, is caused by the non-rival nature of innovation, ideas, the self-organising mechanism that prevents the economy from disappearing into entropy-death or global equilibrium; it kicks the ball uphill again. It shifts economic systems from simple "reproductive mode" to "innovative mode".
From a more intuitive point of view, the very possibility of the existence of perfectly competitive markets can easily be questioned. Theory assumes that in such a market, two competitors sell identical products at the same price. In other words, there is no differentiation between perfectly competitive products. But how can a potential consumer decide from which seller he is going to buy ? If the consumer is perfectly indifferent to the offers, no decision is possible and he finds himself in an "asinus buridanus" position. Something has to convince him to buy from one or the other seller: the pretty face of the sales girl, the fancy colours of the shop, the music played inside the shop, etc. In other words, the seller with the (for the consumer) most appealing combination of inputs will do the sale. Differentiation is a necessary condition for markets to exist, although imperfectly. Slight imperfections actually trigger the consumer's choice and enable a transaction to take place.
In a way, differentiation creates an epistemological problem for the concept of "markets". Perfectly competitive markets are defined as homogenous markets, that is with no differentiation in the goods traded and pure price-taking behaviour for consumers and suppliers. This is a circular definition (Gravelle and Rees, 1981, p. 289). In the light of the preceding analysis, it may be concluded that suppliers always try to maximise differentiation and thereby strengthen their market position. Homogeneity is thus only conceivable at the level of a single supplier and therefore, de facto, in a monopolistic market - which is exactly the opposite of perfect competition.
This vision of imperfectly competitive markets brings us closer to the everyday reality of business management. Business managers do not strive for homogenous, perfectly competitive markets. On the contrary, they will make every possible effort to differentiate their products from those of their competitors - that is the purpose of advertisements - and thereby hope to trigger a consumer's decision in favour of their products. The intellectual and innovative efforts of business managers are fundamentally directed at differentiation, to stay away as far as possible for perfectly competitive and homogenous markets. Even for such intrinsically homogenous products as washing powder and petrol for cars, enormous marketing campaigns are launched in the hope of creating a slight differentiation.
Endogenous growth theory has forced economists to abandon perfect competition and has brought economic theory closer to everyday economic reality. Several authors have coined the term "Neo-Schumpeterian" for this new school of economic thought. J. Schumpeter was one of the first economists to emphasise the importance of entrepreneurial behaviour, the relentless drive of producers to gain competitive advantage, to innovate and to improve the production process.
3. Some applications and scope for further research
These diversions from perfect competition and the recognisance of the entrepreneur's inherent tendency towards "monopolistic" behaviour are not new to economics. Research into imperfect competition and monopolistic behaviour started in the 1930s (Chamberlain and Lerner) but remained by and large a sidelane in economic theory where "mainstream" economists focused on the further development and sophistication of competitive equilibrium theory. Whatever research was produced on imperfect markets and market failures was usually considered of marginal importance. But in recent years, imperfect competition models have scored successes, notably in international trade theory where they managed to provide a better framework for the understanding of trade flows and trade policy in an increasingly competitive world.
These new insights have also contributed to a better understanding of the nature of economic development and the causes of underdevelopment and poverty. Up to the late 1970s, developing countries were considered as economies with an insufficient capital stock (insufficient investment). As domestic savings were very low because of prevailing poverty, the required increase in investment should be financed through external aid. From the early 1980s onwards, the "structural adjustment school" claimed that developing countries should open up markets and increase competition in order to attract more private (domestic and foreign) investment and enhance the efficiency of investments. This produced some encouraging results in developing countries but failed by and large to generate strong investment and GDP growth rates.
Further research on rapidly developing South East Asian economies (Wade 1992) showed that these countries flouted some of the basic rules of competition through direct state intervention and protectionism but, on the other hand, directed investment into very innovative and highly competitive products. This innovation-oriented approach to economic development enabled the rapid emergence of the "Newly industrialised countries" over a period of less than three decades. These findings give strong empirical support to the neo-Schumpeterian view that innovation and even some limitation of competition is the key to rapid economic growth, rather than a blind focus on investment quantities an un-innovative reproductive processes. Romer (1992) suggested that developing countries do not so much suffer from a lack of capital and physical inputs but rather from a general lack of innovative ideas, from micro-economic production processes up to the macro-level of the organisation of society.
Innovation-based evolutionary economic theories have been developing rapidly, in recent years, in the domain of entrepreneurial producer behaviour. A good overview is presented by Dosi (1994). It borrowed some key concepts from biological (genetic) selection theories (Nelson and Winter, 1982) and sees competition among producers as a function of their capacity to generate innovation in production processes and output. The production of innovation itself is a stochastic process, endogenous to the economy, with uncertain outcomes but necessary in order to face competition. Too the extent that property rights to innovative ideas can be effectively enforced, successful innovators benefit from economies of scale and imperfect market conditions that generate monopoly profits. The search for innovations could thus be described as the search for market imperfections and oligopolistic positions that permit the producer to boost his profit margin over and above the minimum level of capital remuneration set by perfect competition.
Some initial attempts to incorporate the consumer side into models of innovation have been made (Ulph and Owen 1994, Becker 1991, Bichandani et.al. 1992) but more research needs to be done on the systematic transposition of innovative behaviour to the consumer side. Yet, the problem is quite similar to the introduction of innovation on the supply side. Just like technological innovations in the production process were considered to be an external factor in Solow-type growth models, consumer behaviour parameters are considered exogenous and consumer sovereignty is a sacrosanct principle in general equilibrium models. In real economic life, there is of course no doubt that consumer behaviour is to a large extent endogenised and subject to innovations, otherwise there would be no point in spending money on marketing campaigns.
The concept of innovation in consumer behaviour is likely to run into the same incompatibilities with competitive general equilibrium theories as those that occurred on the supply side, that is non-convexities caused by non-rivalry of idea-driven innovation in consumer behaviour. But further research is required to come to a meaningful economic interpretation of increasing returns and monopoly rent for consumers. It is likely that such an interpretation will be situated outside the domain of pure economics and will be related to such concepts as social autopoiesis and the emergence of the self and identity in cognitive systems (which are discussed in other papers submitted to this symposium).
4. The irreversible evolution of the economic process
Time is a key variable in macro-economic growth models. Capital accumulation, productivity enhancement and the discount rate are economic concepts intimately related to time. Neo-classical economics has also defined the concept of time. Time preference, as measured by interest or discount rates, allows to make an economically meaningful distinction between moments t and t+1. In a competitive equilibrium situation, interest or discount rates indicate the relative value of a future bundle of goods or income compared to its present value. However, in neo-classical models, the time concept has not much sense of direction.
In most mainstream macro-economic models, time's arrow can easily be reversed without fundamentally challenging the underlying hypothesis or mechanics of the models. The values for all variables at time t+1 are computed from values at time t and the reverse can usually also be done: values at time t can be computed from the values at t+1. Macro-economic models are reversible because there is no loss of information, no differentiation, in the time dimension. Time has no influence on complexity or entropy. This has changed recently, with the introduction of innovation into macro-economics.
In micro-economic competitive equilibrium theory, irreversibility does occur but has not been given much attention, so far, in mainstream economics. Consider the example of two economic agents who carry out a transaction, exchanging two goods. They will do so if and only if both agents gain from the deal, that is when both consider themselves to be better off after the deal than before. In economic jargon, we say that both agents have increased their total utility through the transaction. In that case, they are unlikely to be willing to reverse the transaction. Voluntary economic transactions are thus, in principle, irreversible.
This is consistent with the views explained above that competition, and the resulting transactions, constitutes an entropy-increasing force in the economic system. Indeed, in a closed economic system without innovation or new external inputs, the available potential for further transactions diminishes with each additional transaction. Each transaction brings individual agent's marginal costs and benefit perceptions more in line with market prices and thereby pushes the economy closer to general equilibrium where no agent can further improve his position, his subjective well-being, through a voluntary transaction. When general equilibrium is reached, transactions stop and the economy collapses into non-activity: it dies an entropy death. Whereas competitive general equilibrium is bliss point for the neo-classical economist, it means death to the neo-schumpeterians.
Transactions can be reversed if and only if after the deal, new information becomes available that shows that it was not beneficial for any of the parties involved in the deal. When you discover (new information) that the second hand car which you just bought is not really in the excellent condition described by your car dealer, you can try to externalise your revised cost perception to him by treathening him with legal action or breaking his shop window. Once he has digested this new information and is convinced that his actual profits from the deal are inferior to the expected future costs of not reversing the deal, than reversal becomes possible. New ideas thus act as a force that could potentially reverse transactions.
Assume that a new idea, an innovation, leads to the development of a new product (output) or a new production process that, through competition, gradually replaces an existing output or process. The latter is unlikely to become competitive again, ceteris paribus, in the course of time. A producer will replace a piece of old equipment with a new one if it improves the profitability of his firm. Why should he then revert to the old one? Similarly, a consumer will switch to the consumption of a new product when he considers that is generates more utility for him. A successfully introduced innovation should thus be considered as an irreversibility in the economic process.
There does exist, of course, a consumer demand for antiques, products and technologies which have long ago been displaced by competitors. However, obsolete technologies and products are rarely re-installed to serve their original purpose but more often as museum pieces or to satisfy a consumer's specific demand for romanticism (which is a perfectly acceptable argument in a utility function). Price changes (for instance, an oil price increase) may revive obsolete products and processes (wood and coal stoves) back into profitability. But price changes are basically a new information signal, so again it is information that allows to change the direction of economic evolution.
5. The trajectory of ideas
Ideas are non-rival and, as such, can be diffused throughout an economic system without additional costs. They have no marketable value unless they can be made excludable. In order to acquire marketable value, ideas have to follow a trajectory of embodiment into rival and more easily excludable forms. However, not all ideas necessarily follow this trajectory down to the level of a private rival and excludable - and thus tradable - good. Some remain pure public "goods" and others travel down to an intermediate level of collectivity only.
Ideas are the product of cognitive processes which, so far, occur only in intelligent biological entities such as human beings. We produce thousands of ideas every day, most of which are just fleeting thoughts related to a specific activity. Some of these ideas serve more often - they are memorised - and become a guideline or a rule that facilitates decision making when confronted with situations that occur repeatedly: putting on a raincoat when it rains, giving meaning to speech and other symbols emitted by other individuals, buying bonds when interest rates are expected to go down again, etc. The set of rule-embodied ideas that an individual retains in memory through learning processes constitutes his "human capital". Some ideas may be exchanged with other individuals through communication processes and may eventually become a prevailing belief or an understanding within a group. Language systems, for instance, are based on a common understanding of symbols. This way, ideas become embodied into collective rules or understandings, values and standards of behaviour in a group or society. Individuals who do not conform to these rules put themselves outside the group.
Some rules may need to become embodied in an institution in order to ensure and verify their implementation. Religious ideas become embodied in churches and sects; concepts of law and order are embodied in judiciary systems and police forces, the concept of a nation in borders and armies to defend them. In his 1993 Nobel lecture, D. North (1994) defines institutions as "humanly devised constraints that structure human interaction". The rules and regulations that institutions are trying to enforce in a social group (a family, a club, a company, a community, a nation, the world) are basically "ideas" that have been generated through a learning process (improvement of older ideas, a response to new challenges posed to the group, such as competition from other groups). "Ideas" may range from a more efficient way to clean stained shirts to new ideologies, "a shared framework of mental models that a group of individuals possesses". According to North, "the rate of learning will reflect the intensity of competition among organisations". This is true at all institutional levels, from families and companies to nations. A social group, an institution, that gets socially, politically, or economically "stuck" embodies ideas that fail to solve the challenges it is confronted with.
North's institutional view implicitly builds on, but goes further than, the neo-Schumpeterian school. It does not only explain economic growth as a function of innovation or learning new ideas. It also explains the direction of economic change as a function of the "fitness" of mental models (basic ideas) that institutions or social groups develop to confront challenges. These mental models shape the perception of new ideas and act as a filter to enable the institutional embodiment or the rejection of certain ideas. For example, the welfare-state idea in most European societies introduces certain rigidities in labour markets which make them less competitive compared to, say, American or Asian societies and may finally result in less welfare, forcing these societies to rethink their ideas. Ideas are thus constantly subject to feed-back and screening by other ideas at different levels.
Institutional embodiment is especially necessary for collective rules that give a high premium to free riders. Individual property rights and the rules for exchanging property (commercial law) are enforced through the judiciary institution. Without effective enforcement of property rights, free-riders (thieves, charlatans and mafia-extortionists) are likely to grind the voluntary transaction-based economic system to a halt. A private company is the institutional embodiment of a set of rules that determines the behaviour of its employees and shareholders with the aim of generating income through the production of goods and services. Some institutional embodiments may also edge towards increased rivalry. While playing tennis is clearly a non-rival idea, its embodiment into a tennis club makes it much more rival: when congestion sets in, the admission of new members creates decreasing benefits to scale.
Some ideas eventually become materially embodied into goods (and services), that are the object of economic transactions and thus form the basis of economic activity. Ideas on "wheels" are embodied in every wheel. The "computer" idea is institutionally embodied in a computer-producing company and materially embodied in its output, computers.
The importance of institutions is not a new idea in economics. Numerous authors have studied their role and, at the same time, lamented the absence of a more formal economic theory that permits the analysis of institutions (Delorme 1994, Lesourne 1994, Matthews 1986). The combination of innovation, institutional embodiment and innovation-based competition, along the lines suggested by North (1994) will probably open the door to such a formal model, which still needs to be developed.
Let us return now to the end of the trajectory of embodiment of ideas and to the nature of economic activity, transactions. Ideas could be interpreted as information that introduces separators (constraints) into the system and thereby enables differentiation that drives the system away from noise equilibrium or maximum entropy. Following the same line of reasoning, we could generalise the trajectory of ideas. Ideas are embodied into rules that act as separators between behaviour required to reach a specific objective and all other options of behaviour. Similarly, institutions - whether they are public services, clubs or private companies - can be defined as a sub-group of individuals who's behaviour is differentiated from the rest of society by the specific set of rules which they adhere to in order to reach the institution's objective. Again, it is the underlying idea that acts as a separator. If the specific objective is the realisation of a material object, than the idea will eventually become "materially embodied" and produce an object that is "formatted" according to the agreed rule and thus separated from all other "unformatted" matter. Ideas thus follow a cutting-edge trajectory of embodiment into the world, separating idea-conformity from non-conformity at all levels. By doing so, they reduce entropy in society.
The cutting-edge trajectory of ideas and their role as separators can help us to get a better understanding of the nature of economic transactions. Two economic agents can conclude a voluntary transaction when both recognise their respective property rights (a rule-embodied idea) to the bundle of goods which they possess and plan to exchange. The property rights rule thus acts as a separator that creates mutually accepted excludability. It enables the emergence of economic transactions and thus of economic systems. Without this separator, the transaction would simply collapse into a fight (Skaperdas, 1991) and there would be no voluntary exchange on the basis of an agreed price or exchange rate. Contrary to the implicit assumption made by Romer (1990), excludability is not an inherent "natural" characteristic of conventional rival goods, it is a characteristic which they acquire through the property right rule. Excludability is a rule-embodied idea in itself, but a very essential one that allows the emergence of transactions and thus of economic systems.
Excludability thus makes a good tradable, it generates exchange value. However, this value is reduced to the marginal cost of production if identical versions of the same good exist and create competition. In economics jargon: competition increases the price-elasticity of demand to infinity. The supplier can not influence the market and becomes a pure price-taker. The only way to escape from this minimum profits trap is to differentiate the market and pile more innovations into the goods so as to distinguish them from similar goods offered on the market. Differentiation reduces the price elasticity of demand to less than infinity and allow the supplier to increase his price above competitive market prices and thus above his marginal cost of production: it earns him a monopoly rent. The profit motive is the driving force behind innovation and thus behind the self-generating capacity of economic systems.
As Baumol (1990) points out, acceptance of new ideas or innovation is a fairly new innovation in itself in the history of mankind. His example of the Roman glass maker who invents unbreakable glass and is promptly beheaded by the ruling elite illustrates this point. Innovation may put at risk the existing socio-economic and political order and is therefore not always welcomed. Innovation-as-fact-of-life became slowly acceptable somewhere in late-Medieval times and is strongly linked to the European Renaissance. This marked a crucial turning point: society became more open to change and individuals were allowed to compete with one another, irrespective of their place in society. It became socially acceptable for a poor man with a good idea to become richer than the noble man and surpass him in social, economic, and eventually political, status. Only the gradual introduction of the concept of equality and equal rights between men could start the relentless race for inequality, for differentiation between individuals not on the basis of their birthright but on the basis of their achievements.
This could explain why strong economic growth is so closely associated with a "modern" society that recognises the rights of individuals. Conservative societies with "frozen" social structures and status symbols have an aversion to innovation because it destabilizes society and creates socio-economic mobility.
In this paper, we explained how the neo-classical paradigm fails to produce a self-sustaining economic system and how the incorporation of ideas is an essential ingredient for sustainable economic systems and self-generating capacity. However, innovation is incompatible with neo-classical competitive equilibrium. We have explored the trajectory of ideas through economic systems and explained the importance of embodiment of ideas into rules and institutions that may finally produce the goods and services that are the object of transactions, the fundamental economic activity.
This paper does not present a formal model in support of the proposed dualist paradigm for economics. More research work will be required to develop a formal theory that incorporates these modifications to neo-classical theory, including a formal model that combines institutional autopoiesis and economic transactions (Pasinetti, 1994). Furthermore, the introduction of innovation in consumer behaviour is still to be examined. The production of ideas themselves, the cognitive part of the model, will, for the time being, remain an exogenous factor, until cognitive science will have developed a more formal model of the creation and functioning of the self and "the economic motive" (or any other "motive" for that matter). Until then, the generalised evolutionary economic model will remain an "open" model, wherein ideas are an exogenous input that works its way through the system (the trajectory of embodiment of ideas) but without feedback mechanisms into the self.
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