Home > Uncategorized > Complexity, institutions and firms

Complexity, institutions and firms

from Peter Radford

Are they associated?

We all know that one of the central problems of economics is the existence of uncertainty.  At least since Frank Knight’s work in the 1920s, uncertainty has been something of concern to economists.  Knight’s description of uncertainty as being a condition in which no probability distribution existed, or could exist, has led some of the most eminent theorists of economics to argue that theorizing is simply not possible.  Which is a rather formidable obstacle.  I assume they meant that their particular form of theorizing was not possible.

One person who rose to the challenge represented by uncertainty was Douglass North, who famously built his theory of institutional change to show how humans respond to  the endemic uncertainty they deal with on a day-to-day basis.

I am going to use three separate quotes from North’s book “Understanding the Process of Economic Change” as a starting point for this short discussion.

First:

“But uncertainty is not an unusual condition; it has been the underlying condition responsible for the evolving structure of human organization throughout history and pre-history”

Exactly.  But the mere existence of uncertainty is insufficient to explain modern economic institutions — or any other institutions for that matter.  There has to be more to it.  He goes on to reference Ronald Heiner who identified that the gap between a person’s competence and the difficulty of the problem being solved.  Here is North picking up the story:

“The human agent in the face of such a gap will construct rules to restrict the flexibility of the choices in such situations.  We know these rules as institutions.  By channelling choices into a smaller set of actions, institutions can improve the ability of the agent to control the environment.”

Very true.  Anyone who has lived in the business world will recognize themselves in this situation.  The whole point of containing the entire process of production within an organizational boundary is to set limits on the variability of outcomes.  Which is something the vastness of a market cannot do — at least outside the imaginations of economists.  North describes it as controlling the environment.  It is this need to reduce the options available to just a few specified by the plan the business is trying to execute that is the essence for the existence of a firm.  In the surrounding swirl of uncertainty it would be impossible to construct the products and services that businesses routinely produce.

But one person’s control adds to another person’s uncertainty.  North goes on:

“While the deep underlying source of institutions has been and continues to be the effort by humans to structure the environment to make it more predictable, this effort can and frequently does make for increased uncertainty for some of the players.”

This is intriguing.  It is also familiar to anyone in business.  Not only do I as a manager have to take into account and limit the problems presented by uncertainty in my surroundings, I have to take into account the actions of my competitors who are also trying to control uncertainty.  Life gets complicated.  We are all caught up in the swirl.  We make it worse for others as we each try to tame it for ourselves.  It’s as if the amount of uncertainty is a constant and that by controlling it locally we simply export it back into the wider environment.  Maybe there’s a law of economics somewhere in this that needs articulating.

But this raises an interesting question: what is the relationship between uncertainty and complexity?  Are they relates?  Are they the same thing?  Are they just two concepts passing each other in the night?

North gives us a clue — the rest of his book is his explanation.  But let’s move onto our own speculation:

By creating structures to contain and thus localize our environments we multiply the loci of uncertainty.  We restrict it within the boundary of the structure, but we add to it outside the structure.  This sets in motion a competition to create more structure and thus to add to the multiplication of uncertainty.

But this simple process is simultaneously adding to the complexity of the known environment.

Each structure is created to carry sufficient useful information to accomplish whatever task the structures creators intended.  In the case of a business firm the production of something.    Setting the boundary is one of the most important tasks a manager has to accomplish.  What ought to sit inside the boundary?  What can be left outside?  Structures like business firms hoard information in order to maintain their own identity and ability to differentiate themselves.  They become repositories of information.

Of course the information constantly leaks out into the surrounding environment: whenever a product is sold it carries along with it its design so someone on the outside can reverse engineer it and extract that information.  The quantity of information in our environment is constantly rising.  This is one way it does.

This is, however not our central question.  Our real concern here is, what explains the emergence of institutions through time?  Why, if North is correct, did things like our current business firms not exist in prior ages?   Was uncertainty less of a problem?  Was there less uncertainty?

 

No.  I don’t think so.  And this is my quick way of associating complexity with uncertainty, at least for our purposes:  as we expand the circle of our knowledge we simultaneously make the management of what we know more complex.  We increase the number of inter-relationships.  We make our decision making more difficult simply by revealing more to ourselves and increasing the number of options available.  We have great deal more information to process.  This is, of course, just a modification of the ages old paradox that the more we know the less we know.  Except in this case we are trying to make the paradox applicable to our explanations of economic growth and the development of structures within the economy.

North focuses on uncertainty as the underlying cause for the creation of institutions.  But that leaves us only half way to understanding why things like business firms exist.  Yes, they deal with uncertainty.  But uncertainty is endemic.  It is fact of life.  Why did firms become more important as the economy grew beyond its agricultural and early industrial roots?  Because the rising complexity created by each wave of structures necessitated a new layer of structure to handle the flood of information.

Uncertainty is in this sense a constant.  Complexity is not.  As complexity rises we should see an institutional response.  The history of organization and management suggest this is true.  And the current transition into a more digital economy suggests that we will need newer structures in the future.  Will, for instance, older business firms be replaced by networks?

Or will older firms find ways to simplify things sufficiently to remain relevant?  It is, after all, the role of a firm to simplify and codify its information so it can replicate its products easily.

Which is where machines enter the story.

  1. Laurent Leduc
    February 22, 2021 at 2:44 pm

    Sounds a lot like energy and entropy.

  2. February 22, 2021 at 8:43 pm

    Very insightful – thanks!
    I might have overlooked it but it occurs to me that an important aspect of uncertainty is missing in the text. Isn’t it that uncertainty that really matters to us is created by humans themselves? Uncertainty is not out there per se because the the natural world is ruled by natural laws which are accessible by science whereas the world of economics is there only thanks to human imagination. Did Nordhaus say anything on that?

  3. gerald holtham
    February 23, 2021 at 12:30 pm

    Christian makes an interesting point. I think it was Mordecai Kurtz who distinguished endogenous uncertainty from exogenous uncertainty, The world may be governed by natural laws but that does not necessarily make it predictable. Some natural processes are chaotic; we cannot predict the weather far in advance or the timing of earthquakes. That exogenous uncertainty permits people to form different theories about what is going on and to form different expectations about the future. In turn that makes the actions of other people less than fully predictable to us and introduces further uncertainty – endogenous uncertainty- into human interaction. The existence of different beliefs among people is one of the essential feattures of human life, including economic life. That is why assuming homogenity of belief, as in “representative agent” models is such a perverse approach and so likely to be misleading.

  4. March 2, 2021 at 4:28 pm

    “Institution” is a term the meaning of which is extremely ambiguous. It can signify social or organizational, enforced or spontaneous constancy of behaviors and relations that occur frequently or very rarely. Is Peter Radford still considering mainly the raison d’être of firms? Or does he want to know the raison d’être of institutions? It is not clear. But I here suppose he is considering firms.

    If he is considering why firms emerged and why they continue to exist, the “environment” may mean two: (1) the economy in which the firm operates, and (2) the environment that surround the economy. Let us call environment in the second meaning the nature. Without making this crucial distinction, Radford seems to consider environment often in the second sense. However, the weight of the economy is much greater than that of the nature. The uncertainty of the nature may not have changed much since Roman empire times. But the complexity of the economy changed very much. Consider the number of (kinds of) products. In medieval ages, there were about two hundred specialized professions. If each profession produced a hundred of products, the economy produced barely twenty thousand products. Now, a country like the United States or Japan produce or imports at least twenty million products. Thus, the information that flows in the economy increased enormously.

    This does not mean that the economy became more uncertain. On the contrary, except financial and asset markets, production of goods and services became much more certain and reliable. If you go to supermarkets, you can get almost all you want for your everyday consumption. If you are a manager of a producer firm and you must procure two thousand different items for your factory (this is the normal case for an automobile producer), parts and components come in smoothly in normal times. Of course, in the case of giant hurricane, earthquake and tsunami, or great breakdown of power system, we come to know the fragility of the economy. But, this kind of disaster attacked as often as after the industrial revolution as before and the results were more disastrous.

    Another good comparison is the centrally planned economy that we experienced in the ex-communist countries. The economy there was the economy of shortage (after Janos Kornai). The main tasks of manages were to find necessary parts and components or raw materials in order to achieve the imposed (or self imposed) targets. The uncertainty was much greater than the normal market economy.

    Neoclassical economics explains that this proves the excellency of the price system. However, this is the greatest error of neoclassical economics. Small number of products, such as agricultural products, depend on price adjustment, because those are products the quantity of which is difficult to adjust quickly. All other industrial products are produced at a constant selling price using inputs with stable prices. When the selling volume of a product is low, the producer reduces its production. When it sells well, the producer increases the production, at a constant price. In modern industrial production, it is rather easy to adjust the production volume per day or per week. The economy is a large network of inputs and outputs and all dependent on all. This huge network as big as a country’s economy (or even the world economy) can adjust to the slow change of the demand, fist by using inventories and then by adjusting production flows. Modern industry has a large range of production in which production cost remains constant. It can adjust production flows far quickly than agricultural products which normally requires a year to adjust their production volume, with inevitable fluctuation of production volume by the change of climatic conditions. Modern industrial economy has escaped from this instability and changed the economy to a very different system from that the neoclassical economics assumes. It works with stable prices and changed itself to a system in which the supply adjust to the demand with constant prices. Of course, there is certain limit to this quantity adjustment, but this system can follow the change of the final demands as long as each of time average of the final demand moves slowly. (This is the main result of our book. See book reviews here and here)

    Modern industrial economy (as far as we are concerned with the real economy) works with a totally different principle (that may be called “quantity adjustment mechanism”). If we admit it, the story changes a lot. Modern market economy provides a quite reliable system for the quantity fluctuation. We may call it a highly reliable system by analogy of highly reliable organizations (HRO). In this system, it is not necessary to collect all available information that may concern the production of a product. Let us consider a passenger car (old internal combustion engine case). To produce it, it is necessary to procure more than two thousand items (if we count each piece of the same product, the total number exceeds ten to fifteen thousand). But, if we cannot assume reliable supply, we have to extend information beyond the first tier producers to second and third producers. We have to extend this information gathering without bounds in order to guarantee the smooth stable production. In order to compete with this precariousness, the firm must extend its border enormously as it was widely observed in planned economy. Peter Radford may be worrying this situation. In such an economy, it is natural that he is overflowed by the information that he must collect and operate. Fortunately, modern industrial economy is highly reliable system in a normal situation. Purchase department safely assume that their first tier producers supply the necessary quantity of products (for input) at the necessary time.

    The significance of environment changes a lot whether we consider the economy or the nature. The nature may not have changed much, but the economy have changed enormously. This change is not the result of the change of the nature. It is the economy itself that changed the modern industrial economy to a highly reliable system. In this sense, it is a self-organized system. Firms were instrumental in this self-organization but they are only viable in this environment. There is a co-evolution between firms and the economy. This is the reason why we must consider the economy as evolving system. (This is also the reason why we need evolutionary economics instead of neoclassical economics.)

    Before closing this post, it would be necessary to add some words on how the prices work in the modern industrial economy. As I have emphasized above, price changes are not the main mechanism that bring supply and demand equal (except financial and asset markets as I have indicated above). However, prices play a crucial role in changing the economy to a more productive one. They provide a measure for the choice of production techniques. The tremendous change of modern economy since the industrial revolution was guided by this measure. Cumulative effects of reducing the production cost brought the real income growth of workers and the economic growth. For this point, see my recent paper: A new framework for analyzing the technological change.

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