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Managerial, Institutional and Evolutionary
Approaches to Environmental Problems: Welfare
and Policy Implications
Jonathan Michie
University of Oxford
and
Christine Oughton
SOAS, University of London
New Directions in Welfare
A conference for economists and policy makers
St Catherine’s College, Oxford University
Oxford 29 June - 1 July 2009
“Climate change is the greatest challenge
facing humanity at the start of the 21st
Century. Failure to meet that challenge raises
the spectre of unprecedented reversals in
human development.”
United Nations Development Programme
(2008), Human Development Report 2007/08
Welfare Effects
• Negative externalities generate social costs
• In the case of environmental damage, social
costs may be:
– difficult to observe
– greater in countries far from where they were
generated
– greater in the future than at the time of generation
The nature of the problem
Source: United Nations Development Programme, Human Development Report 2007/08
Source: United Nations Development Programme, Human Development Report 2007/08
“Recent observations confirm that, given high rates of
observed emissions, the worst-case IPCC scenario
trajectories (or even worse) are being realised. For
many key parameters, the climate system is already
moving beyond the patterns of natural variability
within which our society and economy have developed
and thrived. These parameters include global mean
surface temperature, sea-level rise, ocean and ice
sheet dynamics, ocean acidification, and extreme
climatic events. There is a significant risk that many of
the trends will accelerate, leading to an increasing risk
of abrupt or irreversible climatic shifts.”
The International Scientific Congress on Climate
Change 10-12 March 2009 Copenhagen
Does standard economic theory provide an
adequate framework to deal with
environmental problems, their welfare
implications, ethical issues and policy design?
What can managerial, institutional and
evolutionary approaches offer?
Standard Neoclassical Analysis
• Based on a ‘representative’ firm or agent
• Firms’ behaviour is explained by assuming
instrumental rationality; decisions are reduced to
calculus and marginal analysis
• There is no scope for ‘managerial’ decisionmaking
• Cost curves are assumed to be well behaved
• Innovation is a ‘bolt on’ to standard analysis
• Consumer preferences are exogenous
Standard Welfare Analysis
• It is possible to identify an optimal level of
pollution or abatement
• For example, in the case of carbon emissions,
the optimal level occurs where the marginal
abatement cost equals the marginal social
cost of carbon
• Market based instruments e.g. carbon trading
schemes can be shown to be efficient
Problems
• Are cost curves well behaved?
• The representative agent/firm: whom/what
does it represent (Kirman, 1992)?
• Innovation – how do firms innovate?
• Is there a trade-off between abatement and
social cost?
• Rationality – is instrumental rationality an
adequate model of business and consumer
behaviour?
Badly-behaved cost curves?
“The chief obstacle against which they [firms] have to
contend when they want gradually to increase their
production does not lie in the cost of production – which,
indeed, generally favours them in that direction – but in
the difficulty of selling the larger output of goods…”
Sraffa (1926, p. 543)
“at the empirical level, nobody doubts that in any
economic activity which involves the processing or
transformation of basic materials – in other words, in
industry – increasing returns dominate the picture”.
Kaldor (1972)
The myth of the representative firm
“The question of what makes for good policies is what
the business management field is all about.”
“in most of economics, firms are treated as simple
entities… management chooses the policies that will
‘maximize’ firm profits. The ‘question’ that is at the
centre of concern in the business management field is
assumed trivial to answer. And since it is, all firms in the
same economic context are presumed to have the same
policies – those that are best in that context – and to do
the same thing.”
(Nelson, 1991, p. 347)
Innovation
“To be successful in a world that requires that firms innovate and
change, a firm must have a coherent strategy that enables it to
decide what new ventures to go into and what to stay out of. And it
needs a structure, in the sense of mode of organization and
governance, that guides and supports the building and sustaining of
the core capabilities needed to carry out that strategy effectively.”
“If one thinks within the frame of evolutionary theory, it is
nonsense to presume that a firm can calculate an actual ‘best’
strategy. A basic premise of evolutionary theory is that the world is
too complicated for a firm to comprehend, in the sense that a firm
understands its world in neoclassical theory.” (Nelson, 1991, pp. 68-9)
Systems of Innovation
“the network of institutions in the public and
private sectors whose activities and interactions
initiate, import, and diffuse new technologies”
(Freeman, 1987, p. 1).
Institutions
“That institutions affect the performance of
economies is hardly controversial. That the
differential performance of economies over time
is fundamentally influenced by the way the
institutions evolve is also not controversial… the
institutional framework (of rules, norms, and
enforcement characteristics) together with the
traditional constraints (budget, technology) of
economic theory determine the opportunities
available at any moment in time.” (North, 1993,
pp. 242-243).
“A central insight provided by the systems-ofinnovation approach is that firms do not generally
innovate in isolation, but do so in interaction with
other organizational actors (such as other firms,
universities, or standard-setting agencies) and
that this interaction is shaped by (and shapes) the
framework of existing institutional rules (laws,
norms, technical standards). The approach takes
into consideration the actions of both firms and
governments. In short, this conceptual approach
regards innovation as a process of interactive
learning.” (Edquist, 2001, p. 1623)
Implications
“A major implication of the characteristics of
cumulativeness, tacitness, and partial
appropriability of innovation is the permanent
existence of asymmetries among firms, in terms
of their process technologies and quality of
output. That is, firms can be ranked as “better”
or “worse” according to their distance from the
technological frontier.” (Dosi, 1988, 1155-1156
Is there always a trade-off?
• The Porter Hypothesis and SEM question the trade-off
between abatement and profitability
• If innovation and SEM are profitable why don’t all firms
use them?
• Firms’ environmental strategies are subject to bounded
rationality and/or procedural rationality
• Suggests a role for policy to overcome bounded
rationality and lock-in to procedural rationality
• Strategic environmental management and regulation
can become important competitive tools
Strategic Environmental Management
“The opportunities for this kind of strategic
repositioning are thought to originate in broad social
and environmental trends. Hart (1997) argues that
while “bottom-up pollution-prevention programs
have saved companies millions of dollars” (67-68) –
with increased cost savings and hence profits coming
from reduced waste and energy use – the best is yet
to come. He points to the smaller number of firms
that have begun reorienting their long term
strategies, and plans for revenue growth, around
solving sustainable development problems where
their basic capabilities give them expertise.”
(Goldstein, 2002, p. 497).
Evidence and policy implications
• Goldstein (2002) looked at environmental projects
in 17 companies, 16 increased profitability
• Cambridge Econometrics and AEA Technology
undertook 65 case studies and found significant
cost savings from increased resource productivity
(both as a % of value added and as a % of profits)
• Role for policies to promote training in SEM
Rationality
• Does instrumental rationality provide an
adequate model of agents’ behaviour?
• What about other models of rationality?
– Bounded rationality
– Procedural rationality
– Expressive rationality
– Kantian Rationality
• How do we explain cooperative behaviour and
trust, do institutions matter?
• Do firms have an ethical or CSR dimension to
their strategies?
The Tragedy of the Commons
Externalities
Externalities
No externalities
No
Externalities
(1, 1)
(0, 5)
(5, 0)
(3, 3)
The Tragedy of the Commons
Externalities
Externalities
No externalities
No
Externalities
(1, 1)
(0, 5)
(5, 0)
(3, 3)
Limits of Instrumental Rationality
• Two so-called ‘irrational’ agents could do better
• It’s not easy to explain cooperation under IR – it can be
done (e.g. Axelrod, 1981) but it requires:
– an indefinite time horizon (and therefore a belief in
the possibility of one’s own immortality) and the
existence of a player (or group of players) who
starts by cooperating
– or a finite time horizon and asymmetric information
with the injection of a rogue ‘irrational’ cooperative
player (e.g. Kreps and Wilson)
Policy Implications
• Neoclassical analysis relies on market-based instruments
that change monetary payoffs
• Managerial approaches point to regulatory policies that
rule out certain strategies and policies that catalyse
innovation (possibly in combination with taxes)
• Voluntary business policies rely on cooperation – depend
on other models of rationality
• Innovation and SEM change the structure of the game
(relative payoffs)
• International agreements change the game from noncooperative to cooperative
Voluntary Actions, Rationality
Regulation, Innovation and
Abatement
Complex Systems Theory
• Views the economy as part of a complex
system, made up of many different agents
• Complex systems may be distinguished from
simple systems by virtue of the fact that the
actions of individual agents have
macroeconomic or system wide effects
• Allows the incorporation of different
managerial strategies, institutions, innovation,
diffusion, lock-in and evolution
Examples of System Wide Effects
• Externalities – that result in system wide
changes
• Firms cutting back production 
unemployment and recession
• Lock-in to inefficient technologies
– QWERTY keyboard
– Petrol cars
– Carbon intensive technologies
Sources of Lock-in
•
•
•
•
Economies of scale in production
Network externalities
System effects in education and training
Conventions in production (by firms) and transfer
of inefficient technologies to developing
countries
• Inertia in consumption patterns
Policies to deal with lock-in
• Market based instruments may not be effective (in
isolation) at dealing with lock-in
• Regulatory instruments, such as standards,
conventions may be more effective and induce
innovation
• Training in SEM
• Policies for creation and diffusion of innovation
• Policies to ‘nudge’ consumer choices
• International coordination
Conclusions
• Market based instruments are good at
changing financial incentives – they may
induce technical change but they don’t help
much with lock-in and they ignore other
determinants of innovation
• Managerial, institutional, evolutionary
approaches offer a wider and more
sophisticated set of policy instruments
• We need a better theoretical understanding of
firms’ behaviour and of complex systems
“To achieve the societal transformation required to
meet the climate change challenge, we must overcome
a number of significant constraints and seize critical
opportunities. These include reducing inertia in social
and economic systems; building on a growing public
desire for governments to act on climate change;
removing implicit and explicit subsidies; reducing the
influence of vested interests that increase emissions
and reduce resilience; enabling the shifts from
ineffective governance and weak institutions to
innovative leadership in government, the private sector
and civil society; and engaging society in the transition
to norms and practices that foster sustainability.”
International Scientific Congress on Climate Change 10-12 March 2009 Copenhagen
Tim Foxon, Jonathan Köhler and Christine
Oughton (eds) 2008, Innovation for a Low
Carbon Economy, Edward Elgar.
Complexity Economics for Sustainability
ESRC seminar series is organised by Dr Tim Foxon
(Principal), Dr Terry Barker, Professor Jonathan
Michie and myself
Simon Dietz, Jonathan Michie and Christine Oughton
(eds) The Political Economy of the Environment,
Routledge, forthcoming.
First seminar held at Oxford University November
2008 – papers can be found at:
http://www.see.leeds.ac.uk/research/sri/projects/
esrc-research-seminar-series.htm
Second at University of Bolzano:
http://www.unibz.it/en/economics/events/Innovat
ionSystems_researchseminar.html
Third at University of Leeds 23-24 June 2009
Next seminar:
3-4 December 2009, University of Cambridge