Metcalfe - 1998 - Evolutionary Economics and Creative Destruction PDF

EVOLUTIONARY ECONOMICS AND
CREATIVE DESTRUCTION
The central theme of this book is competition treated as an evolutionary process in

which the focus is upon economic change, and not economic equilibrium. This
theme is explored by linking together differences in economic behaviour with the
role of markets as co-ordinating institutions. In this picture, innovation plays a
central role as a primary source of differential behaviour of firms and the purpose of
the book is to identify the consequences of these differences for competition and
competitive advantage.
In the past decade there have been numerous important contributions to an emerging
evolutionary economics. In many cases these have proceeded via simulation of simple
economic models with differential behaviour. This volume integrates many of the
relevant themes into a formal analytical treatment based around what is called Fisher’s
Principle. Fisher’s Principle is a development of a central theme in evolutionary
theory; namely that variety drives change.
The prestigious Graz Schumpeter Lectures are presented annually at the University
of Graz, Austria, by a scholar with an international reputation, whose work relates to
Joseph Schumpeter’s economic and social analyses. This volume, the first in a Routledge
series, is based on theories put forward by J. Stanley Metcalfe in his 1995 presentation.
J. Stanley Metcalfe is Stanley Jevons Professor of Political Ecand Cobden Lecturer at

the University of Manchester. He is Director of the ESRC Centre for Research on
Innovation and Competition at the University of Manchester. His research interests
focus upon matters of innovation, technical change and the economic and policy
consequences which follow. He is President-elect of the International Joseph Schumpeter
Society. He has published over 90 articles and books.
© 1998 The Graz Schumpeter Society

THE GRAZ SCHUMPETER LECTURES
1. EVOLUTIONARY ECONOMICS AND

J. Stanley Metcalfe

EVOLUTIONARY
ECONOMICS AND
J. Stanley Metcalfe
London and New York

First published 1998
by Routledge
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Simultaneously published in the USA and Canada
by Routledge
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Routledge is an imprint of the Taylor & Francis Group
This edition published in the Taylor & Francis e-Library, 2001.

All rights reserved. No part of this book may be reprinted or reproduced or utilised in any
form or by any electronic, mechanical, or other means, now known or hereafter invented,
including photocopying and recording, or in any information storage or retrieval system,
without permission in writing from the publishers.
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ISBN 0–415–15868–0 (Print Edition)

ISBN 0-203-01892-3 Master e-book ISBN
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To Joan, Gillian and Peter, in appreciation

CONTENTS
Figures
Foreword
Preface
Part I The evolutionary economics of creative destruction
PROLOGUE: CHANGE WITHIN CHANGE
1 ON RIVAL CONCEPTS OF COMPETITION AND THE

EVOLUTIONARY CONNECTION
2 FISHER’S PRINCIPLE AND THE PROCESS OF

COMPETITION
3 ECONOMIC VARIETY AND MODELS OF CHANGE
EPILOGUE: ON BEING DIFFERENT, ON BEING

COMPETITIVE
Part II Evolutionary approaches to technology policy
4 SCIENCE POLICY AND TECHNOLOGY POLICY WHEN

COMPETITION IS AN EVOLUTIONARY PROCESS
COMMENT
Heinz D. Kurz
CONCLUDING COMMENT
J.S. Metcalfe
Notes
Bibliography

FIGURES
2.1 Strategic interdependence of pricing

2.2 Growth, prices and profitability
2.3 Replicator dynamic trajectories with three firms
2.4 Selection, marginal firms and exit
3.1 Selection with differential propensities to accumulate
3.2 Product selection and process selection
3.3 The mutual determination of entry and selection
4.1 Innovation, time – cost trade off

FOREWORD
The Graz Schumpeter Lectures
At the age of 28, in 1911, Joseph Alois Schumpeter (1883–1950) was appointed to the
chair in political economy at the University of Graz, Styria (Austria). He remained a
member of the Graz Faculty until 1922. Schumpeter used to call the third decade in
the life of an intellectual ‘the sacred age of fertility’. The final part of this age thus fell
into his Graz period. His time in Graz was indeed fertile, seeing the publication of
some of his major works.
In 1995 the Graz Schumpeter Society was founded. In the same year the Graz Schumpeter
Lectures were inaugurated, thanks to generous financial support by the Government
of Styria. The Lectures will take place on a yearly basis. A search committee will
appoint well ahead of time the Graz Schumpeter Lecturer for a particular year. The
Lecturer is chosen on the grounds of his or her originality and scholarship. The aim
of the Lectures is to inform about the frontiers of knowledge in fields of socio-
economic research characterized by rapid innovation and the potential applicability
of the results arrived at in economic and political decision making. The Lectures are
also meant to transcend a single disciplinary discourse and lead towards a more
comprehensive view of socio-economic phenomena. While for obvious reasons the
Lectures are named after Joseph Alois Schumpeter, the concern of the Lectures is not
restricted to him and his work. It includes socio-economic study of individual decision
making units in relation to their politico-economic environment (Governments,
Corporations and Labour Organizations).
Heinz D. Kurz
(Chairman of the Graz Schumpeter Society)

PREFACE
The University of Graz was Schumpeter’s only academic home for most of his career
in Europe until he moved to Harvard in 1932.1 To be invited to give the first of the
Schumpeter lectures in his old university is indeed a privilege. I cannot express
adequately enough my appreciation to Professor Heinz Kurz and his colleagues for
their kind invitation, for their attention and stimulating discussion, and for their
generous hospitality during my visit. My interest in Schumpeter has lasted for many
years. The Theory of Economic Development was the first book I read as a newly graduated
research student and it shaped my view of the economic and social world to a degree
which it is impossible to overstate. In the final analysis it helped me to find a
framework within which to fit the ever present diversity of economic life. Schumpeter
also gave me a compelling interest in the study of history in general and the history
of technology and science in particular. For that I have been particularly grateful.
A good number of my colleagues and students have taken the trouble to read
these lectures and provide me with comments and suggestions. I am grateful to
Cristiano Antonelli, Robin Cowan, Michael Ghiselin, Mike Hobday, Heinz Kurz,
Brian Loasby, Richard Nelson, John Nightingale, Jonathan Shapiro and Ian Steedman
for detailed comments on early drafts of these lectures. I particularly wish to thank
my graduate students, Mario Calderini, Nic De Liso, Ricardo Leoncini, Francesco
Lissoni and Fabio Montobbio for their comments and intellectual challenges over a
number of years. My debt to Michael Gibbons is also considerable. Successive drafts
of the lectures were completed in a number of pleasant environments and I thank
Gilberto Antonelli of the Istituto di Ricerca Sulla Dinamica dei Sistemi Economici,
Milan, Ulrich Witt of the Max-Planck-Institut zur Erforschung von Wirtschaftssystemen,
Jena, and Clem Tisdel and John Foster of the Economics Department, University of
Queensland and their colleagues for welcome hospitality at crucial stages.
Unusual as it may be, many of the stimuli for my thoughts have come from
discussions with industrialists and policy makers made possible by the generosity of
the Economic and Social Research Council and the Engineering and Physical Sciences
Research Council. To both funding bodies I am obliged. Nick Weaver provided
valuable research assistance and Sharon Boardman coped with numerous drafts as

efficiently as ever. To both of them I am very grateful. None of the above can of
course be blamed for the final product. Others bear responsibility unwittingly, and
by intellectual osmosis, they will know who they are! I owe an enormous debt to the
University of Manchester, my intellectual home for the past two decades. I am
particularly grateful to my colleagues in PREST, the School of Economic Studies and
the McDougall Centre for providing a stimulating, congenial and refreshing
environment. Most of all I thank my family to whom this book is dedicated.

Part I
THE EVOLUTIONARY
ECONOMICS OF

PROLOGUE
Change Within Change
My purpose in these lectures is simply stated but less easily achieved. It is to explore
the nature of particular kinds of evolutionary processes as they apply to the question
of economic change and development. The underlying but implicit empirical
background is the ceaselessly changing pattern of economic activity expressed over
time by the emergence of new activities, the demise of existing ones and the changing
relative importance of those that currently compete for markets and resources. In
this regard we are dealing with a defining feature of the modern capitalist system: the
ever present phenomena of structural change and the corresponding differential
rates of growth of different activities.
Schumpeter’s vision was perceptive and correct: stationary capitalism or even
capitalism with the growth of all activities at a uniform rate is a contradiction in
terms. Nor is it kaleidic, to use Shackle’s powerful imagery. Patterns of change have
a coherence and a logic which, at least over the longer term, an evolutionary method
is perfectly suited to explain. Evolutionary processes are processes which explain the
changing patterns in the relationships between entities. Creative destruction is an
apt description of the genre, and what makes capitalism distinctive is the decentralized
and distributed capacity for introducing new patterns of behaviour; whether they
be technological, organizational or social, they are the fuel which drives economic
change.
Of course, not all structural change is necessarily evolutionary in origin and so we
will spend some time demonstrating which kind of economic processes may sensibly
have the label ‘evolutionary’ attached to them. However, what we have in mind
should be clear to anyone aware of the rich tapestry of economic change in modern
times. The automobile displaces horse transport, electricity replaces gas lighting,
satellite and cable channels vie with terrestrial transmission in the markets for television
services, new drugs displace old in the treatment of heart disease, genetic methods
transform the nature of farming the major world crops and information technologies
displace a myriad of practices in the banking and retail sectors. The software industry
may well rival the automobile industry in its scale of activity. The focus of world

production in any industry shifts continually as new nations replace old as the global
leaders in production with consequential change in patterns of trade, foreign
investment and the ownership of national capital stocks. Similar phenomena occur at
the regional level within nations as we witness the ever changing balance of activity.
Thus, once great sea ports, Liverpool and Baltimore, for example, find their economic
raison d’être undermined as air travel displaces the passenger ship and containerized
cargo handling methods displace the traditional labour intensive ways of handling
goods. Much of the pain and disappointed hope associated with economic development
is linked closely with such changes in structure.
Some examples follow. Over the quarter century to 1993 the shares of the USA
and the UK in world exports of manufactures fell from 19.1 per cent and 10.6 per
cent to 13 per cent and 5.9 per cent respectively. Over the same period the share of
Japan rose from 8.5 per cent to 12.9 per cent and the combined share of Taiwan and
Korea rose from 2 per cent to 9 per cent. These are remarkable changes in such a
short space of time and they are changes which must have been underpinned by
concommitant changes in shares of world manufacturing production. Of course, at
these broad aggregate levels many indicators of change must cancel one another out,
so one finds better evidence for evolution in the economy the more one probes into
the micro detail. Consider the world cotton spinning industry as an example. In
1960, Western Europe and the USA accounted for 44 per cent of world capacity but
by 1995 this had decreased to only 9 per cent. Over the same period China’s share
rose from circa 7 per cent to 25 per cent and that of Central and South America from
6 per cent to 10 per cent. Japan’s share fell from 10 per cent to 3 per cent. Similarly
in steel production. Whereas the USA and Western Europe accounted for 65 per cent
of world production in 1954, by 1994 the share had reduced to 30 per cent. Thus the
patterns of change become particularly sharp at industrial level and even more so
within industries. Kuznets (1971) made this abundantly clear in his detailed researches
into changing patterns of production in the USA, an example of which is shown in
Table 1.1.
The table speaks powerfully to the theme of pervasive structural change and
beyond it to the changes in employment, investment, urban development and
decline, and indeed changes in lifestyle which so marked this period in American
history. Within 50 years, one economy had been transformed into a quite different
type. The growth factors, the ratios of output in 1948 to output in 1880, are useful
single figure summaries of these changes once we recognize that, for manufacturing
as a whole, the growth factor was 15.2 per cent. For what matters in understanding
changes in economic structure is how growth differs from the average. Even these
figures are highly aggregated and so we can expect that beneath them lies even
greater diversity of growth experience in terms of the performance of individual
firms and, a fortiori, business activities.1 Everyday experience indicates that this is so.

Table 1.1 Growth diversity and structural change
Shares in output Growth factor
1880 1948
Group A 3.2 35.6 168.7

Petroleum refining 0.3 10.4 525.9
Motor vehicles related 0.6 19.4 588.6
Silk and rayon 0.3 1.6 80.9
Electrical machinery (inc radio) 0.1 4.9 743.3
Group B 15.3 26.3 26.1

Iron and steel 4.1 8.3 30.7
Other food products 1.6 4.6 43.6
Group C 24.8 22.9 14.0
Sugar refining 1.1 0.6 8.3
Cotton goods 5.2 1.2 3.5
Group D 56.7 15.2 4.1

Boots and shoes 4.2 0.9 3.2
Sawmill products 11.3 1.3 1.7
Note: The figures relate to shares in the value of output at 1909 prices for 38 branches of manufacturing
over the period 1880–1948 which have been divided into four sub-groups, within each of which an
indicative number of industries is highlighted.
It is at the microeconomic level of competition between the different activities of

rival firms that we find the strongest evidence of evolutionary change. One need
only consider the recent history of the computer industry to see the power of
differential growth in changing the fortunes of rival firms.2 It is from this micro
diversity that the more coherent patterns of change at sectoral and economy levels
emerge. We may measure at the macro level but the dynamics of change must be
explained at the level of the micro phenomena. Thus, the overriding concern of
these lectures is with the microeconomics of change arising from competition between
different business activities. The implications for higher levels of measured economic
activity are for another occasion. In this, of course, we recognize one of the central
issues in modern evolutionary theory, namely evolution at different levels of the
economy and the interaction between them.
The reader will have no difficulty in adding his or her own examples or in
wondering what dictates this change of pace and how change is linked to economic
mechanisms.3 Why is it that rising standards of living are gained at the price of such
massive changes in economic patterns and a continuous shifting around of the
world’s economic activity? Could life not be less turbulent and more balanced? In
answer to these questions I hope to produce a clear set of principles, summarized in

the nature of competitive economic evolution and based upon the twin pillars of
endemic variety in behaviour and economic selection by market mechanisms. In so
doing I deal with a number of areas which are common currency in evolutionary
biology, a subject as prone to dispute and ritual blood-letting as is economics. Nothing
expressed below has anything whatever to do with biology at any level, from genetics
to palaeontology. What it is concerned with are the principles and concepts which
define an evolutionary mechanism, the milestones, as it were, in the development of
modern evolutionary theory. These concepts and principles hold true for any
evolutionary theory irrespective of its domain of application. This does not mean
that economics, and social science more generally, cannot learn from biology in the
sense that biological science has discovered the difficulties and debated the issues
before the rest of the world caught up. However, argument by analogy is not part of
my brief. I do insist that economic evolution is not Darwinian in the sense in which
this uniquely biological mode of evolution is normally understood. Economic
variation is simply not random enough for the Darwinian process to work.
In all modern evolutionary argument two issues are centre stage: the causal
mechanisms which produce different behaviour patterns in a class of entities, and a
dynamic process of selection which resolves these different behaviours into emergent
patterns of change. For some purposes it is adequate to treat the two processes as
independent, as we shall do through most of the lectures, but in other cases it is
important to recognize how the consequences of selection have implications for the
pattern of variety generation. This is particularly so in economic and social spheres
as is made clear by some outstanding recent reviews of evolutionary theory across
many disciplines including culture, epistemology, law and medicine as well as economics
and sociology (Dennett, 1995; Cziko, 1995; Nelson, 1995; Plotkin, 1994). There is in
the air a sense of evolutionary imperialism so perhaps one needs to be particularly
careful in understanding what evolutionary processes entail.4
Modern capitalism presents us with a paradox. The individual acts of creativity
on which its mechanisms of change depend are remarkable for their lack of co-
ordination. Yet the consequences of this immense micro creativity depend deeply
upon the strong co-ordination of the fruits of that creativity by market processes.
The joining together of the uncoordinated striving for innovation with the subsequent
market co-ordination of the resulting activities is for me the distinctive feature of
the capitalist mode of change. It is my purpose in these lectures to provide a framework
within which we may understand innovation driven change.
Innovation is my starting point in understanding change in capitalism, as expressed
by Brenner (1987) ‘every business competes by betting on new ideas’. However, the
economic and social consequences of innovations depend directly on the extent that
they are drawn into general use and their degree of diffusion, while the spread of
influence depends on the way in which markets co-ordinate rival innovations. It is a

mistake, therefore, to play down the role of the market mechanism and prices in the
analysis of innovation and technological change more generally. It is undoubtedly
true that price competition is less important than process or product based
competition in many lines of activity. Pricing policy alone is not usually a basis for
anything other than a temporary competitive advantage. But this does not mean that
the price mechanism is irrelevant in the world of innovation-based competition.
Quite the contrary. Since the economic consequences of innovations depend on the
rate at which they spread into their environment, it follows that these consequences
must depend on how the behaviours of rival firms and consumers are co-ordinated.
Moreover, one consequence of co-ordination is a distribution across firms of rewards
(penalties) for innovating (not innovating) and it is from these rewards that the
resources are normally found to support the generation of subsequent innovations.
I find it impossible to understand innovations and their consequences without
simultaneously emphasizing the market context within which the game of innovation
based competition is played. However, this does not mean that we must view markets
as disembodied allocators of given resources to best meet given needs. Rather, markets
are to be judged by their capacity to adapt to new opportunities and to facilitate the
creation of new resources, and it is this openness to change which is the defining
characteristic of market capitalism.
I cannot postpone any longer a few remarks about the approach used in these
lectures since it may appear to the reader to be somewhat paradoxical. For these
lectures discuss innovation without saying anything of substance about the origins
of innovation. Let me explain. The central point about innovations is that they
introduce new varieties of behaviour into the nexus of existing competitive relations.
What matters for economic evolution are the differences in behaviour and we are
entitled as a first step to take the set of different behaviours as given. We may then
focus on the processes of market co-ordination which resolve those different
behaviours into patterns of economic change. Innovations which do not gain a
significant market position, or those that fail completely, do not matter for us
although they may prove to be very important signposts to the future development
of the relevant technology. In focusing on the co-ordination of given variety we are
taking the necessary first step to a fuller treatment of innovation. In the subsequent
steps we will want to allow the experiences of market co-ordination to feed back their
influence on the development of technology and organization. Technologies do not
emerge fully fledged into the world, they develop painfully in a trial and error
fashion, through sequences of related innovations which are very much responses to
the experience of market development. Whether this process of endogenous innovation
is capable of being understood in all but its broad outlines seems to me to be
doubtful. But I would hate to dissuade anyone from trying.

It is for these reasons that the lectures take in hand the more limited task of
analysing the co-ordination of given patterns of variety in firm behaviour. In this
we are able to link together the differential growth of existing activities, the failure
of some of them, and the entry of new activities, which often involves some form of
innovation. Growth, entry and exit are entwined together in a single explanation of
the evolutionary dynamic of creative destruction. Of course, this is not a trivial task.
Innovation and market turbulence are closely related concepts but I have to suppress
much of the turbulence to make transparent sense of market co-ordination.
Computational models are undoubtedly of great help in providing a more general
treatment but I think that it is necessary at first to get the basics straight.
What images can I hope the reader will take away from these lectures? First, that
the economic world changes because of the variety contained within it, that innovation,
of whatever kind, is the driving force in historical change. Second, that innovation-
driven economic processes are open-ended with the economy never in equilibrium,
or even close to equilibrium, in the long run sense in which this term is used in
economy theory. Outcomes are to be discovered, not presumed in advance of the
event. No doubt a world without innovation would settle into its own equivalent of
a thermodynamic ‘heat death’; Schumpeter obviously thought so, but this is not the
world as I see it.
♦ ♦♦
The lecture format is peculiarly seductive and free from constraint. One chooses
one’s own field of discourse and one shapes the argument as one wishes, bringing the
essential to the fore and letting all those inconvenient details sink into obscurity.
Lectures are like sermons. In writing up the delivered version of the lectures I have
had to proceed more carefully. The summary phrase, the compelling conclusion, the
obvious argument all turned out on reflection to require far greater elaboration
than I had at first thought necessary. This is particularly true of my attempts to
summarize modern evolutionary theory in the first lecture. I have added much detail
and I hope the reader will not be too burdened by the consequences. Nonetheless,
the structure of the lectures remains as delivered even if their content may have
turned out ex post to be a surprise to the lecturer.
The material in the lectures is ordered as follows. In Part I, the first lecture deals
with contrasting concepts of competition and the way in which they are connected
to the modern evolutionary concepts of variety, selection and fitness. The second
lecture takes these themes and develops an evolutionary model of competition in
which structural change emerges from the market co-ordination of diverse behaviours
in a population of competing firms. The core of this lecture is what I have called

Fisher’s Principle in which the rate and direction of evolutionary change depend
explicitly on how variety is co-ordinated. This connection between the distribution
of differences in behaviour and the nature of market co-ordination is a thread which
ties together each of these lectures. The third lecture is an exploration of Fisher’s
Principle in a number of different contexts including that of firms producing different
products, and markets in which entry is significant. This is the most technical of the
three lectures. The epilogue draws the threads together with a discussion of the
behaviour of firms and the link with the notions of competitive advantage and
competitiveness, so bringing us back full circle to the nature of the process of
competition.
Before turning to the substance of the lectures let me first warn the reader of what
will not be found in the following pages. There is no discussion of inter-industry
relations, nor of foreign trade and investment, nor indeed of the welfare consequences
of competition.5 Each of these constitutes a necessary development of the evolutionary
programme. My intention is solely to provide a starting point from which future
developments may flow.
Finally, Part II contains the text of a public address delivered as the first of the
four Schumpeter lectures. It is written in an entirely different style from the lectures
in Part I and is to that extent a self-contained discussion of some recent developments
in science and technology policy in the United Kingdom viewed through the
evolutionary lens. It may be read independently from the other lectures.

1
ON RIVAL CONCEPTS OF
COMPETITION AND THE
Always history is being made; opinions, attitudes and institutions change,

and there is evolution in the nature of capitalism.
(Knight, 1923, p. 184)
RIVAL CONCEPTS OF COMPETITION
In this first lecture I propose to examine the role of competition as a progenitor of

economic change and to link these twin concepts of competition and change with
the modern evolutionary notion of selection processes. I will begin with a review of
some competing, well-established concepts of competition, for it is not easy to
resolve the meaning of this word, despite its being widely recognized as one of the
core concepts of economic theory. Perhaps inevitably it has attracted multiple
meanings and shades of emphasis.1 These many shades of emphasis can be broken
down into a number of dualisms: equilibrium vs. process, trading vs. rivalry; and
uniform vs. diverse behaviours. Needless to add, the mix of these various constituent
aspects of competition depends on the explanatory purpose of the particular
competitive concept. A theory which is designed to illuminate the allocation of
given resources to given ends will be thoroughly different in character from one
which is designed to explore the nature of economic development and the creation
of resources and opportunities over time. If the first was perceived as the limiting
outcome of the dynamic process implied by the second, the two could be seen as
natural complements. But in this regard there are good grounds to be cautious: the
limit of a competitive process is not normally the dispersal of economic influence
but the very opposite: its concentration. Thus the continuation of competitive
conditions comes to depend very much on matters of dispersed innovation and
entry, a theme we explore at a later stage.
Consequently, I must come clean at the outset. I want my concept of competition
to help us to understand why the economic world changes in the way it does and to
identify the sources of change, the processes of change, and the mutual

interdependence between source and process. It is inevitable that innovation, as a
primary source of change, will loom large in this story but it is as well to recognize
that innovations are not simply to be equated with changes of technology in a
narrow sense. Schumpeter (1911, p. 66) opened his discussion of economic development
by distinguishing at least five different categories of innovation and I certainly do
not wish to retract from his broad perspective.2 Moreover, it remains an open
question as to the relative contributions of technological vs. organizational and
social innovations as sources of the long term increase in living standards. The safest
position is that they are inseparable and mutually determining.
Competing concepts of competition
I want to begin with an exploration of the theme that the development of economic
theory has involved a corresponding development in the concept of competition,
and that the concept appropriate to a world of structural change and development is
quite different from the concept appropriate to a world of equilibrium. To explicate
competition is to explicate what economists consider their subject matter to be.
Perhaps the only place to open this brief review is with Adam Smith and the subsequent
classical school of economic writers.3 In Smith, competition has two interrelated
aspects: as co-ordinator of activities and as promoter of economic development
through the enhanced division of labour (Richardson, 1975). In the subsequent
development of economic theory these interwoven but logically distinct notions
became separated into ultimately incompatible dimensions of competition; the
dynamic concern with a self sustaining development process becomes subordinate to
a concern with the properties of unchanging equilibria.4
As far as the co-ordinating or resource allocating aspect of competition is concerned
the classical theory coalesced around two central propositions. First, that competition
would tend to bring actual market prices into equality with natural prices. Second,
that natural prices are also competitive prices in that they correspond to a situation
in which the allocation of investible funds across different lines of activity has
established a uniform rate of profits on the capital invested (due allowance being
made for risk), while the allocation of labour across activities has imposed a uniform
wage for skill and effort of each given type.5 The dynamics of competition consequently
involves two steps. Competition within a sector drives market prices into equality
with costs of production, and competition between sectors establishes a pattern of
costs consistent with a uniform rate of profits on the capital invested. The resulting
prices are called natural prices and are said to form centres of gravity to the system in
the presence of disturbances. Thus, the very meaning of natural prices implies the
operation of competition; the two concepts are inseparable. Notice that competition
in this sense also implies a widespread awareness of the different profit opportunities

arising in different fields of production, with due allowance again being made for
the risks associated with different lines of investment. Here, already, we see the
beginning of a dualism between competition as a process of resource mobility and
competition as a terminal outcome, a long period position in which prices of
commodities are measures of the natural costs or values.
The ultimate refinement of this method came with Marshall and his attempt to
deal with the time dimension of the competitive process in terms of stages in which
different sets of data are taken as given; so reducing a spectrum of market responses
to a series of discrete categories, market period, short period, long period and
secular period. There can be little doubt that Marshall favoured a process view of
competition and that he was always careful to emphasize that the data are never
constant, so creating particular difficulties for any concept of a normal position.
Indeed, it is worth noting that Marshall was reluctant to use the word competition at
all preferring the much looser term, ‘freedom of industry and enterprise’, in order
to emphasize the importance of open economic conditions. Thus another dualism
emerges between the need for a precise set of conditions to define competition and
the need to be aware of the infinite, open-ended diversity of ways in which competition
can arise. Marshall saw competition not only as a process but also as involving
deliberate action; not as a state of affairs but as a pattern of behaviour.
This emphasis on behavioural, competitive intent is captured in another of Adam
Smith’s themes, that of rivalry between independently acting competitors. But before
we turn to this we must consider the alternative view of competition that emerged in
contradistinction to the classical school.
Competition as equilibrium states
Put simply the dominant themes of this alternative approach are competition expressed
in terms of trading activity and competition as a state of equilibrium, as the limit to
the process of rivalry. These themes are ultimately connected with the work of Jevons,
Edgeworth and Cournot and form the basis for the neoclassical perspective on
competition found in virtually every undergraduate textbook. The equation of
competition with trade and exchange was the natural outcome of the search for
criteria to judge the efficacy of market institutions in co-ordinating the allocation of
resources. The consequent emphasis upon the nature of market institutions, the
distribution of information about rival offers and demands, and the matter of who,
if anyone, sets prices moved to the centre of the theoretical stage, and indeed moved
economic theory away from questions of longer run development towards questions
of immediate resource allocation. This change in perspective on competition was
closely tied in with the marginal revolution. Jevons (1871), for example, linked together
his concepts of the market and competition in two requirements: that all traders have

perfect knowledge of the conditions of supply and demand, and that there be complete
freedom for anyone to trade with anyone else.
Important new insights followed, not least the notion of a perfect market (quite
distinct from the notion of perfect competition) in which all transactions for identical
goods or services are consummated at the same price. As to who sets prices, and
setting Walras’s fictional auctioneer aside, there emerged a wealth of possibilities
ranging from market makers, merchant-traders who release and absorb stocks and
quote prices on organized anonymous exchanges, to individual firms who quote
prices and sell to customer order on a personalized bilateral basis. In the latter case
from whom one buys may be as significant as what one buys. Ultimately, these
categories of price setting were reduced by Hicks (1965) to a distinction between
those market behaviours and institutions which promoted price flexibility and those
which promoted price rigidity. Roughly speaking, a distinction between markets in
which centralized, specialized merchant-traders set prices and markets where individual
firms set prices (Okun, 1981; Lachmann, 1986). There can be no question that this
emphasis on the character of the institutions of the market and the arrangements for
diffusing information is of the first importance and an essential part of any study of
the development of competition in an industry.6 However, this is not the aspect of
the neoclassical revolution which has received most attention; much more pervasive
has been the emphasis upon competitive equilibrium as a state of rest relative to
given data.
The crowning achievement of this strand of thinking is the theory of perfect
competition. This brings together three independent ideas: that of a perfect market;
that of atomistic behaviour; and that of freedom of entry and exit in regard to any
level of activity. In the first and last respects it mirrors classical thinking. The crucial
innovation is that of atomistic behaviour, the explicit hypothesis that no one trading
in the market has a sufficient volume of sales or purchases to influence the market
price.7 Without question atomistic competition has been the central organizing theme
of the last century of economic theory. It is the foundation of the theory of general
equilibrium and its offshoots in international trade theory, public finance and welfare
economics; and it is the basis for judging the (in)efficiency of any market situations
which depart from its axioms. It has been central to the work of major economists
including Jevons, Walras and Wicksell but not, as we have already hinted, Marshall.
Through the postulate of freedom of entry and exit it encompasses the classical
concern with resource mobility and the equalization of suitably defined rates of
return on investment. Through the conditions equating behaviour at the margin
with market prices it gives a coherent set of standards for saying whether given
economic arrangements are efficient or otherwise, and gives market prices a deeper
meaning as indexes of relative scarcity. Over time the whole apparatus has been
extended. Monopoly and perfect competition provide the extremes of market
organization, with the middle ground filled in with monopolistic competition and,

where strategic interdependence cannot be ignored, duopoly and small-numbers
oligopoly concepts.
Now, it is essential to understand what brings together the assumptions of atomistic
behaviour and free entry conditions in the determination of a perfectly competitive
equilibrium. It is the assumption that conditions of production and organization
set an economic limit to the size of the firm such that it forever remains small
relative to the overall scale of the industry. Being small is a necessary and sufficient
condition for the firm not to influence the prices at which it trades. In the terminology
of the theory, each producer must have a ‘U’-shaped long run average cost curve, the
minimum point of which becomes that ‘Clapham Junction’ through which all the
requirements of competitive equilibrium converge.8 But this is equivalent to denying
the possibility of pervasive increasing returns or internal economics, which, as we
have understood it, was the second great legacy of Adam Smith. Unless each firm
runs up against decreasing returns when it is small relative to the overall market, the
key stone of the theory fails and this promises, as Hicks so aptly remarked, to ‘threaten’
the wreckage of the greater part of general equilibrium theory.9 Notice though that
the damage does not come only from increasing returns. Pervasive constant returns
have exactly the same implications for the viability of atomistic conditions. Faced
with this dilemma the majority of economists choose to steer for calmer waters;
others recognize that an alternative strategy would be to build a more serviceable
vessel and it is to this strand of thinking we now turn. Before doing so it is important
not to forget the achievements of competitive equilibrium theory, they are impressive
and they certainly impressed Schumpeter as any reading of his Business Cycles will
indicate.10
Constructing a more serviceable vessel has primarily involved a return to the
older concept of competition as active rivalry, action which involves much more
than trading. That is to say, to return to the idea of competition as a process of
endogenous change driven by the differential behaviour of the competitors. A wide
variety of economists have expressed their dissatisfaction with the equilibrium view
in a number of ways, some less polite than others, and it will be as well to outline
several of the main contributions. Thus, Morgenstern (1972) claims that competition
as a word employed by economists has lost touch with reality simply because it has
replaced struggle and rivalry with equilibrium. J.M. Clark (1961) in his major
contribution to this literature began by claiming that the shift from equilibrium to
process was the most challenging question in the theory of competition, and he
suggested four broad elements necessary for effective competition: competent customers
able to appraise accurately the competing products on offer; freedom of individuals
and organizations to engage in any trade or activity (remember Marshall!); access to
all the necessary means of production; and a climate of independence of attitude and
strategy among firms in the industry.
Given these elements, the actual conditions of competition would depend upon

the organization of the market, together with the competitive behaviour of the
rivals, and foremost among the competitive behaviours will be changes in the nature
of what is being supplied. In short, the elements of a theory of competition should
not be chosen to characterize equilibria but to explain economic change. Particularly
interesting in his appraisal of competition theory is Georgescu-Roegen (1967) who
points to the fact that, as normally portrayed, competition is absent within the
industry and only takes place between industries,
the condition commonly labelled as a ‘perfectly competitive industry’ actually

involves no competition at all.
(p. 32)
Firms within a perfectly competitive industry only adjust passively to prices which
are externally determined. As to what is needed in order to develop a theory of the
competitive process we are encouraged to recognize that,
In every domain, but especially in economics, competition means in the first

place trying to do things in a slightly different manner from all other individuals.
(p. 33)
Here is an important clue as to how we are to proceed. We are to recognize that,
the most general form of competition among individual concerns is

differentiation of product, involving a little innovation, not cut throat pricing.
(p. 34)
Here is a major paradox: competition only becomes active when we allow a monopoly
element premised upon the fact that firms are different, and scope for competition
lies not in the number of firms but in the conditions creating diverse behaviour. In
a sense, all the elements above were contained in Chamberlin’s Monopolistic Competition
but for him the grip of equilibrium thinking was too strong. Brenner (1987) is also
a notable contributor to this literature, with the emphasis being placed on bets upon
new ideas and the insistence that,
Businessmen pursue strategies to discover a combination of customers and

services with respect to which they have an advantage over those who they
perceive as their competitors.
(p. 49)

Among all the economists who have been critical of the equilibrium approach none
has been more devastating from my perspective than Hayek (1948, 1978) with his
view that an equilibrium concept of competition is a contradiction in terms. In a
much quoted passage he suggests that,
if the state of affairs assumed by the theory of perfect competition ever existed,
it would not only deprive of their scope all the activities which the verb ‘to
compete’ describes but would make them virtually impossible.
(p. 92)
Instead competition is a succession of events, a dynamic process, a voyage of

exploration into the unknown in which successively superior products and production
methods are introduced, and consumers discover who meets their particular needs
and how. Neither producers nor consumers know in advance the outcome of the
competitive process, for that can only be established by trial and error. Putting it
another way, atomistic competitive trading implies the absence of all competitive
actions. Again we begin to see a link between the process view and the emphasis on
differential behaviours of rival agents, and we should note Hayek’s insistence that
differentiation of this kind undermines any claim that agents can have complete
knowledge of all the factors relevant to market behaviour.
Knight, too, favoured an exploratory perspective on the economic process in
which not only the capabilities of firms but the preferences of individuals become
the endogenous outcome of a trial and error economic process.11
In many ways this viewpoint has been most felicitously expressed by Fisher and
colleagues in their compelling account of an ill-starred anti-trust case against IBM, a
case which ultimately collapsed because of a confusion between the requirements of a
competitive equilibrium state and a healthy competitive process. Thus they suggest,
When new opportunities continually arise, one will see under competition a
continuing process of change which carries with it continued opportunities
for profit and growth. One cannot hope to understand the competitive nature
of such a process by examining it in terms of static competitive equilibrium.
(1983, p. 39)
Here lies another clue: a competitive process creates patterns of change, something
that Schumpeter, to whom I now turn, understood well. Indeed, Schumpeter could
have written several of the above quoted passages himself.
Let us begin with the later Schumpeter, of Capitalism, Socialism and Democracy, for
there he outlines the obvious fact that economic progress has continued unabated
despite the absence of perfect competition as an organizing principle in industry.
Nonetheless, progress is closely linked with competition which is

intrinsic to the mechanism of capitalism which is by nature a form or method
of economic change and not only never is but never can be stationary.
(1945, p. 82)
The driving force in competition is not the adjustment of price but innovation, the
theory of which had occupied Schumpeter in two previous major works, Business
Cycles and The Theory of Economic Development. For it is through innovation that firms
command a decisive cost or quality advantage affecting not their marginal profits
but their very existence. Thus it is a matter of comparative indifference whether
atomistic price competition in the ordinary sense operates more or less promptly.
Capitalism is not to be judged in terms of its immediate efficiency in allocating
given resources across given opportunities but in terms of its ability over time to
create resources and opportunities. Hence Schumpeter’s central idea of change driven
from within, brilliantly captured in his phrase ‘creative destruction’. This, it should
be emphasized, is not an optional extra to the capitalist process but is the capitalist
process: equilibrium capitalism is for Schumpeter a contradiction in terms.
Consequently, it would seem one cannot understand capitalistic competition in terms
of a comparison of sequences of equilibria.
This is not the place to debate whether Schumpeter was or was not an evolutionary
economist; Hodgson (1994) for one has provided reasons for being sceptical and for
pressing the greater claims of Veblen (1898), others have disagreed (Helm, 1996). It is
not unusual to find economists whose influence far outstretches the formal content
of their theories. But what is not in doubt is that Schumpeter has inspired many
scholars whose interest lies in the development of evolutionary approaches to
competition. Whether they are Schumpeterians in some broader sense is, I suggest,
not the point. Nor is it difficult to understand the reason why Schumpeter has had
this influence; put simply, he appears to have been in touch with history. He knew
full well that economic growth proceeded jointly with qualitative change in the
available consumption goods, with new methods of production in factory and farm
and new forms for creating and applying energy. After all, his life had witnessed the
railroad, the bicycle, the automobile, the telephone, the aeroplane, gas and electricity,
radio and television, the increasing sophistication of innovation at all levels, and the
emergence of a stream of inventors and entrepreneurs of great stature such as Thomas
Edison and Elmer Sperry.12 What Schumpeter had deduced from this was the central
role of innovation to competitive rivalry with his repeated, perhaps excessive, emphasis
on the new firm and the new entrepreneur as the vehicles of innovation. Wittingly
or otherwise he had stumbled upon the principle elements in any evolutionary
argument, that is to say, a process of co-ordinated change driven by variety of
behaviour.
Let us take stock and summarize the specific charges brought against the equilibrium
view of competition. We take them seriatim.

Because the degree of competition is identified with the number of competitors,
and not the behaviour of competitors, it ends up condemning attempts to create a
competitive advantage as attempts to gain monopoly power. Competition depends
on differences in behaviours and independence of action, which can as well be
satisfied by two firms as any. Numbers do not obviously enter into the matter
beyond this. This was the complaint of Morgenstern and Hayek but it has been well
put by Joan Robinson (1954) in the following terms:
In the broad sense in which businessmen understand it [competition] largely

consists in destroying competition in the narrow economists sense.
(pp. 245–246)
Competitive behaviour is in part motivated by the search for monopoly positions.

It is from this that an ambiguity in the interpretation of any firm’s alleged monopoly
profits follows naturally. Are these profits a consequence of monopoly power or are
they the consequence of superior behaviour?
Of course, the number of competitors becomes a very imprecise concept as soon
as we identify potential entrants currently outside the industry but willing to enter
if prospects improve. It has been suggested that the threat of potential entry can be
as strong a discipline as actual entry, a claim which is explored in depth in the
literature on the contestability of markets (Baumol, 1982; Shepherd, 1984). Moreover,
the identification of competition with the number of competitors, simpliciter, implies
that these competitors are identical, otherwise they cannot be represented by a single
number. This has several unfortunate consequences: it rules out behavioural
heterogeneity, it equates competition with the opposite of monopoly (McNulty,
1968), and it ignores two other important implications of a greater number of
competitors, as a barrier to collusion and in their role as multiple independent
sources of variety in innovative behaviour. This is a point made by Clark (1961, p.
197) but it is perhaps most fully expressed in a famous passage in Marshall:
Every locality has incidents of its own which affect in various ways the methods
of arrangement of every class of business that is carried on in it: and even in
the same place and the same trade no two persons pursuing the same aims will
adopt exactly the same routes. The tendency to variation is a chief cause of
progress: and the abler are the undertakers in any trade the greater will this
tendency be.
(8th edn, p. 355)
Thus an industry is not competitive simply by virtue of the number of firms it

contains but because increasing numbers imply increasing scope for differential
behaviour (Loasby, 1982).

Perhaps the most obvious and well documented indicator of the lifeless nature of
the equilibrium concept is its inability to encompass entrepreneurial behaviour. By
definition the rewards to entrepreneurship are transient and relate to the operation
of markets in conditions of disequilibrium. Such rewards cannot be included in any
definition of equilibrium. They are, in Schumpeter’s words, ‘at the same time the
child and the victim of development’.13 This is well understood. Like Schumpeter,
Baumol (1993) has emphasized the non-routine behaviour involved in
entrepreneurship, encompassing such traits as imagination, boldness, ingenuity,
leadership, persistence and determination in pursuit of wealth, power and position.
These are not obviously amenable to Cartesian analysis. In equilibrium this group of
attributes cannot be rewarded, as all that can be rewarded is the routine behaviour
which defines the good stewardship of existing resources. I note in passing that
entrepreneurial behaviour is necessarily differential behaviour, a theme to which we
will return below. Notice also that the transient incomes associated with innovation
related profits may provide the resources for further innovations and so create the
possibility of a self-exciting economic system which is permanently in transition.
It is also an inevitable consequence of the equilibrium view of competition that it
cannot provide links with the mechanisms of structural change and economic growth;
with the fact that competition driven growth is always uneven in its pattern and
effects. To deal with this undoubted stylized fact, competition has to be given a
broader remit, linking innovation to the consequential changes in economic structure
and the division of labour (Kuznets, 1954; Burns, 1938).
Finally, the equilibrium view can provide only limited guidance on matters of
competition policy. In the United Kingdom, for example, any monopoly enquiry
undertaken by the Monopolies and Mergers Commission is required by law to focus
upon the ‘steps, actions and omissions’ attributable to the alleged monopolist. That
is, the focus is upon behaviours which are enabled by a monopoly not upon the
monopoly structure itself. This is precisely the point involved in the IBM anti-trust
case referred to above: monopoly positions can be created by superior ability so that
a dominant market position is not necessarily an index of the abuse of market power
but rather is a measure of superior performance.14
Competitions and contests
In popular usage the word competition is reserved almost entirely for the concept of
a contest: a race or game or sport involving competitors playing according to agreed
rules of the game.15 One of the first economists to elaborate upon this connection
was Frank Knight in his essay ‘The Ethics of Competition’ written in 1923. Here
Knight makes the point that participation in business is stimulated not simply by
the desire to satisfy wants but by the search for achievement and the satisfaction

derived from participation: that is to say, by the desire for action. Here is a framework
for interpreting competition which focuses upon actions and behaviours and fits
naturally, as we shall see, with the evolutionary perspective.
Any contest has a number of important characteristics. Chief among these is a
clear set of accepted and enforceable rules of the game which determines the nature
of the contest, the principles on which contestants are to be rewarded, and the
principles on which they can enter or be eliminated from the contest. The rules of
the game, a code of conduct, serve to co-ordinate the behaviours of the rivals, define
permissible behaviours and establish the set of prizes, and they are to be judged in
terms of their neutrality or otherwise towards rival contestants, that is by their
fairness.16
The second element is the set of contestants and their particular attributes of skill,
dexterity and effort. However, should these contestants be uniquely ranked in all
circumstances we would hardly term the situation a contest, for its results would be
perfectly predictable. Hence the final element in any contest is the inherent
unpredictability of outcomes. In part this may arise from uncertainty about the
environment of the contest, since not all contingencies can be written into the rules,
and in perhaps greater part from a lack of predictability about the behaviour of the
contestants. Neither the outside observer nor the contestants can observe or anticipate
the plans and strategies of the various rivals or predict the multiplicity of contingent
circumstances which affect performance at a particular play.17 Luck is an essential part
of all contests, the fall of the favourite, the emergence of the dark horse, and as this
degree of unpredictability declines so often does the desire to call it a contest. In this
regard, contests are discovery procedures to find the best behaviour out of a set of
rival behaviours. Of course, what is best is entirely contingent on the rules of the
game and entirely relative to the set of contestants. As Alchian (1951, p. 213) so aptly
remarked:
As in a race, the award goes to the relatively fastest, even if all the competitors
loaf. Even in a world of stupid men there would still be profits.
(my emphasis)18
Hayek too would find this idea of a contest fully compatible with his own insistence
that the results of the competitive process cannot be foreseen. In short, true contests
have rivals competing according to established rules. The rivals apply skill and effort
to win prizes but the outcomes are neither entirely predictable nor entirely random.
If they were entirely random there would be no incentive to apply effort to the
conduct of the contest.
Let me sum up this brief and selective discussion of competing concepts of
competition. There is scarcely a writer on economics who does not recognize that
rivalry is a component element in what is meant by competition. Yet, paradoxically,

rivalry has no meaning in a state of competitive equilibrium. This we have known
since Adam Smith with suitable reinforcement from Hayek, Schumpeter and others.
But in emphasizing process we must not forget the other strand in Smith’s thinking,
that of co-ordination. For the great strength of equilibrium economics, whether
classical or neoclassical, is to have put together the elements of a co-ordination theory
by insisting on understanding how different economic behaviours fit together, We
certainly cannot make sense of the process of competition without a theory of market
co-ordination even if we can dispense with competitive equilibrium.
I have completed all that I need to say about the rival concepts of competition.
We have sufficient groundwork behind us to turn to the main purpose of these
lectures which is to develop an economic framework for the analysis of evolutionary
change.
The process perspective on competition has a natural connection with the modern
theory of evolution, and I intend to explore this connection in depth. The theme
will be that contests are selection processes and the contestants are to be distinguished
by their differential behaviours. Variety drives selection in all contests of which the
economic contest is one of the most important. A number of questions naturally
arise at this point. What are the rules of the economic game, and to what extent do
they depend on the institutions of the market place, the factors which condition
trading as we outlined previously? What constitutes a good set of rules? What shapes
the behaviours of the contestants, how different can they be and what processes
result in those differences? What are the uncertainties that make economic contests
unpredictable and indeed open-ended in their possible outcomes? Where does
organizational and behavioural innovation fit into the competitive scheme of things?
Now, before we can attempt to frame these questions more precisely we need to
devote some time to understanding the elements of modern evolutionary theory.
In the next section we shall see how evolutionary ideas may contribute to this
process perspective on competition, indeed, I shall argue that competition is an
evolutionary process. Two elements must be distinguished and kept in play. To
anticipate, these are: the market context, those institutions and rules of the game
which control the rate and direction of competitive change and, equally important,
the rivalrous behaviours of firms. These differences in behaviour become competitive
in relation to a particular market context and it is through market co-ordination
that they are resolved into economic change.
THE EVOLUTIONARY CONNECTION
Competition as an evolutionary process
It has for long been a part of the folklore of evolutionary theory that Darwin hit
upon the idea of a ‘struggle for survival’ after reading Malthus’s Essay on Population.

To the extent that this is true it may be a reflection of the deep similarity in structure
between the idea of competition as a process and the idea of evolution by natural
selection. At the outset we ought to make clear that the concept of an evolutionary
process is quite independent of its application to any particular set of phenomena.
That evolution is a core concept in biology does not mean that it is an inherently
biological concept. Evolution can happen in other domains providing that the
conditions for an evolutionary process are in place. Thus, as economists applying
evolutionary ideas to economic phenomena, we can learn from the debates on
evolutionary biology in order to understand better the logical status of concepts
such as fitness, adaptation and unit of selection without in any sense needing to
absorb the associated biological context. This does not mean that economic evolution
is similar to Darwinian evolution. It is not. Fortunately, there is no need to limit
evolutionary concepts to the language of genetics, even though their application to
genetic problems has been a principal source of theoretical development. It is also
comforting to note that controversy in biology is as fierce as controversy in economics.
Terms like adaptation are as much contested as terms like competition, which is all to
the good.19
Evolutionary processes
Let us begin with an abstract statement of what evolution means. An evolutionary

argument explains changing patterns of co-existence between certain kinds of entities,
the patterns being described in terms of frequency measures of the relative importance
of the entities. More precisely, an evolutionary argument based upon selection processes
is concerned with explaining how the relative importance of specified entities changes
over time, why some are eliminated and others continue to survive. Thus the concern
is ultimately with two phenomena: viability, and the differential growth of entities
between which meaningful comparisons can be made. What is the criterion for
meaningful comparison? It is that the entities are elements in the same population.
Before looking at this in more detail we should set down the three widely accepted
ideas which jointly define an evolutionary process (Lewontin, 1974; Brandon, 1990).
These are: the principle of variation, that members of a relevant population vary
with respect to at least one characteristic with selective significance; the principle of
heredity, that there exist copying mechanisms to ensure continuity over time in the
form and behaviour of the entities in the population and the principle of selection,
that the characteristics of some entities are better adapted to prevailing evolutionary
pressures and consequently increase in relative significance compared to less adapted
entities. Essential to this view is the idea that the entities interact in a particular
environment in a way that the differential growth advantage of any one entity depends
on the characteristics of the rival entities and the specification of the environment.

Evolutionary change therefore involves the mutually supporting ideas of interaction
and co-ordination. From this it is easy to see how influential writers such as Mayr
(1982) have categorized evolution as a two-step process: variety is generated by some
mechanism, and variety is subsequently selected to produce a pattern of change
within the relevant population. Rather more precisely, Endler and McLellan (1988)
distinguish five distinct processes which define an evolutionary mechanism, as follows:
• processes which generate variation in the pool of characteristics in the population

by adding or subtracting competing entities or by altering the characteristics of
existing entities;
• processes which restrict and guide the possible patterns of variation in behaviours;
• processes which change the relative frequency of different entities within the
population;
• processes which determine the rate at which the above three processes regulate
change; and,
• processes which determine the overall direction of evolutionary change.
In economic terms the first category covers the entire field of innovation, radical or
incremental, carried out by existing firms or associated with the creation of new
firms, together with the processes determining rates of entry and exit into and out
of a population. In this the elimination of ‘old’ patterns of behaviour is as significant
as the creation of ‘new’ ones. The second category points to the guided nature of
variations in behaviour, how it is focused within limited regions of the possible
design space of technological and organizational innovations, and how behaviour is
not infinitely adaptable. In any evolutionary argument there is always a place for
inertia and constraint. The third category leads us towards the dynamics of resource
allocation in market contexts for it is through markets that the waves of evolutionary
change are transmitted. Processes four and five in the list cover the overall framework
of institutions and behavioural norms which shape innovation and the way in which
markets transmit change. The economic historian, P.K. O’Brien, provides a fine
example of these top-level evolutionary processes in his comparative discussion of
the different rates of structural change in British and French agriculture and the
correspondingly different rates of urbanization:
structural change in France was in large measure ‘predetermined’ by a

combination of geographical endowments and a system of property rights
inherited from its feudal past. Both constraints, operating within the context
of pre-chemical and pre-mechanical agricultural systems, so limited the scale
and scope of French endeavours to follow the path taken by Britain between
the sixteenth and nineteenth centuries, that ‘the British way’ as Count Mirabeau
told Arthur Young, became almost irrelevant to conditions in France.
(1996, p. 214)

Thus innovative activities and market evolution fit within a wider context of beliefs
and institutions which are rate and direction determining.
The most significant feature of all of this is that evolutionary arguments are
concerned with patterns of change not only in the entities themselves, which could
be treated as entirely fixed in nature, but in terms of the relative importance of these
entities in the population. Williams (1973) puts this well when she expresses the
distinguishing feature of evolutionary processes as a matter of selection acting on
individual entities to produce changes in the structure of the population. Change in
the set of entities is not reducible to changes in the entities themselves; a property
which gives evolutionary thinking an inevitably holistic cast. It is on processes of
structural change, rather than the generation of changes in the behaviour of the
competing entities, that I want to focus these lectures. With this as a background let
us turn to the nature of population thinking and demarcation criteria for population
membership.
Population thinking
Population thinking is the phrase first coined by Mayr (1959) to distinguish the
emerging pattern of thought in what has since come to be termed the modern
evolutionary synthesis. It is the central notion in any selection type theory in which
there is interaction between entities to produce the effect of differential rates of
growth and survival (Darden and Cain, 1989). Now, the fundamental point is that
selection type theories are concerned with frequencies of behaviours which differ,
not with uniform behaviours, and there is a considerable shift in emphasis by
comparison with typological thinking. Typological thinking is concerned with ideal
types in which the entities are regarded as fixed and identifiable in terms of a limited
number of defining characteristics, characteristics which constitute the essence of the
entity. In this essentialist perspective, all variations around the ideal type are accidental,
aberrations due to interfering forces, lacking in information content like the flickering
shadows on the walls of Plato’s cave.
By contrast, in population thinking, the focus of attention is on the variety of
characteristics within the population and, pace typological thinking, variety is not a
nuisance which hides the underlying reality, rather it is the distribution of variety
which is the reality and which is the prerequisite for evolutionary change. As Sober
(1984) has expressed it, variety is a natural state in evolutionary theory and it is the
operation of interfering forces in the shape of selection dynamics which produces
uniformity. Typological thinking is turned on its head. Equally significant is the fact
that the population perspective does not require a theory of how variety is generated.
It is sufficient to take variety as given and work through the consequences.
While it is enticing to subscribe to a theory of variety generation – mutation,

imitation, innovation or whatever – this is not necessary to make the population
perspective coherent. It is for this reason that evolutionary theory is often described
as being a type of statistical theory (Horan, 1995), not in a probabilistic sense but
rather in terms of dealing with the frequencies of entities with deterministic
characteristics. It follows that the statistical moments of the population distributions
of characteristics – mean, variance and covariance to successively higher orders, and
their rates of change over time – provide measures of the rate and direction of
evolution. We shall see below that this is the insight which underlies Fisher’s Principle.
Such statistical explanations are based only on abstract counting properties derived
from, but not equated with, the properties of the individual population members.
The relevant population moments are our theoretical constructs defined as appropriate
functions of the characteristics of all the members in the population. Such statistical
moments are convenient summaries based on the information contained in the
population; they are convenient descriptive aggregates, but they are not representations
of any individual.
More fundamentally, however, they are the basis for understanding the dynamics
of change and for incorporating many different kinds of populations within the
same conceptual framework. Thus the essential point about population thinking is
that deterministic systems allow explanation in terms of statistical properties, and the
case for such explanation rests on the foundation it provides for understanding the
dynamics of change. Of course, none of this forbids the use of probabilistic reasoning
to explain the characteristics which the entities possess or indeed the selective forces.
But then, if probabilistic reasoning is to be meaningful, one must have grounds for
writing down the appropriate probability generating function; if not the probabilities
are devoid of explanatory content.
Thus, while being open to probabilistic reasoning, our discussion will be taken as
applying to a frequency distribution in some well-defined and deterministic
characteristics space. For many expository purposes it is perfectly sensible to treat
the underlying characteristics as if they are properties of unchanging entities, as one
step in a more general account of structural change and development. In short, we
are interested in the evolution of populations, not in the change in the individual
entities which make up those populations. More generally, one would wish to
incorporate entity changing processes and exploit a third step in evolution where
experiences gained in the process of selection indeed feed back to shape innovation
and behavioural change in the entities themselves. For the moment such endogenous
innovation is unfinished business.
One consequence of this approach is a shift in emphasis away from the adaptability
of the individual entities making up the population. Selection is quite consistent
with change in the entities but what it does require is an element of inertia which
holds the competing varieties in a form for long enough for selection to change their
relative importance. If entities were perfectly adaptable in all relevant dimensions,

and so adapted their behaviours uniformly to the dictates of the environment, there
would be no scope for selection. However, and especially in the economic and social
spheres, there are multiple sources of inertia which prevent entities such as firms or
consumers responding instantaneously to market pressures.
A major issue which arises within the population perspective relates to the criteria
by which an entity is to be assigned to a particular population. A population is an
aggregation of entities and it is in the nature of such a collection to have members
assigned to it on the basis of specific principles of inclusion. Clearly the members
must share some attributes in common but they must also be different enough for
selection to be possible. Evolutionary populations cannot be based on identical
entities. They could, for example, be defined as possessing a common qualitative set
of characteristics while holding those characteristics in different quantitative degrees.
But which characteristics, and is it absolutely necessary that the entities have qualitatively
identical character sets? The answer is, I think, no. What matters in defining the
members of the population is not their characteristics per se but that they be subjected
to common environmental and selective pressures.
They are in competition one with another, yet the entities become mutually
interdependent by virtue of being subject to common selective pressures. It is this
which unifies the entities into the relevant population and, incidently, identifies the
characteristics which have selective significance. The consequence of this is that the
relevant population cannot be identified unless the relevant selection environment is
also specified. On this view there is surely nothing amiss in seeing the same entity as
being a member of more than one population if, with respect to one group of
entities, it faces a common set of selection pressures while, with respect to another
group, it faces a different set of pressures. Similarly, entities which appear to be
radically different in their characteristics can still compete within the same population.
All this means that the entities are classified not by their attributes but by the fact of
their competing in common environments; they are members of the same population
by virtue of being subject to the same selective forces. Indeed, this is what the
biologists imply when they refer to populations as spatiotemporal aggregates (Brandon,
1990).
How then should we proceed? What in economic terms is the appropriate unit of
selection? Only when this question is answered can we decide which characteristics
contribute to the definition of selective advantage and disadvantage. This is a set of
issues which have proved endlessly controversial in evolutionary biology. I hope to
escape more lightly.
The unit of selection
If we remember that our central concern is with the changing relative importance of
different economic activities, this suggests immediately that the appropriate unit of

selection is a transformation process in which productive activity translates inputs in
one form into outputs of another form. At first glance, the unit of selection is a
method of production for some set of goods or services and as such it denotes a
particular pattern of behaviour. It may entail transformations in the state of matter
and energy, transformations in the spatial location of matter and energy, and
transformations in the temporal location of matter and energy, or production,
transport and storage in short.
While appropriate, this emphasis on the transformation process alone is not
enough. Under the capitalist rules of the game, transformation processes are activated
for a purpose, to make the value of the output exceed the value of the input. Indeed,
they are activated by business units responsible for the operation of the transformation
process. Transformation cannot be a matter of technique alone, it must also depend
upon matters of organization within the business unit together with matters of
intent. Thus the appropriate unit of selection is, I suggest, an organizational cum
technological complex: a set of instructions for translating input into output for a
purpose. This complex is constituted by a set of routines to guide behaviour, routines
which collectively constitute the knowledge base of the particular activity. We shall
call this complex a business unit simply because I want subsequently to discuss a
model of economic selection at the level of the industry. There are many other
possible units of selection that I do not discuss. In some cases, the business unit is
coterminous with the idea of a firm but not in general. The modern firm is typically
an aggregate of different business units, it is a unit of ownership not a unit of
transformation. It is a convenient simplification, and nothing more, if we use the
terms business unit and firm as if they are entirely interchangeable in the following
exposition. More generally, though, it is clear that the evolution of populations of
business activities is not the same as the evolution of populations of firms.20
On what principle are different business units to be combined into a particular
population? The answer will now be obvious: when they are subject to common
market pressures. Selection environments mean market environments, product markets
and factor markets. Two business units competing in the same product market belong
to the same population. If they draw upon different factor markets for their inputs
we could further say that the overall population consists of two interacting sub-
populations. However, to say that a business unit is selected by a market environment
needs unpicking further. Take the first case of product market selection. What are
selected are the outputs of the competing transformation processes, outputs which
have certain performance attributes in the perception of users and which have a
price attached to the attributes bundle.
Product markets define selection environments in a number of distinctive ways.
They relate to particular groups of customers, whether individuals or organizations.
They have a scale and an aggregate rate of growth or decline. They have an institutional
context which shapes how efficient they are and the degree to which the overall

market is divided into partially competing segments. This institutional context is
often reflected in the existence of specialized intermediaries – merchant, wholesale or
retail traders – linking suppliers to their customers. They have a legal and regulatory
framework and they are characterized by contractual arrangements of different kinds
and durations. The frequency of selection varies considerably. In some markets selection
decisions are made at infrequent intervals, e.g. in the markets contracting for defence
equipment or civil aircraft, in others the selection process operates continuously, as
it does in many commodity markets. They may be stable or they may suffer turbulence
in a way which is often used to describe markets for fads and fashion goods. Hence
market selection environments are complex institutions in their own right.
Similarly with factor markets. In labour markets, we may imagine workers choosing
from rival business units those which offer the more favourable wage and employment
conditions. In the same way with capital markets and the flow of finance to firms,
investors form views on which firms would provide the desired return on their
capital, due allowance being made for perceptions of risk. Both kinds of factor
market environment are describable in terms of scale, growth, efficiency, role of
intermediaries, frequency of operation and turbulence.21
Hence the business unit is selected by virtue of being caught between selection
environments for products and factors. It competes for customers and it competes
for inputs, and the outcome of this competition will be a change in the scale of its
activity relative to that of rivals. What makes it competitive are its organizational and
technological attributes which underpin the design of the product it produces and
the method of production. It is these attributes which underpin the variety we seek
across the business units.
An appropriate framework for exploring this further is the notion of the business
unit as a bundle of routines for conducting its activity. It is these routines which
ultimately determine the competitive fate of the business unit. Market mechanisms
do not, of course, select between these bundles of routines directly. Rather it is the
specific product attributes and the factor utilization attributes which determine the
selective fate of the business, and it is these performance characteristics which are the
direct consequence of the design of the business unit. No performance characteristic
will be determined uniquely by a single routine, and any routine will impinge upon
a number of characteristics. It is the ensemble of routines which matters and it is the
ensemble which gives the business unit its systemic properties, its distinctive signature
(De Liso and Metcalfe, 1996).22
To summarize, it is the business unit operating a transformation process for a
purpose which forms our fundamental unit of selection. Each business unit has its
own technological and organizational design attributes, its routines, which jointly
underpin the characteristics of the output and the method of production. It is the
product combined with the production method which are directly selected in product
and factor markets. Consequently, it is the activity of the business unit which is
selected indirectly. The simplest case to tie all this together is a population of single

product business units drawing resources from the same factor markets. It is a case we
shall explore in detail in the second lecture.
Differential growth and fitness
We have suggested that an evolutionary process explains how population structures

change over time, and how structure is an emergent property. Necessarily, therefore,
it is concerned with the differential rates of expansion of the competing, interacting
members of the population. This topic takes us into potentially troublesome waters
for it involves the nature of fitness, a notion which has been enormously contentious
in evolutionary biology in part due to the mistaken tautology claim associated with
the phrase ‘survival of the fittest’. Needless to say, when it is properly specified, no
question of tautology arises at all.
In answer to the question, ‘change in the relative frequency of what?’, our response
should now be clear. The relative frequencies are defined in terms of the contribution
each transformation process cum business unit makes to total activity in the
population; they are measures of differential economic importance, or, as I prefer to
call it, the economic weight of the activities of the rival business units. In some cases
these measures translate easily into observable data such as the share of the output of
a particular business unit in the total market which defines the population, or the
corresponding share in total employment or total capital used. In other cases the
appropriate measures are not so obvious.
Three distinct types of change in activity are implied by this definition of economic
evolution and they correspond to the familiar categories of innovation, imitation
or adoption, and diffusion. Innovation accounts for the introduction of new kinds
of behaviours into the population either via the vehicle of new business units or via
changes in existing business units. The consequence is to change the activities of the
firms and introduce new or modified products, or new or modified methods of
production.
While innovation is a matter for individual business units, or occasionally co-
operating sub-groups of business units, diffusion is a population phenomenon, the
differential spread of the activities of rival business units. Such changes in frequency
are inherently questions of differential growth and survival closely connected over
the longer term to investment routines and the allocation of capital resources. It is
this kind of dynamic which is captured by our selection processes.
Bridging between these two categories of change is the third element, imitation
or adoption. This concerns change in the behaviour of the individual business units
while also being an inherently population phenomenon. It may involve the copying
of particular routines, or the adoption of particular devices to improve the production
process, or the incorporation of particular design features in a product. Whatever is

involved, the behaviour in question has first been recorded elsewhere in the population
and, it goes without saying, imitation could not arise in a world of uniform behaviours.
If A knows what B knows and conversely what is there to imitate? We reserve the term
diffusion for the process which changes the relative frequency of competing, given
activities, and innovation, and imitation/adoption for the processes which change
those activities in some way. Moreover, since imitation involves a comparison between
different kinds of behaviour it relates naturally to evolutionary discussions of cultural
transmission of behaviour patterns (Boyd and Richerson, 1985; Cavalli, Sforza and
Feldman, 1981). However, our sole concern here is with the class of diffusion processes
which change the relative importance of different business units.
This brings us directly to the question of fitness which we define as follows.
Economic fitness is a measure of rates of expansion and decline of activity and, since
it applies to the business unit, it is partly determined by the capabilities and intention
of that unit. However, the crucial property of economic fitness is that it is not a
property of the business unit alone, but arises from the interaction between rival
business units in a given market environment. It is inherently a feature arising from
membership of that particular population. It is caused by the interaction between
the individual business units and those population cum environmental relationships;
it does not cause anything which, incidently, disposes of the tautology problem.
Economic fitness is simply a measure of the differential tendency of competing
business units to expand as a joint result of environmental effects and behaviour
traits. It follows that a change of environment will normally entail a redistribution in
economic fitness across the population.
The conventional view of evolutionary theory, built around the concepts of
variation and selection, has been broadened in recent years by the addition of two
new concepts which have been used to expand the modern theory of evolution and
to apply it to new domains. The new concepts define two distinct processes, replication
and interaction, and different stylized entities, replicators and interactors (Dawkins,
1986; Hull, 1988; Harms, 1996). The new concepts bear directly on the issue of the
unit of selection.23 For us, the fundamental idea behind replication is copying of the
elements which underpin behaviours. The philosopher David Hull has described a
replicator as ‘an entity that passes on its structure largely intact in successive replications’
(1988, p. 408). What is replicated in our context is the capability to undertake the
activity of the business unit in a sequence of productive and other operations; while
the structure which is passed on is the set of routines and practices, formal and
informal, codified and tacit, which defines the operation of the business unit. Business
activity tomorrow is a repetition of business activity today, and what is copied
across sequences of production is the ‘knowledge’ embodied in the business routines.
Sterelny et al. (1996) provide a useful set of criteria for saying when entity B is a copy
of A which bears directly on our definition of the activity of the business unit as a
replicator unit. A and B stand in a replicator relationship if A plays a causal role in

producing B, if B contains information similar to and performs a similar function
to A, and if B participates in a repetition of the process leading to C and so on. On
all these counts we are justified in taking the business unit as not only a unit of
selection but a unit of selection with replicator properties. In this specific sense
business units engage in replication; they have built in copying mechanisms to
ensure that production can take place tomorrow, and the day after and so on in a
way which preserves a particular pattern of activity. What is copied and transmitted
over time is the firm’s knowledge – scientific, technological and managerial – a template
to maintain its capability, in Nelson and Winter’s terms the collectivity of routines
(1984).
Notice that this does not mean no change over time in the capability of the
business unit. Copying processes cannot be expected to be perfect and we might
expect that favourable errors tend to be built into the routines to benefit future
applications of the transformation process while unfavourable errors are perhaps
not repeated. Indeed much managerial activity is associated with trial and error
attempts to improve business performance. In this way the operation of the set of
routines can drift over time within an essentially unchanging structure. Moreover,
there is a natural Lamarkian tendency in all this incremental innovation. Not only
random copying errors but also intended experiments in the redesign of the business
unit are tested by the environment and the favourable ones incorporated in the set
of routines. Learning is an integral part of the modern capabilities perspective on
the firm (Montgomery, 1995) and it is learning from experience, the incorporation
and passing on of favourable experiences as acquired behaviours, which is one
characteristic of a Lamarkian process (Tuomi, 1992).
Of course, this raises important questions about the way in which errors are
discovered and corrected and the stimuli for experiments to occur, but these are not
our current concern. How much change can we allow and yet maintain that replication
takes place within the same business unit? When does change cumulate to give a new
business unit? Our approach to this is to recognize that the basis for replication is a
bundle of ideas at different levels. At the topmost level is the theory of business
which defines the unit, the conceptual framework which defines the transformation
process and the markets it serves. Below this are all the myriad operating routines
which determine day to day activity. Maintaining the business unit intact means
keeping the theory of business and the associated activity intact. In this way change
at lower levels can be accommodated but presumably not too much change too
quickly otherwise day to day replication becomes impossible to articulate. Stability
of the operating routines is usually a necessary condition for the firm to exist at all.
Notice that these puzzles are not a problem for a theory of selection, rather they
are problems in making clear the practical criteria for defining the appropriate unit
of selection. If at some point one kind of replicator becomes another kind of replicator
so be it. This discussion, it may be noted, is not unrelated to the notion of heredity,

i.e. that there be a sufficiently close correlation between parent and offspring generations
otherwise one cannot have evolution. The analogue is the fidelity of the copying
mechanism. In the same spirit the behaviours of the business unit must be closely
correlated across sequences of production activity. Capability today must correlate
with capability yesterday, not identically but closely. As Winter (1963) pointed out
many years ago, behaviours which vary randomly over time cannot be said to evolve.24
Consider next the idea of interaction. Hull (1988) has defined interactors as a
second fundamental evolutionary category. An interactor is ‘an entity that interacts
as a cohesive whole with its environment in such a way that this interaction causes
replication to be differential’ (p. 408, my emphasis). If business units replicate, what
interacts? Our answer is that it is again the business unit associated with the particular
activity, or rather those particular dimensions of the activity, namely the products
that are produced and the methods by which they are produced. The answer reflects
the fact that competing to sell the product and competing to acquire the inputs are
the two principal forms of economic interaction. Thus, to paraphrase Sober, there is
selection of the products and selection for the underlying activities and business
units in which they are produced (1984, p. 100). Or, as originally stated, there is
‘selection of objects and selection for properties’. ‘Selection of’ relates to the effects
of selection while ‘selection for’ relates to the causes of selection. In our case, the
‘causes’ are the differential behaviours, routines, of the business units and the ‘effects’
are the changes in the market shares of the different transformation activities.
Similarly, we can approach the interactor problem from the perspective of factor
markets. Just as the business units compete to sell their products so they also compete
to attract employees of the requisite quantity and quality. They make wage cum
conditions of employment offers and potential employees select which business unit
they wish to work for. Business units also compete for capital funds and capital
markets supply capital on the basis of judgements about the profitability and risks of
different business units. In each case there is market interaction which conditions
the rate of replication. One consequence of this is that economic replicators are
typically associated with multiple sources of multiple interaction in a range of product
and factor markets.
Sorting and selection
Let us return to the discussion of fitness by making a distinction, first introduced

by Vrba and Gould (1986), between sorting and selection. The issue here is that
selection is only one kind of sorting process. A sorting process is any process in
which members of a population experience differential growth with the consequence
that the weight of the population is attached increasingly to the fastest growing

entity. Market growth in the presence of different income elasticities of demand is a
familiar basis for sorting in this sense (Pasinetti, 1981; Leon, 1967). Selection requires
much more. In a selection process the growth rates of the different entities are
mutually determined by the interaction between members of the population in a
given environment. Mutual determination is the key, the fitness of any one entity is
a function not only of its own characteristics and behaviour but of the characteristics
and behaviour of all of its rivals in that population (Byerly and Michod, 1991;
Brandon, 1990). Darden and Cain (1989) put this rather well when they distinguish
the variant properties of the units of selection from the critical factors in the
environment which evaluate those variant properties. It is the variant properties of
the units of selection which play the causal role and the critical factors which translate
the variant properties into the differential fitness of the units of selection. Fitness
itself is not a variant property of anything. Thus fitness is what some philosophers
call a dispositional variable, a conditional statement that with a set of characteristics
or variant properties ‘a’ and an environment E, the fitness of the entity in question
will be g. Change ‘a’ or E and the theory will predict the change in g, and the rest, as
they say, is evolution. To repeat, fitness is not a determining attribute of anything,
it is a determined consequence of variety and selection. This is why the market
context is so important. Markets co-ordinate the behaviour of the different business
units, and it is in market contexts that interaction takes place and economic fitness is
determined.
Now all this provides an important bridge between economic and management
perspectives on evolution. From an economic viewpoint, interaction and differential
growth of activities are the defining features of competition. But to be able to
interact, the business unit must be able to replicate, to copy its routines over time.
From a managerial viewpoint this treats the activities from a different perspective, in
terms of the underlying capabilities or competencies and the way in which those
capabilities change. Both perspectives are important to the evolutionary approach.
Finally, let me comment on a further aspect of the fitness debate, centred around
the so-called propensity interpretation of fitness (Mills and Beatty, 1979; Sober,
1984; Brandon, 1990). In many ways economists will be familiar with the general
theme of this debate, which is akin to the distinction between ex post and ex ante
conditions. On this reading the economic fitness of the business unit is an ex ante
concept. It relates to the expected rate of expansion. Realized expansion, the ex post
consequence of interaction in product and factor markets, can be quite different
from what was expected. Thus recorded fitness is some blend of the expected and the
unexpected, the combination of selection with interfering forces. Interference may
come from changes in the environment or from fluctuations in the behaviour of the
business units and to the extent that it is non-systematic it gives rise to random drift
in the population frequencies. One way to look at this is to say that fitness has short
term and long term components. In what follows, I am solely concerned with the

long run perspective, sustainable fitness, while recognizing that short term fitness
may deviate significantly from long run values. All this connects with environmental
turbulence and the impossibility of predicting future states of the world with any
degree of exactitude. Originally intended as an escape from the tautology claim, I
suggest that the distinction between systematic and non-systematic forces is not vital
to our present understanding of differential growth.25 Consequently, I ignore stochastic
effects from now on. In what follows, economic fitness means rate of expansion of
activity, a rate of growth, and it is caused by the interaction between business units
competing for customers and factor inputs in populations defined by common
market pressures.
To summarize this brief survey of evolutionary concepts, the units of selection
are the transformation processes (bundles of technological and organizational routines)
identified with individual business units. The behaviours of these business units are
such that they involve replication and interaction. Thus, following Hull’s account,
we find that ‘the differential extinction and proliferation of interactors cause the
differential perpetuation of the relevant replicators’ (1988, p. 409).
Survival, adaption and adaptability
As we have developed the argument, the distinguishing feature of evolutionary theory

is the existence of variation of behaviour in a population. We need not ask where the
variation comes from in order to explain the dynamics of selection nor need we
allow the units of selection to change during selection. A canonical evolutionary
model is one with stasis at the individual level but change at the population level. On
the other hand, a deeper account must certainly encompass the sources of variety in
behaviour in the population, the stimuli and the constraints, and this brings us
briefly to the question of adaptability.
A consequence of selection is adaptation and it is often said that being fit also
means being adapted to the resulting environment. Good entities are well designed,
they have attributes which fit the environment and they satisfy a test of fitness for
purpose. A number of points need to be clarified here, not least of which is the
unfortunate tendency of using fitness to mean different things, on the one hand
differential growth, on the other hand differential survival.
To cope with these difficulties one must first distinguish between fitness as
differential growth and fitness as survival or between adaptation as process and
adaptation as outcome. Although we have dealt with the former in terms of changing
scales of activities in different business units, it is clear that a survival test must be
passed before differential growth is possible. However, survival of the business unit
is a separate question and involves different considerations from differential growth.
It is a question of viability: business units making negative profits usually do not

survive. Now this raises several complex issues, not least because there is not necessarily
a close link between economic viability and survival in the relevant population, at
least in the short term.
What are the rules for declaring a business unit non-viable and terminating its
activity? Clearly they are a vital aspect of the market institutional context in which
business units operate. What if the business unit has massed resources to fund its
operation even though currently unprofitable, and what if it is part of a firm prepared
to subsidize its activities from the profits of its other business units? What if the
government finds failure unacceptable and injects subsidies to maintain the activity
of loss making business units? Over what time horizon is survival of a marginal
business determined? Each of these questions raises relevant issues about adaptation,
by which I mean the survival of good business designs and the elimination of bad
designs. These issues are very much a part of the understanding of market processes.
Just as many new businesses are created in any month so many others fail. Thus the
criteria for adaptation play an important role in evolutionary arguments.
I have found Toulmin (1981) to be particularly helpful in clearing up some of the
confusion surrounding the notion of adaptation. An entity which is adapted has the
property of aptness; it is in a viable relationship with the demands of its environment.
In contrast, adaptability is about the potential to adjust to changing circumstances in
an appropriate way. As Toulmin points out, there are three basic mechanisms by
which an entity in a social science context can change to become better adapted. One
is calculation, the intentional response to the perception of circumstances; a second
is homeostatic, the following of specific rules in relation to target behaviours; and
yet a third is developmental, the cumulative unfolding of new behaviour patterns
within a specific set of constraints. Each of these is a viable way of being adaptable,
indeed they constitute multiple mechanisms for the design and modification of
behaviours. Theories of adaptability have also been termed instructive theories in
that the behaviour of the unit of selection varies as the signals (instructions) from
the environment change. The traditional, calculative economic theory of the firm is
of this nature. For example, in choosing how to produce from a given set of activity
options, the business unit is guided by its perception of relative factor prices.
Now none of this is a problem for evolutionary theory as long as adaptability is
differential. What would kill the evolutionary argument stone dead would be if all
units of selection adapted their behaviour in identical fashion to the appropriate
signals. Then we would have uniform agents, no variety and no evolution. Fortunately,
neither empirically nor conceptually are there grounds for believing that business
units adapt identically to perceived market pressures. They do not necessarily perceive
the same pressures nor do their theories of business lead them to interpret the
evidence in the same way. In part this relates to the limitation of Olympian rationality
and the corresponding relevance of bounded capabilities (Langlois and Robertson,
1995). Business units live in the same world but see different worlds; they do the best

they can to be rational in the intentional sense but their optimizations are at best
local, not global.26
More fundamentally, it is inherent to modern capitalism that firms seek competitive
advantage by trying to be different and by protecting the sources of differential
advantage from rivals for as long as they possibly can. Competition is not the passive
state depicted in the textbooks but an active process of rivalry in which differentiation
counts for everything. Being continually better than one’s rivals is the only route to
sustainably superior profitability, which in turn provides the link between competition
and the stimulus towards improvements in transformation processes. It is not only
differential adaptability which is important to the evolutionary argument but we
must also include limited adaptability, at least if selection is to play an important
part in the process of structural change. Again we find that evidence and conceptual
considerations lead us in this direction. Limitless adaptability is not a property of
any specialized organization such as a business unit.27
The domain of evolutionary logic
Before proceeding, one or two remarks are in order to assuage readers tempted to
think that the use of biological analogy is fundamentally inappropriate in economics
or any social science. Let them be assuaged. Nothing I have said is intrinsically a
matter of biological analogy, it is a matter of evolutionary logic. Evolutionary theory
is a manner of reasoning in its own right quite independently of the use made of it
by biologists. They simply got there first and, following Darwin’s inspired lead,
built arguments for dynamic change premised upon variety in behaviour in the
natural world. What matter are variety and selection not the natural world.
More to the point, in the economic world we are offered an immensely richer
basis to apply evolutionary concepts. The fact that rates of economic evolution are
extremely fast relative to many natural processes, combined with the fact that economic
behaviour is intentional and that it depends on anticipation and feeds off memory,
create a powerful basis for generating new varieties in behaviour. Indeed it is the
distinguishing feature of modern capitalism that what it capitalizes upon is this
infinite scope for the distributed and disaggregated generation of variety. Two
individuals faced with the same market information may claim to know differently
precisely because their different past experiences or different expectations lead them
to interpret that information differently.
Indeed, it is essential to the idea of individuality that we hold different theories
and interpret information through different distorting mirrors. Thus an evolutionary
approach to economic behaviour welcomes mistakes and errors, the differential
ignorance of individuals and their false hopes. All add to the source of variety and,
insofar as beliefs depend on past experience, they give rise to the possibility of path

dependence in economic processes. That individuals and organizational teams learn,
possess memory and imagine is a chief source of irreversibility in economic affairs
and of creativity in behaviour. This is precisely the dimension which gives to economic
and social evolution a limited Lamarkian character, as many have observed.28 Macro
consequences emerge as the consequence of the market co-ordination of micro variety
and while we can always measure at the macro level we can only understand economic
change as a micro driven phenomenon.
Less clear-cut is the fact that selection environment and unit of selection are not
always so easily separated. Business units quite understandably wish to bias selection
environments in their favour: influencing the regulation of markets, defining
standards, lobbying for tariffs or other privileges are all part of the political economy
of business. They inevitably blur the distinction between environments and selective
units, but they do not destroy the distinction. I consider that these complications
greatly expand the scope for evolutionary thinking in economics, and provide a
framework in which policy in relation to competition, science and technology and
innovation has a clear role.29 It is well known, for example, that many, if not the
majority, of anti-competitive practices reduce to attempts to bias the operation of
market selection processes in favour of a particular firm or group of firms.
In understanding evolution the fundamental point to grasp is that it is concerned
with changes in the frequency of competing patterns of behaviour. All behaviours
are significant and merit attention but not all behaviours are of equal standing. What
then signifies standing and how does a particular pattern of behaviour acquire standing?
To answer these questions we have to give close attention to what is meant by variety
in behaviour, how that variety is to be measured, and how that variety is to be
connected with patterns of structural change. It follows that an evolutionary explanation
is quite different in kind from an explanation based upon the concept of a
representative agent, that is a class of agents with uniform behaviour. In such an
essentialist world change can only be defined in terms of changes in the representative
agent and if they are to remain identical and representative, then all must change in
identically the same fashion. Hence representative agent thinking precludes any
consideration of structural change or innovation as it is normally understood.
Innovation is a matter of differential behaviour, and differential behaviour is the
basis for structural change.30
It may now be clear why evolutionary economists have found so much inspiration
in Schumpeter’s writing. For he was describing economic worlds of continual structural
change, driven from within by entrepreneurs introducing new (different)
combinations from those already in use. Acts of entrepreneurship meant differential
behaviour in the form of localized technological change the consequences of which
spread throughout the economic system, and much of Schumpeterian theory is
about the rate determining processes which govern the speed with which innovations
are absorbed into the system. Nothing to do with biology, but everything to do

with evolution. In short, Schumpeter combined two kinds of change: transformational
change as entrepreneurs brought innovations into effect and, variational change as
market processes selected between the competing innovations.
For some it mattered: making the connection
As a bridge to the more formal content of the next two lectures I shall dwell briefly
on the contribution of a number of economists who have made the connection
between economics and evolution. In a delightful pair of essays Mary Morgan (1994,
1995) has unravelled the relationship between the thought of leading American
economists of the turn of the century and evolutionary ideas about competition. As
she recounts the relationship, the emphasis was upon competition as a dynamic
process, ‘they wanted to understand why firms grew, why monopoly and oligopoly
formed, and why the industrial structure in an industry switched between competition
and various forms of monopoly’ (1994, p.330). However, their use of evolutionary
concepts ultimately failed to be selected within mainstream economics, not least
because they lacked clear theoretical equivalents to notions such as variety, fitness and
adaptation. Moreover, in the first third of this century Darwinism was in decline,
the intellectual climate was simply out of tune with the evolutionary metaphor.
The period since 1950 has witnessed the resurgence of the evolutionary framework.
First came Alchian’s (1951) controversial paper arguing that predictions in economics
arise not from the detailed knowledge of individual behaviours, but from an
understanding of selection processes which resolve behaviours into predictable patterns
of aggregate response to change in the market environment. Almost simultaneously
Joseph Steindl (1952) published a remarkable book which focused upon the empirical
evidence concerning wide cost differences between firms and the consequences for
the competitive process. Cost differences meant profitability differences and a dynamic
of accumulation in which ‘superior’ firms gradually pushed ‘inferior’ counterparts
into marginality and bankruptcy.
No less remarkable was the pathbreaking, highly original book by Downie (1958)
with its joining together of the dynamics of selection, which he termed the transfer
process, and the dynamics of innovation. Central to his argument is how differences
in efficiency are translated into differential fitness, growth rates, and a changing
population structure. Innovation is presented as the only effective counter to the
concentrating effects of competition and, like many others, Downie articulates a
pressure theory of innovation – innovations as the response to economic decline.
Others have explored Downie’s contribution in depth (Devine et al., 1985;
Nightingale, 1996). I suggest that he must be considered one of the principal
contributors to the evolutionary connection. In all these contributions we find a

common thread in which differential behaviour gives rise to differential economic
rents, rents which are then the basis for the differential accumulation of tangible and
intangible assets (Itami, 1987).
No account of modern evolutionary economics can fail to relate to the authoritative
and original work of Nelson and Winter (1984). It is they who provided the catalyst
for the subsequent flowering of work in the area: the emphasis on routines, non-
maximizing behaviour and the individuality of firms, the central role of markets as
selection processes, and the resort to the computational simulation of evolutionary
models has defined the new paradigm framework for many. Dosi et al. (1988), Hodgson
(1993), Witt (1993), Eliasson (1985, 1996) and Anderson (1994) are among the many
who have followed the Nelson–Winter line. So shall I, in the spirit of clarifying how
market co-ordination resolves behavioural variety into economic change.

2
FISHER’S PRINCIPLE AND THE

PROCESS OF COMPETITION
The essential point to grasp is that in dealing with capitalism we are dealing
with an evolutionary process.
Capitalism then is by nature a form or method of economic change and not

only never is but never can be stationary.
(Schumpeter, 1943, p. 82)
In this second lecture I intend to deal with a single theme, the nature of competition
interpreted as an evolutionary selection process. Our first task will be to investigate
how the dynamic consequences of differential behaviour can be analysed in some
simple cases. We shall build on the evolutionary concepts outlined in the first lecture,
population thinking, differential fitness and adaptation but in an explicitly economic
context. The third lecture will introduce a number of complications into the
competitive process, including product differentiation and the entry of new firms.
The conclusion of our first lecture was that evolutionary competition is active
when the relative frequency of various entities in a population is changing under the
influence of an explicit selection process.1 Structural change is inseparable from this
view of competition, as Schumpeter put it:
Industrial change is never harmonious advance with all elements of the system
actually moving, or tending to move, in step. At any given time, some industries
move on, others stay behind; and the discrepancies arising from this are an
essential element in the structures which develop.
(1939, pp. 101–102)
What is true between industries applies a fortiori within industries, as we discussed

briefly in the prologue to the lectures.
The other side of structural change is, of course, differential growth and thus an
economic explanation of evolution is an explanation of why growth rates differ.
Evolutionary theory of this kind is inescapably dynamic, and provides a conceptual
bridge between the concern of the classical economists with growth and change and
the concern of Austrian economists with order and change of order.2

Following the line in the first lecture, I take the unit of selection to be a business
unit producing a particular product. Each business unit articulates a particular and
different transformation process. However, all the transformation processes result in
an identical product. Since each firm (business unit) is a single product firm, the
shares of each firm’s product in the total output of the population of competitors
can be used to describe the structure of the population at each point in time. By
structural change we shall mean changes in these market shares, the economic weights
of the different firms. In this case the measurement of economic weight is
straightforward, which it is not in some of the cases considered in the third lecture;
one thing at a time.
SOME SIMPLE ARITHMETIC OF POPULATION EVOLUTION:

ENTRY, EXIT AND SELECTION
A population evolves as the relative frequencies of the entities of which it is composed

change in response to differential fitness. How are the changes in frequency to be
accounted for? Or, to put it more formally, what are the transition laws for the
population? (Witt, 1996). In answering this question we have to distinguish carefully
between changes in the number of entities due to birth and death processes and
changes in the relative rate of activity of the existing entities. In terms of our current
concern this reduces to three issues: entry of new business units, the exit of existing
ones when they fail a viability test, and the differential growth of the established,
surviving business units.
Consider the events which occur between two census dates t and t + ∆t, and at the
same time take a deep breath. To get the right answer we need to pay close attention
to the details of entry and exit. At date t a total of k business units are operating,
while at t + ∆t there are k' where k' = k + new entrants–exits. However, the accounting
we adopt is not with respect to changes in the number of firms but rather it is with
respect to the associated changes in flows of output. The entrants over the period t +
∆t are easily handled. We label their contribution to output, indexed at census date
t + ∆t, by N(t + ∆t). Let ‘n’ be the ratio of the output of the new entrants to total
output, X(t + ∆t) at the second date. It is with respect to the surviving and exiting
firms that we have to tread carefully, since, in general, the firms which exit at some
point before the second census date also contribute to the output within the period
∆t. The way we proceed is to partition the output flow X(t) into two, one portion
being the output produced by the businesses ‘alive’ at the two census dates, the
remaining portion being that produced by firms which leave the industry during
the interval ∆t. Let e be the fraction of output flow X(t) produced by the firms which
subsequently exit between the two census dates, let ge be the aggregate output growth
rate associated with these firms, and let gs be the aggregate output growth rate of the
survivors. Then, the aggregate output at the second date can be written as

X(t + ∆t) = X(t)[(1 – e)(1 + gs) + e(1 + ge)] + nX(t + ∆t)
That is to say, total output is the sum of three distinct flows of production: that
produced by the survivors; that produced by the firms which exit the industry
between the two census dates; and that produced by the new entrants between those
same census dates.
If g is now defined as the growth of total output between the two census dates, we
can write X(t + ∆t) = (1 + g)X(t), and it follows that our various proportions and
growth rates are related by
(1 – n)(1 + g) = (1 + gs) + e(ge – gs)
We call ‘n’ the entry rate and ‘e’ the exit rate, remembering that they are appropriately
defined fractions of output at the two dates.3 A very convenient simplification is to
assume from now onwards that all exits occur at the beginning of a census period so
that these firms make no contribution to aggregate output of the period. This
implies that ge = -1 and our relation simplifies to
The growth rate of the survivors exceeds or falls short of the aggregate growth rate of
the population as the exit rate exceeds or falls short of the entry rate.
Now consider how the relative frequencies in the population change in response
to differential fitness, entry and exit. For any one of the surviving firms we define
the frequencies as market shares si(t) = xi(t)/X(t) and si(t + ∆t) = xi(t + ∆t)/X(t + ∆t)
hence,4
This immediately yields the standard replicator equation for the change in frequencies,
However, g is not the same as the aggregate growth rate of the surviving firms
precisely because of the entry and exit of businesses in the population. Taking account
of this, and assuming that all exits occur at the beginning of the census period, we
can also express the change in frequencies as

From this we see that the differential growth of a business relates to changes in its
market share in two ways. If gi>gs, the business is increasing its share in the output of
the cohort of surviving firms and conversely if gi<gs. If gi>g, the business is increasing
its share in total population output and conversely if gi<g. It is clearly possible for a
business to be increasing its market share on the first definition while its share
according to the second definition is declining.
If we now let the interval ∆t shrink to zero and redefine the growth rates as
exponential rather than compound rates we obtain the continuous time replicator
equation
New entrants capture market share at the instantaneous rate n, failing firms lose share
at rate e and continuing firms gain share at rate g – g.
i
It follows from the above account that economic fitness, as we have defined it, is
only one of the elements which shapes the evolution of population structure; entry
and viability, or rather the lack of viability, must also be given their due weight.
Indeed we have a wealth of evidence on the role of entry and exit in the competitive
process. Mayes (1996) and colleagues have established the considerable degree of
‘churning’ which takes place at enterprise level across UK manufacturing sectors, and
how the net balance of entry and exit varies over the business cycle. They also establish
that entrants tend to have higher productivity and exits have lower productivity
than the average in a sector. Industry case studies provide further evidence on the
importance of entry and exit processes. Both population ecology analysis (Hannan
and Freeman, 1989) and industry life cycle analysis (Klepper, 1996; Utterback, 1995)
find strong evidence for high entry rates in the early days of an industry followed by
a period of intensive exit and then relative stability as entry and exit rates decline to
low and comparable values. But this is as far as I want to go in this especially important
matter. I will deal with exit below and bring entry back in Lecture 3 but for the
moment we are going to focus on a population in which entry and exit are absent.
Consequently, all frequency changes are governed by the simple replicator system in
continuous time
which is fundamental to all that follows. It embodies the crucial ‘distance from mean’
principle, in which the relative frequency of a business unit changes according to the
economic fitness of that business relative to the average economic fitness of all the
business units in the population.

THE GROWTH OF THE BUSINESS UNIT
This takes us directly to the theory of the growth and decline of firms and the central
point of this lecture, that patterns of evolutionary change depend upon the way in
which the population is co-ordinated. Co-ordination governs interaction, interaction
governs economic fitness and economic fitness governs economic change. For reasons
explored in more detail in the first lecture we shall treat the firm as a bundle of
interacting routines for decision making following the lead given by Nelson and
Winter (1984). The nature of this bundle gives the firm its distinct identity and how
this bundle is designed and implemented reflects a process of evolution within the
firm. These routines apply at many different levels and to many different aspects of
the firm’s behaviour and they are the embodiment of what the firm knows about
itself and its objectives. For the moment it will be sufficient to divide the sets of
routines into three broad groups. First, routines which are concerned directly with
the process of transformation and which determine the nature of the product and
the efficiency with which it is produced. This group of routines is as much to do
with matters of organization as it is with matters of technology. Second, routines
which concern the rate at which the firm increases its scale of production: routines
linking together matters of finance and investment policy. Finally, there are routines
concerned with organization and technological innovation: routines which change
existing transformation processes or add new transformation processes to the firm’s
activities. We will label these routines: the production routines, the accumulation
routines and the innovation routines respectively.
We shall not consider at this stage whether the routines in any one firm satisfy
well-defined optimality criteria. Whether they do or do not is ultimately an empirical
question, but it is apparent that each routine must give the firm control of an aspect
of its operations and provide the information to establish the efficacy of that control.5
This suggests, as a matter of comparative information advantage, that the routines
will predominantly reflect reliable information, that is to say, information internal
to the firm, the information which is most comprehensive or least subject to conjecture.
We would not be surprised to find routines whose information base relates to the
cost of production, to the cost of expansion and to the state of order books in
relation to current levels of production and capacity. All this information is immediately
available to the firm’s decision makers. It does not depend, please note, upon the
answers to hypothetical questions. Less available is information in relation to the
market environment and the actions of competitors. Prices may be known, but even
a basic statistic such as the firm’s market share may not be well defined.6 The total size
of the market may be unclear as may the number of active competitors. Thus we will
imagine that a firm’s principal routines are related to information which it generates
internally in relation to actual activities.

With these observations in mind let us turn to a more explicit theory of the firm.
The first point about our firm is that it and no-one else sets the price for its product.
What this price is depends upon the interaction between three sets of considerations:
the cost structure of the firm; the limitations set by the market environment and the
pricing behaviour of rival firms and the objectives of the firm. As with any sensible
account of pricing behaviour we are led to a mark-up theory of pricing in which the
mark-up is not rigid but is a function of well-defined circumstances. We will begin
by assuming that there are no limits from technology or organization to the size of
the firm. As a first step we also assume that unit costs do not vary with the scale of
production. Similarly we will follow tradition, perhaps unwisely, and assume that the
behaviour of the firm is independent of its age.7
While there are no limits to the size of the firm we cannot assume that there are
no limits to the rate of expansion of the firm. In fact we can identify five specific
kinds of limitation to growth: in relation to the ability to purchase inputs and sell
output as determined by the growth of the relevant market environments; in relation
to the availability of internal and external finance to expand capacity; in relation to
the managerial implications of growth for the ability to control costs (Penrose,
1959); in relation to the growth of rival firms and thus the specific market of the
firm; and in relation to the ability to imagine and articulate growth opportunities.
All of these elements come together to determine what we called in the previous
lecture the economic fitness of the firm. Let us see how.
AN ELEMENTARY MODEL OF SELECTION
The kind of theory I explore is widely employed in the evolutionary literature as a

basis for constructing computable models to simulate evolutionary competition.
Computability is required because of the complexity of the model structures (sets of
non-linear differential equations) and the role of stochastic processes in producing
‘noisy’ variety on which selection can act. This is a line of modelling pioneered by
Nelson and Winter and extended imaginatively by, among others, Witt (1986),
Silverberg et al. (1988), Silverberg and Lehnert (1993), Silverberg and Verspagen
(1996), Anderson (1994), Saviotti and Mani (1996) and Kwasnicki (1994), each one
providing ample testimony to the richness of the evolutionary method. Yet the
details of these models are often difficult to unravel and so my aim here is to write
down the simplest version which serves to capture the evolutionary metaphor in full,
and also allows us to build bridges with established parts of the non-evolutionary
economic literature.
We first specify cost conditions in a given firm, remembering that all firms
produce the same commodity but do so using different constant returns to scale
transformation processes. We may imagine that the methods reflect different firm-
specific innovation histories. Suppose there are only two inputs, labour and a machine,

with the amounts of each required to produce a unit of the commodity being ai and
ci respectively in the ith firm. If all firms pay the same wage for labour (w) and price
for machines (pc ) and follow the same conventions with respect to capital charges we
can write unit cost of production at full capacity operation as hi = wai + (r + d)pc ci.8
This figure we call normal unit cost. The normal unit profit margin, mi , is simply the
difference, pi – hi. between the price the business sets and receives for its product and
its normal unit costs. This margin bears a determinate relationship to the rate of
expansion of the firm’s capacity, gi, in the following way, gi = fimi. In this expression
fi ,the propensity to accumulate reflects all the accumulation routines which impinge
upon investment and the finance thereof. It is derived as follows. Let πi be the
fraction of profits retained for expansion and ∈i be the amount of external funding
expressed as a fraction of internal finance. Moreover, choose units so that the price
of machines is unity,9 then we can write
(1)
Thus the propensity to accumulate is inversely related to the capital:output ratio and
positively related to the financial parameters πi and ∈i. This way of expressing the
matter reflects the fact that internal finance is a principal source of funds for growth,
without closing off the equally significant fact that the capital can also be raised on
the market. For well known reasons related to the distribution of information such
capital markets are not perfect. We shall return to this below in Lecture 3 when we
allow the firms to differ in their propensities to accumulate.
Provided the firm does not make losses, pi≥hi , we assume that it survives and
continues to produce whatever amount will satisfy the demand for its output. Provided
the firm makes positive profits it expands capacity according to (1), which summarizes
our understanding of the economic fitness of the firm to this point.
Now we must make an explicit decision to focus attention on only one of the
possible dimensions of behaviour in which our firm can vary relative to another,
leaving cases of multiple variation to the third lecture. An obvious candidate is to let
the firms vary in their labour requirements, ai , variations which translate into
corresponding differences in unit costs, hi. There are no other relevant differences
and with the propensity to accumulate the same for each firm we can write (1) as
gi = f[pi – hi], pi>hi

gi = 0, pi≥hi (1)'
Hence our selection process is driven by variation across the population in one
attribute of firm behaviour: differences in labour efficiency. The factors which

underpin the inter-firm differences in unit costs do not concern us here; we take
them as given, they are the fuel which drives change at the population level.
Notice that a consequence of (1)' is to partition the population of firms into
mutually exclusive groups: those which are bankrupt and out of the industry pi<hi;
those which are on the margin of survival but not expanding capacity, pi = hi; and
those which are profitable and expanding their capacity, pi>hi. We call this last group
the dynamic firms and the second group the marginal firms. Notice also how (1)' is
a variant of the classical savings hypothesis that there is a proportional relationship
between the rate of profitability and the rate of accumulation, in this case, operating
at the level of the firm (Pasinetti, 1981; Leon, 1967).10
We now take two further steps. The first is to confine our discussion of (1)' to
normal situations in which the rate of expansion of capacity in the dynamic firms is
the same as the rate of expansion of output, all manner of kinds of market turbulence
are for the moment set aside. Dynamic firms operate at full capacity while marginal
firms generally operate with surplus capacity and in that sense are always in a Marshallian
short period situation (Kahn, 1989). The second step is to treat the propensity to
accumulate as independently given, determined by the appropriate set of decision
routines in the firm, in which case (1)' becomes an explicit relation between growth
rate and unit profit margin, that is between the growth rate and the price set by the
firm for any given level of unit cost.
Before looking at price setting in more detail let us explore some aspects of
competitive selection in terms of the growth rates as defined. The aggregate growth
rate of output of all the surviving firms in the population, g, the average of the
output growth rate of dynamic firms gs and the average of the output growth rates of
marginal firms gm are related by g = (1 – α)gs + αgm; a being the share of marginal
firms in total output. At this point, and only as a first step, it is convenient to
proceed as if there are no marginal firms, α = 0, whence g = gs = Σsi gi , si being the
market share or economic weight of firm i’s output in total output. Whenever there
are differences in growth rates the structure of this market is changing and the
measure of the change in structure is to be found in the changes in the market share
of the different firms. Clearly, a firm’s market share is rising or falling as its growth
rate (the analogue to its fitness) exceeds or falls short of average growth in the
population. Thus we have our replicator principle
(2)
A replicator dynamic, of which (2) is a transparently simple version, is at the core of

any model of evolutionary change. Moreover, we can see immediately how the pattern
of change depends directly on variety in behaviour. What makes this approach
evolutionary is that the growth rates are mutually determined in the presence of a

common selection environment. Differential growth per se is only part of the
requirement; what is also needed is the endogeneity of the growth rate differences.
This, as we explained previously, is the distinction between sorting and selection. An
alternative way to interpret (2) is that it represents the transition law for a multi-
innovation diffusion process, each (process) innovation being associated with a
particular growth rate of its parent business unit.
PRICES AND COSTS
It should now be clear that price setting behaviour is crucial to the evolutionary
dynamic by virtue of the relationship between growth rates and profit margins. We
shall take this connection in two stages.
The first is to consider the market environment of the firm and the factors which
determine the rate of growth of demand for its output, and here we follow an idea
presented in Phelps and Winter (1970). At each point in time each firm has a group
of customers, its customer base, the size of which, measured in terms of units of
product, is growing at a given exogenous rate, for the moment treated as the same
for all groups of customers. At each point in time customers interact at random,
compare prices and switch to a cheaper firm (when they find one) at a rate measured
by a coefficient δij for customers of any pair of firms, i, j. If interactions between
customers of any two firms are taken as proportional to the product of their relative
market shares then the net rate of movement of customers between the two firms may
be taken as δij si sj(pj – pi).The rate coefficient δij we can take to be a measure of the
barriers to switching, of customer loyalty of the dispersal of knowledge of rival
offers or whatever. The set of rate coefficients we can take as a reflection of the
institutional structure of the market or, if one wishes, of the imperfection of the
market arrangements. Of course, it remains the firms who set prices; markets do not
set prices, their role is to constrain price setting behaviour by virtue of the degree to
which the rival offers are widely distributed knowledge. Finally, let these rate coefficients
be the same for all possible customers, equivalent to saying that the market is not
segmented, we can then aggregate across all firms to find the rate of growth of
demand for each firm,11
gDi = gD + δ[ps – pi] (3)
where ps = Σsi pi, is the average market price and gD is the common rate of growth of
the demand of each of the groups of customers. This relationship is of some appeal
because it relates diversity in demand growth to diversity in the pattern of prices
around the average market price. Notice that the condition Σsi gDi = gD is an important
test of the validity of this mechanism: (3), when summed across the firms, cannot
give an average growth rate of demand different from the market growth rate gD . The

demand selection coefficient δ will play an important role in what follows because it
encapsulates the idea of the degree of imperfection of the market environment. If δ
is high, because consumer interaction is high and there are few barriers to switching,
then the dispersion of prices is correspondingly reduced simply because information
is transmitted more quickly across groups of customers, and they respond rapidly.
The limit, δ = ∞, produces the analogue of a perfect market with uniform prices: any
firm charging more than the going rate loses its entire market instantaneously. The
other end of the spectrum, δ = 0, corresponds to a population of isolated monopolies
with customers locked into their existing supplier and not responding to more
competitive price offers from other firms. In between are all the shades of an imperfect
market, due to geographical separation, market institutions, differences in tastes or
pure inertia. Treating the overall growth rate of the market as a given is an enormous
simplification but not, I believe, a crucial one. One could develop an explanation of
gD as a response to the creation of a new market (Metcalfe, 1981; Mahajan and Peterson,
1985; Antonelli et al., 1992) in relation to income elasticities of demand (Pasinetti,
1981), in relation to product life-cycle theory or, more significantly, in terms of a
competitive selection process between rival industries. All of this must remain
unfinished business as far as these lectures are concerned.
Thus far we have established a role for demand and the market environment in
putting constraints on how the prices set by one firm may differ from those set by
its rivals. We have still not established a theory of price setting until we specify the
objectives of the firm. For reasons which we discuss later in Lecture 3 we do not
begin with the postulate that a firm’s decision makers maximize anything, we simply
assume that they have price setting rules which are governed by two considerations,
the survival of the firm and its normal growth. The first condition implies nothing
more than that it will not set prices to produce at a loss, while the second implies that
it will maintain a balance between capacity and the scale of its market. To be precise
we explore what is implied if a firm sets prices so that over time its capacity increases
exactly in line with its specific market. These prices we call normal prices. The firm
posts prices and produces to order. The firm does not pass up profit opportunities
in so far as it seeks to avoid excess order books or excess capacity. Putting it differently,
these are the prices which ensure a balanced expansion of the firm. Of course, the
firm always has precise information on how its current sales stand in relation to its
existing capacity and, while it strains credulity to imagine that it will always get the
balance right, we can reasonably assume that it manages this balancing task over the
long run, so that outcome is in line with expectation. Indeed to assume otherwise
would be to deny that it is profit seeking, which is far stronger than denying that it
is profit maximizing. We return to this matter again in the discussion of market
turbulence below, but for the moment let us keep with the strong hypothesis of
balanced expansion.

The upshot is that there is now a specific link between pricing behaviour and the
economic fitness of the firm. The firm sets its prices to finance the rate of growth
implicit in balanced expansion. What the rate is depends upon the propensity to
accumulate and the prices set by rival firms in the particular market environment. A
price set too high will result in capacity growing faster than demand; a price set too
low will result in an ever extending list of unfilled orders. The balanced price co-
ordinates the firm in relation to its specific market. Hence we require that gi = gDi .
Aggregating across all the dynamic firms we find that gs = gD because shares in total
demand are the same as shares in total capacity in these normal conditions. In short,
the market is also co-ordinated in the aggregate sense when normal prices are set.
IMPLICATIONS OF NORMAL PRICE BEHAVIOUR
Now if we combine (1)’ and (3) we can immediately obtain the normal price for any
firm and it is given by
(4)
We recognize this as a typical mark-up pricing formula, in which one element depends
on the market growth rate and the other is a weighted average of hi and ps. However,
the mark-up is not rigid, nor is it the same for each firm. The price which a firm
posts is greater the greater is the aggregate market growth rate, the greater are its own
unit costs and the greater is the average price in the industry. There is interdependence
of all pricing decisions unless δ = 0 when each firm is an isolated monopoly. To
establish the average price we sum (4) across all firms using the market share weights
to obtain
(5)
where hs = Σsi hi is defined as average practice unit costs for the population of dynamic
firms. It follows that the average mark-up is a constant equal to the growth rate of the
market divided by the propensity to accumulate. This gives us the direct link we
require between average rates of profit and average rates of growth in line with the
classical theory of growth and distribution. The propensity to accumulate, in reflecting
financial conditions, is dependent on the ‘savings’ relationship appropriate to the
industry.12 Notice that this link does not depend on the degree of perfection of the
market. Thus we have the entirely familiar conclusion that faster market growth
implies higher average profitability within the industry (population of firms) and,
comparing firms, those which grow more rapidly have higher rates of profit (Leon,
1967).
By eliminating the average market price from (4) we obtain

(6)
and the corresponding margin on sales
(7)
In (7) we have the first indication of our central evolutionary thread: how the
performance of any firm, as reflected in its margin on sales, is related to where it
stands relative to average behaviour in the population as a whole. One immediate
consequence of this is that we can say more about the various other statistical moments
of the distribution of behaviour in the population. Since we know how average
market prices relate to average unit costs we can immediately establish how their
weighted variances are related, thus,
where Vs (h) = Σsi(hi – hs)2 is the population variance in unit costs. Similarly
We could say that the variance in prices and margins is caused by the variance in unit
costs, together with the propensity to accumulate and the degree of imperfection of
the market. Clearly, in a perfect market, the variance of prices is zero and the variance
in margins is equal to the variance in unit costs. We should note that in constructing
these variances we have been careful to weight each element by its appropriate market
share. The question of the appropriate weights to use when constructing measures of
variation will occupy us further in more complex cases. Notice also that these measures
of variation depend upon the way in which the firms have been co-ordinated in
their market environment. Different rules of co-ordination will imply different
relationships between the moments of the population distribution. Notice also that
none of these relationships depend on the growth rate, a simple reflection of constant
returns to scale at the level of the firm.
PRICES AND MARKET POWER 13
It is worthwhile now treating some traditional questions concerning pricing behaviour

and we first consider what might be meant by market power in this framework. One

way to approach this is to say that the firm has market power to the extent that it can
pass on its own cost increases to its customers or equivalently, reap the benefit of
lower costs through more competitive prices. From (6) we see that
In this precise sense a firm’s market power depends upon and increases with its
market share. Only if it is a monopoly (either δ = 0 or si = 1) can it pass on a cost
increase in an equal price increase. In all other cases it is constrained by the competition
of rivals and this constraint becomes tighter the more perfect is the market. However,
even in a perfect market there is some scope to increase prices, to a degree which is
exactly proportional to the firm’s market share. Only as this share tends to zero, as in
the traditional case of atomistic competition, does this market power evaporate. The
converse side of the argument is that when costs in a rival firm increase this results in
a higher normal price for all the other firms to a degree which depends upon the
market share of that more costly firm. Thus, from (6) again
Consequently, it is only when unit costs in all firms increase by the same degree that
all prices increase pro rata to maintain a constant margin in each firm.
Another traditional industrial organization question concerns the relationship
between market power and the ability to set prices above unit costs and here the
natural question to pose concerns the effect of an increase in one firm’s market share
on the price it sets in balanced conditions. From (5) it is clear that any effect is
transmitted via the effect of a redistribution of market shares upon average practice
unit costs and the average market price. This is not a simple matter to deal with, for
if the share of firm i is increased so the share of at least one other firm must be
reduced pro rata. To clarify the general case, suppose that the offsetting reduction in
shares is born equiproportionately by all other firms.14 Then we can write average
practice unit cost as hs = (si)hi + (1 – si)h's, where h's is average practice unit cost for the
remaining firms, which will not change as we redistribute shares. It follows that
This is not perhaps a result which would be anticipated. The relationship between a
firm’s market share and its price depends on where that firm’s unit costs stand

relative to the industry average. If the firm is more efficient than average its price is
lower for a higher market share, and conversely if it is less efficient than average.
Thus, interdependence of pricing decisions means that there is no simple relation
between changes in market shares and the pattern of prices in the industry. As we
shall see below, this relationship also means that the normal, balanced prices of all
firms fall over time in the competitive process.
Finally, taking structure as given what effect does an increase in the degree of
perfection of the market have upon balanced prices? Again from (6).
which is again a result not entirely anticipated. If the market is more perfect, ceteris
paribus, so balanced prices are higher for firms which are more efficient than average
and lower for firms which are less efficient than average. Since the change in the
degree of perfection does not change the average price this can only mean that the
variance of prices is lower as a result. In short a stronger selection environment, a
more perfect market, increases prices and margins of more efficient firms and reduces
the same in less efficient firms while reducing the overall dispersion of prices. As we
shall see below this is tantamount to speeding up the competitive process.
I am reluctant to try the reader’s patience further but it is worth taking one last
step. I have stressed the interdependence of pricing which arises from the co-ordination
of output over time in our market environment. Now one of the standard exercises
in the theory of industrial organization is to analyse pricing policy in a duopoly, an
exercise which has close links with non-co-operative game theory (Tirole, 1989).
Consider, therefore, a situation where the competing population consists of just two
dynamic firms, of which firm one has the lower unit costs. The price set by firm one
can be expressed in terms of the price set by firm two as follows
with a similar expression holding for firm two. A higher price set by the rival
implies a higher normal price in the other firm; prices are strategic complements. It
is important to emphasize that the relationships between the prices do not require
each firm to take a view of its rival’s pricing behaviour, rather they simply follow
from the assumptions implied by (1)' and (3). Each firm’s balancing of capacity
growth with demand growth produces this result and the clearcut interdependence
of action. Figure 2.1a sketches the relationship implied by the price equations, with
the lines labelled P1 for firm one and P2 for firm two. Point ‘a’ is the analogue of a
Nash equilibrium, firm one setting price Ob and firm two price Oc. If both firms
behave so as to establish this price pattern, there will be no tendency for either to
deviate from this point, given their prevailing market shares. This pattern of normal

Figure 2.1 Strategic interdependence of pricing
prices depends upon the growth rate of the market, the levels of unit costs and the
current pattern of market shares. In an obvious sense, market structure matters.
Passing through point ‘a’ is the line p – p, the slope of which measures the relative
market share, s1 /s2 .Where this locus cuts the 45o line defines the average market price
p's (point d), with Ob<ps<Oc as is required by the assumed ranking of unit costs h1<h 2.
Figure 2.1a also allows us to clarify the meaning of market power in terms of the
relative dominance of a firm in the price setting process. Consider what happens as
we increase the market share of firm one and let it tend towards unity. Then the line
P1 becomes steeper and is vertical when s1 = 1, indicating that any change in P2 has an
increasingly smaller effect on the normal price for firm one. The reason, of course, is
that the price set by firm two has a lower weight in defining the average market price
and thus a lower influence on the price setting behaviour of firm one. Conversely, as
the market share of firm one increases so the influence it has on the price set by firm
two increases to a maximum. As the limit is reached, firm one determines the price
set by firm two without any feedback. This seems a natural consequence of defining
market dominance in terms of market shares, as any manager, let alone competition
authority, would normally do. Of course, all these results depend on an imperfect
market. If the market is perfect, then the schedules P1 and P2 necessarily coincide with
the 45o line through the origin.15 In the converse case of isolated monopolies, each
firm sets a price independently of the other and the loci P1 and P2 intersect at a right
angle.
Now, the pattern of co-ordination indicated by a point such as ‘a’ is a transient
affair. As the competitive process exerts its influence so all the schedules in Figure
2.1a shift in such a way that point ‘a’ is displaced in a south-westerly direction. At

what rate these prices change depends upon the dynamics of competition. By solving,
for the equilibrium balanced prices, we can establish that all points like ‘a’ must lie
on the locus B — B in Figure 2.1b, this locus being parallel to the 45o line. Hence
with h1<h2 it follows that P1 falls relative to P2 throughout the competitive process.16
Before turning to the dynamics of competition in more detail, some comments on
the relation between the above analysis and the existing literature on price setting
behaviour are in order.
KALDOR, KALECKI AND WOOD
Kaldor
Our heading names the three economists who, along with Downie and Steindl,
treated previously, have produced theories of pricing which bear comment in relation
to our approach. Kaldor’s last book, Economics without Equilibrium, contains a great
deal which is of relevance to our pricing theme. There he has a firm set prices
between conflicting constraints; to set them low to increase its share of the market or
to set them high to finance its accumulation of capacity subject to a constant retention
ratio and an amount of external finance complementary to internal finance.17 These
opposing considerations determine the requisite pricing policy. The mark-up is
determined but it is not rigid and it is not determined by the famous Lerner
elasticity formula.18 Not only are firms ignorant about their demand curves (my
emphasis) but a market demand curve is not defined unless all other prices are given
or are the same. As I have shown above, interdependence rules out the first and
variety in behaviour, cost behaviour in this case, the second. Thus our account of
balanced pricing is perfectly compatible with Kaldor’s views about firms setting
prices in imperfect markets subject to the constraints set by the behaviour of rival
firms.
Kalecki
No discussion of price setting behaviour can avoid some reference to Kalecki’s

([1943] 1971) pioneering work on mark-up pricing. Note first an important difference
with our treatment. Kalecki’s is a short run theory, his firms are operating with spare
capacity and there is no reference at all to the requirement for margins to finance
investment. Prices are set by firms in imperfect market settings and yet his price
formula is closely related to our (4). As is well known, we can write Kalecki’s price
formula as pi = mhi + np's m and n being given constants. In his terms hi is to be
interpreted as unit cost excluding capital charges, what he calls prime cost, but this is
not an essential difference in our respective approaches. Aggregating across all the
firms we find,

Taking this into account we can write
where the ratio m/(1 – n) measures what Kalecki calls the degree of monopoly. How
m and n are determined or how they might vary between firms is not clearly elucidated
in Kalecki’s argument.19
Despite the short run focus and the emphasis on prime costs the parallels with
our previous analysis are obvious. We could see this by setting gD = 0 and noting
that our theory would then set
implying, in this case, a unitary degree of monopoly.

Moreover, unlike Kalecki’s treatment, our pricing coefficients are not arbitrary
but are deduced from the interaction between the propensity to accumulate and the
degree of perfection of the market.
Wood
We began this section with Kaldor and it is appropriate to finish with the work of
Wood, whose A Theory of Profits (1975) provides remarkably close parallels with our
approach but arrived at from different directions.20 In his context of imperfect
capital markets, firms set prices in order to finance their desired amount of investment
which leads him directly to a pricing formula comparable to (1), in which the
relation between margins and growth is determined by the accumulation routines of
the firm. These behaviours are rationalized in terms of long run target setting in
which capacity is fully utilized and the various decision routines are unaffected by
short run market turbulence. Firms are assumed to seek maximum growth subject to
the constraints placed by market opportunities which include the behaviours of
rival firms. The crux of our theory in relation to this can be shown in Figure 2.2.
The line labelled hi – gi is the analogue of equation (1)’ above with slope measured
by f. 21 The line D – D is the firm’s one period market opportunity locus with slope
measured by δ(1 – si ) and position dependent on the growth of the overall market
and the average market price.22 Normal conditions are found at ‘a’. The balanced
price is Ob and the maximum growth rate consistent with the constraints is Oc. Any
variation in f or δ or si will change this combination of outcomes. Thus when Wood

Figure 2.2 Growth, prices and profitability
asks the question, ‘Given the operating rules and market constraints, what is the
highest rate of growth the firm can achieve?’, this is equivalent to my posing the
question, ‘Given the operating rules and market constraints what price must the firm
set to achieve balanced expansion?’ Both questions have the same answer. Balanced
growth rates have the property that they are also the highest growth rates in the
prevailing circumstances and routines adopted by the firm.
We have spent a long time, an excessively long time the reader may complain, on
a theory of price formation which seems to have taken us far from the theory of
competition as an evolutionary process. However, I do not believe it is time wasted.
There is little point expounding evolutionary ideas if the ideas cannot be related to
the notion of markets as co-ordinating systems and to the economic behaviour of
firms. And there is no pleasure to be had at all if we cannot demonstrate a link
between our ideas and important precursors in the economics literature. I hope in
this section to have established both points satisfactorily.23 Now let us turn back to
evolution and competition.
COMPETITION AND SELECTION: THE REPLICATOR DYNAMIC
A central theme of our first lecture was the distinction between competition as a
dynamic process and competition as an equilibrium state, the rest point of some
process, and we explored how the first perspective corresponded to the idea of
competition as a process of selection between rival patterns of behaviour. This process
could be reduced to a question of fitness differences between firms, fitness equating
to the expected growth rate of a firm. Fitness, we claimed, is not an intrinsic property
of firms but rather the consequence of the market co-ordination of rival behaviours:
fitness results from the interaction between individual and environment and it is

not an intrinsic feature of either (de Jong, 1994). Hence fitness may be contingent
and transient and we readily recognize that firms having high fitness in one set of
circumstances may lose that position if the market environment changes or there
emerge new rivals with better patterns of behaviour.
We now make these claims more precise using the replicator dynamics introduced
at the beginning of this lecture to co-ordinate the pattern of change between a
population of firms which differ in only one dimension of behaviour or trait,
namely unit cost. Let the firms set prices as outlined in the previous section and
order the firms such that h1<h2< .. <hz. The set of unit cost values we call the selection
set, and it has been created by past differences in the innovative behaviour of firms.
Using the replicator dynamic we can now address a number of consequences of
competition in relation to: the rate at which the relative importance of the firms
changes; the change in average traits over time; whether the average traits are subject
to optimization; and the patterns of association which emerge between the given
traits and the other, endogenous, aspects of firm behaviour. All this is premised on
our population perspective and upon the co-ordination of behaviours by the market
environment.
Let us quickly dispose of the last issue, the patterns of association between various
dimensions of behaviour. What, for example, is the pattern of association between
unit profit margins and unit costs? The obvious way to measure this is by the
covariance between mi and hi. Invoke normal prices and we find that
Hence, margins and unit costs are negatively related and their covariance is proportional
to the variance in unit costs, the factor of proportionality depending on the propensity
to accumulate and the demand selection coefficient. The reader can readily establish
whatever other patterns of covariation are deemed relevant to the competitive process.
We turn now to the normal growth rates of the firms which from (1)' and (6) we
can write as
(8)
Firm i grows more quickly (slowly) than the market average if its unit costs are less
(more) than the average for the population of firms as a whole. Notice carefully, that
this average is not the arithmetic average, it is the weighted average of the unit costs
the weights being defined by the market shares of the firms at that point in time.
This is an important point. The construction of the moments of the distribution of
firm behaviours is not arbitrary but must reflect the underlying theory of co-
ordination and competition. The coefficient ∆ we call the market selection coefficient
and note that it is increasing in the propensity to accumulate and in the degree of

market perfection. It measures the degree of selective pressure on the firms. If the
market is perfect ∆ = f, and if capital finance is in perfectly elastic supply to all firms
∆ = δ.24 The immediate consequence of (8) is to identify the importance of the
distance from mean principle in driving the dynamics of competition. On comparing
(8) and (2) we identify the differential equations which govern the changes in market
shares, thus
(9)
It is this expression (one for each competitor) which captures the dynamics of
competition remembering also that the sum of market shares is always unity, and
hence one of these equations can be derived from the remainder. The principle is
very simple: the market share of firm i is always increasing whenever that firm has
lower unit costs than the population average, and conversely. The velocity with
which the competitive process takes place depends on the market selection coefficient
and it is clear, for example, that competition works more rapidly the more perfect is
the market. Evidence for the existence of competition is evidence that the market
structure is changing; if the structure is constant effective competition is absent.
Now it follows from (9) that the dynamics of competition are governed by a set
of non-linear coupled differential equations, even in this highly simplified case of
firms differing in only one selective trait which, moreover, is given. Yet despite the
acknowledged complexity of such systems there remains a great deal we can say.
The first point to establish is that the system (9) is globally stable; that is to say,
the system has an attracting point for any pattern of market shares satisfying the
constraints, si≥0, Σsi = 1. This attractor assigns an asymptotic market share of unity to
the most efficient firm (firm one in this case) and asymptotic market shares of zero
for all other firms.25 Figure 2.3 illustrates the situation with three competitors satisfying
h1<h2<h3. All trajectories approach the vertex e1 where all the market share has been
acquired by firm one.
An informal proof of stability proceeds as follows. Compare any two firms i and
j then gi – gj = ∆[hj – hi] so that if hj>hi it follows that the market share of j must be
falling relative to the market share of i. Thus the ratio sj /si must tend to zero with
time. Since firm one has lower unit costs than all other rivals it must continually
expand its market share relative to all rivals individually and collectively. Given the
constraint that Σsi = 1 it follows that all possible trajectories converge on the attractor
si = 1, sj = 0 for all j. In Figure 2.3 this is the vertex labelled e1.
In this competitive world with invariant firm behaviours there is only one winner
of this competitive struggle, namely the most efficient firm. Its behaviour constitutes
what is called in game theory an evolutionary stable strategy, no combination of
other firms, possibly including firm one itself, can out-perform firm one alone.26 If
firm one is to be displaced, some form of innovation is required which transforms
some other existing firm into the lowest cost competitor or a new entrant appears

Figure 2.3 Replicator dynamic trajectories with three firms
with the same consequence. For future reference we note that the long term behaviour
of our replicator system is always governed by a boundary of the selection set.
Let us consider some further consequences of the distance from mean principle.
Another way of expressing (9) is to write it as
(10)
That is, a firm’s market share only increases over time to the degree that such an
increase in share reduces average practice unit cost in the population of firms. What
is more, the process ensures that such a firm has an increasing weight in the definition
of average practice. Here we have the basis for an optimizing principle, not for the
individual firms, which by assumption are following rules which may not be optimal,
but for the competitive process as a whole. Since the replicator dynamic seeks the
boundary of the selection set, it simultaneously discovers the lowest cost producer
and we can make precise the Hayekian idea of a market discovery process. In parallel
with evolutionary biology we have an argument ‘for design’ without the presence of
a designing agency. In short, the behaviour of firm one comes to dominate the
industry because it is its behaviour which is best adapted to the prevailing
environmental circumstances. Of course, the implication of this is that the best
competitors become monopolists and the only effective guard against this is the
innovative behaviour of rivals and new entrants. This, it will be remembered from
Lecture 1, is the matter contained in Downie’s distinction between the transfer
mechanism and the innovation mechanism.
In passing, we should also note that the replicator dynamics expressed in terms of

market shares can also be expressed in terms of a Lotka–Volterra dynamic in terms of
the levels of output for each firm.27 Thus we can write for output level xi ,
where X = Σxi , aii = –gD and aij = f[hj – hi] — gD . The properties of these systems are well
known (May 1973, Slobodkin, 1961). In this particular case there is no stable rest
point at which different firms co-exist, and a pattern develops in which firm one
supplies the entire market, growing at rate gD .
FISHER’S PRINCIPLE: THE FUNDAMENTAL AND

SECONDARY THEOREMS OF SELECTION
Since the consequence of evolutionary competition is to redefine continually the

structure of the industry, it is natural to look for ways of summarizing the complex
patterns of change which may emerge. One way to do this, a way which follows
readily from the population perspective, is to investigate the dynamics of the moments
of the distribution of firm behaviours. This I will call the method of Fisher’s Principle
in recognition of the English geneticist R.A. Fisher (1930) who pointed evolutionary
biology in this direction with his Fundamental Theorem of Natural Selection. The
Principle generalizes this special case and, I hasten to add, has nothing whatever to
do with genetics per se. Rather it uncovers the deep structure of the evolutionary
dynamic: that change is driven with respect to rate and direction by variety of
behaviour evaluated within a common environment. We have already shown how
the replicator dynamics reflects this at the level of each firm and Fisher’s Principle
allows us to aggregate these divergent movements to identify how the moments of
the population distribution change over time. Moreover, it tells us how to construct
the moments of the distribution, how to measure variety in behaviour and how to
relate change in population moments to that variety in behaviour. What is fundamental
to this approach is that it depends on the precise manner of co-ordination within
the population of behaviours. Different rules for co-ordination give rise to different
instantiations of the Principle.
Let us begin with the Fundamental Theorem which states that selection improves
average fitness in the population, and that the rate of improvement in average fitness
is equal to the variance of fitness: the most transparent example one could construct
of the idea that variety drives change. Let the population of initially given growth
rates be g , so average economic fitness is g = Σsi gi and using the replicator dynamic
i
we immediately find that
(11)

Vs(g) being the ‘s’ weighted definition of the variance in growth rates. This is the
Fundamental Theorem and it is a direct consequence of a selection process in which
differential growth rates imply structural change. Stated like this the Fundamental
Theorem is scarcely profound but it is the entry point to a deeper understanding of
evolutionary dynamics as I shall now demonstrate.
In applying the Fundamental Theorem to our model of the industry we face two
difficulties: that the average growth rate is constant, by assumption, while the individual
growth rates are not fixed but are determined via the process of market co-ordination
and so change systematically. What then is implied by Fisher’s logic? Instead of (11)
we must write
Now,
whence
(12)
The variance of growth rates measures the average rate of retardation in the growth
rates of the individual firms. Retardation, the familiar theme introduced and explored
by Kuznets and Burns in the 1930s, appears to be an intrinsic property of the
selection process at least when the average growth rate is constant. Here we have the
corresponding statement of the Fundamental Theorem.
However, it also follows from (1)’ that
Since fitness at the individual level is declining over time it follows that the balanced
price set by each firm is also declining over time, indeed, the average rate of reduction
of prices and thus profit margins is28
All of this follows from selection under normal conditions: firms accumulating capacity;
consumers making choices on preferred suppliers and all of this myriad of decisions
co-ordinated by a market process. The Fundamental Theorem is only one example of
Fisher’s Principle at work. Equally well known in the evolutionary literature is the so-

called Secondary Theorem of Natural Selection which many evolutionists consider
to be the more important of the two theorems (Caswell, 1989; Findley, 1990, 1992;
de Jong, 1994). The Secondary Theorem is stated as follows. Consider any behavioural
trait, then the rate of change of the population average of this trait equals the
covariance between that trait and fitness across the population. Since unit cost is the
only trait which varies at this stage we find that
(13)
exactly the Secondary Theorem. Moreover, we shall see that this theorem is independent
of the number of traits which contribute to fitness, which cannot be said of the
Fundamental Theorem. But from (13), a more interesting conclusion follows. If we
use (8) to eliminate the growth rate deviations then we derive a result, which to all
intents and purposes, is the Fundamental Theorem, applied to average unit costs,
namely,
(14)
The rate of reduction in average practice unit cost is proportional to the variance in
unit cost in the population. Selection is an improving process with respect to the
mean behaviour and (14) underlines the point that selection for a single trait has an
unambiguous direction and a rate which increases with the diversity of behaviour in
the population and with the magnitude of the market selection coefficient, ∆. By
repeating the logic of Fisher’s Principle one immediately establishes that
(15)
that is to say, Ss(h), the third moment about the population mean measures the rate
of decline of the population variance.29 As has been observed often in evolutionary
dynamics, if the distribution of behaviours is symmetric the variance of behaviour
will be constant and improvement in mean behaviour will take place at a constant
rate. At the next step this neat symmetry between change in one moment and the
next higher moment appears to be lost for
(16)
where Ks(h) is the fourth moment of the distribution of unit costs around the
population mean.
However, reflecting on relations (14), (15) and (16) it becomes apparent that there
is a deeper logic to Fisher’s Principle, in that the terms on the right-hand side of

expressions (14), (15) and (16) are cumulants of the population distribution of
behaviours. Thus Fisher’s Principle can be stated in the following succinct and general
terms: the rate of change of the ‘n’th cumulant of the population distribution is
proportional to the ‘n + 1’th cumulant of the population distribution of behaviours.
Because the first three moments are equal to the first three cumulants, we find the
results summarized in (14) to (16). History is directional change, and its rate and
direction depend on the precise shape of the population distribution of behaviours.30
It would be just as appropriate to call Fisher’s Principle, the Cumulant Theorem.
Each of these results illustrates the core of Fisher’s Principle, that the relation
between change in population moments at one level depends on the values of
population moments at other levels. Now these relationships are truly statistical, even
though they flow from determinate behaviour. They depend entirely on the nature
of the selection process and different theories of selection will give different
relationships. But in all cases the point to grasp is that we only have economic
change in the sense defined when we have variety in economic behaviour. It is to my
way of thinking a beautiful consequence of the dynamic of co-ordination of behaviour
through markets, a way of making sense of the rich tapestry of historical evidence
relating to change and variety.
Now we have already established as an implication of our replicator dynamic
process that the firm with the lowest unit cost comes to dominate the market, that is
s1 tends to unity and all other market shares tend to zero. The consequence of this is
that hs converges on h1 and all second and higher order movements of the population
distribution tend to zero over time. Thus competition destroys the variety in
behaviour on which it depends, as Lewontin (1985) has expressed it, evolution
consumes its own fuel. If competition is to continue, this requires the injection of
variety in behaviour, in short the maintenance of competitive conditions depends
upon the continued possibility of innovation. In a market where innovation is
absent there may be nothing to prevent the creation of a monopoly position for the
most competitive of the rival firms. Of course, if increasing market dominance were
to go hand in hand with the suppression of innovation this would be a particularly
unfortunate outcome. The case for anti-monopoly legislation may lie less in restricting
the ability of a monopolist to manipulate prices to the public detriment and rather
more in fostering its own ability and that of rivals to innovate.
There is another important feature of the replicator dynamic in relation to Fisher’s
Fundamental Theorem. If we compare the rate of change in hs produced by the
replicator dynamic with that produced by any other pattern of continuous change
in market shares (also satisfying the constraint Σsi = 1) then the former maximizes the
rate of reduction in hs. This is indeed remarkable. The replicator dynamic contains
its own optimizing principle for the system as a whole even though the individual
firms are not, in general, required to follow optimal decision rules.31 In short,
competition according to the rules we have stated is an optimizing dynamic process.

One final point is worth noting in this context and it relates to the immediacy of
the selection process. Selection works with the set of current behaviours and nothing
else. But this does not mean that system outcomes are necessarily myopic in the sense
of being influenced only by current events. Rather it simply means that all longer
term considerations must first be reflected in the current behaviour of the rivals if
they are to influence the competitive process. In this way, all manner of exceptional
phenomena can be included (e.g. the impact of expected factor prices on current
production methods and unit costs) with their immediate impact being reflected in
the selective behavioural traits of the competing firms.32
MARGINAL FIRMS AND THE PRESSURE TO EXIT
So far I have only considered the fortunes of dynamic firms, those making positive
profits, firms with positive economic fitness values as we put it. But not all firms are
dynamic in our sense of accumulating capacity. Some will be profitable but will have
no desire to grow, their propensity to accumulate will be zero. Others may wish to
grow but will not be making the profits to finance that growth or have the ability to
raise the finance which their profitability justifies.33 One particular group of firms
will not be able to grow, the marginal firms which are just breaking even and by
assumption do not accumulate additional capacity. Differences in propensities to
accumulate will be treated in the next lecture, here we consider the consequences of
the industry consisting of two sub-populations, a group of dynamic firms and a
group of marginal firms.
Marginal firms are firms which just break even, firms setting prices equal to unit
costs. They do not invest so their capacity is constantly a relic of their histories
although their degree of capacity utilization can vary with the specific demand for
their output. The dynamic group, of course, operate at full capacity and make positive
profits. Let ‘a’ be the output of the dynamic group as a proportion of the combined
output of the two groups, then the relevant growth rates are related by gD = ags + (1
– a)gm, where gm is the output growth rate of the marginal group.34 The dynamic
growth rate is defined using the shares si , while the growth rate of the marginal
group is defined using the shares mj , the contribution which marginal firm j makes
to the output of the marginal sub-population. Thus, if vk is the share of any firm in
total output it equals asi for a dynamic firm and (1 – a)mj for a marginal firm. Of
course, Σ vk = Σsi = Σ mj = 1. Since gs no longer equates to gD we no longer have the
luxury of fixing the growth rate of the dynamic group independently of the
evolutionary process. The major change involved relates to the dynamics of customer
selection; rather than (3) we must write gk = gD + δ[pv – pk]. Instead of ps we have pv , the
average price for the entire industry, including the marginal firms, defined using the
vk weights, where pv = aps + (1 – a)pm. What this implies is that the growth rate of the

Figure 2.4 Selection, marginal firms and exit
dynamic group depends not only on its own average unit cost value, hs, but on the
average unit cost value in the marginal group, hm , and the share of the marginal
group in total output. Figure 2.4 (a development of 2.3) is one way of putting
together these different elements.
Along the horizontal axis are arranged the unit costs of all firms with positive
output, with unit costs ranging from ha, best practice to hz worst practice. Prices set
by each firm are also measured on the same axis. Growth rates are arrayed on the
vertical axis. The line D-D is the market selection schedule showing how the growth
rate of demand for each firm ‘varies’ with its price; given the market growth rate and
the average price within a population. This schedule cuts the horizontal axis at the
boundary unit cost value ho – gD /d + pv and any firm with unit cost equal to this
boundary value has a zero growth rate. The boundary value partitions the selection
set ha – hz into the two sub-populations, dynamic firms hi<ho , and marginal firms
hj>ho .35
For each of the dynamic firms we have an accumulation schedule (1') linking
growth rate of capacity and output for the given unit cost. Each schedule has slope
f and cuts the horizontal axis at the firm’s unit cost level. Where this schedule cuts the
market selection schedule we have the normal growth rate and price set by the firm.
Hence firm one grows at rate g1 and sets price p1. The average growth rate and price
set by the dynamic firms are gs and ps , as determined in relation to the average

accumulation schedule labelled A. The horizontal line labelled gD measures the market
growth rate and where it cuts the market selection schedule determines pv. The
accumulation schedule labelled V indicates the firm which, if it had unit costs hv,
would grow at the market rate gD , and have a constant share in the total market. Since
gs>gD such a firm must necessarily be losing market share in the dynamic group.
Consider next the marginal firms, each of which sets a price equal to its unit cost
level. For each of these firms output is falling over time at a rate determined entirely
by the market selection schedule. The average rate of decline is gm, corresponding to
average unit cost level hm, and the fastest rate of decline is experienced by the current
worst practice firm, z. Now, by definition, the share of the dynamic firms in total
output is given by
and this share is measured in the diagram by the ratio αß/αγ along the schedule DD.
Having worked out the structure of the population at an instant in time let us
now trace the effects of competition. The consequences are deeply connected to the
operation of the Fisher Principle.
Let us begin with the average unit cost levels for the two populations, and here
Fisher’s Fundamental Theorem holds true and tells us that both averages decline over
time, thus
and
Notice that these moments are constructed using the market share weights appropriate
to each group. Notice also the different coefficients of selection between the two
groups (∆<δ). The Fundamental Theorem follows so naturally within the groups
because each of the appropriate weights follow its own replicator principle: dsi /dt =
si(gi – gs), dmj /dt = mj(gj – gm) and dvk /dt = vk(gk– gD).
Now, since gs>gD>gm it follows immediately that ‘a’, the share of the dynamic
firms in the total population output is increasing over time. Since hs and hm are
declining and since hs<hm it follows immediately that hv and thus pv are also declining
over time, and with them the boundary unit cost value, ho. In terms of the diagram,
selection is pushing the schedule D-D left-wards and pushing formerly profitable
firms into the marginal group. Thus in this sense selection is progressive, it reduces
average unit costs in both groups and in the population overall. This matches closely
the arguments put forward by Joseph Steindl (1952) on the dynamics of competition,

with the least efficient firms progressively being squeezed into the marginal group.
As pointed out in the first lecture, Steindl’s analysis, with its emphasis on cost
differences and their link with accumulation differences, was an important precursor
of evolutionary arguments in economics, since it implicitly separated out questions
of economic fitness (growth) from questions of viability (survival).
Although Fisher’s Fundamental Theorem applies within the sub-groups it does
not apply at the population level and it does not apply because the different sub-
populations follow different selection rules.
Nonetheless it is true that Fisher’s Secondary Theorem holds for the population
as a whole in that
Cv(g, h) being the v-weighted covariance between growth rates and unit costs across
all operating firms. However, it is not true that this covariance is proportional to
the variance in unit costs. After a little analysis we find that
It is certainly the case that hv declines over time but the rate of reduction is not
measured in proportion to the corresponding population variance in unit costs.
Indeed the variance of unit cost across the whole population is given by
which is equal to
Vv(h) = aVs(hi) + (1 – a) Vm(hj) + a(1 – a)[hs – hm]2 (18)
This is not proportional to the whole population covariance between growth rates
and unit costs given by (17).36 The reason behind the discrepancy is not hard to
find. It is that marginal and dynamic firms operate according to different selection
rules as reflected in the difference between the respective selection coefficients ∆ and
δ.
That the Fundamental Theorem does not hold in the aggregate should not be a
surprise. It is such a special case, applying to a uniform selection environment in
which entities differ in only one dimension. The general principle though remains

intact; every element on the right-hand side of (17) depends upon some measure of
variety either within or between the two sub-populations. I hesitate to labour the
point but the structure of the economic world changes because of the economic
variety contained within it and the way that variety is co-ordinated. That is exactly
what (17) tells us. It is the appropriate statement of Fisher’s Principle in the presence
of marginal firms.
Finally, I have a little more to say about survival conditions in this population.
As we have drawn Figure 2.4, the market is to a degree imperfect, (δ<∞) and it is this
which permits a range of marginal firms to operate. If the market were perfect, D-D
would be vertical and ho would be the only possible marginal unit cost value consistent
with survival, all firms with greater unit costs would fail the viability test.
Correspondingly, in an imperfect market there are two possible meanings of the
marginal firm. One corresponds to ho , the margin of accumulation; the other
corresponds to hz , the margin of survival. Each marginal firm survives because in an
imperfect market it still has some customer base and can still sell its output. However,
each of their respective customer bases is declining and the marginal firms are
contracting output at rates determined by their unit costs and the market selection
process. At some point, output becomes so small that they exit and the survival
margin drifts gradually down the range of unit costs. This is the mechanism which
determines the exit rate for the industry.37
The economics of exit have a particularly important role to play in the evolutionary
picture as we demonstrated in the section on evolutionary arithmetic. What we now
have is an explanation of the ratio e, the fraction of output lost due to the exit of
firms. The disappearance of the least efficient is one of the primary mechanisms
stimulating productivity growth in a population. Indeed, it was a point that
Schumpeter was particularly fond of emphasizing in relation to his treatment of the
business cycle. However, the will to survive is often strong, even if ultimately fruitless,
and pressure may force changes in behaviour outside the range of normality. If
marginal firms lower prices below unit costs they must find subsidies from somewhere
and these cannot be inexhaustible. Conversely, if they seek to raise prices in an
attempt to restore profitability this can only accelerate the decline in their customer
base. Moreover, if they are unable to shed surplus capacity, their unit costs will drift
upwards from the long run normal values we have assumed with the same negative
effect on the growth of output. Once a firm is marginal it is only a matter of time
before it is forced to exit. Only by reducing unit costs, perhaps under new ownership
and direction, can the otherwise inevitable be forestalled. In short, I suggest that
evolutionary economists should devote serious attention to the analysis of decline,
bankruptcy and exit. After all, Marshall warned us decades ago that the economics of
decline are not the economics of growth with the sign reversed. His contrast between
the long run, to cover expansion, and the short run, to cover decline, were meant to
capture this important distinction, as Kahn (1989) for one realized.

QUALIFICATIONS AND EXTENSIONS
Let me conclude with some loose ends and brief suggestions for the further
development of the evolutionary framework.
Wages and rents
So far we have limited our treatment of the selection environment to a stylized

product market. It is equally important to consider our firms competing in markets
for inputs, in particular labour. The firm which grows faster than its rivals must,
given its efficiency, attract employment faster than its rivals. The ability to do so, and
the likely cost of doing so in terms of any wage premium, will depend on the
efficiency of the labour market. A perfect labour market will impose a uniform wage
on all the rival firms for each quality of labour, hence their unit cost differences
would correlate exactly with the underlying efficiency differences whatever the pattern
of their growth rates.
Suppose, per contra, that the labour market is not perfect, and consider the labour
market version of our customer flow dynamics. At an instant in time each firm has
its own group of employees who know of the wages and conditions in rival firms
but imperfectly, and make decisions to change employer based on their knowledge
of rival wage offers. It is easy to see that in such circumstances the unit cost levels of
the rival firms become endogenous (Metcalfe, 1997). A firm which has greater
production efficiency than average will have a growth rate which is greater than
average and will have to post a below average product price and an above average
wage rate: the first to grow its customer base, the second to grow its employment
base. Greater efficiency is shared partly with the labour force and partly with the
consumers in proportions which depend on the relative degrees of perfection of the
product and labour markets.38 All of this, of course, enhances the range of application
of Fisher’s Principle, and emphasizes the contingent dependence of economic fitness
upon market co-ordination.
Increasing returns
It is well-established among evolutionary theorists that the Fundamental Theorem

may not hold when the traits which determine fitness are themselves dependent
upon the relative shares of the entities in the population. In this case there is feedback
from selection to behaviour. This is a complicated topic and selection in the presence
of increasing returns, internal economies, at the level of the firm introduces precisely
these issues of density dependent selection. Since I have dealt with this matter elsewhere
(Metcalfe, 1994), I merely note here that increasing returns introduce the famous
Kaldor/Verdoorn law to complement Fisher’s Principle, while also raising familiar
matters of selection processes that are sensitive to historical events along the way

(Arthur, 1989; David, 1985; Cowan, 1991). History matters with a vengeance in
positive feedback processes of which increasing returns provides one example.
Demand again39
One final set of observations on the demand side of the selection process is in order.
So far we have ignored changes in the intensity of demand by individual customers,
focusing all the attention on the customer flow dynamics in response to price
differences between firms. To illustrate the issues which can be addressed more generally
let η be the price elasticity of the intensity of individual demand and let this elasticity
be the same for all consumers. Also let the market be perfect. Normal conditions now
imply that the firm in setting its price must allow for changes in the intensity of
demand as well as changes in its customer base. This requires that for each firm
where gDi remains the growth rate of the customer base for firm i as previously
defined. Summing over the population and rearranging we find
From this, it is clear that the normal price is a logistic function of time and that it
converges on the normal value established previously at a rate which varies directly
with the propensity to accumulate and inversely with the elasticity of demand intensity.
Needless to say, introducing this extra degree of demand flexibility does not interfere
with the fundamentals of market selection given that the price elasticity is the same
for all the firms.
There is yet another route through which we can open up the treatment of
demand, by looking beyond the individual sector and considering how it is linked
through the customer selection process with other sectors. In this way we can bring
together different populations and draw a distinction between competition within
the population and competition between populations. One way to do this, and to
endogenize the rate of growth of demand, gD, is to draw again upon our customer
flow dynamics. For sector j we can write gDj = g + µ[p – psj], where g is the average
growth rate across all the sectors, p is the corresponding average price, psj is the
average price within sector j, and µ is the intersectoral coefficient of customer selection.
The reader is free to work through this case at their leisure and to begin to uncover
some properties of inter industry selection processes. We must draw the line at this
point.

3
ECONOMIC VARIETY AND

MODELS OF CHANGE
The fundamental impulse that sets and keeps the capitalist engine in motion
comes from the new consumer’s goods, the new methods of production or
transportation, the new markets, the new forms of industrial organization that
capitalist enterprise creates.
(Schumpeter, 1943, p. 83)
This lecture is, I am afraid, rather more technical than the predecessors for I propose
to deal with our stylized model of competitive evolution in more detail. However, I
do want to raise issues at the heart of the relation between innovation and competition.
So far, I have only allowed firms to differ in one dimension of behaviour – unit cost.
This is clearly too limited; real-world firms differ in many dimensions and their
behaviours change over time so that a full evolutionary framework must be able to
make sense of the multidimensional variety of behaviours. This is the task in this
lecture. To help the reader, the argument is broken down into a number of self-
contained sections which may be read independently. In the first two we introduce
differences in propensities to accumulate as well as firms with different products and
different production methods. These are perhaps the two most important ways of
extending the discussion of differential behaviour. For the rest of the lecture we
move into more complex territory, the processes which add to the selection set in
terms of innovation, entry and the combination of firms. Exit, the process of
subtracting from the selection set, has already been dealt with in Lecture two. These
exercises allow us to develop various diagrammatic techniques and a method for
partitioning the selection set which the reader may find helpful. I also introduce the
difficult task of moving away from normal conditions to incorporate some limited
effects of turbulence on the pattern of economic evolution. Finally, the lecture
concludes with some observations contrasting the dynamic method in evolutionary
analysis with its more familiar use in economic theory. Throughout I will keep
Fisher’s Principle at the heart of the analysis. Each one of the developments introduced
below can be built into simulation models of evolutionary processes and the
predictions tested in an experimental fashion, but I leave this to others who are more

able than I at these time consuming and technically demanding exercises.1 Finally, in
the epilogue, I come full circle to the questions of variety in behaviour, competitiveness
and competitive advantage, the topic of the first lecture.
DIFFERENCES IN PROPENSITIES TO ACCUMULATE:

CAPITAL MARKETS AND SELECTION
We come now to the first occasion on which I abandon the idea that competing
firms differ in only one dimension of their behaviour. The assumption that growth
rates of capacity are proportional to profit margins, the classical saving postulate, has
taken us a long way but only by assuming that this relationship is the same for each
dynamic firm. Yet there are powerful reasons for recognizing that firms are likely to
differ in their propensities to accumulate, that they will not have similar routines to
govern their investment behaviour. The owners of different firms may take very
different views as to the disposition of current profits, preferring dividends today
to prospective capital gains tomorrow. Managers may equally differ in their willingness
to grow and indeed in their ability to manage the process of accumulation. Each
possible source of differential growth may be traced back to its influence on one of
the three determinants of the propensity to accumulate, namely, the capital:output
ratio, the internal retention ratio and the ratio of external finance to internal finance.2
A firm which has a higher than average capital:output ratio will, ceteris paribus, have a
lower than average growth rate. This is a crucial area in which to investigate the
operation of selection processes not least because of the importance of the link
between patterns of growth and the flow of funds from the capital market. We tackle
this in two steps, taking the propensities to accumulate as given but different and
only then introducing a stylized flow of funds from the capital market. Once again,
the argument relates only to the dynamic firms.
The competitive process is now two dimensional. Whatever advantages firms have
in terms of their unit cost levels these must be judged in relation to their associated
propensities to accumulate. Quite possibly the best practice firm may have a low
propensity to accumulate in which case it may not be selected by the competitive
process. How shall we proceed? The first change is that instead of (1') we have to write
gi = fi [pi – hi], when fi is the particular propensity to accumulate. For simplicity of
exposition let the product market be perfect, δ = ∞, so the aggregate growth rate is
now given by
gs = Σsigi = fs(p – hs) – Cs(f, h) (19)
with fs = Σsi fi being the population average propensity to accumulate and Cs(f, h)
being the covariance between propensities to accumulate and unit costs. If the two
attributes are uncorrelated then (19) reduces to a form virtually identical to (4),
except that fs will itself evolve over time. The analysis of selection is greatly simplified

at this point by a logical device, a change in the weights we use to define the moments
of the population distribution. This is a technique which is of general applicability,
and it rests on the proposition that the appropriate definition of economic weight
depends upon the causes of economic fitness differences. Instead of using the market
share weights, si , we now define new weights, ui , which measure the contribution
which each firm makes to the population average propensity to accumulate. Thus,
These weights are the appropriate measures to define the economic significance of a
firm, whenever propensities to accumulate differ.
The outcome of this change in weights is to redefine the population distribution
over any characteristic: a firm whose propensity to accumulate is higher than average,
for example, is given a greater weight in the population than its market share alone
would merit.3 Using the new weights we see that (19) takes on the much simpler
form4
gs = fs[p – hu] (20)
Now the interesting point about the weights ui is that they also evolve over time
according to the replicator dynamic, a not entirely expected outcome given that fs is
not a constant. Just as dsi /dt = si(gi – gs), so dui /dt = ui(gi – gu) and it is this correspondence
which greatly simplifies the dynamics of selection.5
From this it follows that the Second Fundamental Theorem of selection holds,
whichever weighting scheme we use, thus
Notice that the choice of the new weighting scheme has not been arbitrary: the
economic theory of selection has indicated how the weights can be defined so as to
conserve the dynamics of evolutionary change. Before we put these ideas to work, a
diagrammatic treatment may help to clarify the various elements. This is provided in
Figure 3.1. On the horizontal axis are the unit cost values, and on the vertical axis
the inverse values of the propensities to accumulate. Any firm is represented by a
point in this space, and the set bounded by the convex region is the selection set; it
contains all the firms operating or not. The ruling market price is P and, since the
market is perfect, this is both the survival margin and the accumulation margin. All
firms in region C, with costs greater than the prevailing price, are assumed to have
exited the population. The line P–G with slope equal to the market growth rate
further partitions the remainder of the selection set. By construction, any firm on
this line has a growth rate equal to the market average. The averages for the industry,

Figure 3.1 Selection with differential propensities to accumulate
hu and 1/fs , therefore lie on this line as indicated. All firms above this line in region
B are growing but losing market share, while all firms below the line in region A are
growing and gaining market share. Consider next the three firms indicated by points
a, b and c. The slope of the line joining point c to the horizontal axis at P measures
the growth rate of c, hence, by comparison gb>ga>gc. However, unit costs are not
ranked in the same order since ha>hb>hc. The fittest firm is not the firm with the
lowest unit costs: it is the one with the most dynamic combination of unit cost and
propensity to accumulate. How then do we identify which is the best practice firm
within the selection set? Clearly it is ß on the boundary, (defined by the ‘tangent’
PGß ), it has the highest growth rate at price, P, even though there are other firms
which have lower unit costs.
If we engage in a logical exercise and let the competitive process work itself out
with behaviours unchanged, we can find the attractor firm by drawing the ‘tangent’
to the selection set which has slope gD . This firm is identified at ∈ on the boundary
and again it is not the lowest cost firm. When the system has converged to this
attractor, the associated market price would be P∈. This appears to mirror the well-
known result on the inefficiencies associated with growth. Indeed, we can be certain
that the lowest cost firm will dominate the selection set only if the market growth
rate is zero, for in this case the selection environment does not put any value on a
positive propensity to accumulate. This makes the point rather sharply. The process
of selection and its outcome depend upon the prevailing selection environment: to
repeat, economic fitness is not an intrinsic property of firms. Indeed, at market
growth rate gD , the least cost firm, α, must end up ultimately growing at a rate less
than gD. It can, of course, survive but its weight in the population must drop to

zero, despite the excellence of its production routines. A warning, if one was ever
needed, of the multidimensional nature of competitiveness, and of the danger of
assuming that firms defined as best practice over a limited range of dimensions must
have the highest economic fitness values.
It should be readily apparent from the above that Fisher’s Fundamental Law will
not hold when firms are selected in regard to more than one dimension of their
behaviour. It is a lengthy but not difficult task to find the appropriate version of the
Fisher Principle. For the mean unit cost we find that
(21)
and for the mean propensity to accumulate
(22)
Leaving the covariances aside for one moment, it is clear that selection reduces
average unit costs and increases the average propensity to accumulate – there is at
least a semblance of the Fundamental Law. This pattern is reinforced if the covariances
are negative, that is, if firms of above average efficiency tend to have above average
propensities to accumulate. However, if the covariances are positive it is possible for
selection to be perverse, that is, whenever above average efficiency is associated with
below average propensities to accumulate. Notice the use of the ‘u’ weights as well as
the ‘s’ weights in deriving Fisher’s Principle, and how the rates of change in the
population means depend on the growth rate of the market even though production
is subject to constant returns to scale. Even in this more complex world the fundamentals
of evolution hold true, variety drives change in a way which depends on how that
variety is co-ordinated.
So far, the propensities to accumulate have been arbitrarily given. They have
stood in no particular relation to unit costs. Expressions (21) and (22) cover this
general case. However, if we introduce a stylized capital market on which firms can
raise external finance there are surely grounds for presuming that the flow of available
capital will be greater the more profitable is the firm. To this extent ‘efficient’ capital
markets should bring about a negative covariance between unit costs and propensities
to accumulate. As an introduction to a complex issue, let us simply assume that
profitability above average attracts external funds above average and results in a
propensity to accumulate which is also above average. Specifically let
fi = fo + f1(mi – ms) (23)
with mi being the firm’s profit margin and ms = Σsimi , being the average profit

margin in the population.6 This being assumed it follows that the average propensity
to accumulate is fixed, fo = fs , and that Cs(f, h) = –f1Vs(h)<0, as expected. Such a capital
market has the desired efficiency property in our evolutionary sense. I do not claim
for one moment that this approach captures anything other than an important
feature of capital markets which are dynamically efficient. There is much more to
capital markets than this, aspects which will have to be investigated on other occasions.
Let us work through the consequences for Fisher’s Principle. For the individual
firms
gi = [fo + f1(mi – ms)]mi
and for the aggregate of dynamic firms
gs = foms + f1Vs(m)
The average growth rate in relation to a given average margin is greater the greater is
the variance in profit margins and, of course, Vs(m) = Vs(h).
Taking the rates of change of market share implied by these expressions we soon
arrive at the result
(24)
where Ss(h) is the third moment of the population distribution about its mean, a
measure related to the skewness of the unit cost distribution. The first part of the
expression is very close to the Fundamental Theorem; average unit costs fall in
proportion to the variance in unit costs. Moreover, the rate of improvement increases
with the average margin and thus with the growth rate of the market. This persistent
appearance of growth rate influences upon the pattern of selection, which occurs as
soon as we allow propensities to accumulate to differ, is surely of interest. The link
between the rate of selection and the rate of growth of the market illustrates the
importance of our suggestion that the firm is caught between selection processes in
product markets and selection processes in factor markets. Notice that it is the shape
of the population distribution which matters. Skewness provides the modifier: if
negative it speeds up selection, if positive it slows it down. Clearly the way the capital
market links the flow of funds to inter-firm differences in profitability is key in
determining how quickly average unit costs decline over time. The greater the sensitivity
of accumulation propensities to profit margins, the more strongly do unit costs and
propensities to accumulate covary in a negative fashion.
PRODUCT VARIETY AND COST DIFFERENCES
Having introduced a process of selection with two dimensions of behaviour we can

turn to a second example, the important example one might think, where firms

differ in their unit costs and in their products. This is surely central to any theory of
competition in the modern world, to competition which is in the proper sense
Schumpeterian. We proceed as follows.
Our population is defined by a group of single product business units, using
different constant returns to scale production methods to produce different products
which supply different bundles of specific characteristics to users. The firms are
members of this population by virtue of having their activities evaluated in the same
uniform market environment, in that they face a common vector of input prices, w,
and a common vector of implicit monetary evaluations of the product characteristics,
v. Given the process and product attributes we can define for each firm a measure of
its product quality, p*i , and its unit cost of production, hi. If aki is the unit input
requirement of the kth factor and αji the unit product content of the jth characteristic,
then we can write hi = Σkwkiaki and p*i = Σjvjαji . Since I am going to take the structure
of the input prices and characteristic valuations as fixed, we can take one factor price,
call it the wage of labour, and one characteristic value, call it the price of characteristic
zero, as measures of money values. We can then write hi = wo ai and p*i = voαi , where,
ai is real unit cost in terms of labour and ai is real quality in terms of the index
characteristic. Since only relative values matter for the pattern of evolution we can
measure all values (not forgetting the price of capital goods) in terms of the labour
standard, setting wo = 1, whence hi = ai . Figure 3.2a summarizes all the data for the
population in terms of the appropriate selection set. At a given point in time, each
firm is represented by its location in the set and the outer (convex) limit is of
significance because economic fitness is maximized at some point, yet to be determined,
on the boundary.
There is no requirement that the product characteristics be treated only as technical
properties of the rival products. They may reflect service characteristics (after sales
service or delivery time) or indeed any behaviour which is valued positively or
negatively and which influences the relation between consumer and supplier.
Reputation effects, applying to the firm rather than the product, may be particularly
powerful sources of different αi values and of competitive advantage.7
So far we have established our population of different behaviours and reduced
these behaviours to two dimensions by virtue of evaluating the rival firms in a
common market environment for product characteristics and factor inputs. Any
change in relative factor or characteristic prices will change the boundary of the
selection set and the location of each firm within that set. The next step is to establish
the dynamics of change within the population while holding the environment constant.
At any point in time, the population has a particular structure reflecting the
relative contributions each firm makes to total activity. We measure this relative
activity by the shares in aggregate output, si , where aggregate output is measured in

Figure 3.2 Product selection and process selection

terms of an index of outputs weighted by the quality adjusted prices p*i . Thus if xi is
the output rate of the ith firm, its quality adjusted market share becomes
and, provided the set of product qualities, α, is held constant,
the simple replicator principle, where gi is the growth rate of xi and gs = Σsi gi is the
aggregate, population growth rate.8 Clearly this is not the only measure of relative
activity we can use. Another alternative would be to measure the relative size of the
rivals in terms of shares in the total employment of labour. There is no unique
measure; the appropriate choice is simply a matter of convenience in relation to the
problems under investigation. Obviously, any change in the a means a change in the
i
index of aggregate output which one can either ignore (using a base or current
weighted index) or deal with using more sophisticated index numbers. This is how
it should be. A change in the market environment, for example, the relative values vj ,
should imply, through the effects on the values of αi, a different measure of relative
importance in the population. This may make real world comparisons difficult and
somewhat imprecise but in analytical terms matters could not be clearer.
This settled, the question becomes one of determining the distribution of growth
rates in the population. Growth rates of output are our measure of economic fitness
and, as before, they depend upon the interaction between the desired expansion of
the firm’s capacity and the expansion of its market. The growth rate of capacity is
determined as in (1') but now we must adjust our treatment of customer flow dynamics
(3) to reflect the role of differences in product quality.
At a given moment each firm has a set of customers and a volume of sales. Over
time the customers of different firms interact, at random, and they compare the
quality cum price offers of the different firms, switching their demand to those
which offer better value for money. If gi is the rate of growth of the market for the
ith firm and gD is the aggregate market growth rate we can write
g’i = gD + δjΣsj[(pj – p*j) – (pi – p*i)]

= gD + d[(ps – pi) + (p*i – p*)] (25)
where ps is the average market price, Σsi pi , and p* is the average quality adjusted price,
Σsi p*i . We take it that p*i≥pi for any sales to occur. In this market process the coefficient
of market selection d plays a particularly important role, reflecting now the role of
market institutions in diffusing information about prices and qualities across the
population of customers. If δ = ∞, it is as if we have a perfect market in which the
market price for any one firm is the same as its quality adjusted price, pi = p*i .
Conversely, when δ = 0 the market process is inoperative, firms are effectively niche

monopolies with a captive customer base and there is no relation between the market
and quality adjusted prices other than p*i ≥ pi. All intermediate values for δ produce
market processes with p*i>pi and a determinate distribution of the two prices in the
market.
The twin principles of capacity accumulation and market selection now allow us
to determine the growth rate of each firm. Market prices are set by firms and market
institutions determine how well or how poorly this information is distributed across
consumers. Reverting to our normal growth principle, we equate (25) with (1') and
solve for the market price to give
(26)
with the corresponding growth rate being
(27)
Each price and each growth rate depends on the attributes of the individual firm
including its propensity to accumulate, together with the properties of the
environment, as reflected in the coefficient of market selection, δ, and the properties
of the rival firms as reflected in the population average values for as = Σsiai and αs =
Σsiαi.
It will be seen that the growth of the firm is ‘caused’ by four considerations. Of
these, the given growth rate of the market, gD , impinges equally upon all the firms in
the population and therefore, does not contribute to growth differences. The remaining
elements, the value of the index characteristic in terms of labour, vo , the coefficient
of selection, ∆, and differences in each firm’s attributes relative to the population
averages jointly determine the distribution in growth rates across firms. A firm is
fitter to the extent that it has unit costs which are lower than average and product
quality which is higher than average, or sufficiently offsetting combinations of the
two attributes.
As before, firms which are fitter than average increase their market share while
those less fit than average experience a declining market share. All this is summarized
by the distance from mean dynamics of the replicator principle, for, we can write
(27) as
(28)
This applies to the dynamic firms as defined before. Once firms are in a break-even
situation they cease to accumulate and their rate of output growth depends only on
the rate of decline of their market. The break-even condition is straightforward; it is
that pi = p*i = ai or voαi = ai .

Figure 3.2a helps to clarify these distinctions in terms of a partitioning of the
selection set. Through the point of average practice, [αs , as], is drawn a straight line
with slope (1/vo ) and horizontal intercept at gD /∆. All points on this line have a
fitness value equal to the population average. Hence firms which happen to lie anywhere
on this line will be dynamically representative and have constant market shares.
Correspondingly, all firms above the line in the subset Y have greater than average
fitness and an increasing market share, while those below the line, in subset X, while
growing absolutely, are losing market share because they are less fit than the population
average. The line OM, also with slope (1/vo ), demarcates the boundary between growth
and survival. Firms with characteristics located on this line break even and have a
zero growth of capacity. Finally, subset W comprises all those firms who cannot
break even and so are considered to be out of the population; their routines are too
badly designed for them to survive. All the other firms are adapted to the prevailing
environment but to varying degrees. Figure 3.2a is a useful way to represent the
variety in the population and to summarize the dynamics of competition. How a
firm performs relative to its rivals depends on where it is located in the selection set
and upon how the market environment, summarized by vo , ∆ and gD , evaluates that
particular combination of product design and production method.
Let us now draw some further implications from this framework. Consider first
the relative price, (1/vo ), the ratio of the wage to the value of the index characteristic.
At each point of time, the normal value of this is given by the relation
(29)
Given the population means for product quality and unit cost it follows that this
relative price is lower the greater is the market growth rate and the smaller is the
market selection coefficient ∆ . By substituting this relative price into (27) we can
rewrite the growth rate of the firm in terms of its quality adjusted price,
gi = ∆[p*i – ai] (30)
Comparing this with (1') it follows that the normal market price is a weighted
average of the quality adjusted price and unit input requirements
(31)
From this it also follows that the market price falls short of the quality adjusted price
by an amount which is proportional to the growth rate of the firm, that is, pi – p*i
= –gi /δ.
Return to Figure 3.2a and consider which of the firms can be said to have the

greater economic fitness. Instinctively, it cannot be a firm in the interior of this set
but where on the boundary is such a firm located? The answer depends on the ruling
value of vo and we can see immediately that the fastest growing firm is β, located at
that point on the boundary where the ‘tangent’ also has slope (1/vo). It will be clear
that this is not the firm which has the lowest unit costs in the conventional sense,
rather it is the firm which has the maximal value, p*i /hi, the ratio of product quality
to unit cost. This is always the firm which has the highest growth rate in the prevailing
conditions.
Of course, the identity of the fittest firm depends on all the aspects of the market
environment. Any variation in the relative values of the characteristic valuations or
in the relative input prices will change the boundary of the selection set and redistribute
the rival firms within the set. The maximal growth firm under one environment may
not be so favoured in different circumstances. The pattern of economic evolution is
always contingent on the prevailing selection environment (Alchian, 1951). For this
reason the meaning of best practice is similarly contingent as managers and boards of
directors often discover to their chagrin.
Let us conduct a ‘thought experiment’ and enquire as to the outcome if the
competitive process is allowed to run its course, all other aspects of the environment
being held constant. In the context of capitalism this is an artificial question of the
first order but, nonetheless, it helps us understand the process of competition. Given
the nature of our replicator dynamic the answer follows immediately. Market shares
converge on the firm which has the highest economic fitness. We locate this firm in
Figure 3.2b by taking a line (dashed) with origin at gD /∆ and finding the point on
the boundary of the selection set where this ‘tangent’ supports the highest value of
(1/vo ). This is firm µ not firm β, nor the lowest cost firm ξ, and as market share
accumulates around this firm so αs converges on αµ and as converges on aµ. Competition
maximises the value of (1/vo ), the real wage measured in terms of the chosen index
characteristic, and simultaneously defines the attracting firm as the one with the
highest ratio of product quality to unit cost. Even though none of the rival firms
have been assumed to be maximizers in their choice of product design and production
method, the competitive process acts as surrogate maximizer of the appropriate
performance measure. This is not optimization at the individual level but optimization
at the system, institutional level. In short, if we let the market process run in this
experimental way ‘it’ discovers the best practice firm within the given selection set.
Now compare the attractors which emerge from different values of the ratio gD /
∆ . It is clear that a higher growth rate or a lower value of the market selection
coefficient biases the competitive process towards selecting firms with a lower ratio
of αi to ai . There is a relative bias against quality and in favour of inefficiency in
production methods. This can be seen if we imagine that gD /∆ is sufficiently high to
result in firm β being the attractor rather than firm µ. What we cannot do is compare

positions β and µ in terms of the quality cost ratio p*i /hi; since these points support
different values of (1/vo) we have a traditional index number problem to contend
with.9 All we can claim is that as the ratio gD/∆ is notionally increased the attractor
tends to move in a north-easterly direction around the boundary of the selection set.
In this experiment competition ceases when the population means have converged
on firm µ, that is, when all the economically useful variety in the population has
been eliminated. Although this firm dominates the market in a limiting sense this
does not rule out the survival of other firms which at the ruling value 1/vo can still
turn a profit. These are growing firms but they become vanishingly small relative to
the size of the overall market. Because their economic weight tends to vanish they
cease to make any contribution to the relevant population averages. Growth and
survival should not be confused, the first is a matter of economic fitness, the second
is a matter of viability.
FISHER’S PRINCIPLE
We turn now to the derivation of Fisher’s Principle when there is product and
process competition. Consider first the evolution of average costs. In normal
conditions this is given by
(32)
when Vs(a) is the variance of unit costs, and Cs(a, α) is the covariance between unit
costs and product qualities. Both moments are defined with respect to profitable
firms only (sets Y and X in Figure 3.2a) and they are constructed using the market
share weights si . If quality and unit cost are randomly related, (32) reduces to the
equivalent of Fisher’s Fundamental Law of Natural Selection, and since the variance
is a statistic of unambiguous sign this gives evolution a clear rate and direction.
More generally this is not the case, indeed if Cs(a, α) is sufficiently negative in
magnitude and vo is not too small then as can increase over time. Progress! Notice
also, because vo depends on the market growth rate so the rate of change of the
average, as, also depends on this growth rate.10
What of the dynamics of the unit cost variance? By the same methods
(33)
where Ss(a) is the third moment of the distribution of ai around its mean and Cs(a,
α2i) is the co-moment between ai and the squared values of αi. This is a classic reflection
of Fisher’s Principle, in which the dynamics of change of one statistical moment are

functionally related to other (higher) moments and co-moments. It epitomizes the
fundamental evolutionary principle that variety drives change. For completeness we
can also write down the rate of change of average product quality
(34)
Ignoring the covariance term, average quality increases at a rate proportional to the
variance in quality, the Fundamental law again. However, if the covariance is sufficiently
positive this will not be the case and average quality may fall at some points in the
competitive process. Since the covariance has opposite effects on the rates of change
of as and αs (if it is positive, as certainly declines although αs may not increase, and
conversely) it is tempting to seek one overall measure which will capture the extent to
which the dynamics of selection impart a direction to the competitive process.
An obvious candidate is the relative price vo since it is this ratio which is minimized
by competition. One would expect the beneficial effect of competition to be captured
by the rate at which vo declines over time, if indeed it does decline. Let us check.
From (29) it follows that
and so, using Fisher’s Principle to substitute for the changes in the population
means, this becomes
which is equal to
(35)
where Vs(g) is the variance in economic fitness defined across the dynamic firms in
the population. The variance is necessarily positive and we can conclude that
competition is in this strictly limited sense progressive. The quality adjusted product
price falls relative to the wage rate, and the rate at which it declines is proportional
to the variety in economic fitness, and it is greater the smaller is the market selection
coefficient ∆ .
Thus I claim that Fisher’s Principle is an essential component of the analysis of
population change. It allows us to uncover the patterns of change in the underlying
distribution of behaviours to any degree of refinement we might wish. It provides
the natural method for resolving different but co-ordinated behaviours into economic
evolution.

INNOVATIONS, ENTRY, MERGERS
In the previous three sections we have worked through a number of cases of firms
with multi-dimensional behaviours. In terms of our triad of routine categories we
have dealt with variations in efficiency, effectiveness and accumulation. All this is
consistent with the population perspective in which, as a first step, we treat the
behaviours of the firms as fixed and concentrate on the dynamics of population
structure. This can only be the first step. The most obvious feature of real world
competition is that behaviours are not given, the selection set is continually created
and we can think of three distinct processes by which this takes place: technical and
organizational change, entry and the combination of existing firms. Each speaks to
the generation of novelty which is the leitmotif of evolutionary theory (Witt, 1996).
Let us take each in turn.
Innovation
Innovation must take pride of place in any evolutionary theory of structural change
for it is the continual creation of new behaviours which recreates the variety on
which selection depends. It is innovation which makes the economic process open-
ended, providing a necessary antidote to the idea of evolution as a process of
convergence to a given position of rest. While we know a great deal about innovation
processes and their general dependence on opportunities, incentives, resources and
management capabilities we will never, I claim, develop this knowledge to such a fine
level that we can predict the kind of product and process innovations which emerge.
Innovation is about surprise and surprises are not predictable, and this is the essential
feature of the bounded, trial and error variation processes which are characteristic of
innovation in modern capitalism. That innovation is guided by opportunities and
experiences we can readily accept but we must also accept that it is to a degree blind
in Campbell’s (1960) limited sense that the outcomes of innovation trials cannot be
known in advance. One cannot have prior knowledge of something which is yet to be
discovered.11 The outcomes are, of course, anticipated but one needs only a casual
acquaintance with the innovation literature to know how often these anticipations
are fulfilled by events – very rarely. Sometimes the surprises are pleasant, other times
they are not, and it is because of this inherent unpredictability of innovation outcomes
that Schumpeter’s fear about the debilitating effects of ‘innovations to order’ turns
out to be well wide of the mark. The difficulty, of course, is that we usually observe
only a biased sample of innovation experiments, the survivors, and hence the process
of innovation appears to be more guided, more prescient, than it really is.
The problem of innovation is analogous to the problem of speciation and in each
case we need to identify the origins of new concepts and the constraints on the
emergence and further development of these concepts.

For our purposes what is important are the differences between firms in their
innovative performance: no two firms ever innovate in the same way at the same rate.
If there is any aspect of behaviour in which diversity is of overwhelming importance
it is with respect to innovation. Moreover, it is the differences in innovative
performances which underpin the differences in product and process characteristics
which define our selection set. Thus we must imagine our selection set as a continually
changing set of product and process combinations, and those innovations which are
fundamental in an evolutionary sense will be those which change its boundary.
To begin, consider a product innovation in a single firm. This innovation changes
the existing bundle of product characteristics and, depending on their respective
valuations, increases αi by a given amount. If there are no consequences for the
production process it follows that the economic fitness of the firm is increased (a
vertical displacement of the firm in Figure 3.2a). Of course, by how much fitness
increases depends on the selection coefficient and on the real price of the index
characteristic. Single innovations of a given magnitude are easily handled within our
selection set framework.
Now consider the consequences of every firm innovating and let each firm’s
proportional product innovation rate be λi, so that dαi /dt = λiαi. We shall assume λi
to, be positive although cases of quality reducing innovations, are perfectly feasible
when some characteristics are enhanced while others are diminished. (I am sure the
reader can provide his or her own examples.) How then does average product quality
αs evolve under the twin forces of innovation and selection?
The first step is to recognize that any change in product quality also changes the
market share of the competing firm by virtue of our quality adjusted definition of
market shares. Our replicator dynamic now becomes
(36)
Even if all the firms had the same output growth rate, gs , their quality adjusted
market shares would vary as their innovative performance deviated from the population
average.
From this it follows that
(37)
Once again we see Fisher’s Principle at work: change is driven by variety and the
covariation between different dimensions of variety. Besides the variance in product
quality, we find in this expression the covariation between product quality and
process efficiency and the covariation between product quality and rates of product

innovation. These are the statistical moments which drive the evolutionary process.
With respect to both covariances it would seem that we have little a priori understanding
of what their sign or magnitude might be. Are the high quality firms the more
innovative firms, or not? What can we say about the evolution of the average rate of
innovation, even assuming that we hold the proportional rates of progress constant?
By familiar steps we find that
(38)
The variance term indicates that the average rate of progress should increase over
time but the other terms are ambiguous. There is a vast range of empirical work to
be undertaken before we can be clear on these matters.12
The point I want to emphasize here is that innovation is creating the selection set
at the same time as the replicator dynamic is redistributing economic weight within
the set. The two processes work hand in hand and this is what is captured by (38).
Figure 3.2c is a sketch of how the selection set may evolve with innovation. It is
assumed that there are a number of technological configurations, distinctive bodies
of knowledge from which firms can generate the competing products and processes,
and that each configuration has its own particular ‘reduced’ selection set, labelled AB
. . . E. We can imagine the different configurations emerging at different points in
time, (A before B etc) with a sequence of innovations within each configuration
progressively filling out the set. Each subset may be populated by entirely different
business units basing their products and production methods on the rival design
principles. Clearly it is the configuration labelled E which is the most competitive in
the sense that we have explained the concept. Set building is just as important as
selection within the set. It provides the fuel to maintain competition but it is set
building which we understand the least.
Entry
In many cases innovation will be inseparable from another creative phenomenon:

the entry of new firms. Indeed, the lifecycle perspective is particularly useful in
bringing together opportunities to innovate with fundamental changes in technology.13
This we have already considered in the second lecture in our discussion of entry rates
and the arithmetic of population change. Again it is difficult to pin down the
dynamic forces at work but, from our perspective, entry is typically a combination
of innovation and external accumulation and to that extent we have dealt with it
already, if implicitly. Entry from our viewpoint simply adds another firm to the
selection set. The fundamental point to grasp is that entry is driven by a diversity of

viewpoint, in that the potential entrant must consider that it has an advantage over
the incumbents. Nonetheless, many, perhaps the majority, of entrants fail: their
expectations having been based upon a false conjecture of the value of their business
plan.
Entry raises three questions. What is its rate? Where are the entrants positioned in
the selection set? What scale of capacity do the entrants add to the existing capacity in
the population? In terms of the selection set, Figure 3.2a, it is clear that if an entrant
is to improve upon its initial market share it must be above average in its
competitiveness, that is to say, in region Y. If not, say it is in region X, it can grow
absolutely but its relative share must be declining as it sinks towards the survival
margin. It is getting smaller from a relatively small base and its prospects cannot be
good. Not surprisingly, we find an enormous amount of turnover in industries
with respect to entry and exit (Baldwin, 1995). It seems, from the short life span of
many entrants, that entry close to the industry accumulation margin is a frequent
occurence.
To be a long term successful entrant, one clearly needs a better business theory
than average and ideally a better theory than that espoused by the current best
practice incumbent. The point is that the fortunes of the new entrant depend upon
where it is positioned in the selection set and how that set is currently partitioned.
We can also see how the environment can influence the likelihood of a successful
entry. If the overall market is growing rapidly this will imply that margins are on
average higher, and every firm benefits from this effect. Moreover, if product and
factor markets are very efficient this makes it easier for the entrant to prise away
customers and inputs from the existing firms with modest reductions in prices or
increases in wages and other factor payments. Inefficient, imperfect markets can create
formidable barriers to entry. Entry is always likely to prove a struggle but especially
so whenever it takes place in the context of low growth and inefficient markets.
It will be obvious that entry plays a significant role in the dynamics of industry
evolution; in classical thinking it can be viewed as an important inter-market force
for change. Therefore, it is worth spending a little time on how entry fits with our
replicator dynamics. To call what follows a ‘theory of entry’ would be foolish in the
extreme. I think that a formal theory of entry, like the theory of innovation, is
unfinishable business. To use Nelson and Winter’s felicitous phrase, it will forever
remain within the domain of appreciative theory.
The analysis of entry begins from our discussion in Lecture 2, which established
the relation between the entry rate, n, the exit rate, e, and the growth rates, gs and gD.
Setting the exit rate zero, for expositional clarity only, we recall (p. 42) that (1 – n) =
(1 + gs)/(1 + gD), or, in continuous time, gD – gs = n. Do not forget that ‘n’ is not
defined in terms of the number of entrant firms but rather in terms of the contribution
which the entrants make to total market output. This is as it should be, if we want to
work through the implications of entry for the pattern of evolutionary change. A

little reflection indicates that we have two independent relations to take into account.
The first is the relation between the entry rate and the average profit margin, ms , of
the incumbent firms. Let gs = fms as before, whence in continuous time
The second is the relation between the volume of entry and the same average profit
margin. It seems reasonable, as a first step, to assume the existence of a minimum
profit margin, mo , below which entry will not take place, and that beyond this the
value of n increases with the average margin as entrants with progressively less viable
business theories and plans are attracted into the population. Thus we have the new
entrant schedule
Beyond this I hesitate to go. So much will depend on the existing scale of the
industry, on the opportunities to enter, on the perception of entry advantages in
terms of product or process innovations, on the ease with which viable decision
routines can be acquired and on so many other issues. The position of this entry
schedule will be nothing if not volatile.14 Be that as it may, Figure 3.3 brings the two
sides of the argument together to determine simultaneously the average margin and
the entry rate.
On the horizontal axis is the average margin, on the vertical axis are plotted n, gD ,
and gs. As drawn, the rate of entry is determined at the point of co-ordination ‘a’,
with corresponding value no , and average profit margin mso . The vertical distance ab
measures the corresponding average growth rate of the incumbent firms, g s . It will be
apparent from Figure 3.3 that the entry rate will be greater, the greater is the growth
rate of the market, and the richer are the perceptions of profitable entry opportunities
– the further the entry schedule lies to the left. All this fits with the empirical evidence
cited above. Conversely, if entry opportunities are poorly perceived (the dashed
entry schedule) entry may be blocked, in which case we come back to our original
replicator dynamic. We can also note that a high propensity to accumulate on behalf
of the incumbent firms acts as a ‘barrier to entry’; higher values correspond to lower
entry rates. As the industry progresses and average performance improves so it must
become more difficult to enter and we should expect n to decline.15 The point is
simply that the entry rate and the growth rate of the incumbents are mutually
determined. The reader who wishes to incorporate a positive exit rate in the picture
can easily do so, but I caution against giving the ensuing analysis a too spurious air
of precision. Entry and exit are volatile and unpredictable and for good reason.
It is a straightforward matter to derive the appropriate form of Fisher’s Principle
in the presence of entry. So as not to clutter the argument with irrelevant detail let us
return to the case in which firms differ only in their unit cost. Let vi = (1 – n)si be the
market share on an incumbent firm, and let vj = n.nj be the market share of an entrant
firm at the instant of entry. Then the populatton average unit cost becomes h = (1 –

Figure 3.3 The mutual determination of entry and selection
n)hs + nh’n hn being the average of the unit costs of the entrants. A little calculation
shows that, with the rate of entry held constant,
(38)
where Vn(h) is the variance in unit cost across the entrants. With a little further
manipulation we can write this as
(39)
In this expression Vv(h) is the variance in unit costs across the entire population,
incumbents and entrants together, while V(h) is the variance of the sub-population
means around the population average. If entrants were on average as efficient as
incumbents this would reduce immediately to the Fundamental Theorem. More
generally the Principle applies, and whether entry adds to or subtracts from the rate
of decline in average unit costs depends upon the rate of entry and the comparative
variances in (38).16
Combinations of firms
Finally, I want to treat briefly another important source of changes in the selection
set: the combination of previously distinct firms through merger and acquisition.
Suppose two firms merge, and let us assume that firm one has greater economic
fitness than firm two, given the prevailing environment. Of itself such a combination

has no effect on the overall dynamics of selection, it merely redefines a new business
unit whose characteristics are a weighted average of the characteristics of the two
organizations. However, there are two obvious ways in which combination can
change the dynamics of selection. The first is in relation to the accumulation routines
in the merged entity. Since firm one is the fitter of the two it is not implausible to
assume that firm two is used as a source of investible funds, to finance the former’s
accumulation programme. Investment in firm two is terminated and investment in
the routines of firm one is based on the combined profits of the two firms. Under
this investment strategy the economic fitness of the new entity is
which is greater than the growth rate of firm one prior to the merger. This fitness
value is also greater than the growth rate in the combined assets of the new entity
which is s1 g1' = fm’c where mc is the average unit profit margin in the combined
operation. Merger policies of this kind bring an increase in fitness which is greater
the greater is s2 /s1 but which is necessarily temporary.17 Indeed g1' will converge on g1
as s2 /s1 falls over time. This is a good strategy in immediate fitness terms but not one
which changes the longer term fundamentals of selection. It simply means that firm
two passes into obscurity more quickly than would otherwise be the case, while the
life of firm one (or rather its combination of routines) is prolonged. Indeed this is
a standard argument in favour of the market for corporate control; mergers of this
type accelerate the selection process by placing a greater power of accumulation in
the hands of the managers of better business routines. Of course, if the accumulation
pattern were reversed and all the investment went into the second firm, the conclusion
will be exactly reversed. Merger will then have detrimental effects on the selection
process. This is not unknown.
The second potential effect on the dynamics of selection is that the merger will
improve the performance of one or both of the firms. Merger now entails an element
of innovation. Perhaps firm two can be turned into an equivalent of firm one by the
transfer of routines, or, better still, perhaps the combination of routines defines new
routines and new performance levels which are even superior to those of firm one
prior to the merger. Again this is something which is well recognized; mergers are
often rationalized by the need to gain access to routines considered superior to one’s
own. Many outcomes seem to be possible since this is a process which brings together
the invariably distinctive practices and styles of different organizations.
Of course, all of the above is based upon horizontal merger between firms within
our population. The method, with obvious changes, applies to mergers between
firms in different populations, conglomerate mergers, and indeed to vertical mergers.
In all cases the issue reduces to what happens to the routines which determine product
and process behaviour and the pattern of accumulation.

TURBULENCE
I want now to inject some brief remarks about a very complicated issue, namely
departures from the normal conditions of balanced accumulation on which all our
analysis has been based. Normal conditions are the obvious starting point and I
hope I have demonstrated the utility of the device. However, as the previous section
suggests, capitalism is not by nature tranquil; it is turbulent. Changes in the values
which define the selection environment, changes in market growth rates as well as
entry, innovation, merger and acquisition are all likely to drive firms away from
balanced accumulation. It is not unreasonable to suggest that, in the first instance,
the impact of turbulent conditions will be reflected in departures from full capacity
operation, in excess order books or unfilled capacity. It is obvious which way a firm
should change its prices to restore normal conditions for itself but this begs the
question about the existence of routines to do this. How quickly will they work, how
will imbalance affect the rate of accumulation, will imbalance result in revision of the
routines which determine operational efficiency and accumulation? Will it lead to
revision in the routines for determining routines? As soon as the questions are
posed the list of possibilities appears endless which, indeed, is the advantage of the
balanced accumulation approach.
What clearly matters from our perspective is the distribution of shocks across the
population and how the firms respond (differentially) to the new conditions. A one-
off demand shock, for example, which redistributes demand from firm i, while
leaving total demand unchanged, would require firm i to lower its price and all other
firms to raise their prices until balance is restored. A demand shock which impinged
on all firms equally would require all prices to be cut, slowing down capacity growth
relative to market growth again until balance is restored. Of course, a great deal
would depend on the relative rates of response to imbalance and, no doubt, all this
could be stated formally in terms of stability conditions and investigated using
sophisticated simulation methods. Nor need the adjustment fall on prices alone. It
may be translated into changes in propensities to accumulate or other routines and
result in a different pattern of dynamic response. What was that about Pandora’s
Box?
But thankfully, a familiarity with the evolutionary economics of normal conditions
is all I ask.
DYNAMIC PROCESSES: A COMPARISON
I want to conclude this lecture with some remarks comparing the evolutionary dynamic
with the treatment of dynamic questions in economics more generally. To claim very
much in such a difficult area would be unwise but nonetheless some remarks are in
order. We have built our evolutionary approach around the central assumption of

co-ordination of behaviours in the market; this we have in common with the economic
theory of competitive equilibrium. If one wishes to define equilibrium as simply a
state of co-ordination that is fine, but economic theory goes further when it defines
equilibria as rest points for the economic system under investigation. From an
evolutionary perspective this is a step too far for it begs the question of whether
there is ever a state of rest in the sense intended. Evolutionary systems may always be
far from such positions, in the sense that they should be considered to be open
ended in their development.
To understand why the idea of equilibrium or state of rest is so important in
modern economic theory we must recognize its central role in economic dynamics.
According to this line of thinking, equilibria are only interesting to the extent that
they are stable and to the extent that out of equilibrium behaviour converges rapidly
to the state of rest. Equilibria are not simply states of rest, they are simultaneously
reference points for the economy to adjust to. Provided that adjustment is sufficiently
rapid, they are the normal states in which the economy is to be found. Now the
central methods of stability analysis establish these properties by defining the dynamics
of the system in the neighbourhood of its state of rest. In short, to investigate
stability one must first know the equilibrium position and its immediate
neighbourhood.
As is well known the procedure has a number of drawbacks. At a substantive level
there is no way of judging whether an actual economy is in equilibrium or not. If
the relevant variables are changing slowly this may be due to strong inertia in a
system which is yet far from equilibrium. On the other hand very rapid change may
be true of a system which is always in equilibrium but in which the states of rest are
themselves changing rapidly due to changing fundamentals. We simply have no
transparent way of deciding such cases and, as Fisher (1983) has rightly insisted, we
must confine ourselves as a consequence to the understanding of the dynamic
properties of our models.
Here the conventional difficulties are four in number. First, the processes of out
of equilibrium adjustment are ad hoc in that they do not usually derive from the
same behavioural principles which determine the states of rest.18 Second, the presence
of multiple equilibria means that we have no non-arbitrary procedure for deciding
which of the alternative states of rest is appropriate. Third, and more fundamentally,
the method fails whenever the equilibria are changing more rapidly than are the out
of equilibria adjustment processes, the moving target is ever receding. Finally, and
most fundamentally of all, if the states of rest depend on the past history of the
endogenous variables then we have the possibility of path dependence in which it is
impossible to define the equilibria without specifying how those positions are
approached.19
How does our simple replicator dynamic compare with the general method of
describing dynamics around the rest points? The most significant difference is that it
is a distance from population mean dynamic, not a distance from equilibrium dynamic.

The evolution of market shares and output levels depends upon how each firm’s
current behaviour differs from the current population average behaviour. It does
not depend upon how individual behaviours differ from those of any rest point
however the latter is defined. It is a quite different principle of dynamic adjustment,
in which the dynamics can be understood quite independently of their being a rest
point (or, for that matter, a limit cycle) and independently of any changes in that
rest point whether they be small or large, rapid or slow. This is particularly important
in any system which deals with the dynamics of creative destruction. If, for example,
unit costs in the ‘best’ firm were declining more rapidly than the population average,
this would in no way affect the system dynamics which would continue to be governed
by the replicator equations. Equally important is the fact that the speed of adjustment,
the selection coefficient, is not ad hoc but is grounded in the behavioural routines
followed by firms and consumers.
Of course, the fact that our system will converge on the ‘least cost’ producer
within a given population of behaviours means that this producer can be called a
centre of gravity in the classical meaning of this term. As the system evolves this
centre of gravity firm comes to have an increasing weight in the definition of
average behaviour. Indeed, it is this which gives us the notion of system stability.
Nonetheless, what matters is that the dynamics depend on variety in behaviour
around the population mean, a dynamic which discovers the least cost producer. It
follows that the replicator method is perfectly compatible with the classical idea of
centres of gravity; if the data remain constant such an attractor is discovered by our
replication dynamic. However, our results are less fragile and allow us to portray the
competitive process as open-ended. When innovations are changing the underlying
economic data this in no way undermines the replicator dynamic – quite the contrary,
the innovations provide it with more fuel with which to work. This is, I believe, the
great strength of the distance from mean principle. The dynamics of capitalism
require co-ordination; they do not require equilibrium. They certainly do not depend
on the existence of long run centres of gravity and this, I claim, justifies the replicator
dynamic as the model for analysing competition and structural change.
Of course, we have got this far only by assuming stable, invariant routines to
govern each firm’s behaviour. Indeed, one of these routines is critical – that which
ensured that the price posted by each firm was always its normal price. To abandon
this method of analysis would open up an additional dynamic of price adjustment in
response to output mistakes and inevitably output expectations which would take us
way beyond our presently limited analysis. Equally, I have only discussed the process
of competition occurring within a sector. There remains the question of how different
replicator processes interact across sectors to shape the overall rate and direction of
change. Remember also, that positive feedback from the selection process can create
multiple equilibria and indeterminacy in the paths traced by the system. We are no
more advanced than economic theory in general in resolving such difficulties. It is
fortunate that there is yet much to be done.

At the risk of repetition let me sum up this section in the following terms. The
dynamics of replicator systems are not conducted around long run points of rest but
around the current population averages of the relevant behavioural traits. Fisher’s
Principles apply to a world of changing behaviours just as they do to given behaviours.
The hypothesis of given behaviours is not required by the evolutionary method.
Indeed, whenever those individual behaviours are changing rapidly, when long period
positions are changing faster than market adjustments can respond, it may only be
the replicator principle which enables us to understand the competitive process. Of
course, turbulence may be the characteristic of such situations and invite abandonment
of the normal method but if all is unpredictable can any method of analysis work?

EPILOGUE
On being different, on being competitive
It is time to draw together the threads of the evolutionary economics of creative

destruction. Our central theme has been competition, a process driven by rivalrous
behaviour and co-ordinated by market institutions. At root, its dynamic is a matter
of innovation and adaptation. We have argued for the crucial importance of
understanding markets as institutions to facilitate adaptation to better conceived
activities. The standards by which the market is to be judged to be operating adequately
are matters of the effectiveness of markets in making widely known the rival offers to
supply which are available to the population of consumers. Putting it over simply,
but none the less appropriately, firms set the prices and qualities of products, markets
disseminate that information. The outcome is the co-ordination of rival behaviours.
We have not had the time to explore the wide variety of market institutions
which exist in a modern economy or, for example, to consider how a long sequence
of innovations in transport and communication technologies have shaped their
evolution. Evolutionary economists should certainly do so. What is clear is that
there is a strong public interest in the efficient working of market institutions as
facilitators of change, and in preventing firms employing a myriad of practices to
segment markets, discourage entry and innovation, and bias selection processes to
their own advantage. Competition authorities know this well enough. I hope to have
made this clear through our treatment of evolutionary concepts and their application
to a set of problems in the economics of competitive evolution. For this reason I
have focused the discussion on co-ordination with given selection sets. This leaves
me open to an important objection. The method appears to play down the defining
question, ‘where does variety in behaviour originate from?’ Stasis and selection is a
good starting point, our first stage, but it is seriously incomplete as an account of
economic evolution. For evolution to continue we require the continued generation
of new patterns of activity and we require an understanding not of innovation per se
but of differential innovation. This is the primary challenge facing any serious account
of why the evolutionary method provides us with a deep understanding of the
nature of capitalism. It is not markets and contractual relationships alone, but markets
and contracts in conjunction with the vast diversity of innovation outcomes in

technologies, organizations, behaviours and institutions that constitutes the paradox
of capitalism to which I refer in the prologue. This is why I have suggested that
economic evolution is a three-step process: variety, selection and feedback from the
selection process to endogenize partially the regeneration of variety.
This leads me to the two concluding topics that I must briefly address: the grounds
for being different and the nature of competitive advantage. The two are inseparable
for the essential stimulus to behave differently is to gain an advantage over one’s
rivals. It may be noted in passing that the market for academic status has all the
features (good and bad) that we expect of competitive capitalism: the key prizes go to
the major innovators who change the nature of debate or open up entirely new
avenues of understanding (Hull, 1988; Brenner, 1987). This brings me full circle to
where we started with Adam Smith and the twofold nature of competition, with the
need to co-ordinate rivalrous behaviour giving rise to a system-wide development of
the economy.
ON BEING DIFFERENT
In a world of identical behaviours evolution is a logical impossibility. A theory of

economic evolution must be based in the final analysis on an understanding of how
economic agents came to behave differently and to identify the stimuli and the
constraints which shape differentiation.
Any discussion of this nature must confront the issue of rationality. Our analysis
has been based upon profit seeking behaviour but not profit maximization, a middle
ground between the slightly absurd notion of Olympian rationality and the despair
of random behaviour.1 Rationality for us is reasoned behaviour: the directed,
intentional behaviour of firms to create and exploit competitive advantage. It is
nothing more than seeking to do the best with the resources at one’s disposal. But
what is best can only depend upon a knowledge of the available opportunities, that
is, upon a creative, imaginative step, and there is no reason at all to expect all
decision makers to reach common conclusions in this regard. We live in the same
world yet we all perceive different worlds. Not only the definition of options but
the evaluation of options requires imagination. Except in trivial cases this is not a
mechanical process, and this is the point: the positive side of bounded rationality is
that it frees the imagination from the limits of calculation. When problems become
too complex to be well-defined, let alone solved analytically, one is inevitably dependent
on judgement, conjecture and the guiding hand of experience (Lane et al., 1995).
Thus, there is much more to bounded rationality than the idea of rationality
with more constraints (Conlisk, 1996; Radner, 1996). The point is that outcomes to
complex deliberation processes will depend on the procedures by which those
deliberations are conducted. Equally one cannot put any faith in the other end of

the spectrum that reduces behaviour to random forces. The development of behaviours
may be blind, in that consequences are at best anticipated and necessarily reside in
the imagination, but equally they are not the result of repeated throws of the dice.
The search for novelty cannot be random for if it were it would fall victim to the
tyranny of combinatorial explosion, there being too many possible combinations of
ideas to imagine and evaluate. Thus the creation of novelty involves guided variation
within perceptions of a limited set of possibilities. Innovations are never entirely
novel; they are always prefigured in some of their dimensions. Schumpeter was right:
no matter how many horse-drawn carriages one takes one never gets a railroad, yet
the early rail cars looked remarkably like carriages pulled by the iron horse. The
point of all this is that epistemic variations, and innovations are always epistemic
variations, are constrained by cognitive frameworks; whether they be called paradigms,
heuristics or business theories they guide thought and provide exemplars of good
design.
A fundamental issue here is whether there is a unique true model of any given
situation or a multiplicity of reasonable and equally justifiable explanatory alternatives.
Wilson (1990) has raised this in his contrast between rational world views and adaptive
imaginary representations or fictional worlds which simplify complex reality and
provide a set of instructions (exemplar algorithms) on how to respond to certain
circumstances. While the rational views are to be judged by their truth, the latter are
to be judged by their operational effectiveness. They are ‘technological’ rather than
‘scientific’; they are the epitomy of rule guided, trial and error behaviour. So it is, I
believe, with firms. Every firm has a world view, its theory of business which defines
its objectives and modus operandi, and this view is an adaptive imaginary representation
to be tested by its differential efficiency in generating profit. In this regard the
accumulation of managerial knowledge is no different from the accumulation of
engineering knowledge but radically different from that in science. Knowledge, and
particularly business knowledge, is gained primarily through trial and error processes
within constraints set by the theory of business and the accumulated wisdom of the
past. If a practice or concept works it is retained, if not it is rejected. Thus learning
is path dependent and unique to each specific learning context.
A good starting point is the claim that firms differ in their behaviour to the
extent that they hold different, reasonable theories of business. This provides a
direct link with the modern treatment of capabilities (DeLiso and Metcalfe, 1996;
Montgomery, 1995; Leonard-Barton, 1995; Foss, 1996; Loasby, 1991), building upon
and extending the routine-based perspective on the firm. Capabilities are combinations
of resources and routines articulated in the context of the prevailing business theory.
As such they depend very much on matters of organization and communication
within the firm and between it and its market environment, to a degree they are
socially constructed. Thus differences in business theories and differences in
organizational operators provide compelling reasons for differences in behaviour.

What also matters is the interaction between routines; capability is a property which
relates to the integration and joint operation of routines. Consequently, it is empirically
extremely difficult to seek simple explanations of why firms differ, something which
in the literature has the intriguing title of observational difficulty and causal ambiguity
(Dierickx and Cool, 1989).
Moreover, capabilities are not enough. We need to take account of intent and
commitment. As Hamel and Prahalad express it in a much quoted paper, ‘successful
companies have ambitions out of all relation to their current resources and capabilities’
(1989, p.64). Thus, I suggest that the competence of the firm is a combination of
capabilities and competitive intent. Different business theories, different resource
bases, a different complex of routines and different intent combine to underpin
differential behaviour. Capitalism is notable for the manner in which it provides the
conditions for the differential accumulation of competence. It truly is a system
which generates sequence after sequence of business experiments (Rosenberg, 1992).
Of course, all this fits neatly with the managerial literature on competitive advantage,
and indeed provides the necessary bridge to evolutionary economics and its emphasis
on the emergence of novelty and the co-ordination of diverse behaviours. What this
literature advocates is the central importance of being different in a sustainable way.
Porter’s work is emblematic in this field with its emphasis on strategies for cost
differentiation and product differentiation (1980, 1990). Itami (1987) explores similar
themes with an emphasis on the link between capabilities and the accumulation of
non-tangible assets. For here, too, competition is about being different while
recognizing that the requirements for competitive advantage will change over time.
What all this literature is pointing to is the dominant importance of matters
contingent to the business unit in determining behaviour, a conclusion supported
by the empirical work of, among others, Rumelt (1991) and Cool and Schendel
(1988) who find that factors at the level of business unit are the dominant explanation
of variations in profitability, not factors operating at the level of the sector.2 So let
us turn to matters of competitive advantage and enquire what our framework of
evolutionary competition adds to our understanding.
ON BEING COMPETITIVE
The meaning of the term competitive advantage has been a topic of considerable
debate in recent years, particularly in the management literature. Much of this links
back to the resource-based and capability perspectives on the firm referred to above.
Perhaps the obvious starting point is with the concept of economic fitness. A
natural way for a firm to consider it is operating successfully is to believe that it is
growing at a satisfactory rate. Management may perhaps be forgiven for thinking

that a faster rate of growth indicates that their particular complex of routines is
performing better. But they would be mistaken. What matters from the evolutionary
perspective is not absolute fitness but comparative fitness. A firm which grows at 5
per cent one year and 10 per cent the next would be mistaken in congratulating itself
if in the first year the aggregate market grew at 1 per cent and in the second it grew
at 30 per cent. Far from improving, its comparative performance has declined
drastically; it is less competitive not more competitive. Focusing attention upon
comparative economic fitness is, of course, the equivalent of focusing upon changes
in market shares. Simple enough one might think but in all practical cases fraught
with measurement difficulties. Who are the rivals, who are the customers of the firm
(potential as well as actual), what are the relevant market segments and associated
selection environments? These are not trivial issues but I shall gloss over them to
establish the principles.3
Equating competitiveness with differential economic fitness has the advantage of
leading us straight to the replicator dynamic as an appropriate framework. The
required index of competitiveness becomes the rate of change in market share, or
fitness, relative to the population average. This provides us with a transparent way to
measure competitive advantage: by the distance between the firm’s performance
characteristics and the average characteristics for the relevant population.
Let us take Figure 3.2a as an appropriate example. Locating a particular firm in
the selection set, we can measure its competitive advantage or disadvantage by the
horizontal distance between the point representing that firm and the average
performance line. Thus, z has a competitive advantage relative to the average measured
by the distance z–z', and y is at a competitive disadvantage measured by y–y'. Now
these overall distances are also equal to the sum of the individual distances from
mean performance given by [(hs – hi) + vo(αi – αs)], and so depend on the relative
price of characteristics in terms of labour. Hence a firm increases its competitiveness
only by improving its distance from average performance as defined. Because of the
economic link between fitness and changes in market shares this distance is equivalent
to the measure (gi – gD)/∆ so that differential fitness translates directly into
competitiveness. Changes in market share are proportional to the distance measure
of competitive advantage as here defined. Similarly, if we compare any two firms, we
can measure their relative competitiveness by gi – gj which, on the distance principle,
as proportional to the sum of bilateral differences (hj – hi) + vo(αi – αj).
To summarize, the overall measure of competitiveness depends on distances of a
firm’s behaviour from average population behaviour as evaluated by the market
environment. This measure captures the connection between competitive advantage
and changing relative contributions to total output. It can accommodate any number
of dimensions of competitive advantage by a simple extension of the difference
principle.

Of course, the changes in market share are not always equivalent to the competitive
distances from the population mean behaviour. They are ranked identically in a
uniform environment but may not be in segmented environments, where the market
selection coefficient, ∆, will differ across sub-markets. This is yet another way of
making the point that economic fitness is not an attribute of the firm but a dispositional
property, dependent on the behaviour of the firm and its evaluating market
environment. We have also captured the theme that competitive advantage is never
constant even when the behaviours of the competing firms are given. Because
competition is a selection process the population means are continually changing – a
property which biologists often refer to as the Red Queen effect. Competition is a
treadmill. A firm which is better than average is always being caught up; one which
is below average is always falling behind. Competitiveness is a chain relationship, and
no meaning can be attached to the competitive advantage of any firm without locating
its position in the chain. How then does a firm improve its competitiveness? By
innovating better than its rivals, of course. Either it reduces its unit costs relative to
the population average or it enhances its product quality relative to the population
average. This is the point: to increase competitive advantage one must improve
relative to average behaviour.
Again, the normal conditions of balanced expansion help to fix the ideas. If costs
are reduced, the firm sets a lower normal price but with a higher profit margin so
that its fitness is increased. If it improves product quality it can charge a higher
market price and gain margin and fitness in that way. If it does not, the Red Queen
does her baleful work; the firm which fails to innovate in a competitive process is on
the way to extinction.
This brings us neatly to matters of strategy and the trajectories firms might seek to
follow in distributing their innovative effort between cost reduction and product
improvement. If, by spending a certain sum on innovation activity, a firm can
reduce its unit input requirements by dai or improve its product quality by dαi then
the first strategy will improve its normal competitive advantage by –∆(1 – si)dai, and
the second by ∆vo(1 – si)dα i . The absolute effect in each case is smaller the greater is
the market share of the firm, and is also smaller the smaller is the market selection
coefficient. Relatively small firms in more competitive markets have the greatest
absolute incentives to innovate. Sadly they may lack the requisite ability and, in
particular, the resources to innovate. Monopolists by contrast have no incentive to
innovate. They do not need competitive advantage, although they are more than
likely to have the resources. As one should expect, the relative advantage of product
and process innovation depends only on the relative price of quality per unit of
labour, vo . Process innovation gives the greater increase in competitive advantage
compared to product innovation whenever – dai /dαi>vo, and conversely.4 Of course,
all this should be treated in terms of the expected payoffs from innovative expenditure
but that is well known. Notice also how the familiar theme of spillovers enters the

picture. If all rivals can imitate without cost any innovation as soon as it is introduced
then no competitive advantage follows from innovation. As the firm improves its
absolute position, so the population means immediately catch up and competitive
advantage remains unchanged. Hence, patents, secrecy and the comparative speeds of
innovating become incentive preserving mechanisms. As long as one can innovate
faster than the others imitate some semblance of rewards is maintained.
In the longer term, of course, it is matters of innovation which are the deciding
factor in determining whether the competitive process is sustained. But this is where
we joined the argument. A population of identical behaviours cannot generate
competition. Difference is all. Schumpeter knew this well. It is fitting that I conclude
with his words,
The changes in the economic process brought about by innovation, together

with all their effects, and the response to them by the economic system, we
shall designate by the term Economic Evolution.
(1939, p. 86)
I hope in these lectures to have thrown light on a little of this evolutionary territory.

Part II
EVOLUTIONARY
APPROACHES TO
TECHNOLOGY POLICY

4
SCIENCE POLICY AND

TECHNOLOGY POLICY WHEN
COMPETITION IS AN
EVOLUTIONARY PROCESS
A country’s eminence in a field of science is not a good guide to its economic

strength and growth.
(Carter and Williams, 1964, p. 197)
In the past four decades, the relationship between science, technology and economic
performance has rarely been off the agenda for public debate in the advanced industrial
countries. Over this time quite fundamental changes have occurred in the funding
of science and technology and many of these changes have proved controversial with
industry and academia alike but, of course, for different reasons. However, there is,
I shall argue, a logical strand which runs through the evolution of policy in recent
years; a strand which recognizes that if science and technology are funded as national
investments, the crucial issue becomes one of ensuring that those investments yield
an adequate return, a return ultimately reflected in enhanced competitiveness, wealth
creating potential and the quality of life. This thread has characterized technology
policy in the USA and Europe as well as in the UK. A relatively small country such as
the UK will never be able to match the scale of expenditure on science and technology
achieved in the USA and other larger economies. However, it can legitimately expect
to ensure that institutional and other arrangements are in place to make more effective
use of its investment in science and technology. Indeed, to the extent that a more
effective return is obtained from science and technology, this of itself provides the
most powerful of arguments for increased expenditure on research and development
of all kinds.
In a nutshell, my argument will be that science and technology are distinctive but
interdependent branches of knowledge, jointly required as inputs into wealth creation,
and that their effective alignment requires the creation of appropriate technology
support systems. The chief distinguishing characteristic of such systems is the
collaborative and co-operative involvement of industry (my shorthand for the major
user of science and technology) and academia in the execution of technology

development programmes, so that all the relevant and vastly different advances in
understanding required to develop any innovation are tackled simultaneously. For
the crucial points about the modern innovation process are its multidisciplinarity
and multiple institutional sources of relevant knowledge. No firm can expect to
innovate in isolation and the question of how it is embedded within the wider
matrix of knowledge generating institutions becomes an issue of the first importance
for technology policy.
One natural consequence of all this for the science base is, as Weinberg (1967) put
it, a matching of external criteria with the traditional internal criteria for allocating
funds to scientific development. The principal aim of technology and science policy
is thus to ensure the creation of effective technology support systems which link
industry and the science base. It must recognize that firms, universities and public
research bodies are distinctively different kinds of institution each adapted to a
specific purpose. It would be as foolhardy to make academic institutions commercial
as it would be to make private firms non-commercial. The division of labour between
them is not accidental and the central problem of policy is how to connect these
different institutions together in a more productive fashion. In short, science and
technology policy should be concerned with proper process and not directly with
specific innovation events which are inherently unpredictable. It is, perhaps, aptly
expressed as policy for a complex non-linear world.
In this lecture I shall explore four issues to help us better define the nature and
contribution of science and technology policy. These are, in order of treatment: the
distinctive differences between science and technology as bodies of knowledge; the
economic arguments for different kinds of technology policy as viewed from
equilibrium and evolutionary perspectives; the importance of a systems perspective –
the institutional coupling between firms and universities in the generation and
exploitation of scientific and technological knowledge; and, finally, the UK foresight
in science exercise as an example of a new technology policy, the fundamental purpose
of which is to create a set of appropriate technology support systems.
THE DISTINCTIVENESS OF TECHNOLOGY
It is not fanciful to begin by observing that public debate rarely makes adequate
distinctions between science and technology or the activities which lead to their
development. Let us begin then by noting two possible justifications for the public
support of science. The first sees scientific output as a cultural, consumer good
which enlightens and entertains the public at large. This is, of course, a perfectly
valid viewpoint: the discovery of a new star or a hitherto unknown species of plant
are, in these terms, no less meritworthy than the performance of a new symphony.
They enrich and enliven the understanding of our world. Sadly, but understandably,

this is not a style of argument which is usually appealed to when justifying public
support of science. Instead, a second view is taken, promoted and accepted by
government and the science establishment, that science is an investment which generates
a more than compensatory return in terms of wealth creation or improved living
standards via medical advances or better control of the environment. This modern,
science based investment argument was a theme first made public by the Vannevar
Bush report ‘Science – The Endless Frontier’ published in 1945 (although the ‘golden
egg’ view of science goes back at least to Francis Bacon in 1635) in which the strong
claim was made that
New products, new industries and more jobs require continuous additions to
knowledge of the laws of nature . . . essential new knowledge can be obtained
only through basic scientific research. (my emphasis).
As Wise (1985) has suggested, this is the original statement of the modern, linear or
production line model of the innovation process.1 And in the UK, as late as 1968,
the Central Advisory Council for Science and Technology was able to claim that
basic science is the origin of ‘all new knowledge without which opportunities for
further technical progress must rapidly become exhausted’ (my emphasis). This, now
discredited, view was extremely influential for about two decades as were its twin
corollaries that technology stood below science in a hierarchy of importance, that
technology was merely applied science, and that the flow of new scientific knowledge
would increase in proportion to the funds allocated to basic research (Wise, 1985;
Keller, 1984).
The first and crucial point about this view is that at best it covers only a small
fraction of the activities involved in the innovation process. The return in terms of
innovation and wealth creation depends on a wide range of other non-scientific and
technological activities and expenditures of a quite different kind. Unless these activities
are carried out effectively to transfer science into exploitation, the economic return
to extra scientific expenditure is likely to reduce very rapidly.
This brings me to the second flaw in the production line model concerning the
relevant status of science and technology. A wealth of recent research has established
quite clearly that science and technology are largely independent but mutually beneficial
bodies of knowledge, created by different processes of accumulation within distinctly
different communities located in different institutional contexts (Layton, 1987;
Vincenti, 1990; Keller, 1984, Faulkner, 1994). Both solve problems, and are creative
and imaginative, but the problems are quite distinctly different and the communities
respond to different incentive mechanisms.2 In broad terms science is naturally
academic; its legitimate output involves adding to the existing stock of knowledge
for its own sake. Science is open; the outputs are widely diffused in an international
publication culture and the primary incentives are in terms of priority in publication.

Conversely, technology is naturally practical; its legitimate outputs are artefacts
and the means by which they are designed, constructed and operated, and intrinsic
worth is to be judged not by the truthfulness of the knowledge but by its practical
utility. As science is open so technology is closed, with quite different publication
practices and a natural concern for secrecy or patent protection when private property
rights are involved. Moreover, while it is essential to the replicability of scientific
results that they be codifiable, much of technological practice rests in a tacit realm
only easily communicated through observation and trial, not publication. This is
why one important dimension of technology concerns the skills of the practitioners.
An immediate consequence of this is to deny that technology is merely science applied.
Rather technology is a distinctive body of knowledge with its own operating principles
and norms for design activity. Technologists have often designed and operated artefacts
well in advance of any scientific understanding and their labours have directly
stimulated the search for an understanding of the natural laws which underpin the
operation of the artefacts.
There is another way of looking at the science–technology relationship which is
illuminating. It is not difficult to see that if the choice of technological problems
were decided randomly then there would not be much progress. Rather, technological
advance is cumulative, within a set of given design principles it proceeds along paths
which, at least ex post, seem to involve their own inner logic. Technical advance
involves guided variation in which a knowledge of where to search in the set of
possible options is absolutely crucial to rapid advance. Here lies a key contribution
of science; providing knowledge of where to look, and crucially where not to look in
advancing technology (Vincenti, 1995; Pavitt, 1991). Better scientific understanding
is thus a contributor to a more effective technological search (Nelson, 1982; Gibbons
and Johnson, 1974) and so reduces the cost of technological advance. It is not helpful,
consequently, to claim that science leads and technology follows or vice versa. They are
distinctive, mutually supporting bodies of knowledge created for different purposes.
That they illuminate one another is scarcely surprising, and the interesting question
is how this process of mutual enlightenment works and is institutionalized along the
spectrum from the most pure to the most applied.
There is, however, one unique aspect which follows from the practical directedness
of technological knowledge and this involves the close interaction between economic
and social stimuli. What technologists design and construct has to pass the test of
economic viability and social acceptability. Design is ultimately normative: what is
the best (read most profitable) combination of materials turned into components
and linked into systems of varying scales of grandeur which reduce costs to a minimum
or raise product value to a maximum. Such an approach, dependent on the specific
economic and social context, has no meaning when one is seeking for the unique
truth about a natural phenomenon. Equally important is the fact that many technological
advances arising within a given set of design principles, flow from experience gained

in using and producing specific artefacts. This dependence of technological advance
upon practical experience gained in the diffusion and integration of artefacts into
the economy is a quite distinctive factor of technological change which science does
not share. Markets and technologies co-evolve and the way in which technology
develops is strongly shaped by the rate and direction of market application. This is,
of course, one of the key implications of the product/technology life cycle literature
(Utterback, 1995) and the modern analysis of the diffusion of innovation.
THE ECONOMICS OF TECHNOLOGY POLICY
Central to an understanding of science and technology policy is the need to recognize

that technology can be defined in a number of complementary ways as knowledge, as
skills and as artefacts. The focus of policy can involve any combination of these
elements, for example, as a programme of engineering research, or a programme of
training, or a programme to construct a specific device. In each case the traditional
rationale for policy intervention by government is market failure; relative to the
Pareto efficient yardstick of a perfectly competitive economy the actual performance
of the economy will be suboptimal and potentially improvable through policy
intervention. The sources of market failure are well known (Australian Industry
Commission, 1995; Branscomb, 1993; Metcalfe, 1995a) and may be outlined briefly
as follows. Consider first the arguments about market inefficiency in the production
and dissemination of new knowledge.
Here a major source of difficulty lies in the public good aspect of technological
knowledge: it is used not consumed and once discovered is in principle useable by
any individual on any number of occasions. In the terminology of economics there
is non-rivalry and non-excludability. Hence, runs the argument, the incentives for
any one individual to reveal how much they value an item of knowledge are deficient.
Notice, however, that the public good dimension does not imply that the
communication of knowledge is costless; in many cases it requires communication
between ‘like minds’ only open to those who have acquired comparable abilities to
understand the significance of new technological information. Knowledge is a public
good in the sense of non-rivalry in use, but it is not necessarily a free good and this
is particularly true of complex technological knowledge. Hence the oft remarked
point that to benefit from the information generated by others one must make one’s
own substantial investment in technological capability.
Divergences between private and social cost and benefit add a second source of
difficulty. Once a technology has been created, the public good argument suggests
that the knowledge should be made widely available at no more than the marginal
cost of dissemination to maximize the social benefits from exploitation. However, to
do so would undermine the ability of the creators of that technology to cover the

costs incurred in creation. More generally, spillovers of knowledge, as such externalities
are termed, mean that many users of that knowledge do not contribute to its cost of
production and many exploit it to the disadvantage of the creator of that knowledge.
They are ‘free riders’ and destroyers of incentives. Hence the argument for patent
rights in which a temporary monopoly is granted to enable the creators of a technology
to at least partially protect this property.
The third source of market inefficiency in technology creation lies in uncertainty
proper and the difficulties of estimating the technical or commercial returns to an
innovation. Certainly the idea that innovation related risks can be accurately computed
and used in actuarial calculations of expected costs and benefits is fanciful in the
extreme. Innovations are unique events for which the probability calculus is an
inappropriate method of analysis. Much decision making about technology creation
is at root an act of faith, with necessarily unpredictable time delays between knowledge
creation and application. One immediate consequence of this is what economists call
asymmetric information, an imbalance of knowledge between firms and potential
suppliers of capital and between R&D managers and a firm’s board of directors.
Potential lenders cannot accurately judge the credibility of claims made by a firm
nor can boards of directors always accurately evaluate the claims of technical personnel.
Adverse selection and moral hazard are the consequences and both work to create an
inefficient allocation of resources. Firms find it difficult as a consequence to get
others to accept the risks of technology development. In short, it is difficult to
insure technology projects. To some degree this puts large firms at an advantage in
that they can pool the risks from a portfolio of projects and helps us to understand
the pressures towards more collaborative work in R&D and towards mergers and
acquisitions between technology based companies.
Taken together, the consequence of these various market failures is the absence of
markets to promote the efficient creation and exchange of technological knowledge.
This is particularly transparent when we consider more radical innovations where
not only a new technology but a new market has to be created to exploit the innovation.
In normal competitive markets the object of trade is sufficiently homogeneous to
make the identity of buyers and sellers irrelevant to the outcome of the transaction.
This is not so with technological knowledge where the identity of the buyer and
seller greatly influences the valuation process. Bilateral exchanges are the norm,
exchanges which are frequently facilitated by the membership of the parties in an
existing network of relationships. The Arrow paradox (1962) adds to the problem.
This suggests that if a full description of a technology must be communicated prior
to any transaction this obviates the subsequent need to purchase that information:
sellers of technology have an incentive not to reveal all they know to purchasers. The
consequence of all this is that transactions are mediated by non-market methods,
primarily through networks and other forms of arrangement between organizations
and individuals, procedures which build confidence and trust and work to limit the
damaging consequences of asymmetric information.

I turn now to a second broad class of market failures, those that relate to market
power and innovation. Even more fundamental to economic efficiency in knowledge
production and dissemination is the fact that the exploitation of a discovery is
subject to increasing returns: the average cost of producing an item of knowledge
falls as it is used more widely. Since one cannot innovate on the basis of a fraction of
a technology there is an indivisible cost of creating the knowledge behind an
innovation. This fixed cost makes the ex ante valuation of knowledge virtually
impossible and incidently means that marginal cost pricing of innovations would
result in the costs of knowledge creation not being recovered. The result of these
considerations is the complete inadequacy of the perfectly competitive model to
provide guiding principles in a world where firms are required to innovate in order
to compete. The fixed costs they must incur to do so unavoidably mean that such
markets will at best be imperfectly competitive. The only way around this problem
would be for public laboratories to develop technology or for all private research
and development expenses to be fully subsidized from the public purse; neither of
which is remotely likely to occur.
I have spent some time outlining the arguments for market failure because of
their considerable influence on policy debate among economists interested in
technology and innovation. These ideas underpin a belief that market mechanisms
will not allocate the right amount of support to innovative activity not least because
of the peculiarities of knowledge as an economic commodity. In short, there is a
divergence between private incentives and social incentives which governments in
principle can correct.
Leaving aside the well recognized imperfections which governments can be subject
to when they intervene – for example, backing the wrong horse too quickly – it is
clear that market failure as a technology policy framework leaves much to be desired
(Metcalfe, 1995b). The logical underpinning it provides tells us nothing about the
design of policy instruments, nor their appropriate method of implementation, nor
the areas which are most appropriately in need of support in their attempts to
innovate. Is the focus to be on new knowledge, new skills or new artefacts? Is it to be
concerned with design, with construction or with operation? Is it to focus on the
creation of innovation or upon the diffusion of innovation? The answers to these
questions generate very different policy initiatives, in part because the incidence of
market failure varies considerably across the wide spectrum of science and technology.
A second difficulty is the fact that the vision of a Pareto efficient economy is a
distorting mirror into which to reflect the operation of an economy in which
innovation is at the heart of the competitive process. This is one reason why the
policy implications for innovation are very sensitive to the way in which market
competition is modelled. Private firms can be said to do too much innovation or
too little, to do it too quickly or too slowly, or to be too risk averse or not risk

averse enough in the breadth of their innovation activities. More fundamentally, to
define degrees of competition in terms of equilibrium market structures fails to
grasp a central theme of these lectures: that competition is a process of change and
that innovation is the major countervailing factor in offsetting the natural competitive
tendency for markets to concentrate.
Competition depends upon a will to compete which need bear no close relation
to any traditional concept of market structure: that is, to the number of participants
in the market. It is essential to recognize that competition requires active not passive
behaviour and that a framework based upon price competition between identical
firms can scarcely come to grips with competition which is based upon the ability to
innovate. Competition depends upon the search for competitive advantage, and the
development of new products and processes is the principal way this is achieved in
modern competition. The imperfections identified in the market failure approach,
therefore, can be viewed in a different perspective, as integral and necessary aspects of
the production and dissemination of knowledge in a market economy. In this
perspective it is surely perverse to call them imperfections. This is, of course, not a
new point; for those who have studied Schumpeter they are the natural features of an
economic process driven by creative destruction.
It is worth, therefore, coming at the matter from a different direction: one, in
fact, which is being actively developed by scholars working on evolutionary themes
of technological and institutional change.
AN EVOLUTIONARY PERSPECTIVE
While recognizing the significance of the public good dimension of knowledge, the
imperfections of intellectual property rights, indivisibilities and uncertainty, the
thrust of the argument is that their significance is not to be judged by a world of
equilibrium competition but by a world of change in which competition is a process.
This is the view taken in the evolutionary approach to economic change, with its
strong connections with a process view of competition.
In this perspective competition depends on the possibility of firms behaving
differently, and no source of difference is more significant in the longer term than
the articulation of different product and process combinations to serve differentially
the needs of the consumer. Another way of putting this is to say that without
asymmetries of knowledge the competitive process has nothing with which to work.
Thus competition is at root a process of diffusing diverse discoveries, the utility of
which cannot readily be predicted in advance. The market mechanism is a framework
within which to conduct innovative experiments, and a framework for facilitating
economic adaptation to those experiments. Competition depends on variety in
behaviour and those firms with superior product process combinations are able

over time to win customers from rivals and increase their share of the market, as we
have shown in Lectures 2 and 3.
In this process, technological and organizational innovation is at the heart of the
matter. Innovation drives competition and competition drives innovation, as those
who have fallen behind seek to protect and improve their market position. The
social benefits of competition are transmitted into increasingly more efficient
allocations of resources as superior combinations supply a greater proportion of the
market and as inferior combinations are continually improved (Downie, 1958; Nelson
and Winter, 1984; Metcalfe, 1995c). Correspondingly, a primary indicator of the
presence of competitive evolution is evidence on the changing relative importance
over time of different technological solutions to economic problems.
Effective competition depends on diversity in behaviour and over time this can
only be maintained by the continual introduction of new and better products and
new and better methods of production. Consequently the history of economic
competition encompasses two kinds of events: qualitative events, the introduction of
new activities, and quantitative events, the changing relative numerical importance
of existing activities. Now the natural tendency of the evolutionary process is to
concentrate production around the more effective activities, to destroy the diversity
which drives competition and to tend towards monopoly. Businessmen compete to
gain monopoly positions, not to allocate resources in a Pareto efficient way.
Consequently, if competition is to be preserved, procedures must be in place to
recreate diversity. No monopoly position is safe as long as there is scope for innovation
to undermine it. It is upon the innovation mechanism primarily that this burden
falls and by various stages of remove upon technology policy.
In truly competitive situations all positions are open to challenge and it is this
link between innovation and competition which has proved to be the mainspring of
economic growth. Hence technology policy becomes an essential component of
competition policy, the objective being to maintain open economic conditions.
Within this perspective a programme of technology support which privileges a small
number of established and often large firms is clearly open to question. General
support is more appropriate than specific support; policy makers do not have to beg
the question of which firms are more likely to succeed in making significant technical
developments, and they can concentrate on questions of which technological
opportunities are the most promising sources of innovations.
INNOVATION OPPORTUNITIES AND FIRM CAPABILITIES
If technology policy is intended to change the innovative behaviour of firms it must

take into account the perceived relationships firms seek to exploit when relating
their expenditure on technology creation to the anticipated outputs, new or improved
products and production processes. We may term these relationships the innovation

Figure 4.1 Innovation, time – cost trade off
opportunities frontier of the firm, recognizing that this concept must be used
cautiously given the difficulties in deciding how to measure the inputs and outputs
in the innovation process. Nonetheless, without some such relationship there really
is nothing useful to say on the technology policy front. Figure 4.1 illustrates what we
have in mind.
The diagram describes a time-cost tradeoff in the innovation process. On the
horizontal axis we measure the time it takes to achieve a given improvement in the
performance of a product or production process. On the vertical axis we measure
the cumulative innovative effort which is required to achieve that improvement by
a given date. There is a minimum level of effort required to achieve any improvement
at all, Eo, and a minimum time, To , below which it is not possible to compress the
date of innovation. The curve a-a represents the innovation possibilities for a given
improvement in technology, and the curve b-b shows similarly the trade-off for a
more demanding improvement in technology. Both curves are drawn to reflect
diminishing returns to innovative effort. Given the state of current knowledge it
takes progressively greater applications of effort to achieve a given reduction in the
time to innovation. Given the time to innovation it takes progressively greater
applications of effort to achieve a given improvement in performance. The important
point to recognize is that the frontiers are drawn for a given state of knowledge
relevant to that technological area. Any improvement in this state of knowledge and
the frontier shifts. Diminishing returns is a short run phenomenon, for the discoveries
arising from today’s innovative effort become part of the knowledge base for the
next period. So it is possible for there to be long run increasing returns to the

development of technology although, ultimately, we must expect that diminishing
returns re-establishes itself. These longer run effects are what is often implied by the
idea of a technology developing in a cumulative fashion. It is also what is implied by
the idea of a technological trajectory, in which tomorrow’s developments unfold out
of yesterday’s state of the art.
Our current state of understanding about these frontiers may be summarized as
follows. Innovation opportunities vary greatly between technologies, and within
technologies there are considerable differences in the innovation opportunity frontiers
identified by individual firms. Within a given area opportunities unfold over time
although there is very considerable uncertainty concerning the relationship between
inputs and outputs. The quality of the individual minds involved is obviously crucial,
as is the way in which research and development teams are organized. Uncertainty
also implies the failure of many attempts to develop technology; it is a trial and error
process, governed by methods of blind variation. That is to say, the outcomes of any
given programme are not knowable, they are necessarily conjectures. Consequently,
paths of technological development are not random, they represent patterns of guided
variation: a simple reflection of the fact that to make progress one must limit progress.
Innovation opportunities are also characterized by plurality in the kinds of knowledge
which contribute to technological advances, joint disciplinarity and plurality in the
range of institutions in which relevant knowledge is generated. The firm may be the
final determinant of innovation opportunities, but it is a firm embedded in a wider
network of knowledge generating and disseminating institutions. It is this perspective
which is central to the idea of technology support systems and more generally to the
idea of national systems of innovation. Finally, there are also wide differences between
firms in their ability to manage the process of technology creation, and it is these
differences between firms which pose difficult problems for policy.
The consequence of all this is the great diversity in the patterns and timing of
innovation across technologies and firms. Medicine is different from aeronautical
engineering, agronomy is different from computing, large firms innovate in ways
quite different from small firms, and if technology policy is to be effective it must be
sensitive to these differences.
A POLICY DICHOTOMY
In the light of our understanding of innovation opportunities technology policies

can be divided into two clear categories (Metcalfe, 1995a, 1995b). One is primarily
concerned with resources and incentives, taking the technological possibilities and
capabilities of firms as given. These policies work by changing net marginal returns
to developing technology. Tax allowances for R&D, specific innovative subsidies,
public purchasing of innovative products, the terms and duration of patent

protection, and regulatory policies dealing with factors such as the health and safety
of medicines are the most familiar examples of this kind of policy. In terms of Figure
4.1 they encourage firms to exploit a different point on an innovation frontier such
as a-a, or to encourage the development of a superior innovation by moving to
frontier b-b. In both cases the policy is subject to short run diminishing returns.
The second category of policy is quite different, for its purpose is to change and
enhance the innovation possibilities of firms by improving their access to knowledge
and by improving managerial capabilities. These policies shift the innovation
opportunity frontiers by giving firms access to a greater range of existing knowledge
and by improving their ability to exploit that knowledge. Thus b-b is shifted to b’-b’
as indicated by the dotted curve. The central feature of this group of policies is their
attention to the support system for a particular technology, that set of institutions
and relationships which support firms in their technology development activities.
These are policies which have been implemented with increasing frequency in the
past 15 years and they are all concerned to improve the connectivity between firms
and their appropriate technology support systems.
THE SYSTEMIC CONTEXT OF POLICY
The emphasis in these new policies is best summarized in terms of the development
of the science and technology infrastructure in the economy; an infrastructure which
facilitates the intercommunication of existing research results and mutually shapes
the future research agendas of different organizations. This infrastructure is a set of
interconnected institutions to create, store and transfer the knowledge and skills
which define technological opportunities. Many institutions are involved, including
private firms, universities and other educational bodies, professional societies and
government laboratories, private consultancies and industrial research associations.
Between them there is a strong division of labour and, because of the economic
peculiarities of information noted above, a predominance of co-ordination by
networks, public committee structures and other non-market mediated methods. The
division of labour is of considerable significance for the degree to which the different
elements of the system can be said to be connected. Different institutions typically
have different cultures, use different ‘languages’, operate to different timescales and
espouse different ultimate objectives as our brief contrast between science and
technology illustrated. Knowledge is ‘sticky’: it does not flow easily between different
institutions. Thus there is a major policy problem to be addressed in seeking to
achieve greater connectivity.
One strand of thinking in this area has been to emphasize the national domain of
the science and technology infrastructure, and rightly so (Freeman, 1987, 1994).

Policy formulation and implementation is essentially a national process. However,
there are good reasons to elaborate the national perspective both downwards and
outwards. It is important to recognize that different technologies have different
supporting infrastructures so that a sectoral innovation system perspective becomes
essential. This is simply one way of recognizing the specificity of the innovation
opportunities facing firms. On the other hand, it is clear that the infrastructure
frequently transcends national boundaries. Science has always been understood as an
international system and the same is increasingly true of technology. Governments
collaborate increasingly in major technology programmes, often in the defence area,
and transnational companies typically have multiple technology development activities
co-ordinated between different national infrastructures. Consequently we begin to
see the emergence of transnational technology development initiatives as exemplified
by the European Framework Programme which is now approaching its fifth stage, as
well as many small scale inter-firm collaborations. There is an important lesson for
the future in all of this. Governments will increasingly be unable to make technology
policy decisions in isolation; policies will have to be co-ordinated and compatible
for fear of making their country an unattractive location for technology development
activities (Carlsson, 1995).
Let me turn now to some examples of infrastructure building policy in the UK.
Since the mid-1980s there has been an increasing emphasis on programmes of
collaboration in technology development. Single firms are no longer given access for
grants to develop technology, they must collaborate with other firms and, if relevant,
universities. The major example of this trend was the Alvey programme and its
successor the Information Engineering Advanced Technology programme which built
communities of collaboration in the fields of micro electronics and information
technology (Georghiou and Guy, 1991; Cameron et al., 1996). These are large scale
examples of the general phenomenon. By collaborating, firms share costs and exploit
existing innovation opportunities more effectively but, much more importantly, by
pooling their respective knowledge bases they greatly improve these opportunities.
In some areas productive collaborations are premised upon existing commercial
relationships between a firm, its customers and suppliers – vertical collaborations. In
other cases they involve collaboration between otherwise competing firms, so-called
horizontal collaborations.
A second route to building infrastructure has been to create new bridging
institutions between industry and academia to facilitate the effective transfer of
knowledge and to shape research agendas. In the UK this has been exemplified by the
Technology Foresight initiative, about which I want to say a little more, since I
believe it will have a major impact on science–industry relations in the UK and more
widely.

TECHNOLOGY FORESIGHT
There is no more appropriate indication of the switch in policy from matters of

resources and incentives to matters of opportunities and capabilities than the
Technology Foresight Programme initiated by the UK Government. Foresight
activities have been defined as
a systematic means of assessing those scientific and technological developments

which could have a strong impact on industrial competitiveness, wealth creation
and the quality of life.
(Georghiou, 1996)
They appear to have been applied on a most consistent, long term basis within the
Japanese science and technology system (Freeman 1987). The process involved in
conducting a large scale foresight programme is precisely a matter of bridging and
connectivity within a nation’s science and technology base. Before commenting on
recent UK experience it is worth noting that the case for a UK foresight programme
was extensively discussed in a government report, ‘Exploitable Areas of Science’
published in May 1986 (ACARD). The report made a strong connection between the
investment view of science and what the report termed exploitable areas of science,
an area of science
in which the body of scientific understanding supports a generic (or enabling)

area of technology knowledge; a body of knowledge out of which many specific
products and processes may emerge in the future.
(para 2.3.1, my emphasis)
A policy of identifying and supporting such areas of knowledge was carefully

distinguished from a policy of picking commercial winners, potentially ‘winning
artefacts’. The intention was to support the creation of opportunities and capabilities
via a reservoir of knowledge from which as yet undeveloped products and processes
will emerge. Naturally this is a long term process and the report worked explicitly
with a 10–20 year time horizon. Recognizing that the identification of such areas
involves difficult matters of judgement it was argued that a framework was needed to
draw together the various knowledge inputs, establish communication between science
and industry, and mobilize resources according to the development of strategic
objectives. Thus effective interaction between the scientific community and industry
was considered of vital importance if the idea of science as investment was to be
more than rhetorical. Given the appropriate framework, the principle elements in
identifying exploitable science could be summarized at three levels:
• identifying the link between areas of technology and the underpinning scientific
knowledge base;

• identifying the product classes which would be significantly affected by
technological developments over a 20 year horizon; and
• identifying the relevant markets and the related pressures for change in so far as
they influence commercial incentives.
Of course, the provisional, tentative nature of any such analysis was well understood
and from this followed the need to continually update the analysis, recognizing that,
A policy for exploitable science is a process, in which decisions are made in the
light of the best available information and reviewed as and when new
information becomes available.
(para. 2.10.3)
From this followed the principal recommendation of the ACARD group, namely
that
a process should be established for identifying exploitable areas of science,

which has some degree of certainty of continuity, for the long term economic
health of the country.
(p. 12)
Almost a decade after the ACARD group began its work (October 1993) their principles
and objectives were included in the UK’s own Technology Foresight Programme.
This was announced in the 1993 White Paper ‘Realizing our Potential’ and produced
its first outputs in 1995; the result of the bringing together of scientists, engineers,
industry and Government in a major exercise to identify opportunities in markets
and technology likely to emerge in the next 10 to 20 years, and to identify the
actions needed to exploit them. In the process it did not attempt to pick winners
but, as ACARD had suggested, to involve the main parties in the development of
shared visions of the way in which the future may unfold. Behind all this lay the
view that the competitive future of the UK is with high value added sectors of
economic activity. The principal issues involved were the identification of market,
social and economic trends, the identification of the matching knowledge bases in
science, engineering and technology, and the implications for public funding of
research, skill formation and education.
The process involved the creation of 15 sectoral panels of ‘experts’ which consulted
on a wide basis with the relevant communities in industry, academia and government
through regional workshops, a major delphi survey and numerous other activities.3
Each panel has produced a report indicating the main forces for change and the
policy issues which flow from the analysis as well as identifying the likely constraints
on change. It is without question the most extensive consultation of industrial and
scientific opinion which has ever occurred in the UK. It is a simple reflection of the

fact that the development of modern technology is so heterogeneous with respect to
its discipline base and institutional context that it requires the sounding of opinion
in the broadest possible fashion.
It is too early yet to come to clear conclusions concerning implementation, indeed
it is central to the exercise that the consequences may not be fully realized until a
quarter century from now; it really is about the long term health of the economy,
recognizing that the lead time for technology development can be substantial.
It may also be that one outcome of Foresight will be a reallocation of resources
within publicly funded science and technology in the UK. Be that as it may, the
lasting benefit of the exercise is in the process and what the process does to the
formation of commercial and academic strategies to promote innovation, to the
creation of lasting networks between industry, government and the science and
technology community, and to the emergence of coherent visions within their
communities on complementary developments in science and technology. Coherent
vision definitely does not mean a consensus view about specific technologies or
routes to innovation but rather an understanding of the breadth of opportunities
open to a particular sector. Government would be foolish to predict which of the
options might succeed. This is very much a matter for private innovation and market
process. If all these developments ever come to pass not only will the key priorities
become clearer but the case for enhanced public and private funding of knowledge
creation will be difficult to resist. In short, enhanced opportunities and capabilities
provide their own incentives and make their own case for additional resources.
In summary, the Foresight Programme reflects an increasing concern with matters
of co-ordination, creating and supporting the technology support systems of particular
groups of firms, those formal and informal institutions which interact in a specific
technological area for the purpose of generating, diffusing and utilizing technology
(Carlsson and Stankiewicz, 1991; Carlsson, 1995). To create effective networks the
policy maker must know the relevant communities of scientists and practitioners,
understand the rival design configurations and ensure that incentives between the
various parties are aligned appropriately. The sequence of innovations which emerge
and the firms which are successful are the outcomes of the process and are not a
specific concern of the policy maker. Winners emerge, they are not pre-chosen. All
this is entirely consistent with the evolutionary perspective. Since it is an evolutionary
system, the role of policy is to facilitate the ongoing development of innovative
variety, not by second guessing the market but by creating the conditions under
which innovations flow more easily. In this the policy making is not seeking to
optimize the exploitation of given opportunities, but rather to adaptively create the
conditions for the emergence of new opportunities. Government can neither predict
which are the likely innovations nor the promising markets. Rather its proper role is
to build an infrastructure in support of firms and let the innovations follow from
the market process.

CONCLUSION
In this lecture I have reviewed recent developments in technology policy and attempted
to view them through the lens of evolutionary economics. Here the fundamental
insight is the experimental nature of a market economy. As Schumpeter aptly observed
capitalism works by means of creative destruction, a process which is now played out
on a global scale. Patterns of international competition are ever changing and an
advanced country must be ever aware of new opportunities if its standard of living
is to be sustained. Central to this must be the rate of innovative, new technology
based experimentation and I have suggested that a consistent thread to policy has
emerged in the past 20 years of which the Foresight Programme in the UK is a
leading example. The central focus of this change has been the emphasis upon enhancing
the innovation opportunities and innovative capabilities of firms. The ultimate test
of this shift will be the technological creativeness of UK industry over the next two
to three decades. From a political point of view this will be a lot to ask. Experimental
economies have many failures as well as successes; blind variation means that a great
deal of effort comes to nought and that patience is the sure companion to long term
success.

COMMENT
Heinz D. Kurz
Stan Metcalfe’s fascinating account of important achievements and unsettled problems

of the evolutionary approach to economics in his Graz Schumpeter Lectures can be
assessed from different perspectives. Being myself concerned with exploring the
explanatory power of what may be called the ‘classical’ approach, the natural thing
for me to do is to look at Metcalfe’s findings from this perspective. The core part of
his argument then emerges as revolving first and foremost around the problem of
what the classical economists called the ‘gravitation’ of market prices to ‘natural’
prices, or ‘prices of production’ and, correspondingly, the gravitation of the actual
rates of profit to some natural or ‘normal’ level. Whilst in analysing the problem of
gravitation the emphasis is commonly on the tendency, or lack thereof, towards a
uniform rate of profit (or some ‘normal’ pattern of profit rate differentials) across
industries, assuming that the intrasectoral profit rates are equalised, Metcalfe is concerned
with the tendency, or lack thereof, towards a uniform rate of profit within an industry.
This concern is to be welcomed because what happens inside an industry has been
entirely neglected or at best given short shrift in the gravitation literature. Its results
are implicitly based on the dubious assumption that what happens inside an industry
is of no import for what happens between industries. On the contrary, Metcalfe’s
analysis is based on the simplifying assumption that what happens outside an industry
is of no import for what happens inside it.
Before I comment on the latter obvious limitation of his analysis, I should like to
make a few remarks on the general approach chosen by him. In my view, Metcalfe’s
approach is firmly entrenched in the ‘classical’ tradition of economic thought. I see
no fundamental contradiction or incompatibility between the evolutionist mode of
thought permeating his analysis and the way in which authors such as Adam Smith
understood the process of economic development and conceived of competition
and selection. Joseph Alois Schumpeter, as is well known, was fascinated by Walras’
analytical edifice, but apparently not fascinated enough. He did not completely fall
victim to neo-classical general equilibrium theory. In important respects – that is,
those relevant to an understanding of economic dynamics – he tried, rather, to
follow the classical economists and Marx.

However, there are remarks in Metcalfe’s text which seem to suggest that he considers
his analysis as different from and at least partly incompatible with both mainstream
economics, identified with neoclassical general equilibrium theory; and classical
economics. His critical attitude towards the latter is perhaps less pronounced than
that towards the former, but nevertheless critique there is. This critique seems to be
based on two interrelated objections: one methodological, the other substantive. The
first calls into question the classical ‘long-period’ method, according to which economic
systems in motion are best analysed ‘in terms of a comparison of sequences of
equilibria’. In competitive conditions each of these long-period positions is
characterized by a uniform rate of profit and uniform rates of remuneration of all
primary factors of production, such as different qualities of labour and different
qualities of land. The second objection throws in doubt that the ‘invisible hand’
governing the economic process is optimizing. It may be optimizing, but there is no
reason to believe that it always is. Because of the ‘multidimensional nature of
competitiveness’, Metcalfe stresses, there is no presumption ‘that firms defined as
best practice over a limited range of dimensions must have the highest fitness value’.
Hence, it cannot be taken for granted that the selection process leads towards the
general adoption of the best practice technique and thus to a cost-minimizing system
of production.
I begin with the second objection. The first thing to be noted is that the classical
concept of long-period is a flexible one. The ‘long-period position’ is simply the
position which the forces of competition will, in any given set of circumstances,
tend to establish. Therefore, what matters first and foremost is whether at any given
moment of time the basic premiss of the approach is sound; that is, there is a centre
of gravitation, or attractor, towards which the economic system moves. The selection
models elaborated by Metcalfe broadly support the classical view: as Metcalfe stresses,
‘the system has an attracting point’. The second question, then, is what the properties
of the particular attractor are. Metcalfe’s findings may also be regarded as illustrating
the classical view that the properties of such a point depend on a variety of factors,
including the intensity of competition within and across industries, the characteristics
of technology; especially whether there are economies of scale, the importance of
externalities, etc. Over time the properties will change in response, for example, to
technical and organizational change or the exhaustion of natural resources. Therefore,
the finding that the selection process need not be optimizing, i.e. cost-minimizing,
does not by itself imply that the classical approach has to be abandoned. What
perhaps has to be abandoned is the assumption of free competition, that is, there are
no barriers to entry or exit. In Metcalfe’s model firms differ persistently from one
another with regard to the set of principal capabilities contemplated by the model.
In particular, all firms do not have access to all known methods of production. There
are, so to speak, barriers to the general adoption of what is the best practice technique
under any given circumstances, a case dealt with under the heading of ‘monopoly’ in
Smith or Ricardo.

All this appears to me to be fully compatible with the ‘classical’ perspective. For
example, there is no principal difficulty to incorporate differential profit rates (and
wage rates) within and across industries in a classical theory of value and distribution
(see, for example, the discussion in chapter X of book I of Adam Smith’s The Wealth
of Nations ([1776] 1976). However, I think the classical authors were well advised to
not easily give up the assumption of cost-minimization. First, while the possibility
cannot be excluded that firms that are not best practice have the highest fitness value,
it is far from obvious that this is often or even typically the case. It appears to me to
be more plausible to assume that high fitness is normally correlated with technological
advancedness. Second, over a sufficiently long period of time the knowledge about
the best practice technique can be expected to spread out among firms and result in
imitation by the firms lagging behind. In this way technical innovations tend to
become a ‘general good’, as Ricardo called it, anticipating the notion of ‘knowledge’
as a quasi-public good in the literature on ‘new’ growth theory. Third, even if there
were good reasons to believe that the assumption of cost-minimization does not
mimic reality, it appears to be the best at our disposal – at least in a first step of the
analysis. On the basis of this assumption a set of interesting results can be derived
which, in a second step, may then be modified according to the circumstances defining
the particular case under consideration. I wonder whether Stan Metcalfe would agree
with this.
As to the first objection, that is, that economic change cannot adequately be
studied in terms of comparisons of long-period positions, I think there is no
fundamental disagreement. We would like to have a proper dynamic theory capable
of dealing with an economic system in motion. Yet, to the best of my knowledge, at
present we are not possessed of such a theory, despite the effort of generations of
hardworking and ingenious scholars. Nor is there an indication that such a theory
will shortly be available. In these circumstances classical long-period analysis seems to
me to be the best choice among the alternatives open to us, none of which are
satisfactory.
Some of the difficulties encountered by a proper dynamic analysis can be illustrated
with regard to the ‘elementary model of selection’ put forward in Metcalfe’s second
lecture. There it is assumed that a given number of firms produce the same commodity
but do so using different constant returns to scale methods of production. There are
only two inputs, labour and a machine; the labour and machine coefficients in firm
i are ai and ci, respectively. It is assumed that the wage rate is uniform, constant and
given from outside at a level w, and that there is ‘depreciation by evaporation’ at the
rate d of the machine, whose price, pm, is also given and constant. Finally, the rate of
interest is given at the level r. Hence unit costs of production are also given: hi = wai
+ (r + d)pmci, and are assumed to remain constant throughout the selection process.
This model is clearly a partial model and it is perhaps useful to reflect briefly on its
limitations. In terms of Sraffa’s distinction between basic and nonbasic commodities
(Sraffa 1960), the commodity produced by the population of firms under consideration

is a nonbasic of the kind that does not enter, either directly or indirectly, into the
production of any other commodity, that is, a pure consumption good. This simplifies
matters considerably, because one can be sure that a change in the price(s) of that
commodity will have no effect on the price(s) of any other commodity. Hence, any
feedback from changes in the price of the special nonbasic on itself is ruled out.
However, this assumption is not enough to guarantee that the analysis of what is
going on in the nonbasic industry can be carried out as in a vacuum. A further
assumption is needed: there is no similar selection process at work in the only basic
industry of the model, that is, the one producing the machine. It is even assumed
that there is only a single price of the machine, which appears to imply that the basic
industry has already reached its long-period position defined in terms of one or
several methods of production which, at the given wage rate, exhibit the same unit
costs and are all equiprofitable. Hence, at that wage rate, which of necessity has to be
expressed in terms of units of the basic product, i.e. the machine, there is a uniform
rate of profit across all firms populating the basic sector. This rate of profit equals
the rate of interest, r, applied in the determination of unit costs in the different
firms producing the consumption good. Otherwise, one would have to take into
account as many different prices charged for the machine as there are different firms
characterized by differences in unit costs and/or differences in some other
characteristics that are relevant for their price setting. This would tremendously
complicate the picture, because one would have to take into account from which
firm(s) in the basic sector a particular firm in the nonbasic sector buys the machine.
It should also be noticed that with the wage rate fixed in terms of the basic, the wage
rate in terms of the nonbasic (i.e. the real wage rate) tends to increase as the price(s)
of the nonbasic fall.
But this is not all. Since with a selection process taking place in the basic sector,
where the time profile of that process is not independent of the behaviour of the
firms in the nonbasic sector, the prices charged for the machine by the various
machine producers would necessarily change over time. This would in turn affect
unit costs of the different producers of the consumption good, depending on the
machine producing firm(s) from which they respectively obtain the durable capital
good. It is, for example, possible that one firm producing the nonbasic which at one
moment of time exhibits larger unit costs than another firm, at a later moment
exhibits lower unit costs. Clearly, this would be the case if that firm were to obtain
the machine from firm(s) exhibiting a sufficiently more rapid fall in price than those
firm(s) supplying the other firm. Hence, the relative fitness of firms in the nonbasic
sector might follow a much more complicated pattern over time once interactions
between firms in the basic and nonbasic sectors are taken into account. It cannot
even be excluded that firms go through phases in which they first lose in market
share, then regain lost territory, and then lose again, or vice versa. It all depends on
the mix of characteristics of their differential behaviour, including the judiciousness,
or lack thereof, of their policy of procurement of inputs. In short, an answer to the

question of the dynamics of the system under consideration would involve a full
description of the intertwined histories of all the different firms in the different
sectors – clearly a task that is beyond the capacity of economists.
However, even this is not all. If the selection process(es) in the basic sector(s) is
(are) taken into account, then the general rate of profits, given the wage rate in terms
of the basic (or the nonbasic), will change. Alternatively, the wage rate may change.
Since the demand for consumer goods out of wages is a major component of total
consumer demand, it will be important to know not only which commodities wage
earners will buy, but where they will buy them, because their buying behaviour is
one of the determinants of the success or failure of each single firm. With a uniform
money wage rate, commodity wages would be different according to whether the
goods purchased with money wages are bought from firms asking relatively high or
low prices. Therefore, in such a world the concept of a uniform ‘real’ wage rate, and
also that of a uniform money wage rate, would have to be abandoned. What has just
been said about the buying behaviour of wage earners would have to be extended to
the recipients of profits and other kinds of income, such as rents of land or interest.
We would not only need a full description of the histories of all the different firms
but also of all other agents in the system.
While nobody would deny that in reality all these differential behaviours matter
and are responsible for sometimes surprising market outcomes, it seems to also be
clear that a useful economic theory cannot possibly be based on a full description of
individual agents and their differential behaviours. At any rate there is no feasible
algorithm in sight to solve the sketched highly complex problem. As Knut Wicksell
pointed out in the context of a discussion of the problem of the formation of new
capital and the changes triggered by it: ‘To pursue all these changes in detail is quite
impossible, especially as they take place in an infinite number of different ways’
(Wicksell, [1893] 1954, p. 156). This is also the reason why I think that there is no
such thing as a general theory of gravitation. Apparently, poor economists cannot
do without some bold short cuts. Classical long-period theory suggests some such
short cuts. It would be interesting to see what, from an evolutionist perspective, are
deemed sensible short cuts.
There are a few other aspects of Metcalfe’s argument on which I would like to
comment briefly. In one place he assumes that the trait values, hi , ‘depend upon the
relative shares of output’. While employing this assumption suffices to make the
point that with a dependence of the trait (or traits) which governs the selection
process on what happens in the course of that process, that is, the endogeneity of the
trait, some complications may arise and a new pattern of selection obtains, I wonder
whether this assumption can stand on its own or has to be complemented by the
assumption that total output of the industry is given and constant. In conventional
treatments of the problem of increasing returns to scale it is assumed that the long-
period average cost curve of each single firm depends on the size of the industry as

a whole, i.e. its total output. As a consequence, for each quantity of product supplied
by the industry there is a long-period average cost curve for each single firm. This is
the case in which economies of scale are external to the firm and internal to the
industry. At a larger quantity supplied by the industry, the long-period average cost
curves of the firms in the industry will be lower. As a consequence, the long-period
supply curves of these firms are decreasing schedules.
Metcalfe stresses that ‘competition is a process which certainly is not incompatible
with any form of increasing returns’; I agree. In this connection it is perhaps worth
recalling that in his discussion of the division of labour in chapters I–III of book I
of The Wealth of Nations Adam Smith stresses the importance of economies of scale.
He is of the opinion that this does not prevent the analysis from revolving around
the concept of the general rate of profits (or a fairly fixed structure of profit rate
differentials between different employments of capital). Seen from the point of view
of the debate about non-constant returns to scale at the beginning of this century,
Smith may be said to have implicitly assumed that returns are essentially external to
the firm, that is, the size of one or more industries matters in determining the
methods of production available to single firms. Hence, each single firm is taken to
operate basically at constant returns, while total production is subject to increasing
returns. While some examples provided by Smith relate more to the division of
labour within firms than to the division of labour among firms, it is clear that in his
view some of the activities which were originally a part of the division of labour
within the firm may eventually become a different ‘trade’ or ‘business’, so that the
division of labour within the firm is but a step towards the division of labour
among firms. This is an important route through which variety is generated in the
economy.
To conclude, according to my ‘classical’ perspective Metcalfe’s evolutionary model
of differential behaviour and selection provides important insights into the process
of gravitation towards a long-period position. It may be interpreted as a contribution
to a crucial problem with which the classical economists grappled, rendering support
to their intuition that competition gives coherence to the economic system and at
the same time is the source from which that coherence is continually upset.
REFERENCES
Smith, A. [1776] (1976) An Inquiry into the Nature and Causes of the Wealth of Nations, The
Glasgow Edition of the Works and Correspondence of Adam Smith, Volume II, Oxford:
Clarendon Press.
Sraffa, P. (1960) Production of Commodities by Means of Commodities, Cambridge: Cambridge
University Press.
Wicksell, K. [1893] (1954) Value, Capital and Rent, London: George Allen & Unwin.

CONCLUDING COMMENT
J.S. Metcalfe
There is much on which Professor Kurz and I agree but also some matters of substance
where we do not. It would be quite wrong for me to write at length at this point,
after all it is the reader of the lectures who must judge their content, but perhaps I
might be allowed some brief remarks.
First there are matters which we agree require further investigation by evolutionary
minded economists with every prospect of clear and interesting results. The questions
of the relation between intra-sectoral and inter-sectoral competition, the further
elaboration of entry and exit processes, the inclusion of sectors producing means of
production are not matters of fundamental difference – they are simply an agenda
for further research. Equally, a treatment of various kinds of increasing returns is a
natural complement to a dynamic treatment of competition and not the reef on
which the ship threatens to be dashed,1 as is the case with equilibrium theory. If
leaving these developments aside for the moment involves ‘partial’ analyses, so be it.
Now to more substantial concerns which are two in nature. Let me take cost-
minimization first. Nothing in the evolutionary method need deny that firms
minimize their costs. However, what it does insist upon is that those minimizations
are local not global, bounded by the particular circumstances of knowledge and
practice in each firm. Hence the emphasis in the evolutionary economic and
management literature on the central significance of bounded rationality. This is
fundamental: evolution is premised on different behaviour, not uniform behaviour,
and who could possibly deny the existence of these differences as a pervasive aspect
of modern economic life and a central element in explaining its dynamic? The
rationality of behaviour is not the important issue – the variety of behaviour is.
Second, and more fundamental to all, is the role to be assigned to the notion of
classical centres of gravity in our understanding of dynamic processes. I find this
notion not very helpful in a world of continuing technological and organizational
change, however fruitful it may be for other purposes. The evolutionary method
does not conduct dynamic analysis around hypothetical long-period positions, but
in terms of the prevailing distribution of behaviours in the relevant population.
This is the method embodied in the replicator dynamic with its emphasis on the

currently existing ‘distance from average behaviour’. Of course, if the fundamental
behaviours in the population are held constant, an attractor will be established and
in certain circumstances this may have cost-minimizing attributes. What is important
to comprehend is that the attractor is discovered – it is not presumed by the analyst.
Moreover, there is no necessity that the best competitor, in some previously defined
sense, wins the race. History and contingency are important to evolution.
However, it is when we consider normal capitalism that the evolutionary method
comes into its own. For the data are then continually changing, maybe profoundly
at times, regenerating the differences in behaviour on which the evolutionary method
depends. Stationary capitalism is a scarcely credible notion: to put it rather starkly,
these supposed centres of gravity do not themselves have a centre of gravity. It is
such open-ended and essentially unpredictable development that the evolutionary
method absorbs with ease and which leads me to question Kurz’s view that the long
period method is the best choice available to us to understand economic change. If
we are to come to terms with the mode and tempo of historical change in modern
capitalism we must, I believe, also pay serious attention to the evolutionary method.
But let me not overplay the differences with the classical economists for whom
accumulation, structural change and technical progress were important concerns.
Perhaps the evolutionary method may play its role in directing attention back to
these major features of capitalist economies. Let the problems be defined and resolved,
but let the differences flourish.

NOTES
PREFACE
1 Cf. Swedberg (1991) for an account inter alia of Schumpeter’s ‘European Years’ as academic
and politician.
PROLOGUE: CHANGE WITHIN CHANGE
1 Cf. Simonetti (1996) for some interesting comparisons based on the top 300 Fortune list
of companies in the USA. Also Hannah (1996) for discussion of the long run evolution of
giant firms.
2 As I write these final revisions to the manuscript, I have before me an article in the
Financial Times (8/1/1997) in which the Chief Executive of Apple Computer describes the
strategy to revive the company’s fortunes. It is framed in the language of conflict, of war,
which is undoubtedly how the company views the day-to-day experience of capitalism.
Apple had fallen from being a market leader to a position where it enjoyed only 5 per cent
of the market for personal computers.
3 Two classic statements on the history of technological change are provided by Landes
(1968) and Mokyr (1990). Maddison (1991) provides a useful statistical overview of the
development of modern capitalism. Further examples may be found in the highly stimulating
book by Brenner (1987).
4 That is not to say that the evolutionary approach is without challenge. Rosenberg (1994)
provides a recent, articulate statement of why, in his view, economics can gain little from
evolutionary theory. For reasons made clear below I do not agree. Rosenberg errs in
thinking that evolutionary methods will augment our understanding of equilibrium. They
won’t. Evolution is inherently about change not equilibrium. Nor is evolutionary theory
devoid of predictions which are falsifiable in principle. Leaving aside the weakness of
falsifiability criteria, it is simply nonsense to continue to belabour the tautology charge
against evolutionary theory. In passing, Rosenberg’s strictures on Nelson and Winter are
also wide of the mark. Their theory is not about the evolution of organizations per se, rather
it is about the evolution of populations of organizations. To say that organizations evolve
is a statement of a quite different character. Sadly evolution is too prone to use in contexts
where all that is meant is change. Evolution is one specific mechanism for change. It is not
the only descriptor of change more generally.
5 Cf. T.Y. Shen (1996) for a very interesting attempt to judge the welfare significance of the
competitive processes treated in these lectures.

1 ON RIVAL CONCEPTS OF COMPETITION AND THE
1 Stigler (1957), p. 1.
2 Schumpeter adhered to his five categories to the end of his career, cf. (1947) p. 153.
3 McNulty (1967) argues that many of the elements of Smith’s competitive theory had been
well established in the writings of his predecessors.
4 Knight (1933, p. 178), for example, considered Smith’s theory to be ‘self-excitive and
cumulative’.
5 Cf. Kurz and Salvadori (1995) and on the implicit dynamics of the uniform rate of profit
process Duménil and Lévy (1995).
6 Consider the UK electricity market as it has evolved since privatization in 1991. Individual
electricity generators make decisions as to which of their plants will be available to supply
on a given day and time and bid a price at which they are willing to be called into
production. These look like fixed prices based on unit costs plus a suitable markup.
However, prices are not set by the generators; they are set by the electricity pool, the
authorized market institution charged with the matching of supply offers with estimated
demand. The pool judges which generators will be called and, in so doing, sets the marginal
production price. Over the day and between days the pool price has all the characteristics
of a flex-price which is what it is. Crucial to these arrangements are the facts that electricity
is an instantly perishable commodity and that it is impossible for users to distinguish from
whom they have been supplied.
7 Cf. Knight (1946), p.102. ‘The “perfect” market, of theory at its highest level of generality,
is conventionally described as perfect or purely “competitive”. But use of the word is one
of our worst misfortunes of terminology. There is no presumption of psychological
competition, evolution or rivalry . . . atomistic is a better word for the ideas.’
8 For those readers uninitiated in the pleasures of travel from London to the South Coast of
England, Clapham Junction is the meeting point for many of the routes into Waterloo
and Charing Cross stations.
9 Hicks (1939) p. 84. Hicks was well aware that ruling out increasing returns was a dangerous
step, potentially limiting the problems with which economic theory can deal.
10 Schumpeter (1939). Similar views are expressed in the posthumous History of Economic
Analysis.
11 On this see the stimulating paper by Emmett (1994) where the contrast is made between
Knight’s narrow vision of the rational, ‘maximising’ agent and his broad vision of the
‘good sport’ adept at discovering better patterns of economic behaviour. In two of Knight’s
major essays, ‘The Ethics of Competition’ and ‘The Limitations of Scientific Method in
Economics,’ the idea that ‘life is an exploration in the field of values’ plays a predominant
role in the argument. The former essay linked this theme to the idea that wants are
provisional and a consequence of the workings of the prevailing economic system. Seeds
here of an evolutionary theory of preferences which is sorely needed (Knight, 1933).
12 On Edison see A. Millard (1990). The locus classicus on Elmer Sperry is T.P. Hughes (1971).
13 Schumpeter, 1934, p. 154.
14 For interesting discussion consult Brenner (1987), Ch. 3.
15 Marshall (8th edn, p. 5) claims that, ‘The strict meaning of competition seems to be the
racing of one person against another, with special reference to bidding for the sale or
purchase of anything.’ Of course, he was at pains to suggest that this is only the surface
reflection of the more fundamental characteristic of economic freedom. Cf. also Stigler
(1957), p. 1.
16 Which is what businessmen typically mean by a level playing field.
17 This is one good reason to be sceptical of insights from equilibrium game theory whenever

they involve the full enumeration of possibilities including probability distributions of
possibilities.
18 I have to hand a quote which captures this view with perfect sense ‘I am not a good
businessman, it’s just that others are worse than me’, attributed to Mr Wing Yip, one of
Britain’s most successful Chinese businessmen, in Connections Winter 1996, the magazine
of Sun Alliance plc. On Knight’s metaphor of economics as sport, see also Emmett
(1994).
19 The classic account of many of the controversies is to be found in Sober (1984). See Sober
(1993) for a summary and also Hull (1980) for a clear statement of contentious issues.
20 Cf. Hannah (1996) for an interesting discussion of the evolution and survival of firms
over the period since 1900.
21 A familiar model of international trade is one in which firms in different countries
‘compete’ in the same product market while drawing upon local markets for their inputs.
22 That organizations have to be designed for a purpose is emphasized in Bausor (1994).
23 It is important to distinguish replication and interaction from the idea of replicating and
interacting entities. I will require one entity, the business unit, both to replicate and
interact. For discussion of the development of these concepts and their application to
cultural evolution consult Plotkin (1994), Chs 3 and 6.
24 In conducting evolutionary argument it is important to explain what does not change as
well as that which does. Cf Loasby (1991). For further discussion of routines interpreted as
recurring action patterns see Cohen et al. (1996).
25 It may well be vital to our understanding of economic and business history, however.
What might have been had the great entrepreneur not perished in a storm!
26 For a survey of concepts of ‘local’ technological progress see Antonelli (1995).
27 Cf. Mathews (1985) and Winter (1975) for a clear discussion of the role of inertia in
economic models of evolution.
28 In this context I do not think it helpful to equate innovations with random mutations
alone, in strict Darwinian fashion. Imitation is a further important difference between
economic and biological evolution. For comparison of Darwinian and Lamarkian
statements of evolution see Plotkin (1994), Ch. 2.
29 Lecture 4 draws out some of the implications.
30 This is not to deny the usefulness of representative agent theory in other contexts. On the
non-evolutionary limits to the representative agent see Kirman (1992).
2 FISHER’S PRINCIPLE AND THE PROCESS

OF COMPETITION
1 This theme of structural change was explored in depth in the work of Burns (1938) and
Kuznets (1929), (1954), each of whom developed an explicitly microeconomic approach
to growth, an approach out of step with the macro emphasis which followed Harrod’s
brilliant Towards a Dynamic Economics (1948).
2 For an excellent statement of the Austrian perspective consult Fehl (1994).
3 Notice carefully that e is not the fraction of X(t + ∆t) produced by the exiting firms. This
fraction is given by the ratio e(1 + ge)/(1 + g). When ge = –1 this fraction is naturally zero.
4 On this basis, Σsi (t) = (1 – e) and Σsi (t + ∆t) = (1 – e + gs )/(1 + g) are the aggregate shares of
those firms operating at both the census dates. When e = 0 it follows that Σsi(t) = 1 and Σsi (t
+ ∆t) = 1 – n.
5 The maximization hypothesis is of course central to many economic theories of the firm.
However I doubt if even the most ardent admirers would deny that it is not to be taken
literally and that its purpose is to enable effective communication between like-minded
economists. On this see the comprehensive survey of boundedly rational decision-making
by Conlisk (1996).

6 Anyone who doubts this might first consult the anti-trust reports of the European
Commission or any national competition authority. A few days spent talking with
industrialists will not fail to drive the point home.
7 I leave aside how age is to be defined, particularly in the presence of changes in ownership.
The organizational ecologists would find this particularly unpalatable and I admit to
considerable sympathy with their view (Hannan and Freeman, 1989). We are entitled at
this stage to keep the lid on Marshall’s Pandora’s box.
8 In this expression r is the cost of capital, what the firm considers it must pay to debtors and
shareholders, and d is the assumed accounting rate of depreciation. Of course, what is
deemed to be capacity output is not simply a technical question but must also relate to,
among other things, expectations about the volatility of demand around its trend value.
9 This is the same as representing pi and hi relatively to pm.
10 The rate of profitability is simply mi /ci.
11 Of course, one way firms can seek to outcompete their rivals is to limit the ability of their
customers to switch to other firms, that is to seek to reduce the value of their particular
rate coefficients. In competition law such behaviours fall under the rubric of restrictive
practices.
12 If ri is the individual firm’s profit rate, ri = π(1 + e)g i and r = Σsi ri = π(1 + e)gD, a constant for
a given market growth rate.
13 This section is something of a detour from the main argument which is rejoined at page
57.
14 The other ready assumption is to assume that dsi = –dsj ,whence
15 This is the Bertrand case with p = p1 = p2 = gD /f + hs if both firms are dynamic. With a zero
market growth rate this becomes p = max(h1, h2).
16 The equation for the locus B-B is given by
17 The constancy of retention ratios and their dividend cover is one of the stylized facts of
corporate finance implying that dividends rise proportionately with earnings, Kaldor
(1985, p. 51). On the role of self financing of investment see the useful survey by Galetoric
(1995). A fuller treatment of these issues would also require a discussion of the work of
Eichner (1976).
18 In which (pi – hi)/pi = si /∈, ∈ being the elasticity of aggregate market demand. This version
of the formula assumes Cournot behaviour on behalf of the rival firms.
19 The only constraint he places on the coefficients is n<1. However if m≥1 it follows that
there is no upper limit to the unit cost level at which a firm can earn a profit. Alternatively
if m<1 an upper viability bound exists, in that the least efficient firm cannot have costs too
much greater than the industry average. In fact this upper limit is given by max hi = [mn/
(1 – m)(1 – n)]hs.
20 Wood was a pupil of Kaldor at Cambridge.
21 Notice that Wood relates gi not to pi but to the profit sales ratio mi /pi.
22 That is, the average market price of the firms other than firm i. By expanding (3), we can
write the market opportunity locus as gDi = gD + δjΣsj pj – δ(1 – si)pi; i≠j.
23 After delivering these lectures I came upon yet another precursor and indeed one who was
a former professor at my own University of Manchester! This is Ball (1964) whose Inflation

and the Theory of Money can be consulted at pages 109–116 with profit. Also recommended
are Leyland (1964) and Richardson (1964) for the link between pricing and growth.
24 In this last case, all firms would be marginal firms, pi = hi , since all finance becomes
unlimited external finance. It is customer selection alone which then defines the replicator
dynamic, and the growth rate of each firm is exactly determined by (3) above.
25 The formal proof is contained in Hofbauer and Sigmund (1988) and rests on identifying
a Lyapunov function for the system with the requisite properties to identify global stability.
The average unit cost hs is a strict Lyapunov function for the system of equation (9). There
is another less formal way of seeing this. Suppose firm one is the lowest cost producer. If
it is to be the attractor then the pattern of market shares must be such that hi = hs. It follows
immediately that this requires si = 1 and sj = 0.
26 Replicator dynamics plays a central role in modern evolutionary game theory. See Binmore
(1992) for an introduction and Taylor and Jonker (1978) and Vincent, Cohen and Brown
(1993) for more advanced treatments. It is important to note that the dynamics of
discrete replicator systems differ from their continuous counterparts. On the mathematics
of these systems see the useful summary by Joosten (1996) and the references contained
therein.
27 Hofbauer and Sigmund (1988), pp. 134–135.
28 Which is not the same as the rate of reduction of the average price.
29 This reflects the fact that changes in the population mean due entirely to selection have
no effect on the population variance. In other words dVs(h)/dhs = 0.
30 I am grateful to my colleague Jonathan Shapiro for helpful discussion of this point. For
further analysis consult Shapiro et al. (1996).
31 This optimality result was first stated by Kimura (1958). See Crow and Kimura (1970) and
Hofbauer and Sigmund (1988) for details. Metcalfe (1994a, Appendix), gives a rudimentary
outline of the theorem.
32 I leave aside the analysis of the spread of particular innovations within an industry.
Suppose there is a technique ‘A’ which can be adopted by the firms in the industry, a
technique which reduces unit costs according to the proportion in which it is adopted by
the firm. Following Mathews (1985) we may express this as follows. Let qi be the proportion
of the output of firm i that is produced with the new method. We can measure the spread
of A by the fraction D of the total industry output produced by it. Then D = Σi si qi and the
proportionate rate of spread is d log D/dt = Σsi qi [d log qi /dt + d log si /dt]. The first bracketed
term is the change in the rate of intra firm adoption, the second bracketed term is the rate
of selection as previously defined.
33 For interesting evidence on this theme in relation to large samples of UK small and
medium sized firms see Cosh and Hughes (1996).
34 Whereas gs≥0 by construction, gm may be negative, and it will be if ags>gD. It is helpful to
think of gm as a residual growth rate, the consequence of the behaviour of the dynamic
firms in relation to the market growth.
35 Notice carefully, that the position of this D-D schedule is mutually determined by the
market growth rate and the value of hv It cannot be drawn independently of a knowledge
.
of ha – hz. It is not the same as the schedule labelled D-D in Figure 2.2.
36 The last term on the right-hand side of (18) is the variance in the sub-population means
relative to the population average.
37 This does not resolve the question of the order in which the marginal firms exit from the
population. See, for example, the discussion and literature cited in Ghemawat and Nalebuff
(1990).
38 See Blanchflower et al. (1996) for evidence of a positive link between changes in wages and
changes in profitability. On a similar theme, linking wages to innovation, see Van Reenan
(1996). The model behind the above is one in which customer flow dynamics is matched

with a similar mechanism of employee flow dynamics, based on differences between the
firm’s wage and the industry average wage.
39 As a general observation, the evolution of demand is the major missing element in the
current research programme of evolutionary economists.
3 ECONOMIC VARIETY AND MODELS OF CHANGE
1 Amongst the many contributors to this field I recommend Anderson (1994), Chiaromonti
and Dosi (1993), Eliasson (1985), Kwasnicki (1994), Silverberg and Verspagen (1996),
Saviotti and Mani (1996).
2 Remember that fi = πi(1 + ∈i)/ci, πi being the internal finance ratio, ∈i the ratio of external
to internal finance, and ci the capital:output ratio. For interesting evidence in relation to
small firms see Cosh and Hughes (1996), Davidson (1989) and Hambrick and Crozier
(1985).
3 Consult Metcalfe (1994b) for a detailed exposition of the weighting scheme.
4 Notice that if xi is any characteristic of the population then fs(xu – xs) = Cs(f, x) and fs(fu – fs)
= Vs(f) define the relation between the means using the different weights.
5 Proof of this proposition is contained in Metcalfe, 1994b, Appendix 1.
6 Information of this nature is published routinely and in great detail by brokers and
analysts operating in the main stock markets in the industrial countries.
7 That ‘brand image’ may improve as a firm’s market share improves is an important
potential source of positive feedback influences from the demand side of the competitive
process. There are connections here with recent thinking about network externalities
which there is not time to explore.
8 Notice that the weights si here are not the same as the similarly labelled weights defined in
Lecture 2. The relation between the two schemes is as follows: let zi = xi /Σzixi be the
analogue to the output share weights defined in Lecture 2. Then αzsi = αi zi and αz = Σziαi.
It is easily shown that αz>αs since αz(αz – αs) = Vz(α)>0, the variance in αi defined using the
weights zi.
9 At the values associated with β, p*ß /hß>p*µ /hµ, but at the values associated with µ, p*ß /
hß<p*µ /hµ.
10 This contrasts immediately with the situation discussed in Lecture 2, where selection takes
place with respect to one attribute only, unit cost, and the rate of selection is independent
of the market growth rate. Reinforcement, if it were needed, that selection with respect to
one attribute is a very special case.
11 Campbell’s blind variation and selective retention framework has been the focus of much
debate, primarily centred around the multiple meanings of blind variation. For interesting
discussion consult Stein and Lipton (1989), Gamble (1983) and Gatens-Robinson (1993).
It is, I believe, a very useful framework for the study of innovation. On this see Vincenti
(1990).
12 I have had one attempt at a more formal exploration in Metcalfe (1995c).
13 See in particular the studies by Utterback (1995), Klepper and Grady (1990), Elzinga and
Mills (1996) and Jovanovic and Macdonald (1994).
14 The reader who wishes to recast the argument in terms of the average rate of profits rather
than the average margin will not find this difficult to do.
15 See Klepper (1996) for very interesting observations on these entry relationships, but
coming from within an optimizing theory of firm behaviour.
16 It is not difficult but certainly more tedious to extend the argument to firms with product
differences as well as unit cost differences. I leave this to the interested reader.
17 One further point is worth a mention. If firm two is to be held at a constant size it can no
longer set a balanced price in our previous sense. Its price must be raised to ensure that the

growth rate of its particular market is zero. Clearly this raises the average margin for the
merged entity.
18 Cf. Koopmans (1957) and Hahn (1987). This is most obvious in the case of the theory of
price adjustment in general equilibrium. For excellent surveys see Negishi (1962), Fisher
(1983) Ch. 2, and Arrow and Hahn (1971), Ch. 11.
19 A point of which Joan Robinson made a great deal of (1974). This is the strongest form of
historical effect in dynamic models. A weaker form allows the rest points to be defined
independently of the path but makes the choice between different rest points contingent
upon historical accident. Arthur (1984, 1994).
EPILOGUE: ON BEING DIFFERENT, ON BEING COMPETITIVE
1 There are, of course, degrees of rationality. Optimization assuming given objectives is ‘less
rational’ than optimization where those objections have also been constructed by a
rational process. Cf. Winter (1963).
2 For further discussion of the persistence of profits and the rate of convergence towards an
industry norm see the essays in Mueller (1990).
3 See Prahalad (1995) for a useful discussion of different concepts of market share.
4 The reader who likes to think of smooth tradeoffs between the two categories of innovation
can define an optimal strategy with a mix of both kinds of innovation such that –dai /dαi
= vo . Binswager (1984) is still to my way of thinking one of the clearest references in the
theory of induced innovation. Of course, I want to insist that what matters is not
optimization but different innovation possibility tradeoffs across firms. Since vo declines
in the process of selection, our analysis implies that the balance of incentives shifts over
time in favour of process innovations. This is not at all incompatible with the product
lifecycle literature.
4 SCIENCE POLICY AND TECHNOLOGY POLICY WHEN

COMPETITION IS AN EVOLUTIONARY PROCESS
1 Branscomb (1993) also refers to this as the pipeline model of the science technology
relationship.
2 Faulkner (1994) provides a perceptive and thorough review of the more important aspects
of the science:technology relationship and the links with innovative activity.
3 A delphi study takes repeated samplings of opinion within a target group with feedback of
the results to the participants between each sample, and the opportunity to revise their
opinions.
CONCLUDING COMMENT
1 I have had my say on increasing returns in Metcalfe (1994a). The conclusion is that growth
rate effects at industry level are important, that they accelerate the selection process, that
they give rise to potential ‘lock-in’ effects, and that they result in a blending together of
Fisher’s Principle with the growth rate influences on productivity emphasized by Kaldor
and Verdoorn.

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EVOLUTIONARY ECONOMICS AND

The central theme of this book is competition treated as an evolutionary process in

J. Stanley Metcalfe is Stanley Jevons Professor of Political Ecand Cobden Lecturer at

© 1998 The Graz Schumpeter Society

1. EVOLUTIONARY ECONOMICS AND

© 1998 The Graz Schumpeter Society

London and New York

© 1998 The Graz Schumpeter Society

Routledge is an imprint of the Taylor & Francis Group

This edition published in the Taylor & Francis e-Library, 2001.

© 1998 The Graz Schumpeter Society

British Library Cataloguing in Publication Data

Library of Congress Cataloging in Publication Data

ISBN 0–415–15868–0 (Print Edition)

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

Part I The evolutionary economics of creative destruction

PROLOGUE: CHANGE WITHIN CHANGE

1 ON RIVAL CONCEPTS OF COMPETITION AND THE

2 FISHER’S PRINCIPLE AND THE PROCESS OF

3 ECONOMIC VARIETY AND MODELS OF CHANGE

EPILOGUE: ON BEING DIFFERENT, ON BEING

Part II Evolutionary approaches to technology policy

4 SCIENCE POLICY AND TECHNOLOGY POLICY WHEN

© 1998 The Graz Schumpeter Society

2.1 Strategic interdependence of pricing

© 1998 The Graz Schumpeter Society

The Graz Schumpeter Lectures

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

Shares in output Growth factor

Group A 3.2 35.6 168.7

Group B 15.3 26.3 26.1

Group D 56.7 15.2 4.1

It is at the microeconomic level of competition between the different activities of

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

Always history is being made; opinions, attitudes and institutions change,

RIVAL CONCEPTS OF COMPETITION

In this first lecture I propose to examine the role of competition as a progenitor of

© 1998 The Graz Schumpeter Society

Competing concepts of competition

© 1998 The Graz Schumpeter Society

Competition as equilibrium states

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society

the condition commonly labelled as a ‘perfectly competitive industry’ actually

In every domain, but especially in economics, competition means in the first

Here is an important clue as to how we are to proceed. We are to recognize that,

the most general form of competition among individual concerns is

Businessmen pursue strategies to discover a combination of customers and

© 1998 The Graz Schumpeter Society

Instead competition is a succession of events, a dynamic process, a voyage of

© 1998 The Graz Schumpeter Society

© 1998 The Graz Schumpeter Society