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EVOLUTIONARY ECONOMICS
AN INTRODUCTION TO THE FOUNDATION
OF LIBERAL ECONOMIC PHILOSOPHY
J. Potts
School of Economics
University of Queensland
Queensland 4072 Australia
April 2003
Discussion Paper No 324
ISSN 1446-5523
Potts
This discussion paper should not be quoted or reproduced in whole or in part without the
written consent of the author.
EVOLUTIONARY ECONOMICS
AN INTRODUCTION TO THE FOUNDATION
OF LIBERAL ECONOMIC PHILOSOPHY
J. Potts
Abstract:
This is a schools brief style of introduction to evolutionary economics. It
addresses the nature of evolutionary theory in relation to economics, and
examines why evolutionary economists argue that market-capitalism is an
evolutionary system. Finally, it argues that liberal economic philosophy has
much stronger and more direct relationship with evolutionary economic
analysis than neoclassical economic analysis.
1
INTRODUCTION
Evolution is the process of endogenous change in an open
system, an idea that owes just as much to Smith and Hayek
and liberal economics as it does to Darwin and biology.
In 1859, Charles Darwin published The Origin of Species, a
book that redefined the scientific world’s understanding of
the origins of life, the structure of nature, and the deep
relationship between human existence and the natural world.
It is hard to understate the importance of this book in
defining the modern world. Its essence was that the
extraordinary variety and seeming design in nature is the
outcome of three abstract mechanisms —selection, variation
and replication —driving a continuous process of change.
This came to be known as the theory of evolution, and
befitting an idea of such elegant simplicity, it has been
serially misunderstood. The implications of Darwin’s
theory —for example, the common ancestry of humans and
other forms of life —should not be mistaken for the
underlying theory itself.
Evolution is a theory of endogenous change, and Darwin’s
central idea was that three primary mechanisms were
sufficient to generate a process of ongoing adaptive
change. This idea is at the heart of both evolutionary
biology and evolutionary economics.
WHAT IS EVOLUTIONARY ECONOMICS?
Evolutionary economics is a new scientific approach to
economic analysis and one that has come of age in the past
decade or so. It is related to evolutionary biology, but it
is not just normal economic theory with a Darwinian gloss —
2
for example, in the manner of market competition as
‘survival of the fittest’ or a metaphorical transfer
between genes and technologies. Contrary to common
perception, the concept of evolution was not first invented
by Darwin and it was not first observed in the Galapagos
Islands. Rather, evolution was first conceived as a process
at work in the economic realm, and it was first observed in
18th century European and Scottish society by the likes of
Voltaire, Vico, Montesquieu, Adam Smith, and David Hume. It
was generalised in the 19th and 20th centuries by Darwin
and his followers into the natural realm. Since then it has
spread to such contemporary domains as evolutionary
psychology, evolutionary politics and evolutionary
computation.1
Evolutionary economics is a modern recapturing of that
primacy. It is not an historical footnote, but an essential
insight into the relation between evolutionary theory,
economic theory and liberalism. The common ancestry of both
evolution and economics stems from the moral philosophers
of the 18th century Continental and Scottish Enlightenment,
amongst whom were Hume and Smith. They were the first to
think clearly about the nature of human knowledge in a
world of change, and it was they who furnished us with the
idea of evolution. Darwin’s Origin of Species was a
brilliant and far-reaching application of this existing
concept.
1 For example, J. Barkow, L. Cosmides, and J. Tooby. The Adapted
Mind (New York, Oxford university Press, 1992); P. Rubin,
Darwinian Politics: The Evolutionary Origin of Freedom (New
Brunswick, Rutgers University Press, 2002); M. Mitchell, An
Introduction to Genetic Algorithms (Cambridge, MA, MIT Press,
1995).
3
Economic evolution is about how knowledge grows.2 Some ideas
are tested and found reliable. Others are tested and
rejected, and then regenerated by new conjectures that are
often variations upon those same rejected ideas. Knowledge
grows by this evolutionary process.3 Evolutionary economics
is the study of the mechanisms by which this occurs.
Adam Smith: inventor of economic evolution
It was Adam Smith who first generalised this in a way that
was later to underpin economics. Smith is not widely
regarded as a nascent evolutionary theorist, but he should
be. In An Enquiry into the Nature and Causes of the Wealth
of Nations, published in 1776, Smith proposed that the
mechanism of specialisation (the division of labour) was
the key to explaining the wealth of nations. He argued
(book I, chapters 1–3) that specialisation facilitated the
growth of knowledge.
Smith then established the modern orientation of economics
by showing how this mechanism is limited by the extent of
the market. Markets were mechanisms that structured the
growth of knowledge process.4 The wider and more organised
are markets, the greater the possibilities for exchange,
specialisation
2 J. Schumpeter, The Theory of Economic Development (New Jersey:
Transaction Publishers, 1912/1934); F.Hayek, ‘The Use of Knowledge
in Society’, American Economic Review 35 (1945), 519–30.
3 See D. Dennett, Darwin’s Dangerous Idea: Evolution and the
Meaning of Life (New York: Simon & Schuster, 1995); B. Loasby,
Knowledge, Institutions and Evolution in Economics. (London:
Routledge, 1999); K. Popper, A World of Propensities (Bristol:
Thoemmes, 1985); and G. Shackle, Epistemics and Economics
(Cambridge: Cambridge University Press, 1972) for discussion of
this as a general principle of evolutionary epistemology
4 J. Potts, ‘Knowledge and Markets’, Journal of Evolutionary
Economics 11 (2001), 413–31; J. Buchanan and V. Vanberg, ‘The
4
and, by implication, the growth of knowledge to drive the
wealth of nations. To this day, the heart of economics is
the idea that wealth results from the coordination of
specialised knowledge and that this process works best when
organised as a decentralised process of exchange.5
Evolution and the growth of knowledge
Evolution is the algorithmic process by which knowledge
grows.6 It works like this. First, begin with a population
of candidate solutions to a problem, thendefine a selection
mechanism to test these solutions against the original
problem and evaluate how well they solve that problem.
Second, eliminate the worst solutions and replicate the
better solutions. These two mechanisms alone will produce
statistical convergence upon a set of good solutions, but
because they are limited by the set of starting candidates,
they will not necessarily be the best solutions. In nature,
as in society, sometimes you need to think differently in
order to progress.
By adding a third mechanism, variation, we arrive at the
minimum necessary conditions for an evolutionary process. A
mechanism of variation takes the good solutions and
modifies them (randomly or conjecturally) to generate new
candidate solutions, beginning the process again. This, in
abstract, is an evolutionary process: selection tests
solutions against problems; replication carries solutions
and updates problems; and variation generates new
solutions.
Market as a Creative Process.’ Economics and Philosophy, 7: 167–
86.
5 F. Hayek, ‘The Use of Knowledge’.
6 J. Potts, The New Evolutionary Microeconomics: Complexity,
Competence and Adaptive Behaviour, (Cheltenham: Edward Elgar,
2000).
5
Note that this definition of evolution does not turn on
what is actually evolving beyond reference to ongoing
solutions to ongoing problems. This is how it is in biology
(the concept of an analytic gene), and also in economics
(the concept of a rule). Nevertheless, the question of the
proper units of selection, replication and variation is a
source of much argument and debate in evolutionary theory.7
In economic evolution, there are many possible units that
these three mechanisms might operate upon. Examples include
commodities in markets or the characteristics they embody,
the preferences of agents, the skills and routines of
agents, the competences and capabilities of firms, or
indeed of entire firms and industries, or technologies or
institutions.8 These are all examples of structures of
knowledge.
And knowledge is what the economic system is made of. In an
evolutionary economic process, it is knowledge that
evolves. Capital is knowledge in an operational form.
Labour is knowledge in an active form. Money, as a store of
value, is unspecified knowledge potential. Knowledge is
subject to selection, variation, and replication. These
evolutionary mechanisms operate over systems and
populations of rules (that is, institutions) to produce the
7 There is a sizable body of popular literature that presents and
discusses these issues. For example, see R. Dawkins, The Selfish
Gene (New York: Oxford University Press, 1976) and The Extended
Phenotype (Oxford: Oxford University Press, 1984); G. Hodgson,
Economics and Evolution: Bringing Life Back Into Economics
(Cambridge: Policy Press, 1993).
8 For example, R. Nelson and S. Winter, An Evolutionary Theory of
Economic Change (Cambridge, MA: Harvard University Press, 1982);
N. Foss, and C. Knudsen (eds), Towards a Competence Theory of the
Firm (London: Routledge, 1996); P.E. Earl and J. Potts, ‘The
Market for Preferences’ Cambridge Journal of Economics
(forthcoming).
6
growth of knowledge process known as economic evolution.9 It
is the growth of knowledge that ultimately underpins the
wealth of nations.
MARKET CAPITALISM IS AN EVOLUTIONARY SYSTEM
Evolutionary economics is concerned with the nature of the
market capitalist system, in particular the set of
institutions that define this system, and with the
structure and dynamics of its processes of change. Of all
the ways of organising human society, and of all the
possible arrangements of political-social complexes, the
classes of system that seem to most closely embody the
mechanisms of an evolutionary process are those associated
with market-capitalism.
Market capitalism, very broadly defined, embodies certain
mechanisms that are either absent or weak in more highly
centralised systems of any substantial complexity. Market-
capitalist institutions dominate the global economy, and
now, more than at any other time in human history, there is
a pressing need to understand how these mechanisms work. It
is an oversight that borders on negligence how little
mainstream economic theory has to say about these
underlying dynamic evolutionary processes.
Market-capitalist systems are highly robust in the face of
changes in the knowledge-base of the economic system, and
for reasons clearly enunciated by Smith, Hayek and
Schumpeter alike.
9 K. Dopfer, J. Foster, and J. Potts, ‘A micro-meso-macro
framework for evolutionary economic analysis.’ Journal of
Evolutionary Economics (forthcoming).
7
Human minds are, amongst other things, creative and
enterprising. When provided with opportunities and
incentives, the basic instinct of humans is to develop
better ways of doing things by socially coordinating and
re-integrating complex specialisations. In an environment
of market-capitalist institutions, this is what firms and
markets do. And this, not incidentally, is why we are so
successful as a species: we work together for our own
individual aims, and we solve economic problems as we go.
Unparalleled not just in human history, but also in nature,
a liberal market society is the best way yet we have
developed for harnessing this creative enterprising drive.
The most characteristic feature of a market-capitalist
system is a driving process of endogenous change. The
market-capitalist system is often a highly fecund
environment for growing knowledge, yet not all systems have
this property. Not all political-economic systems cope well
with continual change, and fewer still seem to be
predominately characterised by it.
The idea of market capitalism as a process of evolutionary
change is not new. In 1942 Joseph Schumpeter, the patron
saint of modern evolutionary economics, wrote in
Capitalism, Socialism and Democracy that10
Capitalism, then, is by nature a form or method of
economic change and not only never is but never can be
stationary . . . The fundamental impulse that sets and
keeps the capitalist engine in motion comes from the
new consumers’ goods, the new methods of production or
transportation, the new markets, the new forms of
industrial organization that capitalist enterprise
10 J. Schumpeter, Capitalism, Socialism and Democracy (London:
George Allen & Unwin, 1942), pp. 81–2.
8
creates . . . The essential point to grasp is that in
dealing with capitalism we are dealing with an
evolutionary process.
This is why market capitalism is such a dynamic or restless
system.11 Uncertainty is normal, which is why there is a
rational drive to limit exposure to turbulence and to
provide safety nets. Growth and turbulence go together,
just as Karl Popper recognised in the discontinuities of
science, which is a species of knowledge that is
instrumental to capitalism. The same is true of technology
and other useful-knowledge systems. Market capitalism
produces growth because it is a set of institutions that
foster the growth of knowledge. All discussion of
allocation is moot before this point, and it has taken us
most of the 20th century, and unfortunately untold lives,
to fully appreciate the fundamental significance of this.
WHAT DRIVES MARKET-CAPITALISM?
For evolutionary economists, market-capitalism —by which we
mean a system of institutions based about the exchange of
property rights— is at heart an experimentally organised
process of competitive rivalry, driven by the discovery of
new ideas and ways of doing things.
For evolutionary economists, the concept of competition
does not mean a large number of identical firms in a market
for a homogeneous good. Rather, it means that someone is
looking at a particular way of doing things and speculating
that they could do it better, or, perhaps, that they could
11 S Metcalfe, Evolutionary Economics and Creative Destruction
(London, Routledge, 1997); F. Louca, Turbulence in Economics: An
Evolutionary Appraisal of Cycles and Complexity in Historical
Processes, (Cheltenham: Edward Elgar, 1997).
9
do something that would make it unnecessary to do what was
being done in the first place.
Competitive or entrepreneurial actions create new knowledge
and/or destroy old knowledge, and the market— the democracy
of economic agents —decides whether or not it is a good
idea. People are motivated by private gain, but if they
succeed, then it becomes a public gain: an old problem is
better solved, or a new problem is solved. This is what
entrepreneurs do, and it is why they are central to the
health of an economic society. Entrepreneurs drive economic
evolution, and thereby, if harnessed, economic growth.
Humans are all biologically similar, but economically
different, and that is what matters. We do not all carry
the same knowledge, and this is why our economies can grow.
Indeed, if we were all the same there would be no need to
interact, to access the web of knowledge, because there
would be no gains from specialisation and trade. Each
economic agent is a specialised component of knowledge, and
the central economic problem is how to coordinate this
specialised knowledge. Provided interaction is preserved
and remains open, both production and growth are possible.
The upshot is a society of knowledge into which agents fit
(in the biological sense of ‘fitness’) and within which
agents can move around by acquiring new specialisations and
making new connections.
This is market capitalism. Entrepreneurs propose,
institutions facilitate, markets decide, and knowledge
grows. And when knowledge grows, societies progress. As new
knowledge is discovered and used to solve problems,
invariably generating further problems, the economy evolves
as an ever-changing structure of opportunities and
10
constraints in an ever-present cloud of uncertainty and
rival conjecture.
EVOLUTIONARY ECONOMICS AND LIBERALISM
When we observe market-capitalist systems, the predominant
thing we observe is change. There are many ways an economic
system can change, including systematic market fluctuations
(that is, business cycles) or growth convergence. But the
sort of change that is of interest to evolutionary
economists is qualitative change in the content and
structure of the system as an ongoing process of
transformation. This sort of non-cyclical, non-stationary,
and significantly, non-predictable change is what is meant
by economic evolution. Although this sort of change is an
aberration in an equilibrium system, it is actually quite
typical of market-capitalist economic systems. Indeed, it
is what makes them tick.
But the mainstream approach to economic theory —that is,
neoclassical economics —is not, and never really has been,
concerned with processes of change. Neoclassical economic
analysis is based on the concept of equilibrium and the
attendant definitions of the economic problem as one of
optimal substitution (best allocation) under conditions of
known resource scarcity. This is certainly an economic
problem, but it is not the main economic problem faced by
modern globally connected economies in which competition is
mostly about introducing new options for consumers in the
face of ongoing uncertainty, and not simply about beating
down existing suppliers facing a known opportunity set. If
risk is quantifiable, and salaried managers are the most
highly rewarded agents, then this is not market capitalism.
And its problems are certainly not the economic problems
11
that Smith and the other early liberal philosophers —
Voltaire, Vico, Hume and Montesquieu— wrote about.
Market capitalism is, as Schumpeter argued, an evolutionary
process that is by nature dynamic, and that means that
static representations (that is, neoclassical economics)
are like photographs of the wind; they somewhat capture it
as it was, but never essentially as it is.
Evolutionary economics is focused about how complex open
systems self-organise about ongoing processes of change.12
Economic evolution is the process of changing knowledge,
and the methods by which it changes are the markers of
market capitalism —namely, profit, entrepreneurship,
enterprise, turbulence, venture-capital, creative-
destruction, uncertainty, freedom and prosperity. The point
that has been curiously misunderstood in much otherwise
good liberal thought, and only first corrected by Hayek,13
is that the economics of the growth of knowledge are the
economics of evolution in a complex open system, and that,
despite appearances to the contrary, this is not what
mainstream neoclassical microeconomics is about.
Evolutionary economic theory is a much better foundation
for liberal concern with economic problems than
neoclassical economic theory.
CONCLUSION
12 S. Kauffman, The Origins of Order: Self-organization and
Selection in Evolution (Oxford: Oxford University Press, 1993; J.
Potts, The New Evolutionary Microeconomics; J. Foster and J.S.
Metcalfe (eds) Frontiers of Evolutionary Economics: competition,
self-organization and innovation policy. (Cheltenham: Edward
Elgar, 2001).
13 F. Hayek, ‘The Trend of Economic Thinking’, Economica 13 (1933),
121–37; F. Hayek, ‘The Use of Knowledge in Society’, American
Economic Review 35 (1945), 519–30. See also L. Lachmann, The
Market as an Economic Process (Oxford: Basil Blackwell, 1986).
12
Evolution is an endogenous process of change that, if it is
genuine change, will be surprising. Liberal market-based
societies are adapted to being surprised and to taking and
managing risks, because this is how they grow. Market
economies and liberal societies are essentially adult
environments in which people take responsibility for their
own actions and react to the perceived incentives and
opportunities around them. It is, in this sense, ultimately
child-like to believe that there must exist one person or
group of people who knows what is best for everyone else;
dictators, great leaders or bureaucratic planners,
irrespective of how benighted, enlightened or highly
trained they might be, are never smarter or more capable
than the systems they try to control. Hayek called this
‘the fatal conceit’, and predicted the imminent failure of
any complex economic society organized along these lines.
Subsequent events have proven him correct, and
13
evolutionary theory explains why.
The ongoing success of liberal societies and market
economies is not because they are generally successful in
most efficiently allocating scarce resources. Often, in
fact, they are not very effective at this; free-market
societies tend to produce sometimes highly skewed
distributions of income and are prone to turbulence and
instability. If the goal is static efficiency in
allocation, then a centrally planned society is best, and
this is where neoclassical economics is most appropriate as
a guiding analytical tool.
However, if the goal is to grow the wealth of nations and
societies, then this will invariably involve growing
knowledge, and the best way to do this is to unleash
evolutionary forces. A liberal market-based economic order
works because it harnesses the creative energies of all the
agents in the system, and the more diversity and rivalry
there is, the greater are the possibilities that better
solutions will be found.
The wealth of nations is widely, but mistakenly, thought to
be a product of the exploitation of natural resources.
Wealth is ultimately a product of specialised and
integrated knowledge, which is to say as an ongoing product
of all people, and not just elites. This is the essential
difference between a society of bees or ants, and a society
of humans. This was the original liberal idea of the
Continental and Scottish Enlightenment, and the original
message of Adam Smith —the idea of evolution and its direct
connection to the improvement of the welfare and
capabilities of society.
