Living Economics Part 3: Consumers, producers, and the evolution of economies

The first two blogs in this series have explored hidden phenomena on the demand and supply side of markets that keep our economies healthy.  This third post will discuss how the desires and reactions of each individual economic actor shape the direction of an entire economy.  To make it easier to comprehend these forces at an abstract level, I want to suggest an extended metaphor.

Any static economy can be thought of as an ecosystem.  The evolution of a particular species within that ecosystem depends upon generations of genetic selection, where individuals possessing traits that were more rewarded by the natural environment during their reproductive lifetimes had a greater chance of survival than individuals possessing traits less rewarded by the environment.  The ancestor of the giraffe with the longer neck, for example, had a higher probability of survival than his compatriots with shorter necks.  Within this analogy, one can think of each surviving producer in the economy today as an individual member of a particular species:  the natural forces of supply and demand, in theory, should have ensured that only those suppliers (giraffes) that are well-suited to their environment (have long necks) have survived.  A whole species would then be a whole set of suppliers, all of whom have hit upon essentially the same method of survival: e.g., all producers of drapes.  Such a group may all have an interest in preserving the niche that they occupy, giving rise to the Drape Manufacturers’ Association for example, and yet at the same time each drape-making firm is in competition with every other one to see which particular firm will survive and thrive the best.

Which element in the real economy plays the role of the natural environment in this Darwinian metaphor?  The environment, which implicitly rewards and punishes individuals, is like the collectivism of economic consumers who reward and punish individual suppliers via their purchasing decisions.  The implicit power of consumers in the economy is hence collective in nature:  no single consumer has any power whatsoever.  Yet the overwhelming implicit power of the environment means that species evolution exhibits niche strategies:  finding a particular, fairly stable set of environmental settings and focussing on getting rewarded by them.  No single animal species can hope to hit upon a genetic configuration that allows it to be rewarded in every part of the ecosystem, from the bottom of the lake to the tops of the trees, so playing to a particular niche is the way to survive.  In economic terms, rather than trying to please everyone, suppliers segment the base of potential customers in the market and focus particularly on getting rewarded mainly by a subset of target customer types.  In the case of the drape manufacturer, he has implicitly decided not to even try getting rewarded by people who prefer blinds over drapes.  He has implicitly bet on the continuing existence of a good number of drape-preferrers, and it is based on this bet that he has invested into the business of making drapes as well as he can.  For this to be a sensible way to use his resources, it must be that drapes are not an ephemeral fad.  If it turns out that they are, then the drape manufacturer will go the way of the dinosaur.

This metaphor helps to clarify the source of my previous advice to the benevolent economic consumer: “Have strong desires; don’t follow fads to ridiculous extremes; and let your true preferences be known.”  The analogy to a lazy or passive set of consumers is a set of environmental conditions in which it is extremely easy to thrive – say, a mild climate with plenty of water and sun, somewhat akin to what was observed in many places of the world during the late Jurassic period.  This type of environment places relatively few restrictions on the types of characteristics that will be acceptable in a species, meaning that a fantastic variety of creatures can survive because there are so many different ways that they can discover to be rewarded by this forgiving environment.  Now, this sounds idyllic, and it is fine if indeed the true preferences of all consumers are so weak that (say) they truly are just as thrilled with ice cream that is smooth and creamy as they are with ice cream that is wet and sludgy.  It is also fine if the underlying reason for the forgiving nature of the ecosystem in aggregate is that the ecosystem features many different niches.  As Adam Smith said, specialization is limited by the extent of the market:  the larger the ecosystem, the more unique niches are available.  The key in terms of the long-run development of the economy is to ensure that consumer behaviour in every market niche, represented in the metaphor by the pushes and pulls observed in the natural environment in regard to the particular traits of species vying for that niche, is a true representation of consumer preferences.  If consumer behaviour does not match consumer preferences, then consumers are not driving the evolution of suppliers in the direction of generating more aggregate utility.  A corollary of this is that our governments and our cultures do best for economic progress when they place the least restrictions on the ability of people to exhibit their true preferences.  Arguably, this type of freedom is also a desirable thing from the perspective of static welfare.  In the words of John Stuart Mill:  “To be prevented from doing what one is inclined to do, or from acting according to one’s judgment of what is desirable, is not only always irksome, but always tends, pro tanto, to starve the development of some portion of the bodily or mental faculties…and…it partakes, either in a great or in a small degree, of the degradation of slavery.” [Chapter XI, Of the Grounds and Limits of the Laissez-Faire or Non-Interference Principle, form Principles of Political Economy]

As is the case with genetic evolution, no economy can develop in the absence of random mutations.  In the case of the evolution of species, such random mutations provide the trials in the trial-and-error process that results in the selection of a particular identifiable trait over another.  Without mutations, species would simply clone their individuals every generation, and no change in the cross-sectional distribution of traits from generation to generation would be observed.  This would also mean that no long-run adaptation to gradually changing environmental conditions would be possible, meaning that for life on this planet, having no mutations as part of one’s reproductive process is a losing strategy.  Similarly, without the random economic mutations created by suppliers trying new things, no mechanism would exist for generating improvements in the ability of suppliers to get rewarded by consumers.  Today we turn on electric lights to read instead of lighting candles, an advance made possible by technological experimentation.  Throughout the economy, such experimentation has only rarely – but then often very dramatically – resulted in a huge reward to the `trait’ pioneered by the experimenter.  It is profit, not physical survival, that motivates people in the developed world to try new things, and it is this experimentation that underpins all economic advance.

This is the type of mental model that leads the economist to look liberally rather than conservatively upon innovation; to push for ways to make it easier for economic agents to send loud signals to other agents; and to advocate support for competitive markets, such as the abolition of trade barriers and the creation of level playing fields in regard to market entry.  We want to see markets give rise to a natural abundance of creative ways to make people happy. To quote Jeremy Bentham:  “Nature has placed mankind under the governance of two sovereign masters, pain and pleasure.  It is for them alone to point out what we ought to do, as well as determine what we shall do.”