The Origin and the Evolution of Firms

Front matter

The Origin and the Evolution of Firms

The Origin and the Evolution of Firms

Information as a Driving Force

Preface

The universe, the galaxies, the solar system, the earth, life, humankind, science, economies, markets and firms developed and develop in a spontaneous process we commonly term evolution. In this book, we attempt to develop a consistent theory that traces the evolutionary path that connects the birth of the universe in the Big-Bang to the complexity of today’s socioeconomic system with, among others, its firms and markets. What are the regularities or, if you like the laws, and the forces that drive this evolution?

As far as living organisms are concerned, we owe a landmark body of theory to Darwin and Wallace. Darwin publishes his work “On the Origin of Species” in 1859. His work highlights the existence of a continuous “Tree of Life” that connects the present life forms to a common ancestor. In the evolution of life on earth, we clearly see a development in the direction of increasing complexity. Matter becomes increasingly organized. Evolution clearly involves increasing organization.

Later on, when we explore the molecular basis of life and its evolution, we realize that evolution derives from the processing and communication of information. Life largely rests on the evolution of DNA macromolecules that provide the information for the biological structure that engages in competition for scarce resources with other structures based on different DNA codes. In this book, we unveil that information processing and its perfection through competition forms the basis of the evolution of society based on the appearance of new sets of information beyond the DNA macromolecules that drive biological evolution. Information is the scarce commodity that drives economic progress. A continuous line of evolving information sets connects the Big-Bang to the present-day socioeconomic system with its firms and markets. We term the evolution beyond the replicating DNA exogenic evolution.

No doubt, the theory of evolution Darwin introduces in the 19% century marks a monument in the history of scientific thinking and for that matter the philosophy of science. Earlier in that same century, the French engineer Sadi Carnot analyzes the workings of the “heat engine”. It is a contraption that allows the conversion of high temperature heat, obtained by the combustion of energy resources such as coal, into motive work. This greatly increases the availability of sources of motive power beyond those provided by human and animal muscles and e.g. waterpower. As we explain in this book, this increased availability of sources of useful work, triggers the industrial revolutions in the 18" and 19" century. These revolutions mark a strong increase in economic prosperity measured in terms of per capita Gross Domestic Product. This development becomes particularly manifest after 1850 when we witness the birth of many industrial initiatives that are the precursor of large industrial corporations that appear in today’s economic landscape.

Sadi Carnot’s analysis of the heat engine marks the birth of an important body of theory that, just as in the case of the theory of evolution, marks a revolution in the history and the philosophy of science. It spawns thermodynamics, the theory that governs the transformation of sources of energy, such as heat and the various flavors of work. The theory of thermodynamics introduces a number of laws that put restrictions to the transformation of said energy sources. The first law states that energy is conserved: It cannot be created or destroyed in any process. Hence, the total energy in the universe today is the same as the amount that exists when it emerges 13.5 billion years ago. In addition, thermodynamics introduces the intellectually evasive quantity entropy. The second law of thermodynamics states that entropy can only increase in the processes that take place in a closed system. Hence, the total entropy of the universe increases in the evolution of the universe after its birth and it continues to increase in the future. This leads to an apparent conflict with the process of evolution we introduce earlier. Evolution leads to a local decrease of entropy reflected in the increase of

Vii organization of matter. We see the evolution of organized systems, such as organisms. Prigogine and his coworkers (see e.g. Nicolis and Prigogine (1977)) importantly contribute to removing the apparent paradox of the laws of evolution and the laws of thermodynamics. The theory of non-linear non-equilibrium thermodynamics reconciles the local evolution of “Order out of Chaos” with the second law direction of spontaneous processes. The theory shows that in non-equilibrium systems forces exist that locally drive processes in a direction against the natural direction the second law dictates. Such a development can take place as long as for the universe as a whole entropy increases. This introduces the concept of dissipative structures that organize themselves against the direction of the second law by using sources of energy in the environment. Organisms are examples of such dissipative structures. This book extends the concepts of thermodynamics beyond the conventional “physical” sources of work to include economic work. We thus identify organizations like firms as dissipative structures. Another important result from thermodynamics introduces the notion that entropy intimately relates to the information we have about the details of complex systems. It identifies the information that is missing in our picture of reality as a scarce quantity that comes at a cost. In addition, this leads to the identification of the forces that drive evolution. This highlight the important role of information in thermodynamics and this closes the circle between evolution, based on the processing and communication of information, and our extended interpretation of thermodynamics.

We combine the information-based forces of thermodynamics with the information-based forces behind the theory of biological and exogenic evolution to arrive at a systems theory of evolution. This theory shows that evolution rests on the coupling of forces that drive processes in the natural direction defined by the second law, to processes that drive evolution against the natural direction dictated by the second law. This also holds for the coupling of economic work that drives our economy and the evolution of the socioeconomic system with its markets and firms, to the downhill processes that result from the non-equilibrium situation in the universe. Our theory allows tracing the path from the Big-Bang to the contemporary socioeconomic system. In this way, we trace the origin and the evolution of firms.

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Chapter 4. Macroscopic And Microscopic Models: Statistical

THERMODYNAMICS. 4.1. Introduction. 4.2. Statistics and probability theory. 4.3. Information theory: Quantifying information. 4.4. Statistical thermodynamics.

= o U m =

12 12 13 16 19 21 22

24 24 24 25 30 33 34

35 35 35 38 39 42

Chapter 5. A General Theory Of Transformations And Economic

TRANSACTIONS. 5.1. Introduction. 5.2. A general Economic Value Theory. 5.3. The Capital Asset Pricing Model and Economic Value Theory. 5.4. The nature of energy and value revisited. 5.5. The second law of Economic Value Theory. 5.6. The heat engine revisited and more.

5.7. Forces in thermodynamics and Economic Value Theory.

5.8. Transformation of information in economic value: The concept of price.

5.9. A more generalized market transaction.

Chapter 6. Systems Theory Of Evolution

6.1. Introduction. 6.2. The linear value transducer revisited. 6.3. Instability of steady states and evolution.

6.4. The Benard problem and instability of the macroscopic branch.

6.5. Instability of the macroscopic branch in chemical reaction systems.

6.6. Evolution through fluctuation and selection: The general case. 6.7. The starting point of biological evolution: Prebiotic evolution. 6.8. Competition and sustained evolution.

6.9. The dynamics of competition.

6.10. Biological evolution: Dissipative structures.

Chapter 7. The Firm And Information Processing

7.2. The dynamics of competition and selection.

7.3. The error threshold in evolution.

7.4. Models of Darwinian systems: The Hypercycle.

7.5. Competition and selection: An approach based on EVT.

7.6. The nature of the firm and its evolution.

7.7. Differences and similarities between biological and economic evolution.

81 81 83 85 86 89 91 93

CHAPTER 8. SOME CONCEPTS OF ECONOMIC THEORY. 8.1. Introduction. 8.2. The nature of markets and industries. 8.3. The nature of value and value transaction processes. 8.4. Self organizing systems: Dissipative structures. 8.5. The pivotal role of information. 8.6. The internal value chain.

8.7. Macroeconomics.

8.8. Microeconomics: The interplay between demand and supply.

8.9. Models of economic growth, business cycles. 8.10. The behavioral theory of the firm.

8.11. Transaction cost theory.

8.12. Agency theory of the firm.

8.13. Evolutionary theories of economics.

8.14. Industry structure: The nature of entry barriers. 8.15. Strategy development.

CHAPTER 9. THE EVOLUTION OF THE UNIVERSE. 9.1. Introduction. 9.2. Our present-day picture of the universe. 9.3. Understanding the small and the large. 9.4. Evolution of the structures in the universe.

CHAPTER 10. THE CO-EVOLUTION OF EARTH AND LIFE.

10.1. Introduction. 10.2. The evolution of the solar system.

10.3. Origin of earth.

10.4. The formation of the continents, oceans and atmosphere.

10.5. The origin of life. 10.6. The proliferation of advanced life forms. 10.7. The heat balance of earth.

115 115 115 117 121 125

CHAPTER 11. HUMAN EVOLUTION.

11.2. History of ideas about human evolution.

11.3. Evolution of the apes.

11.4. The relation between humans and the great apes. 11.5. Genus Homo.

11.6. Use of tools.

11.7. Modern humans: The “Great Leap Forward”. 11.8. Out of Africa model of human evolution.

CHAPTER 12. HISTORY OF SCIENCE.

12.2. Pattern of the evolution of science. 12.3. Early developments in science. 12.4. Medieval Science.

12.5. Impact of science in Europe.

12.6. Modern science.

12.7. Social sciences.

CHAPTER 13. THE EVOLUTION OF TECHNOLOGY.

13.2. Drivers of technological progress.

13.3. Geographical and temporal aspects of the evolution of technology. 13.4. The industrial revolution.

CHAPTER 14. THE INDUSTRIAL REVOLUTION.

xii

14.2. Causes of the industrial revolution in Britain.

14.3. Role of inventions and innovations.

14.4. Continental Europe.

14.5. The second Industrial Revolution and later evolution.

145 145 145 146 147 148

CHAPTER 15. THE DEVELOPMENT OF SOME OF THE LEADING FIRMS. 155

15.1. Introduction. 155 15.2. An evolutionary view of corporate development: Gist-brocades. 155 15.3. The evolution of some leading multinationals. 160 15.4. The paradox of strategic planning. 170 15.5. Conclusion. 172

CHAPTER 16. TRACING THE SOURCE AND THE DIRECTION OF EVOLUTION:

A SUMMARY. 175

16.1. Introduction. 175 16.2. Non-equilibrium, free energy and economic value. 178 16.3. The ubiquity of cyclic interaction. 186 16.4. Evolution and sustainability. 194 16.5. Reflections on predictability issues in evolution. 199 16.6. Conclusion. 201 CHAPTER 17. EPILOGUE 203 17.1. Introduction. 203 17.2. Summary of the highlights of the basic theory. 203 17.3. The Origin of Markets and Firms. 207 17.4. Prospects and challenges. 209

LITERATURE CITED 213 xiii

CHAPTER 1. INTRODUCTION. 1.1. Introduction

Daily observations show that reality is complex. At the intermediate level of sizes in the biosphere, we observe complex organized forms of matter. Plants and animals are examples of such organized matter. We hold the position, following Darwin (Darwin (1859)), that the biosphere on earth arose spontaneously in the process of evolution. Evolution introduces change, also in the direction of increasing complexity, through processes driven by random events, by chance. As we explain in this work, evolution is a necessary consequence of the conditions in the universe. Evolution towards increasing complexity is inevitable. The Nobel laureate Jacques Monod (Monod (1971)) uses the notion of “Chance and Necessity”.

The second law of thermodynamics provides an arrow of time to the direction of spontaneous processes. Over the years, the literature shows a variety of formulations of this second law. One of the popular formulations is that systems, if left alone, develop in the direction of increasing disorder. In absence of maintenance buildings turn into ruins; we never observe the reverse process. The theory of evolution of Darwin, on the other hand, explains how complexity, such as in living systems, results under the conditions on earth and broader in the universe.

The apparent contradiction between the theory of evolution and the second law of thermodynamics puzzled many early investigators. Evolution generally proceeds in the direction of increasing complexity. Organized systems, such as humankind, evolve apparently spontaneously out of an initially unordered state. Fortunately, scientific developments in the 20" century lead to a reconciliation of thermodynamics and evolution. Prigogine and his coworkers formulate a thermodynamic theory of evolution (Glansdorff and Prigogine (1971), Nicolis and Prigogine (1977), Prigogine (1980), Prigogine and Stengers (1984)).

The discovery of the role of DNA and RNA in biology shows that biological evolution is of an informational nature. The processing and communication of information lies at the roots of the evolution of increasingly complex organisms. Evolution results for an extensive period of the history of life on earth exclusively from the further refinement of DNA (or RNA) macromolecules. Relatively recently, other ways of developing and communicating information emerge when the brain appears and evolves to sophistication when Homo sapiens appears. The brain triggers the so-called exogenic evolution; evolution based on transferring and developing information beyond the information carrier DNA. This also leads to the development of the socioeconomic system, with its institutions such as universities, economies, markets and firms. Communication of information through e.g. teaching and in written form complements the communication by DNA replication. It is the ambition of this book to investigate the relation between the theories mentioned above and the storage, processing and transfer of information. In this way, we grasp the dynamics of economies, markets and industries and trace the evolution of society as we know it today back to the birth of the universe.

Most of the systems that are of interest to physicists, chemists and biologist are far too complex to model in detail. In physics, this leads to the widespread use of macroscopic models that take only part of the microscopic details of complex systems into account. In using macroscopic models, science develops a reduced information picture of the systems of interest. As we explain later, this approach leads to limitations to the predictability of the future behavior of the systems we explore. In addition, this leads to limitations to the extent we can exploit the potential sources of energy and economic value (economic value is a concept we introduce and discuss in Chapter 5) in the system. The extent of this loss quantifies in the statistical entropy of the macroscopic description. It provides a quantification

Introduction

of the information that is lacking in the macroscopic description. We discuss the nature of the concept statistical entropy more extensively in Chapter 4.

In this book, we discuss some further limitations of modeling when applied to evolving systems. The first limitation relates to the observation that evolution develops in the direction of an increasing interaction between the evolving system and its environment. Here a traditional assumption of modeling breaks down. In most modeling exercises, relevant processes only take place in the system. The environment does not change due to the evolution of the system. We show that this is often not the case as the environment and the system engage in a process of co-evolution.

A second modeling problem is of a very different nature. One of the basic assumptions in modeling is that the system and its model are independent. This implies that the existence of the model does not influence the processes that take place in the system. This proves a dangerous assumption if the actors in the system know the predictions of the model and use these predictions to shape their behavior. This leads to a fundamental problem in the modeling of the socioeconomic system and the validation of the resulting models.

The ambition of this book is to develop a consistent theory of evolving systems with special reference to industries, markets and economies. We show that the basic driving forces behind the transactions that take place in our markets, industries and economies rest on the creation and maintenance of asymmetries in information. Furthermore, the value (and the cost) of the information is quantitatively defined using the concept of statistical entropy. This results in a general theory of evolution applicable to a wide range of systems. The theory allows tracing the origin of society.

We apply this basic formalism to systems in which asymmetries in information exist and develop. Furthermore, we analyze aspects of the theory in terms of accepted economic concepts, such as the perfect competition model, transaction costs economics, the concept of dynamic capabilities and the evolutionary approaches to organizations. This leads to the conclusion that the application of evolutionary approaches to markets, industries and economies does not rest on a mere analogy with biological evolution but is a reflection of a general evolution theory of complex systems. We argue that there are both similarities and differences between biological and socioeconomic evolution. The theories underlying the approach (thermodynamics of complexity, information theory, statistical thermodynamics and the theory of evolution) are not free from mathematical intricacies. We describe the formalisms in earlier work on the subject (Roels (2010)). This book differentiates itself by avoiding mathematical intricacy as much as possible without sacrificing rigor. It tries to address a multidisciplinary community of readers.

The main distinguishing feature of this book is that it develops a conceptually consistent framework for the existing concepts used in organizational economics in a way that should be accessible to readers not familiar with modeling approaches in physics, chemistry and biology. The author hopes that this book thus augments on and complements existing approaches in the literature on organizational economics and evolutionary approaches to organizations. In addition, we illustrate the application of the systems theory of evolution analyzing the evolution of the universe, the evolution of earth and life on earth, the scientific revolution and the industrial revolutions and derive the general features of these systems as non-equilibrium phenomena that lead to evolving information sets of an ever-increasing complexity. The book thus bridges the gap between the Big-Bang that creates the universe and our present-day socioeconomic system based on one universal theory of evolution. Evolution is very pervasive, its influence stretches from the universe at a cosmic scale through our socioeconomic system with organizations like firms, to science and technology and the invisible viruses that caused a Mexican flu epidemic in 2009. Also our species, Homo sapiens, is a product of evolution.

Introduction.

We stress that evolution continues to progress as the forces that drive it still exist and continue to develop. Consider the development of language. Since the appearance of the ancestor language of Dutch, called Diets, it significantly changed and it is in a process of constant evolution today. Whether this leads to any improvement is a matter of taste and depends on the definition of improvement we choose to adopt. Certainly, evolution has an arrow of progression; it proceeds in a certain direction. Whether this direction leads to improvement depends, as said, on individual taste and the definition of improvement. To evolution itself, this question is not even marginally relevant.

In this book, we show that where conditions exist that necessarily lead to evolution, it exhibits certain regularities or laws no matter what the substance of the evolution may be, be it languages, industrial corporations, religions, human cultures, galaxies or minute viruses. Laws like the laws of physics govern the evolutionary path. Just as the law of gravitation invariably leads to planets orbiting stars, laws exist that govern all evolution processes. This book unravels some of the regularities in evolutionary processes. We discuss a systems theory of evolution (Chapter 6), show its foundation from the scientific perspective and illustrate its application to reality.

Before embarking on our journey, we provide the reader with a preview of the main conclusions we intend to reach. In addition, we highlight the flavor of the main elements of the organization of this work.

1.2. The main ambitions and features of this work.

Competition

Fig. 1.1. Evolution through change by chance: Learning by doing.

In this book, we intend to analyze a wide range of evolutionary phenomena ranging from the very large, stellar objects, to the very small, e.g. the molecular machinery underlying life phenomena. We also argue that immaterial systems such as science and technology are subject to laws of evolution. In fact, also our economies, institutions and firms are subject to and result from processes following the general features of evolution. We intend to explore the sequence of complex events that connects the Big-Bang to our present socioeconomic system. The processes that created increasingly complex structures such as the objects in the universe, the life forms and economies and industries result from the operation of forces that drive these changes. We identified these forces in earlier work (Roels (2010)) and we further

Introduction.

illustrate the nature of these forces as a direct consequence of the conditions that apply when the universe emerges. We thus arrive at the general features of evolution both in material systems, e.g. organisms, and in immaterial systems such as science and technology.

A concept we introduce and frequently use is the learning by doing cycle (Fig. 1.1) that is very basic to any type of evolution. In fact, it represents the archetype of an evolutionary cycle. We discuss this cycle in detail in Chapter 6 in the context of a systems theory of evolution. Fig. 1.1 highlights the pivotal role of information. All the systems we discuss in this work develop and communicate an information set, be it in a tangible form (e.g. an organism’s DNA) or in an abstract or intangible form, such as in a scientific theory. The information translates in some kind of organization, e.g. the organism’s structure, its phenotype, the understanding and the predictions that result from a scientific theory or the products and services and other aspects of the manifestation of an industrial enterprise. We will collectively indicate these manifestations of the information sets as “phenotype”, also beyond the purely biological systems. In the process of communication of the information set changes appear, either by more or less directed change, e.g. by R&D or the gravitational force in the universe, or by error. This variation is vital, as it is one of the sources of progress. The phenotype competes for scarce resources that are the origin of the forces that drive evolution. Examples of such resources are energy and, more general, value, a concept we introduce in Chapter 5. We discuss these resources in a general way below and in far more detail in later chapters. This competition may also take place in the intangible world, e.g. where rivalling scientific theories compete for explanatory power in the light of experimental evidence. The competition for scarce resources leads to selection of the most competitive phenotype and hence its related, often changed, information set. This process leads to the selection of information sets that are coding for phenotypes that are more efficacious. It leads to closing a positive feedback cycle that is the basis of sustained evolution. We stress that closing the cycle leads to a blurring of cause and effect. Once the cycle closes, the familiar distinction between cause and effect disappears as these cyclically interact to drive evolution. The activities of the structure that the information sets code for both result from and are instrumental in the creation of the forces.

In addition, a cause and effect cycle closes between the structures and their environment. This in principle holds for all the elements of the cycle. The resources, the variation, the information set, the phenotype, the competitive environment and the selection process relate causally and are both cause and effect of the evolution taking place.

A second aspect that we introduce is the concept of sustained evolution (Fig.1.2) as introduced by Prigogine and his co-workers (e.g. Nicolis and Prigogine (1977)).

non- Self reproducing Innovation through equilibrium information variation

Selection for Increasing forces increased coupling

Fig. 1.2. Sustained evolution.

The drivers of the process of sustained evolution derive from the fact that we have a system that is not in equilibrium, i.e. in the system forces exist and evolve that drive processes. In the

Introduction.

Big-Bang theory of the evolution of the universe, this non-equilibrium situation emerges on the creation of the universe. It initiates a sequence of events in which information sets emerge that define the structures in the evolving universe. These information sets are self-reproducing and are subject to changes both in content and in nature. In the case of the evolution of the systems around us in the universe and on earth, the Bing-Bang creates a large amount of energy. This is the source of the forces that drive evolution and the origin of the nonequilibrium situation that arises on the creation of the universe. This amount of energy, the source of all the driving forces in the universe, remains constant in the history and in the future development of the universe. The famous first law of thermodynamics proclaims energy to be a conserved quantity, i.e. the amount of energy in the universe cannot change in any imaginable process. The amount of energy in the universe and the potential to perform work, including economic work to add economic value, thus remains constant in the estimated 13.5 billion years of evolution of the universe to date.

In the universe a background of electromagnetic radiation exists that is to a high degree of accuracy the same in any direction we choose to observe it. However, small variations in the energy of the background radiation do exist. These variations represent the initial information characterizing the early universe. The corresponding variation in energy density forms the initial self-organizing information. These differences in energy density amplify by gravitation and lead to increasing inhomogeneities in the local energy density in the evolving universe. This triggers the subsequent ignition of the stars by the energy that nuclear fusion processes release. Hydrogen was one of the early elements that form in the evolving universe and is the initial resource for fusion processes.

One of the systems that form in this way is our solar system that also contains all of the higher chemical elements beyond Hydrogen. In this way the constituents of the life forms, being mainly Carbon, Hydrogen, Oxygen, Nitrogen and Phosphorus appear. In the solar system, the planet earth develops. Life emerges on earth using the scarcely available sources of forces provided by mainly inorganic fuels and/or organic materials that form under the influence of solar radiation. DNA based self-replication appears and this leads to the first photosynthetic bacteria that harness the energy in solar radiation. This drastically increases, both in size and in number, the forces that drive evolution and fuels the development of organisms that feed on the organic material produced by the photosynthetic autotrophs. It leads to the food webs we know today. In the process of evolution on earth, the brain emerges and becomes perfected when the genus Homo starts to evolve and our species Homo sapiens appears. With the brain, new replicators appear beyond DNA and a so-called exogenic evolution emerges resulting in science and technology, the first and second industrial revolutions and our present-day socioeconomic system. In these processes the driver of evolution continues to derive from the forces that result from the initial non-equilibrium created in the early universe and the selection of sets of information that compete for the capacity to do useful work that derives from those forces. As is clear both the nature of the forces and the nature of the information sets, be it DNA, information stored in the brains of the life forms or information in written form or in computer files, change drastically in this extended process of evolution. We again stress that both the forces and the information sets are part of a cycle in which the information sets are both the consequence and the source of the forces and vice versa. In fact, the information contained in the information sets allows the transformation of the potential to do work, also in an economic sense, contained in the energy that emerges in the Big-Bang, into work that is useful from the perspective of the structures that feed on these energy resources. The structures for which the information sets encode are termed dissipative structures as these feed on the capacity to do work derived from the energy resources in the environment, i.e. these structures dissipate energy. These entities contain the information to create forces based on the available energy resources and the information to effectively couple to these forces to

Introduction.

fuel their growth and development.

It is perhaps useful to illustrate these phenomena using an example. We imagine a landscape in which a river is flowing downhill. The energy contained in the difference in altitude characterizing the slope that drives the flow in the river, is the source of the potential to do work. In order to extract useful work from this potential we need additional information, e.g. a blueprint of a dam to build in the river and an electricity generator in the dam. Building these structures in the river allows the generation of electrical energy that is able to do work using a variety of electrical appliances. Without that additional information, the potential to de work is not available as a source of useful work.

The discussion above leads to the identification of a very important second concept that emerges in the theory of thermodynamics. It is the difficult and evasive concept of entropy. Entropy is a quantity that is of informational nature. It quantifies the amount of information that is lacking to transform the energy in a resource fully into useful work. In fact the essence of the second law of thermodynamics is that in any natural process in a so-called closed system, that is a system that cannot import energy resources from the environment, the information lacking to fully use the potential to do work contained in the energy in the system can only increase and the ability to extract useful work from that energy resource can only decrease. Entropy defines the direction in which natural processes spontaneously proceed. Any such spontaneous process results in the production of entropy.

The cycle of sustained evolution depicted in Fig. 1.2 clearly emerges in this broad-brush description of the processes that finally lead to our present-day socioeconomic system.

In Chapter 6 where we introduce the systems theory of evolution, we highlight the following conditions as characteristics of the evolution of dissipative structures such as organisms, firms and economies: