Armen Alchian, behavioural economics and the firm

There is a new working paper out by Geoffrey A. Manne and Todd J. Zywicki on Uncertainty, Evolution, and Behavioral Economic Theory. The abstract for the paper is,

Armen Alchian was one of the great economists of the twentieth century, and his 1950 paper, Uncertainty, Evolution, and Economic Theory, one of the most important contributions to the economic literature. Anticipating modern behavioral economics, Alchian explains that firms most decidedly do not – cannot – actually operate as rational profit maximizers. Nevertheless, economists can make useful predictions even in a world of uncertainty and incomplete information because market environments “adopt” those firms that best fit their environments, permitting them to be modeled as if they behave rationally. This insight has important and under-appreciated implications for the debate today over the usefulness of behavioral economics.

Alchian’s explanation of the role of market forces in shaping outcomes poses a serious challenge to behavioralists’ claims. While Alchian’s (and our) conclusions are borne out of the same realization that uncertainty pervades economic decision making that preoccupies the behavioralists, his work suggests a very different conclusion: The evolutionary pressures identified by Alchian may have led to seemingly inefficient firms and other institutions that, in actuality, constrain the effects of bias by market participants. In other words, the very “defects” of profitable firms — from conservatism to excessive bureaucracy to agency costs — may actually support their relative efficiency and effectiveness, even if they appear problematic, costly or inefficient. In fact, their very persistence argues strongly for that conclusion.

In Part I, we offer a short summary of Uncertainty, Evolution, and Economic Theory. In Part II, we explain the implications of Alchian’s paper for behavioral economics. Part III looks at some findings from experimental economics, and the banking industry in particular, to demonstrate how biases are constrained by firms and other institutions – in ways often misunderstood by behavioral economists. In Part IV, we consider what Alchian’s model means for government regulation (with special emphasis on antitrust and consumer protection regulation).

Some behavioural economists have argued that models which assume rationality and self-interest on behalf of market participants are of little value when it comes to predicting future behaviour. The Manne and Zywicki paper argues against this conclusion. Manne and Zywicki point out that Armen Alchian's model, detailed in Uncertainty, Evolution, and Economic Theory, helps to explain why this is so: evolutionary pressures of the marketplace select those most fit for survival under given conditions, which often means those best at constraining the behavioural biases behavioural economics love so much. Manne and Zywicki also note that this implies that seemingly inefficient market and firm structures may exist to ameliorate these biases and thus confer unappreciated efficiency. They then argue that with this point in mind, regulators should be wary of making the leap from diagnosing biases in a laboratory to intervening in the marketplace.