Economics as a Complex System

1. Economics as a Complex System Alessandro Cappellini November 19th 2004 cappellini@econ.unito.it

2. “In fact, Adam Smith’s “invisible hand” (1776) is a classical example of unexpected features that complex systems exhibit whenever their participants reach a critical mass and self-organize, in this case into a centralized competitive market.” (Lewis L. Smith 2002)

3. Agenda • Economics as a Complex System (Network) • Complex System (Lewis L. Smith) • Karl Popper • Mainstream and Complex System approach • Product Function - Keynes • Firm as Complex System • Macro Meso Micro • Firms as Complex Systems 1/2 • Firms as Complex Systems 2/2 • Alfred Marshall • Remarks

4. Economics as a Complex System (Network) • Quantitative associations between monetary associations and variables. • Learning and experimentation forge new connection between network elements. • Joseph Schumpeter: innovation and growth are to be paralleled to the extension of new credit. • If everything is fully connected to everything else (perfect knowledge) then there is no real distinction between elements and systems. • Complex system are not fully connect but partially, and have actual potential connection with other system.

5. Complex System (Lewis L. Smith) Properties: • A critical mass of varied participants with some characteristics in common (“heterogeneous agents”). • Access of this participants to some local information. • A set of rules for their interaction. • Exhibit surprising emergent properties. • Ability of self-organization depend on positive feedback. • Spend more time in dis-equilibrium than in equilibrium. In economics and markets instability and disequilibrium are normal, stability and equilibrium are not.

6. Karl Popper Warning on historicism (trying to predict the course of history in context that involve open system and evolutionary change). Modern economists say that: • Theory and history should be separated ; But: • Historical trends can be separated by theoretical propositions, concerning logical tendencies towards never existing long run equilibrium state.

7. Mainstream and Complex System approach • from individual (psycological system) to the whole economy (macroeconomic system). • from logical proposition to represent tendencies observed to underlying principles that govern behaviour of system. Value of economics: • Veblen (1898): to explain and to predict in historical contexts. • Marshall: to address historical events over short period.

8. Product Function - Keynes • Production function is a trivial association of input and output. • Data and process are correlated but separated in quantitative and qualitative domains. • Data represent only a manifestations of historical process. • Keynes theory was general because it could encompass the historical experience of systems as reflected in quantitative data. • Aspects of process that investigate macro-instability. • There isn’t supply/demand dichotomy at the aggregate level, but only a network of connections for expenditures and income for good and services.

9. Firm as Complex System Firm is a governance structure (Williamson). • In the case of the firm, full information (full connectedness) allows economists to treat the firm as a single decision-making entity that can optimize in a way that permits a supply curve to be derived from its cost structure. • This kind of economics as about over-connected, simplistic systems that, by definition, are not representations of reality. • Network structure flow and asset values. • Connections that are definably ‘economic’ are those that have a monetary value attached.

10. Macro Meso Micro One of the limitations of Keynes’s analysis is that the macroeconomic level of inquiry is inappropriate to capture the complexity of processes in an economic system – what we observe are the stock and flow of funds consequences of complex interactions. The elements and connections that make up the network structure of the economy and how this changes are, rendered invisible by aggregations of value flows and asset valuations. At the same time, a wholly microeconomic perspective that tries to build up from individual elements and connections is not very helpful either because so much behaviour at that level constitutes component connections between elements embedded in higher level network structures. ‘Meso-level’ analysis, that identifies the generic rules that govern the behaviour of complex systems, is most appropriate approach. There are many examples of complex network structures in the economy that are governed by generic rules that are meso in character. The one that we wish to focus on here is the firm.

11. Firms as Complex Systems 1/2 • Firms are complex adaptive systems with connected network structures that evolve over time not occur across the total space of connective possibilities but evolves sequentially from a pre-existing network base then unique connective structures emerge. • The profitability of a firm ultimately depends upon making the right internal and external network connections and knowing how to break connections that no longer perform a useful function without, at the same time, destroying connections that still deliver value.

12. Firms as Complex Systems 2/2 • Thus, a supposedly suboptimal configuration of inputs and outputs may allow the firm to survive simply because the neglect of optimizing calculations and adjustments allows the firm to concentrate on, for example, learning by doing and experimentation in the product development and marketing activities that are crucial to generate revenue flows. • Not directly related to production but to other processes going on – as time passes, the environment changes, requiring new products and processes, but much of the network structure of the firm is committed to earlier strategies. Thus, this relates to the emergence of external disconnections as time passes.

13. Alfred Marshall • All inputs can be varied in the long period, he recognized that the complex nature of the firm and its environment diminished the usefulness of constrained optimization theory. • ‘Partial’ constrained optimization should be used implies that network connections are restricted and incomplete.

14. Remarks • It is possible to obtain simple representations of their growth and decline by theorizing about the flows of funds that parallel the processes that such systems enact. • The creation, growth and destruction of firms are emergent processes that can be understood analytically and empirically investigated. How we construct emergent models must be guided by multi-agent simulations that are subject to the operation of stylized rules that are calibrated on actual rules we observe in the real world.

15. “… Does our market converge to the rational expectations equilibrium of the academic theory or does it show some other behavior? What we found to our surprise was that two different regimes emerged. One, which we called the rational expectations regime, held sway when we started our agents off with sets of predictive hypotheses close to rational expectations. […] But there was a second regime, which we called the complex regime, and it prevailed in a much wider set of circumstances. We found that if we started our agents with hypotheses a little removed from rational expectations, or alternatively, if we allowed them to come up with hypotheses at a slightly faster rate then before, the behavior of the market changed. Subsets of mutually reinforcing predictions emerged…”. (W. Brian Arthur, The End of Certainty in Economics Talk given at the Conference Einstein Meets Magritte, Free University of Brussels, July 1994. )

16. Bibliography Based on: • John Foster Why is Economics not a Complex Systems Science? presented at: International J.A. Schumpeter Society Conference University of Bocconi, Milan, 9-12 June 2004. • W. Brian Arthur, The End of Certainty in Economics, Talk given at the Conference Einstein Meets Magritte, Free University of Brussels, July 1994. Appeared in Einstein Meets Magritte, D. Aerts, J. Broekaert, E. Mathijs, eds. 1999, Kluwer Academic Publishers, Holland. Reprinted in The Biology of Business, J.H. Clippinger, ed., 1999, Jossey-Bass Publishers. • John Foster From Simplistic to Complex Systems in Economics, presented at Economics for the Future Conference Cambridge (UK) 17-19th September 2003 • Lewis L. Smith, Economies and markets as complex systems: Looking at them this way may provide fresh insight, 2002