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Amoeba, Fish, Lizard, Ape, Human, Investor.. Meet Evolutionary Economics

Via ConvergEx's Nick Colas,

We’re always interested in alternative economic frameworks that can help address the sizable gaps left open by classical approaches. Behavioral economics can fill part of that void, of course, as it describes some basic shortfalls in the assumption that we’re all superhuman welfare maximizing individuals. One step beyond that is evolutionary economics, which borrows from biology rather than psychology to form models about economic behavior.

 

The key differences between this strain of economic analysis and the textbook stuff we’ve all learned are twofold.

  • First (and like their behavioral counterparts), evolutionary economists do not believe that humans act to simply maximize individual well-being.
  • Second, they discard the notion that any economic system can be in equilibrium. Rather, they see the process of setting price by supply/demand as dynamic and, well, evolutionary.

Open adherents to this approach are thin on the ground in official circles, although Bank of England research chief Andy Haldane does have some clever economic “hacks” that leverage its ideas. But we can’t help but think that venture capitalists and many public equity investors are closet “Evolutionists”, so this is a discipline worth a few words of explanation.

I do most of my shopping online, and I tend to only use two retailers: Amazon and eBay.  I am a Prime customer on the first and have 15+ automated searches on the second.  If anyone ever puts up an ancient Ferrari Mondial convertible without a reserve, I plan to be the first person to know about it.    Hasn’t happened yet, but there’s always hope.

After a purchase from either company, there is always a request to leave feedback.  I always leave feedback for eBay vendors, but never for Amazon.  The way I see it, the guy with the weird eBay user handle needs every positive rating he can get. Amazon, not so much. 

By the rules of classical economics, I shouldn’t bother with either.  I have enough eBay ratings that no seller is going to reject my bid.  Amazon has my credit card number and shipping address; they don’t care either.  Even looking at the web page or email that requests feedback is a waste of time – something a selfish, wealth and welfare maximizing economic agent would never do.  

Ever since the Financial Crisis everyone from professional investors to academics to anyone who cares about public policy has been searching for better paradigms to understand how people make economic decisions.  Classical economics – the theory that profit and welfare maximizing humans make individual decisions that lead to optimal societal allocations of capital – seems a bit too Gordon Gekko-ish now. Even Alan Greenspan famously admitted that his belief that free markets need little regulation had a “Flaw” in his 2008 post-mortem/testimony to the House Committee on Oversight and Government Reform.

Behavioral economics has taken up a lot of the slack, with its common-sense approach to humanizing the models used by classical economics.  Instead of modeling a world where everyone grabs every penny off the street, this discipline inserts some humanity into the narrative.  We’ve written in the past about the Ultimatum Game: two strangers have to split up $100 in negotiation of one offer and then accept/reject decision where a rejection means no one receives any part of the money. Classical economics says $1 is the correct offer, since the person receiving it is still better off than before they started the game. Of course, in real life every offer of $1 gets rejected; people want $20-$60 dollars or they are perfectly happy to spite the other player so that no one gets anything.  “Spite” is not any input in any classical or neoclassical economic model. 

Now there is a modest but growing interest in something called “Evolutionary economics” which uses concepts from biology rather than psychology to inform economic analysis.  The history of this discipline is actually close to 100 years old and its most famous early advocate was Joseph Schumpeter, who argued that innovation disturbs macroeconomic equilibrium and forces adaption in a manner much like a changing environment pushes a species to adapt or die.

Evolutionary economics now is something quite different, for it rejects two core assumptions of classical economics.  None other than Paul Krugman, in a speech back in 1996, outlined it quite well if you want to read his take.  The two key differences are:

“Evo-economics” doesn’t believe that humans only make decisions to maximize their own selfish welfare.  Instead, it points to our biological predilection to work in small groups rather than going it alone. Evolution pretty clearly favors those who can get along with others rather than the greedy misanthropes of classical economics.  

 

It also doesn’t believe that economic systems exhibit equilibrium – the notion that there is a stable market clearing price where buyers and sellers meet until something changes in either one or both of their situations. Rather, everything is in a state of constant flux like a predatory animal – either asleep after a heavy meal or on the prowl for her next one.

The whole thing has a Lennon-esque “Imagine there’s no heaven” quality to it, but there is some merit to considering what evolutionary economics can tells us about economics, markets and business models.  One narrow but useful example comes from the Bank of England’s research head, Andy Haldane. During the lead up to the Scottish Referendum the BoE actively tracked social networks for signs of bank runs.  If Twitter users started to use words like “Panic” and “Scottish bank”, the UK central bank would have an early warning that depositors were losing confidence in the banking system.  This is exactly what the U.S. Centers for Disease Control do to track flu season – and something that classical economics would tell you is a waste of time.  Why would depositors worry?  That’s irrational. 

Now, the chance that mainstream economists – especially those in policymaking organizations – will embrace a system that has no concept of equilibrium is, oh, about zero.  Without the “=” sign there is little of the elegant certainty that gives economics its current social standing and central banks the preeminence in western society.  Fair enough – everyone’s got a mortgage payment to make and kids to get through college.  Even economists. 

But as I read through the basics of evolutionary economics, it strikes me that much of the current spate of venture capital spending on technology is closely aligned with the concepts we’ve reviewed here. Social networks – broadly defined to include everything from Facebook to WhatsApp to Uber – are very much about harnessing groups of people with smartphones to remake social interaction on a very wide scale. And, in case you hadn’t noticed, these companies get huge valuations when they get things right. Human beings want the most convenient ways possible to connect with other humans, for commerce or personal interaction, and they are willing to hand over money, privacy, and time to get that. It’s not that classical economics couldn’t have predicted the rise of these businesses; it’s just that evolutionary economics does a better job of explaining why they work so well.

Of course, the more difficult part of evolutionary economics is the thought that everything is perennially in flux and the stability offered – even theoretically – by classical economics is a flawed concept.  We want there to be stability, even if it is momentary.  A chance to rest and catch our breath before anything changes.  A world where the lion is always chasing us seems too exhausting to consider.  But again, the world of technology and venture capital sees it differently.  As VC Mark Andreesen famously said in a 2011 Wall Street Journal editorial, “Software is Eating the World”. That’s evolutionary economics at its harshest but likely most real.  Eat, or be eaten.

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