Introduction to Economic Theory

It’s not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.

Charles Darwin                                              

Introduction and Summary

Economic theory, generalizations about economies, and economic history began as attempts to understand the Industrial Revolution.

The economic theory posts on this blog describe and analyze economic development and economic growth since the start of the Industrial Revolution in the late 1700s. 

Some writers describe the current economic trends as the Fourth Industrial Revolution. Other observers and commentators believe that information and communication technology and applications have become so central to the economy that we are in the Information Revolution. And others believe that we are at the beginning of the Biotechnology Revolution. These posts will concentrate on the ongoing, underlying dynamics of economic change and, for simplicity, will use Industrial Revolution as the historic label. But it will stress the vital role that information plays in economic development and economic growth. 

The Information revolution was an integral part of the Industrial revolution. Information, through electronic communication starting with the telegraph in the 1840s, and new internal management and control information systems in the second half of the 19^th century, made large and complex economic organizations possible. 

Any economic discussion should describe or explain the dynamics and the resulting organizational structure of the Industrial Revolution. Market structures are commonly oligopolies, concentrated industries dominated by a few large corporations. One reason is the economies of scale of production that are the result of power-driven machinery. Within these structures, large, established corporations and innovative newcomers compete in a process of “creative disruption.”

Different types of information are a part of this process and affect different types of economic decisions. One process is central: new information and knowledge are applied to create new technology (“useful knowledge”), new products and services, and new types of economic organizations. Innovation is the central driver of competition and economic change.

In a capitalist economic system, corporations attempt to turn the commercialization of knowledge, information, and invention into profitable innovation and, collectively over time, economic development. What economics should describe is the continuous  commercialization and application of information and knowledge, summarized as technology.

Technological innovation and organizational innovation developed together; it was the combination of the two that made economic development and growth possible.

This innovation process is the driver of economic development. Economic development is the dynamic driver of economic growth. Economic growth is the basis for higher standards of living, increases in real income per capita, lower prices, and a greater variety of goods and services. The innovation process is also mostly responsible for longer life expectancies, reduced infant mortality, and the explosion of drugs and medical technology to fight diseases and epidemics. 

In summary, this book:

o   Emphasizes the dynamic forces in an industrial capitalist economy and how they lead to economic growth and higher standards of living.

o   Describes and analyzes the resulting industry and corporate structures and how they affect competition, market behavior, and prices. Emphasizes the central role played by innovation. Argues that innovation, not price, is central to competition. Feasible strategies of different types of corporations are discussed.

o   Highlights the role of various types of information in the economy and how different types of information influence competition and market outcomes.

Descriptions of market mechanisms are presented. After that, the book discusses a competitive, industrial/informational economy. It attempts to describe and explain the dynamics and structure of an economy dominated by large corporations and subject to ceaseless technological and organizational change.

Economic theory and economic history are taught separately. Economic theory is “ahistorical,” supposedly valid over the 250 years of the Industrial Revolution. This is hard to believe given the incredible technological and organizational changes that have occurred and continue to occur. Theories that lead to equilibrium seem inadequate to explain the “permanent revolution” of ceaseless change and disruption. 

Any discussion of economic dynamics – change over time – involves history. Here, economic dynamics and resulting structure are illustrated by case studies and examples from economic and business history.

Most of this discussion assumes a relatively unregulated, private enterprise, capitalist economy.

The Industrial/Informational economy is facing several crises. The core crisis is the exponentially rising social costs (negative externalities) of industrial production and consumption such as pollution and the effects of climate change. These costs are threatening the long-run survival of the underlying economic system. To survive, much of public and private investment in the future – investment in new technology and organizational structures – will be aimed at reducing the causes and effects of the social costs of the economic system. The also present new opportunities for companies and economies to innovate to reduce social costs.

Economic growth and development are influenced by underlying long-run trends. Many long-term trends are in the process of slowing or reversing, particularly demographic trends. A stable or declining number of people in the labor force is one cause of the increased investment in capital-intensive and information-intensive production. On the other hand, greater research and investment in biotechnology is partly the result of an aging population.

Macroeconomics focuses on theories and analysis as support for government economic programs such as monetary and fiscal policies. In addition, I would like to focus on the tensions and stresses between an expanding global economy and a political world of 200 nation-states: in particular, the conflicts between multinational corporations and national governments.  

My experience as a corporate economist and strategic planning manager, small business manager and director, business consultant, and nonprofit board member has been in the American economy. As a college professor I have taught a wide variety of courses in economics, finance, management, international economics and politics, and economic history.

Innovation and Entrepreneurs

Economic theory emphasizes that companies compete on the basis of price. Yet surveys of industries, especially capital goods and input industries, indicate that companies compete primarily on the basis of innovation.

Existing companies applying core knowledge to develop new products and processes. They also buy innovative capital goods, information systems, and inputs to reduce unit costs, increase efficiency, and improve management control.  

New companies develop and improve new technology. These new companies are founded by combinations of entrepreneurs and investors.  Their motivation is to turn knowledge and information into commercial technology for profit. 

There is a long tradition of successful companies being started by a combination of individuals with specialized knowledge and skills teaming up with other individuals with capital and management experience. One current model is research scientists, often molecular biologists, commercializing their research by starting companies with financing from venture capitalists. Venture capitalists often provide initial advice and guidance. As the company develops, new management is brought in, often from large biotechnology companies. Crucial inputs for growth and efficiency are purchased from other innovative companies with new technology.

The result of this basic dynamic is “creative disruption,” not equilibrium.   

The Structure of the Economy

We can think of the modern real sector of the economy as consisting of three parts – digital, physical, and biotechnological. Much of current innovation results from the interaction of these three parts.

An economy is divided between consumer goods and capital goods. Consumer goods are products and services sold to individual consumers. Most consumer goods are produced by large corporations and sold under either brand names or the name of the company. Producers usually do not sell directly to consumers, although ecommerce websites and digital platforms come close. Most consumer goods markets are mediated by market-makers, particularly retailers, that bring producers and consumers together. The internet version of market-makers such as Amazon, Etsy, Airbnb and Expedia have also reduced transaction costs for consumers; more product information is available to consumers at a reduction in the search costs of time and money. On the other hand, massive amounts of information on individual consumers have made more refined price discrimination possible. The idea that markets are undefined abstractions where producers and consumers come together and create a “market-clearing” equilibrium price does not explain how markets actually work.

Market-makers may write software eliminating agents, other market-makers. Travel agents and stock brokers are two areas. Tesla sells cars directly to buyers, eliminating car dealerships.

Much of the economy consists of markets for capital goods and inputs. Markets for capital goods are summarized as investment; markets for inputs are usually summarized as supply or value-added chains. In these markets, both buyers and sellers are usually corporations. Corporations are buyers in some input markets and sellers in others along the supply chain. Efficiency and profit may depend on how well companies can negotiate prices and transaction conditions, and coordinate buying and selling.

Large corporations account for over half the economy. Most markets are oligopolies, with large corporations producing a large percent of total industry output. When industries dominated by large corporations buy and sell in markets with large corporations on the other side, the market structure is bilateral oligopoly. 

Small and medium sized companies play vital roles. New, innovative companies start as small companies; they challenge the market dominance of the large, mature companies. Other small companies, somewhere between 20 and 30 million in the United States, add choice and “local knowledge” to the mass production and distribution of products and services from large corporations. They are also a major market for the products and services of large corporations.

An economy can be divided into mature companies and innovative companies. The increase in sales of mature companies depends mostly on the growth of total nominal disposable income. Many also grow through mergers and acquisitions. 

Innovative companies are often characterized by sales growth rates substantially higher than the growth rate of total income. Innovative companies provide much of the economic development, and thus economic growth, of an industrialized economy. Mature companies provide stability and structure. Many small companies provide variety and flexibility.

Information has been an important input since the beginning of the Industrial Revolution. Different types of information pervade all aspects of the economy. Mature companies spend large amounts on marketing and advertising. Capital goods and input companies provide information to their corporate customers. Information, a combination of hardware and software, is now an important output to final consumers and customers.

Corporations turn public information into private information. Private or proprietary information is a source of corporate profit. Some of the impact of economic information is due to asymmetric information, where a company in an economic transaction has private knowledge or information not known to the other. This affects market outcomes. Some of the transaction costs are the costs of obtaining information to reduce asymmetric information. This creates opportunities for market-makers, organizations and individuals who reduce transaction costs partly by providing specialized information.

The Economic Role of Government

Government is a vital part of a modern economy. In the United States, all levels of government provide over 20% of all goods and services, a higher percent in Europe. The fund and manage public goods and services. They usually fund many programs that directly or indirectly contribute to economic development and economic growth. These programs, however, have to compete with funding national defense and social welfare and income distribution programs.

Governments can provide stability and reduce transaction costs through laws and regulations. They can, directly or indirectly, reduce the social costs of production and consumption. 

Advances in communication and transportation technology have expanded markets geographically and made them global. Large national corporations are becoming multinational corporations (MNCs) that sell globally and coordinate global supply chains. Through the internet, even small companies can potentially appeal to a global market. National and local companies now depend on global supply chains and information networks. All this is made possible by a dense global fiber optic network. 

The expansion of the global economy has created new tensions and conflicts between national governments. It had also created tension between national governments and multinational corporations.

 The Themes of These Posts

The Industrial Revolution is a break in human history.

The Industrial Revolution, in its capitalist, private corporation version, is “permanent revolution.” It is based on unpredictable change caused by invention, innovation and disruption. Invention can occur anywhere but innovation occurs mostly inside corporations.

Innovation is both technological and organizational. This determines industry structure, and through supply chains, market structure.

Price competition is unstable and complicated. Market prices are not a single price determining equilibrium. Market prices and sales conditions are often determined by negotiation between large corporations. Prices (and competition) are influenced by asymmetric information. Proprietary information inside organizations is a source of competitive advantage.

Information is both an input and an output.

Companies in most industries compete on the basis of continuing innovation. This is true of the supply side of the economy – capital goods and inputs to other corporations.

Economic growth is mostly a function of innovation. Innovative products and services turn potential demand into effective demand.

An economy contains both innovative, disruptive forces, and stabilizing forces. Not all market and industry stabilizing forces are positive.

An economy is a form of chaos. Part of the economy evolves from disruptive, unpredictable forces into more orderly, predictable structures. They, in turn, are disrupted by new rounds of innovation. Again, “permanent revolution.”