The Origin of Wealth

Eric Beinhocker
McKinsey Global Institute

HEEDNet Seminar
DEFRA 26 November 2007

Copyright © 2007 McKinsey & Company, Inc. All rights reserved.

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“The ideas of economists and political
philosophers, both when they are right and
when they are wrong, are more powerful than
is commonly understood. Indeed, the world
is ruled by little else.”

John Maynard Keynes

2
Today’s discussion

• The three most stunning empirical facts in economics

• Characterizing the economy – what is it?

• The evolution of economic design

• What does it mean?

3
Today’s discussion

• The three most stunning empirical facts in economics

• Characterizing the economy – what is it?

• The evolution of economic design

• What does it mean?

4
Fact no. 1 – wealth has grown explosively
World GDP per capita, constant 1992 US$

2.5m BC to 2000 AD 15,000 BC to 2000 AD 1750 to 2000

7000 7000 7000

6000 6000 6000

5000 5000 5000

4000 4000 4000

3000 3000 3000

2000 2000 2000

1000 1000 1000

0 0 0
-2500000 -1500000 -500000 -15000 -10000 -5000 0 5000 1700 1800 1900 2000 2100

Source: J. Bradford DeLong, U. Cal. Berkeley 5

Fact no. 2 – complexity has grown explosively

From . . . To . . .

102 SKU economy 1010 SKU economy

• Wal-Mart 100,000 SKUs
• Cable TV 200+ channels
• 275 breakfast cereals
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Fact no. 3 – no one is in charge

7
Today’s discussion

• The three most stunning empirical facts in economics

• Characterizing the economy – what is it?

• The evolution of economic design

• What does it mean?

8
Traditional economics cannot explain key
characteristics of the economy
Economy viewed as an equilibrium system . . .

. . . but such a
system cannot

• Grow explosively

• Create novelty

• Spontaneously
self-organize

9
The accidental history of equilibrium in economics

IS E
TREAT
S ON
E ME N T AL
THE EL NATUR
OF O PHY
S PHILOS
STATIC
BY
ON
HOMPS
LIAM T
BY SIR WIL

OINSOT AND
LOUIS P IE TAIT
GUTHR
PETER
1803
1867

Léon Walras William Stanley

Jevons

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A different explanation – the economy is a
‘complex adaptive system’
Complex Adaptive System

Many interacting Designs and Macro patterns

agents and strategies evolve emerge from micro
organizations of over time behavior
agents

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Dynamics

Traditional – fixed point attractors Complexity – dynamic attractors

P
S

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Agents

Traditional – perfect rationality Complexity – realistic rationality

• Deductive logic • Inductive rules of

• Self-interest thumb
• Perfect information • Strong reciprocity
• Infinite • Imperfect
computational information
power • Finite computing
• No errors, biases power
• No learning • Errors, biases
• Learning over time

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Networks

Traditional – networks don’t matter Complexity – network structures matter

• Interactions – only via markets • Interactions – via networks

• Information – prices, quantities • Information – anything
• Institutions – Walrasian auctions • Institutions – bilateral trade, posted
prices, corporations, etc.

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Emergence

Traditional – assumes linear Complexity – non-linear interactions

additivity create emergent patterns

Macroeconomic
behavior
Time

Representative
“super agent”

H H

Individual agents

O
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Evolution

Traditional – no endogenous theory Complexity – innovation as

of innovation evolutionary search

“Add successfully as many mail

coaches as you please, you will
never get a railway thereby”
Joseph Schumpeter

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A paradigm shift
Traditional economics
Economies are closed, static,
Dynamics linear systems in equilibrium
Homogeneous agents
Agents • Only use rational deduction
• Make no mistakes and have no
biases
• Are already perfect, so why learn?
Assume agents only interact
Networks indirectly through market
mechanisms
Treats micro and
Emergence macroeconomics as separate
disciplines
Contains no endogenous
Evolution mechanism for creating novelty
or growth in order and complexity
Complexity economics
Economies are open, dynamic,
non-linear systems far from
equilibrium
Heterogeneous agents
• Mix deductive/inductive
decision-making
• Subject to errors and biases
• Learn and adapt over time
Explicitly account for agent-to-agent
interactions and relationships
No distinction between
micro- and macroeconomics; macro
patterns emerge from micro
behaviors and interactions
Evolutionary process creates
novelty and growing order and
complexity over time
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Today’s discussion

• The three most stunning empirical facts in economics

• Characterizing the economy – what is it?

• The evolution of economic design

• What does it mean?

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Long history of evolutionary ideas in economics
(and vice versa)

1838
• Malthus
Problem
• Darwin
• Mandeville • Driven from a metaphor
• Marx with biology
• Spencer
• Marshall • Not built on a general
• Menger computational view of
• Veblen evolution
• Schumpeter
• Hayek
• Nelson and Winter
1982

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We are accustomed to thinking of evolution
in a biological context

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Evolution is a search algorithm for ‘fit designs’
Create a variety of Select designs that Amplify fit designs,
experiments are ‘fit’ de-amplify unfit
designs

Variation Selection Amplification

Repeat
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Evolution creates complexity from simplicity

Information Physical
World Rendering World Order,
of design complexity Entropy
1
0
1
Variation,
1 selection,
0 amplification
0
1
0 Feedback on
0 fitness
0

Design encoded in a schema Interactor in an environment

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Who designed the modern bicycle?

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The reality – evolution through ‘deductive-tinkering’

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Technologies evolve

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Economic evolution occurs in three ‘design spaces’

Physical Business Social

technologies plans technologies

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Business plans are a form of economic ‘design’

• Strategy
–High-end microprocessors
–Integrated chip sets
–Communications
chips/components

• Physical technologies
–Semiconductor design
–Testing
–Fabrication

• Social technologies
–Innovation processes
–Direct sales
–Brand
–Competitive culture

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Business plan evolution works at three levels

Individual minds Organizations Markets

A+C?
A? D? E?
A? 6?
B?
B+D+E?
D?
C? E?

Independent
booksellers

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What would economic evolution look like?

• Bursts of
innovation/
punctuated
equilibrium

• Spontaneous self
organization

• Decreasing local
entropy/ increasing
order

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Today’s discussion

• The three most stunning empirical facts in economics

• Characterizing the economy – what is it?

• The evolution of economic design

• What does it mean?

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The end of left vs. right?
Adam Smith Karl Marx

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A new view of human nature
Right
• Humans are inherently
self-regarding
• Markets channel this
instinct to positive social
ends
• Hume, Locke, Hobbes
Left
• Humans are inherently
cooperative and altruistic
• Markets encourage
greed, state can make
society more just
• Rousseau, Marx
Complexity
• Humans are conditional
cooperators and
altruistic punishers
• Institutions should
mobilize strong
reciprocity
• Bowles, Gintis, Fehr,
Boyd
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A new view of markets vs. states
Right Left Complexity

• Markets are most • Markets may be a • Markets are not perfectly

efficient mechanism for necessary evil, but do efficient at allocation, but
allocating resources not produce just are highly effective at
outcomes evolutionary wealth
• States distort market creation
outcomes thus state • States are an essential
interference should be mechanism for ensuring • States create
minimized social justice and institutional conditions
protecting people from for economic evolution
market failures
• Democratic societies
have a right to use
states to shape
economic fitness
function

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New approaches to public policy?

• Giving up the illusion of prediction

and control Example issues

• Realistic view of human behavior • Healthcare reform

• Focus on creating institutional • Environmental policy
conditions for economic evolution
• Pensions
• Evolving portfolios of “policy
experiments”? • Tax policy
• Emphasis on empiricism and data - • Education
do more of what works less of what
doesn’t

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Final thought…

“Evolution is cleverer than we are”

Orgels’ second law

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