NEOCLASSICAL ECONOMICS IN PERSPECTIVE
In this section, we describe some of the principles of neoclassical economic theory, with two caveats. First, our characterization is a necessarily simplified version of a diverse body of work that does not always fit into neat categories.
Second, our characterization emphasizes principles that have evolved significantly in recent years in reaction to, among55
other things, some of the subsequent thinking that we describe. Nevertheless, the principles that we describe below arise out of a fundamentally different way of understanding economic activity than prevails to varying degrees today.
Neoclassical economics generally tries to understand economies by way of models that posit rational actors interacting through competition, reaching equilibrium in which supply and demand intersect in an optimally efficient manner. As more complications to the operations of real-world markets became evident, this strain of economics developed ever-more complicated models to compensate. A chief critique of this trajectory of thinking has been that as models increasingly rely on esoteric mathematics, they more easily diverge from reality. Even as they become more complicated, they maintain reductionist assumptions and even introduce new abstractions. This issue alone is not cause enough to reject what has become mainstream economic theory, but closer scrutiny of its foundational principles in the context of the Internet era yields sufficient reason for realignment. The neoclassical line of reasoning proceeds from its traditional roots in Adam Smith and Leon Walras to transitional figures like Kenneth Arrow, Friedrich A. Hayek and - in retrospect - Joseph Schumpeter.
3.2.1 Market Equilibrium
Neoclassical economic theory states that the economy is a static equilibrium system, existing at rest, and moving from one equilibrium point to another as it seeks balance.
Under this view, the economy is a closed system (Taylor, 2004, pp. 239-40). Neoclassical theory sees an ‘invisible hand’ - as first articulated by Adam Smith in 1776 - at work in competitive markets. In such a free market, supply equals demand, resources are put to their most efficient use, and the resulting balance optimizes social welfare. Economic processes are dominated by dampening, negative feedback that keeps things contained. The theory typically assumes indeterminacy away by means of econometric models (Ormerod, 2005, pp. 79-80). The business cycle of boom and bust is determined exogenously - that is, by occasional shocks originating from outside the system itself. Leon Walras, champion of economic equilibrium theory, famously noted, ‘For, just as a lake is, at times, stirred to its very depths by a storm, so also the market is sometimes thrown into violent confusion by crises, which are sudden and general disturbances of equilibrium’ ([1874] 1954).The idea that the market tends toward optimally efficient equilibrium runs headlong into reality. Lawrence Summers (1986) has noted that careful analysis, ‘call[s] into question the theoretical as well as empirical underpinnings of the Efficient Market Hypothesis’. Shiller et al. (1984) claim that, ‘the efficient markets hypothesis represents one of the most remarkable errors in the history of economic thought’. These critics decry the inapt metaphor appropriated from the Industrial Revolution - the economy as a human-made machine like a steam engine, whose behavior is fixed, stable, predictable, and controllable (Axelrod and Cohen, 2001, pp. 28-31).
3.2.2 Perfect Competition
According to the traditional view of economic dynamics, ‘perfect competition’ compels free markets to allocate scarce resources in the most efficient manner possible. In this view, perfect competition will allow free markets to squeeze as many useful goods and services as possible out of the available resources (maximal output at minimal prices); anything that interferes with the price system’s ability to do so is a detriment to social well-being (Case, 2007).
When the supply of every traded good or service is precisely equal to the demand for it at prevailing prices, the economy rests in perfect equilibrium. The theory sees diversity of products, locally contingent factors, and variation in motivation of market actors as all interfering with this idealized state of affairs.Unfortunately for this theory, competition is rarely, if ever, perfect. The theory posits an inherently top-down view of the world, in which the market conditions are static, and the actors all play by the same set of rules. As Friedrich A. Hayek observed, ‘When we deal, however, with a situation in which a number of persons are attempting to work out their separate plans, we can no longer assume that the data are the same for all the planning minds’ (1948, p. 93). Indeed, these market actors are shaping the market from the inside out through their individual goals, innovations, and connections with others.
3.2.3 Rational Actors
In traditional neoclassical economics, individuals rationally pursue their self-interest on the basis of utility. For decades, many economists assumed that people are ‘representative agents’ who are perfectly rational and consistent in their behaviors (Hartley, 1997). This casts agents as homo economicus (Thaler, 2000). University of Chicago professor Frank Knight stated emphatically in 1946 that economics must assume that actors possess ‘rational and errorless choice, presupposing perfect foresight’ and ‘foreknowledge free from uncertainty’ (cited in Parker, 2005, p. 197).
In the real world, barriers to decision-making almost always exist. Information is costly, incomplete, and rapidly changing. At best, we employ bounded rationality, by making decisions in the face of obvious constraints and motivations. Ormerod observes that every individual decision involves massive complexity and defies the orderly application of the rational calculations of traditional economic theory (2005, p. 125). That is not to say that market participants are not acting ‘rationally’ in the colloquial sense, but rather that they do not uniformly follow a single deterministic set of rules.
3.2.4 Abstract Models
Traditional economic theory has proven inadequate in terms of the two standard criteria for a scientific theory: prediction and explanation.
The theory’s models often use simplifying and highly restrictive assumptions. Famously, Milton Friedman has insisted that unrealistic assumptions in economic theory do not matter so long as the theories make correct predictions (1953, pp. 30-31).Such optimism seems misplaced. Assumptions must be appropriate for the purpose of the model, and must not affect the answers the model provides for that purpose. In econometrics, statistical correlations do not provide a causal explanation of the phenomena, and assumption without verifiable explanation is mere faith. As Philip Ball (2006, p. 181) explains: ‘economic models have been augmented, refined, garlanded, and decorated with baroque accoutrements. Some of these models now rival those constructed by physicists in their mathematical sophistication. Yet they still lack their “Newtonian” first principles: basic laws on which everyone agrees’.
3.2.5 The Turn to Innovation Economics and Endogenous Growth
By the middle of the twentieth century, certain economists had turned their attention to the source of economic growth, reframing Adam Smith’s ‘invisible hand’ hypothesis in the context of entrepreneurial innovation. Whereas Smith theorized that firm efficiencies would lead to optimally efficient pricing, these economists pondered why markets often grow beyond this in bursts that defy the predictions of static equilibrium. Joseph Schumpeter, an unorthodox Austrian economist, pointed out that often one firm battles another in order to unseat it in a process he called ‘creative destruction’. He observed that the critical advantage of a winning new entrant is its improved technology. Through this process, innovations occur in a stair-step fashion rather than a continuous line. These innovations spur fundamentally new ways of producing wealth rather than incrementally improving efficiency (Schumpeter [1942] 1976).
Much of economic growth theory has focused on how best to encourage development of these technologies - with ‘technology’ defined broadly to mean any innovative means of production or organization.
Robert Solow (2007) observed that Schumpeter:[...] worked out his conception of the entrepreneur, the maker of ‘new combinations,’ as the driving force and characteristic figure of the fits-and-starts evolution of the capitalist economy. He was explicit that, while technological innovation was in the long run the most important function of the entrepreneur, organizational innovation in governance, finance, and management was comparable in significance... I think that this is Schumpeter’s main legacy to economics: the role of technological and organizational innovation in driving and shaping the growth trajectory of capitalist economies.
Schumpeter’s insight would nevertheless lie somewhat dormant until the 1980s, when a new generation of economists began to consider where these innovations came from. Traditionally, economists thought of production in terms of land, labor, and capital. They assumed that human knowledge and new ideas were factors outside of the economic model. In 1990, then-unheralded economist Paul Romer released a paper in which he concluded that the new factors of production should be classified as people, ideas, and things (Romer, 1990). Most importantly, new ideas emerged from the economic actors themselves - an activity that is internal or endogenous to the economy. This helped to spawn ‘new growth theory’. This theory indicates that the fastest-growing economies are those that feed ideas back into the system, allowing others to adopt, adapt, and innovate in a way that multiplies productivity (Warsh, 2006).
3.2.6 Internet Economics as Evolutionary and Generative
We now live in a highly networked economy, formed bottom-up by interactions between individuals in a globally connected marketplace. Some basic rules govern these interactions, but for the most part the system emerges freely and unpredictably. Economic actors become nodes of growth, and the structure of the market evolves based on their collective practices. Whereas neoclassical economics defined these relationships statically, the Internet economy thrives on experimental evolution.
New ideas emerge and technologies are constantly refined. In section 3.3 we describe this as an instance of a ‘complex adaptive system’.The mechanism for growth is innovation, and these innovations serve as a platform for further growth. While neoclassical economics tells us that productivity comes simply from adding more capital or generating greater efficiency, we now see that new technologies are essentially better recipes for production. Economists use the phrase ‘virtuous circle’ to describe systems that contain such positive feedback loops. Rather than moving toward equilibrium, these economies are self-reinforcing and have the potential to multiply their effects. The Internet - its software protocols, social norms, and polycentric governance - is structured in such a way that innovators are free to make use of this ‘generative’ platform in unexpected ways (Zittrain, 2008). In section 3.4, we describe how this platform facilitates highly productive interactions within and between different ‘layers’.
Yet, the dynamics present in the Internet economy are not entirely new - particularly in the case of communications-based technology sectors. Indeed, ‘the forces at work in network industries in the 1990s are very similar to those that confronted the telephone and wireless industries in the 1890s’ (Varian et al., 2004, p. 3). Many of the elements at play in today’s economy have been present to some extent for decades, but are becoming dominant in the highly networked Internet economy.
3.3