DP10269 | How Darwinian should an economy be?

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30/11/2014

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Abstract

This paper studies aggregate dynamics in a cobweb model where learning takes place through a selection mecanism, by which more successful firms are replicated at a higher rate. The structure of the model allows to characterize analytically the aggregate dynamics, and to compute the effect on welfare of alternative levels of selectivity. A central aspect is that greater selectivity, while bringing the distribution of firm types closer to the optimal one at a given date, tends to make the economy less stable at the aggregate level. As in Nelson and Winter (1982), firms differ in their labor/capital ratio. They do not choose it optimally, rather it is a characteristic of a firm. The distribution of firms evolves over time in a way that favors the most profitable firm types. Selection may be inadequate because firms are being selected on the basis of incorrect market signals. Selection itself may reinforce such mispricing, thus generating instability. I compare economies that differ in the volatility and persistence of their productivity shocks, as well as the elasticity of labor supply. The key findings are as follows. First, a trade-off arises since greater selection allows to better track shocks and limits mutational drift in firm types; on the other hand, selection may strengthen cobweb oscillatory dynamics. Second, there seems to be a value in maintaining a diverse "ecology of firms", because the firm types that will be more adequate in future (uncertain) environments have to be drawn from the pool of existing ?rms. If selection is too extreme in the current environment, the firms that are best adapted to a given future environmental change, yet performing poorly in present circumstances, will be very scarce, and it will take longer for the economy to produce a large number of such firms in the new environment