Do our economic models work for industry policy?

Do our economic models work for industry policy?

The impetus to review the most common schools of economic thought originate in the way the world we live in has changed from a policy perspective since the origination of some of these schools of thought. We find that as complexity increases in the policy domain it becomes more important that capability is held in all the different economic schools and lenses. Hence our interest in understanding the potential usefulness of the different economic schools of thought in policy formulation.

The policies we chose are a function of the issues we see and in the industry policy domain these issues are shaped by the economic lenses we use to observe the world. It is therefore important to understand the differences between these lenses so that we can understand whether a given lens is appropriate in a given situation and context and also so that we can understand the differences in assumptions that underpin the different economic lenses. 

It is important to note that models are simplified and abstract representations of a complex underlying reality. As a consequence, it is important to be fully informed of the simplifying assumptions made to enable the mathematical model to be developed. When models are unthinkingly applied, alternatively misused or abused as a consequence of not fully understanding the limitations of the model, the consequence, in the public sphere, is frequently policy failure. What has to be kept in mind is that essentially “all models are wrong but some are useful”.

In this paper we compare the six most commonly used economic lenses: Neo-Classical; Neo-Keynesian; Neo-Schumpeterian; Evolutionary, Institutional and Complexity as well as looking at the emerging lens of Economic Complexity.

The impetus to review the most common schools of economic thought originate in the way the world we live in has changed from a policy perspective since the origination of some of these schools of thought. The evidence based policy paradigm that have so characterized the last decades is being increasingly challenged by a world where facts are uncertain, values in dispute, stakes high and decisions urgent.

We find that as complexity increases in the policy domain it becomes more important that capability is held in all the different economic schools and lenses to align with Ashby’s Law of Requisite variety. This law applies to any system, whether economic, social, mechanical or biological. It has practical relevance for systems that need to survive and grow in uncertain, turbulent environments and it is central to the design of governance systems. It has been claimed that Ashby’s Law is as fundamental to the disciplines of management and economics as Newton’s Laws are to physics.

This also has some practical implications for the role of government. In our context this means that the individuals involved in the policy related activities should have a higher level of diversity in their mental models the higher the complexity of the policy domain (and these different mental models should of course be useful, representations of the underlying complex reality). 

Hence our interest in understanding the potential usefulness of the different economic schools of thought. Main insights around each economic school of thought are briefly summarised below

1. Neoclassical economics. This school of thought minimises the role of innovation in growth and government’s capability to spur innovation and largely advices policymakers to manage the business cycle, reduce allocation inefficiencies, and support greater fairness. It assumes that people have rational preferences between outcomes that can be identified and associated with values; that individuals maximize utility and firms maximize profits; and that people act independently on the basis of full and relevant information.

In the presented policy challenge context however, these assumptions cannot be said to be fulfilled and hence this lens should not be used.

2. Keynesian Economics. The focus is on restoring economic output to levels compatible with full employment. The main policy target is the (aggregate) demand side of the economy. The main policy instruments are fiscal and monetary policy. The policy focus on aggregate demand assumes that supply will respond to demand. Thus, there is little attention paid to the role or impact of innovation. These assumptions differ from those in the neo-classical world primarily in the assumptions of sticky prices and wages and imperfect competition. 

In the presented policy challenge context the underlying assumptions can be said to be, at best, partly fulfilled and in addition the policy tools at the disposal of a state government would only be able to impact the public sector component of the economy. Hence this lens should only be used within the boundary of the public sector.

3. Neo-Schumpeterian economics is about facilitating investment in knowledge-creating activities, such as research and education, and to encourage agents of change, or entrepreneurs, to innovate. This leads to a wide range of policy targets and instruments with a balance between supply and demand side. The assumptions differ on almost all points from the neo-classical lens and assumes heterogeneous agents with bounded rationality and hence, individuals and firms are not rational maximisers. It assumes that evolving and learning formal and informal institutions are critical for economic growth and innovation is the means by which to reach productive efficiency and adaptive efficiency that underpins economic growth, and this is a continuous process since the economy strive away from equilibrium. 

The underlying assumptions can be said to be fulfilled in the presented policy challenge context and therefore this lens should be used.

4. Evolutionary economics on the microeconomic level is about understanding the process that describes how an agent (using his cognitive and imaginative capabilities as well as his interactions with other agents but within a setting of bounded rationality) originates, adopts, adapts and retains a novel generic rule. Evolutionary economics on the meso-economic level is about dynamic replication and diffusion of generic rules. This creates a backdrop of continuous change which leads to a continuous disequilibrium state on the meso level. Evolutionary economics on the macroeconomic level is about the analysis of complex structures and the associated processes. The macro level structure is determined by self-organisation and self-ordering since rationality, choice and behaviour is governed by bounded rationality and hence non-existent in the rational sense. This complex structure has an almost indeterminable behaviour since it is made up of both a surface-structure and a deep-structure that differ from each other. The evolutionary economic school assumes heterogeneous agents with bounded rationality that strive to satisfice rather than maximise. It assumes that the firm is a unique bundle of resources of which routines, embodying the most appropriate knowledge of the firm at the time and aimed at securing the firm viability, are a critical part. The company competes based on the way it sets up interactions between, and transformations of, these resources. The firm is formed in a path dependent and context specific way through the institutional selection environment in which it exists and this institutional selection environment vary over e.g. technology domain, space and time.

So far, the underlying assumptions can be said to be fulfilled in the presented policy challenge context and for that reason, this lens should be used.

5. New institutional economics (NIE). Considered an extension or enhancement of neo-Classical economics, this school of thought brings in broader societal structures, like social and legal norms (i.e. institutions) and seriously qualifies assumptions of fully rational optimising agents. The theory offers a supplement of historical specificity and comparative analytics to neo-Classical accounts of the market and market behaviour, focussing for the most part on how institutions lower or raise transactions costs. NIE modifies the neo-classical assumptions by assuming imperfect information and bounded rationality and the existence of opportunistic behaviour. It also assumes the existence of transaction costs and the presence of asset specificity (e.g. site specificity, physical asset specificity, human asset specificity, dedicated assets, brand name capital and temporal specificity). It also states that the frequency of transactions involving incomplete contracts guides the investment in alternative governance structures.

Thereby, in the presented policy challenge context the underlying assumptions can be said to be partially fulfilled and so, this lens should be used but with care.

6. Complexity Economics states that markets left to themselves possess a tendency to bubbles and crashes, induce a multiplicity of local attractor states, propagate events through financial networks, and generate a sequence of technological solutions and challenges, and this opens a role for policies of regulating excess, nudging towards favoured outcomes, and judiciously fostering conditions for innovation. Complexity Economics also states that we will never fully understand the complex evolving economy and hence we should not aim to control the economic system but should instead try to influence and nudge the system towards more favourable outcomes. It assumes that the economy is an evolving complex system, which has competing forces operating all the time. It is in constant change and flux. Economic reality is rife with uncertainty and with a variety of phenomena and actors that are not easily predicted or understood (chaos prevails). Complexity Economics also assumes heterogeneous agents with bounded rationality. It assumes that the economic system is in disequilibrium on one scale with multiple temporary equilibria on another scale and throughout the system there is continuous systemic emergence, tension and chaos on all scales of the system and that this generates dynamically emerging patterns and structures that continuously change and that innovation is the source of and result of permanent disruption. 

Consequently, this lens should be used given the fact that the underlying assumptions can be said to be fulfilled in the presented policy challenge context. 

7. Economic complexity. The economic complexity lens states that the prosperity of a nation is a function of the uniqueness of what it can produce as well as the depth and width of the input system required for this production and what proportion of this input system can be found within the economy. Following on from this the role of industry policy is to increase the economic complexity of the jurisdiction and prosperity follows. 

The underlying assumptions of this school of thought can be said to be fulfilled in the presented policy challenge context and thus, this lens should be used.

We have looked closer at six schools of economic thought and one emerging economic lens. We have done this against the backdrop of the economic challenges that are facing many, primarily smaller, economic jurisdictions as a consequence of ongoing structural shift in the economy. We are trying to understand which schools of thought and which lenses should be used to formulate policy.

The main conclusion after this review is that the assumptions underpinning the neo-classical and Keynesian economics approaches are not fulfilled in the present industry policy environment.

Nonetheless, policy should be developed through a discourse between experts that are well informed in Neo-Schumpeterian Economics, Evolutionary Economics, New Institutional Economics, Complexity Economics and the Economic Complexity Lens.

 

Escrito por Prof. Gorän Roos, South Australian Economic Development Board.

*Publicado en Estrategia #000005

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