Culling Improves the Herd

Culling is a well-known phenomenon in biology — the process of selective removal of weaker individuals from the breeding stock. Although not done deliberately, something similar happens in markets. Entities that are “weak” are selected out of the marketplace, and the health of the economy improves.

In a previous post, I wrote:

If an unprofitable firm fails, it is bad for the workers of the firm. But the failure of firms within an industry could be good for the health of the industry and for the larger economy. At the next level up, an entire industry could fail and cause misery for its workers, and yet that could be very good for the economy.

This follows from the logic of any modern economy. Large economies are dynamic, complex, emergent systems. Meaning the system evolves with time, and that evolution is not under the control of any particular entity, and the complexity of the interactions between the subsystems rule out precise predictions about future states of the system.

But that does not mean that no predictions are possible. Pattern predictions are possible but they generally lack content. Here’s an example. We can predict that 100 years hence, orders of magnitude more energy will be used by humanity, but the precise mix of energy technologies used for energy cannot be predicted. Perhaps the majority of our energy needs will come from fusion, or from some yet unknown source.

The unpredictability of emergent systems is because what happens is contingent and not necessary. A dynamic system explores the search space, as opposed to a static system which just sits where it is. Movements entails removing some bits of the system, and adding other bits.

OK, so why do firm failures good for the industry?  First, firms fail because they make losses in a market system which is characteristically “profit and loss.” If a firm is making losses, it means it is using up more value than it is creating. If the revenues are $100 and the costs are $130, then the firm is destroying $30 worth of wealth. Conversely if the revenues are $100 and the costs are $70, then the firm is adding $30 of wealth.

When a firm fails, it tells market participants to not do what that firm was doing. That’s valuable information. A dynamic system gives birth to many attempts to create value, some of which fail but those failures make the system more robust. If firms are prevented from exiting the market — as often happens when the government props up failed public sector firms or bails out failing firms — the economy suffers.

What’s good for the industry is not necessarily good for the firm, and what’s bad for the firm is not necessarily bad for the industry. Failed automobile companies improve the auto industry.

Similarly, when an industry dies, it means the economy has changed and most often it is for the better. At its peak, around 150,000 people worked as telephone operators in the US. Today no one works as a telephone operator; those jobs have been replaced by electronic switching systems. People who would have worked as telephone operators are doing some other more valuable work.

Generally speaking, mistaking the economy to be a static system instead of a dynamic system leads to all sorts of confused thinking. For example, many worry that humans are using up the world’s resources, or that the world is on an unsustainable path. But the world is never going to run out of resources.

Incorrectly believing the world to be static is bad enough. But what’s worse when powerful people try to force a dynamic system to be static — that is they resist changes that emerge. That’s what socialists try to do, and that what impoverishes countries — such as India.

It’s all karma, neh!

Author: Atanu Dey

Economist. View all posts by Atanu Dey