Economic Darwinism During Recessions

2 September 2007 at 10:00 pm Peter G. Klein 7 comments

| Peter Klein |

Some version of the survivor principle, or “economic Darwinism,” underlies much economics and strategy research. While the term “survivor principle” was coined by Stigler (1968), the idea is usually attributed to Alchian (1950) and Friedman (1953). Alchian argued that even though theories about rational decision makers making “optimal” choices are clearly unrealistic, the predictions of such theories need not be. The quest for profit, combined with competitive selection forces, ensures that the average firm will tend to behave like those described by theories of rational behavior (Alchian, 1950). Friedman (1953: 22), defending the profit-maximization hypothesis, puts it this way:

[U]nless the behavior of businessmen in some way or other approximated behavior consistent with the maximization of returns, it seems unlikely that they would remain in business for long. Let the apparent immediate determinant of business behavior be anything at all — habitual reaction, random choice, or whatnot. Whenever this determinant happens to lead to behavior consistent with rational and informed maximization of returns, the business will prosper and acquire resources with which to expand; whenever it does not, the business will tend to lose resources and can be kept in existence only by the addition of resources from outside. The process of “natural selection” thus helps to validate the [maximization] hypothesis or, rather, given natural selection, acceptance of the hypothesis can be based largely on the judgment that it summarizes appropriately the conditions for survival.

The problem with Friedman’s strong version of the survivor principle is that we know little about how such competitive selection processes actually work. Are these processes fast and precise enough to justify the assumption that surviving firms are “efficient,” or at least approximately so? What if environmental conditions change, such that the selection process has a moving target? What if imitation eats away at competitive advantages, so that efficient first-movers do not survive? These and many other problems question the use of the survivor principle in applied research.

Lasse Lien and I have several papers in progress looking at applications of the survivor principle. To whet your appetite for those (not yet circulating) papers, check out these items on the Darwinian selection process during the recent Japanese recession:

Kiyohiko G. Nishimura, Takanobu Nakajimab, and Kozo Kiyotac, “Does the natural selection mechanism still work in severe recessions? Examination of the Japanese economy in the 1990s” (JEBO, September 2005)

This paper investigates whether the natural selection mechanism (NSM) of economic Darwinism works in severe recessions. Based on micro data, we constructed a comprehensive firm-level panel dataset for Japan from 1994 to 1998 to analyze a firm’s entry, survival, and exit and its relationship with TFP. Empirical results show that efficient firms in terms of TFP exited while inefficient ones survived in the banking-crisis period of 1996–1997. Further, this phenomenon is observed mainly for new entrants and contributes substantially to a fall in macro TFP after 1996. These facts strongly suggest a malfunctioning of NSM in severe recessions.

Tae Okada and Charles Yuji Horioka, “Comment on Nishimura, Nakajima, and Kiyota” (NBER Working Paper 13298, August 2007)

Nishimura et al. (2005) analyze the entry/exit behavior of Japanese firms during the 1990s and find that relatively efficient firms exited while relatively inefficient firms survived during the banking-crisis period of 1996-97. They conclude that the natural selection mechanism (NSM) apparently malfunctions during severe recessions, but we offer a more plausible interpretation: NSM continued to function effectively even during this period, but aberrant banking practices caused a shift in the type of natural selection from directional to disruptive selection, with the most efficient as well as the least efficient firms being favored and firms of intermediate efficiency being selected against.

Entry filed under: - Klein -, Evolutionary Economics, Management Theory, Strategic Management, Theory of the Firm.

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7 Comments Add your own

1. Fred Thompson | 3 September 2007 at 12:35 am

See also Permanently Failing Organizations by Marshall W. Meyer and Lynne G. Zucker (Sage, 1989), which vigorously disputes the efficacy of selection mechanisms on empirical grounds.
2. Paolo MARITI | 3 September 2007 at 4:34 am

The “survival of the fittest” is a long run process. I think that a four-years period, no matter how large the data sample, is too short to draw any reasonably robust conclusion. Some factors (e.g.,as suggested by Okada et al, aberrant banking practices) may take place in the meantime, without the full development of other compensating ones. Banks cannot keep forever to finance ineffcient firms.
3. spostrel | 5 September 2007 at 6:36 pm

1. Survival is the wrong metric to look at. What is wanted is some sense of the “biomass” accounted for by the firm. If two firms survive, but one grows to 100 times the size of the other, that’s fairly meaningful but missed by the survival metric. On the other hand, if one firm exits while another “survives” at very low size and value-creation, it’s not clear that the difference is meaningful.

2. You have to worry about niches and market segments. If two firms are in the same “industry” but never compete for the same transactions, then inferences from differential survival are inappropriate.

3. Riskiness of strategies is pretty important. A higher expected-value strategy may lead to more exit than a lower expected-value strategy.

4. Exit may result from higher opportunity costs. A set of assets with better alternative uses is more likely to be withdrawn from a focal use if that focal use becomes more competitive or otherwise less favorable. The losers stick around and the winners move on to greener pastures. You need a multi-market perspective to understand this.

5. Both the numerators and denominators of TFP need to be measured and interpreted very carefully. High revenue per input unit could be a sign of market power that disappears during big recessions. Quantity measures of output must be quality corrected. And input quality is pretty difficult to pin down, although dual methods can be used to deal with this to some extent.

These kinds of studies are interesting, but I’m not sure the data are strong enough to overcome even modestly informative priors.
4. Peter Klein | 5 September 2007 at 6:53 pm

Steve, I agree completely, particularly with point #4. Efficiency requires that assets be allocated to their highest valued uses, which does not at all imply maintaining the status quo. That is the basic problem with firm survival as a performance metric. Nonetheless, the survival of particular _strategies_ or organizational structures provides valuable information about the specific mechanisms by which value is created through asset ownership and changes in ownership patterns.
5. Jim Robins | 10 February 2008 at 5:53 am

This idea also has origins in Marshall and it was fundamental to Schumpeter’s early work on capitalism (originally his doctoral research, later published in the 1920’s).

It does not necessarily require a principle of survivorship, however – at least, not survival of organizations. Schumpeter argued that people learn through habit and custom to behave in ways that approximate rationality. In part, this was a response to the Austrian view that tended to emphasize individual rationality. It is a more sociological view of survival – patterns of individual and group behavior that provide better outcomes tend to survive over time.

It may work only at a very local scale. Aggregating beyond the group that shares a set of customs to a larger society creates a host of logical problems. Quite a bit was written on the problem of aggregating decisions by political scientists in the 1950’s-1960’s in an attempt to understand the mathematical possibilities for participatory democracy.

The logic of getting from local or micro processes to processes that take place at the level of the society or economy is difficult. I wonder if we are still taking the invisible hand far too much for granted?
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