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Complexity, institutions and firms

Summary:
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

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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.

Peter Radford
Peter Radford is publisher of The Radford Free Press, worked as an analyst for banks over fifteen years and has degrees from the London School of Economics and Harvard Business School.

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