The Competitiveness of Nations

in a Global Knowledge-Based Economy

October  2003

AAP Homepage

Brian J. Loasby

Cognition, imagination and institutions in demand creation

Journal of Evolutionary Economics

2001, 11: 7-21



1. A question of rationality

2. Mental processes

3. Institutions

4. Innovation

5. Conclusion



Formal rationality plays a limited role in human cognition, which originated in the creation of patterns to interpret phenomena and link phenomena with action.  The creation of new patterns rests on imagination, not logic, typically stimulated by a perceived inadequacy in established patterns.  Internal routines of the brain and external institutions form structures of cognitive capital; the institutions of markets, including money prices, aid the development of consumption capital, which simplifies most choices and provides scope for selective experiment and innovation in creating goods.  Such innovation depends on differences between individuals and changes in their circumstances.


1. A question of rationality

In a paper presented to a symposium on ‘Cognition, Rationality, and Institutions’ at the Max-Planck Institute in Jena, Andreas Ortmann and Gerd Gigerenzer (2000) examined the parallel conflicts in psychology and economics between those who believe that people act rationally, as rationality is prescribed by the principles of logic and probability theory, and those who believe that people systematically deviate from these principles.  The definition of rationality as a purely formal relationship between premises and conclusions, was, they claimed, not in dispute between the contending parties in either discipline, and this was reflected in the experimental procedures by which both psychologists and economists attempted to test their beliefs.  Many experiments in which subjects were set explicit reasoning tasks had generated apparently strong evidence of ‘rationality failure’;

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but in more recent experiments, subjects presented with problems that were formally identical to these reasoning tasks, but with substantive content and context, had performed much better.

What conclusions should we draw from the evidence that Ortmann and Gigerenzer presented?  We might simply argue that since all choices that are of professional interest to economists are made in well-defined contexts (arid, we might add, are subject to strong personal incentives) the predictive validity of rational choice theory is confirmed rather than undermined - at least for economics; economists might be happy to allocate the study of irrational behaviour to psychologists.  This is not a conclusion which is explicitly drawn by the authors, although they do warn us against accepting the results of context-free experiments as a straightforward refutation of models which rely on formal rationality.  Their principal recommendation is that experimental design, in both psychology and economics, should reflect the danger of isolating subjects from precisely those factors which maybe major determinants of their performance in non-experimental situations.

This is a valid, and important, warning - though it is best interpreted not as a recommendation to avoid context-free experiments but as a reminder that these should be the first experiments in a sequence.  Technological innovation typically begins with the isolation of a potentially valuable effect, but this initial result is no less typically followed by a development process which is intended precisely to discover what significant factors have been excluded by this experimental isolation.  Managers of innovation might also remind us that the most common result of this development process is that the initial results cannot be reproduced within the wider economic and social context - often not even within a manageable technological system - and that the prospective innovation must be rethought or abandoned.  Experimental isolation is an invaluable introduction to the study of complex phenomena, because it excludes many possibilities at low cost; it should not be expected to demonstrate the truth of any conjecture.  Theoretical isolation has similar virtues arid similar dangers: it may identify crucial factors and relationships, but the simplifications which allow us to reach clear conclusions may exclude precisely the factors which tend to dominate in the practical situation which the theorist is trying to represent.

The contrasting experimental results from differing styles of presentation likewise suggest that the application of rational choice theory to human decisions may be problematic.  If people behave in a way that seems to correspond to a formal definition of rationality in familiar situations, but not when presented with a technically straightforward logical problem, perhaps their powers of reasoning are available only in response to familiar cues: rational sequences may be domain-specific.  (This possibility is discussed by Ortmann and Gigerenzer.)  If that is so, this is a significant feature of human behaviour, not least in designing systems that are intended to prevent accidents, which so often involve a failure to respond appropriately to an unusual event.  But perhaps what we observe when people appear to act rationally is not the result of formal reasoning at all; perhaps people are not choosing their actions by calculating the consequences


of the alternatives that are available to them - or even the consequences of the alternatives which they perceive to be available - but are simply applying rules, often unconsciously, which connect their perceptions of the situation with established patterns of response.  When they are deprived of perceptual cues, as in the simplified experiment, these rules are inaccessible.  Choi (1999, p. 68n.) generalises this proposition by claiming that “whatever explanatory power neoclassical economics has comes largely from the fact that people are often ruled by conventions arid customs, the very factors that are ignored or absent in modern economics”.

I wish to suggest four general inferences from this discussion.  First, it illustrates what we might call Pounds’ principle, that problems - in this instance problems for the analyst - are defined by differences (Pounds, 1969; see also Loasby, 1976, chapter 6); for it was the apparently systematic difference between the results of context-free and context-specific experiments which indicated that there was something worth discussing.  Second, it reminds us that information, such as these experimental results, can only be interpreted within a framework (as indeed is implicit in the original conception of ‘bits’ of information), and that a change of framework may easily produce a change of interpretation.  This is not a remediable defect, since every framework is a decomposition imposed on a system which is imperfectly decomposable, and the total system cannot be encompassed within any attainable scheme of human thought.  Indeed, despite the common attribution of ‘rationality failure’ to ‘framing effects’, it is not at all clear that the effect of frameworks on interpretation is fundamentally a defect at all, although, like most kinds of human behaviour, it has its own pathology.  The great virtue of ambiguity in interpretation is that it makes variety possible, and the generation of variety is a condition of progress.

In this particular instance, the apparent conflict of experimental evidence has suggested hypotheses about human mental processes, and the external influences on these processes, which would not be suggested by either class of experiment alone.  That this should be so leads to the third inference, which is the proposition, familiar to us from our reading of Schumpeter, that the source of novelty is a new combination.  By connecting the second and third inferences we can produce a fourth, that what new combinations are possible in any situation (many of which will not be realised) is governed by the context in which the relevant mental processes are operating.  These four inferences may serve as a guide (or interpretative framework) to the following discussion.


2. Mental processes

To understand increased product variety and changing preferences we need to understand how new combinations arise.  Now if what appears to the observer to be rational action is simply the application of a familiar routine, there would seem to be no possibility of innovative activity.  The absence of rationality apparently frustrates our inquiry.  No doubt many economists, especially those working

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within North American analytical systems, would agree.  However, I shall argue that it is precisely by escaping from formal concepts of rationality that we can make room for innovation.  Formal rationality, even when extended to include probabilities and information costs, ties outcomes firmly to premises, and the fundamental premises are themselves not the results of rational choice but natural givens.  Any change in behaviour must therefore be a consequence of a change in one or more of these givens; all innovation must be exogenous to the analytical system.  People may be surprised, but they always respond optimally to surprises; their own actions are never surprising.  Routines, however, are not natural givens; they are evolved procedures which are provisionally matched to a poorly specified range of circumstances.  The formation, use, and modification or replacement of routines all need to be explained; and the explanation provides a basis for understanding human innovation, including innovation by consumers.

Alfred Marshall (1994) produced a simple evolutionary model which still appears serviceable as an introductory parable to current ideas of human cognition.  In this model, the evolution of the brain is governed by the basic needs for survival, which require swift responses to threats and opportunities.  Evolutionary fitness is therefore promoted by an architecture which permits rapid access to stored information, leading to rapid interpretation of complex phenomena, and the triggering of complex action patterns.  Our decision models must be quickly closed so that action can be taken.  Marshall’s model brain conforms to these requirements: it collects impressions, initiates actions, and collects impressions of what follows; a combination of positive and negative feedback then establishes increasingly strong links between clusters of impressions which represent artificial categories of phenomena and action sequences which have been selected as appropriate to each representation.  The creation of such networks has a clear evolutionary priority over the serial processing which is privileged in the economic and psychological conceptions of rationality considered by Ortmann and Gigerenzer.  Some evolutionary economists would no doubt suggest that the development of cognitive systems should be treated as an example of self-organisation, but I shall do no more than indicate this possibility, so that readers may be alerted to the option of construing parts of what follows in those terms.

The present comparative advantage of the human brain over the brains of other species may lie in its capacity for ratiocination; but its absolute cognitive advantage is not in the formation of rational sequences but in making and using combinations.  The architecture of the brain, certainly in humans, has the potential for the formation of a very large number of alternative networks; but they are necessarily alternatives - the establishment of one set of connections precludes the establishment of many others within the same brain.  Thus for each person at any time many possible phenomena, some of which may be important in other locations or other conjunctures, have no means of representation.  But within a human population there is the potential for many different combinations.  In what circumstances and in what ways may what part of this potential be realised?


Within a stable environment (in which stability is to be interpreted in terms appropriate to the climate rather than the weather) evolutionary success depends on the formation of connections which are appropriate to that environment; and so successful adaptation gives the appearance of rationality, even though no rational calculations whatever occur.  What we observe is a retrospective ‘logic of appropriateness’, which within this environment has become isomorphic with the anticipatory ‘logic of consequences’.  As Schumpeter (1934, p. 80) observed, though rational choice is always a fiction, it can be a good predictor of behaviour if time has hammered logic into men - or, we should add, into other animals; and some biologists have duly adopted this fiction in order to explain patterns of animal behaviour in terms of optimisation.  But if this behaviour, in either biological or economic systems, is a selected adaptation which is effectively a situationally-closed model and not a specific application of a general logic of choice, then the introduction of substantial novelty - a change not of weather but of climate - is liable to be severely disruptive, as Schumpeter also insisted.

However, humans have some capacity to escape from backward-looking behaviour: in Marshall’s model of the human brain this capacity is located in a second compartment, which deals, not with impressions and actions, but with ideas of impressions and actions, and can project these ideas into the future.  It is this faculty of imagination which allows us to open up our stored representations and to contemplate a future which is more than a mapping from the past, thus making possible a reasoned choice of novelty.  Imagination is not a logical process, as both Marshall and Schumpeter recognised.  Moreover, since what appears to be formal rationality is actually behaviour that has been programmed to respond to familiar situations, response to novelty may be highly problematic.  Indeed, the evidence reported by Ortmann and Gigerenzer suggests that the response to novel problems that are technically simpler versions of familiar problems which have been routinely solved may be quite inappropriate.  This suggestion is supported by non-experimental evidence, including evidence from profit-seeking firms.

We should also note the restrictions which Marshall places on the extent of human reasoning, restrictions which seem to be confirmed by recent work.  Reasoning is expensive in time and energy, and should therefore be used sparingly.  Whitehead ([1911] 1948, pp. 41-42), who was an expert mathematician, castigates the “profoundly erroneous truism... that we should cultivate the habit of thinking of what we are doing.  The precise opposite is the case.  Civilisation advances by extending the number of important operations which we can perform without thinking about them.”  Marshall anticipated Whitehead’s argument; only by ceasing to think about old problems can we find the time and energy to tackle the new.  Once the imaginative powers of the brain have produced a satisfactory linkage between ideas of impressions and ideas of action, the corresponding linkage between impressions and action is installed in the brain’s operating system, where it works by imposing appropriate patterns rather than by anticipating possible consequences.  Thereafter new possibilities may be imagined in other contexts, arid new choices may result; but the proportion of human activities

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which is governed by routines increases.  Many of these routines are entrusted to machines, though we can never be sure of their range of applicability, as has been demonstrated by the millennium problem in computers.

In Marshall’s model, not only does the practical management of daily life remain the province of routine behaviour; the stimulus to imagination arises from failures of routine.  It is when a standard response no longer seems to work, and the ‘sequence impression of situation - action - impression of satisfactory outcome’ cannot be completed, that a signal is sent to the part of the brain that is capable of imagining alternative ways of classifying situations and of assembling action sequences in response.  Within this model conscious thought is a response to a perceived problem; and what is perceived as a problem within an individual brain is a mismatch between the operating routines of that brain and the perceptions of the situation with which it is trying to cope.  This may be retrospectively regarded as a precursor of the ‘aspiration-achievement gap’ in behavioural theory.  It is also an application of Adam Smith’s (1980) psychological theory of scientific progress; for Smith believed that the perception of new anomalies was a necessary stimulus to the generation of new knowledge.  It is apparent from many passages in Marshall’s Principles  that he believed such stimuli to be important for human progress; the capabilities of each person’s imaginative faculty are developed by exercise, and so satisfaction with all current routines is hardly compatible with “self-reliance, independence, deliberate choice and forethought” (Marshall, 1920, p. 5).   But we should not forget the dual importance of these routines, both in economically preserving successful products of the imagination and also in providing the impetus to thought which may lead to further innovation.


3. Institutions

It will not have escaped readers’ attention that the internal routines of the brain appear to perform similar functions to the external phenomena of institutions, which serve to classify phenomena, simplify complexities, dissolve uncertainties and constrain choices.  In the imaginary world of unboundedly rational choice, neither mental routines nor institutions would be necessary (including the institutional system which is constituted by rational choice theory).  But if the networks that can be formed within any brain can represent only a fraction of the possibilities, and if what is formed in each individual’s brain is dependent on the perceived features of the particular environments to which that individual has been exposed, subject to selective interventions by the imaginative part of the brain, then outside assistance can be extremely helpful.  One of the most significant features of Choi’s (1993) analysis of conventions is that they first appear as individually-generated rules and patterns, which are indispensable in order to resolve - or often to suppress - complexity and uncertainty, even in the absence of any interaction with other people.  But each person’s ability to develop serviceable conventions is severely limited, and it is therefore an attractive economy to adapt conventions that appear to work for other people.  The shared


conventions that we think of as institutions thus emerge as people try to make use of other people’s experiences, arid other people’s ways of behaving, in order to improve their own abilities to cope with uncertainty and complexity.  It is the recognition of this personal benefit which provides the basis for common, though independent, use.  The advantages in communication - notably the reduction in the costs of transacting ideas - which result then encourage their acceptance as regulators of human interaction within the group of common users.  Menger’s ([1871] 1976) explanation of money is the classic analysis of this process within economic thought; and as we shall shortly see, it is of particular relevance to this paper.  Sometimes the adoption of other people’s conventions becomes a problem-solving routine: the rule is to follow the fashion.  Examples range from clothing and holiday destinations to formulae for successful management and for economic analysis.

For each individual, the combination of internal connections and external institutions economises on the scarce resource of cognition, first by allowing many operations to be performed without thinking about them, and then, when thought is required, by providing both cognitive maps (Eden, 1992), with which to make sense of novel situations, and decision premises (Simon, 1959), to which logical reasoning may be applied.  They do this by drawing on the stock of previous examples of successful performance and of previously successful ways of making sense, not only within the direct experience of each individual but also within the experience of members of that individual’s reference group.  Direct access to other people’s experience is unnecessary; provided that their experience is assumed to be relevant, observation of their current practices is sufficient.  Furthermore, each individual has reason to believe that as long as they observe these helpful conventions their behaviour, even when reacting to situations which have some novel characteristics, will be acceptable to other people within the group, and compatible with their actions.

The relevance of Smith’s (1 976a) Theory of Moral Sentiments to this analysis should be clear; but to develop the connections would produce a paper that was either longer or somewhat different.  I prefer to make two other links.  The first is to the Austrian conception of capital structures as specific combinations of elements, oriented towards a range of possible future conjunctures; cognitive and institutional capital appears to be a structure of just such a kind, which allows knowledge to be repeatedly reused.  The theme of capital as reusable knowledge is developed by Langlois (1999), but although he extends the concept of capital to include context-specific managerial skills, he does not take the further step of considering cognitive skills arid institutions as reusable knowledge; his purpose is different.  The second link is to Alfred Marshall’s (1920, p. 138), assertion that “Capital consists in a great part of knowledge and organization”.  In the present context what is especially notable is Marshall’s recognition of the importance of the knowledge which each business gains through its external organisation, and which, in the terms of this discussion, helps to provide it with cognitive frameworks and decision premises.  Its present relevance is that each individual, whether running a business or not, has a particular external organisation on which

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to draw; and, as Marshall noted, the range and quality of this external organisation generally reflects the individual investment of effort and the effects of time.  If we are thinking specifically of individuals as consumers, we may say that each develops a stock of consumption capital, which is likely to be heavily dependent on external connections.

For consumers, a particularly important set of external connections is provided by the institutions of the various markets to which each consumer has access.  We may take our definition from Ménard (1995, p. 170): “a market is a specific institutional arrangement consisting of rules and conventions that make possible a large number of voluntary transfers of property rights on a regular basis”. A market is thus a set of devices for reducing the costs of each transaction through the provision of reusable knowledge.  In any market with which they are familiar, consumers do not need to think how to transact, arid can therefore concentrate on what to transact.  Moreover, as Marshall (1919) and Casson (1982) explain, it is generally the suppliers who have the greatest incentive to invest in the development of transaction technologies; customers therefore need to expend relatively little of their cognitive resources in order to discover effective transaction routines.  Competition between suppliers, as Hayek (1948, p. 97) pointed out, then helps customers to discover who is most effective in meeting their particular requirements, and thus allows a further simplification of their decisions.

An efficient set of market institutions gives consumers ready access to those who have the capabilities which are necessary to meet their demands; in such an environment consumers have both the incentive and also the combination of routines and decision premises to develop their own consumption capital, and thereby to increase their own welfare.  Markets thus facilitate consumer innovation.  Langlois and Cosgel (1998) develop this argument, examining the circumstances in which consumers may have a comparative advantage or stronger incentives to develop the capabilities and institutions which are relevant to particular innovations.  Before turning directly to innovation, however, we should return to Menger’s explanation of the institution of money.  The replacement of multilateral barter by direct monetary exchange not only reduces transaction costs; the extensive set of money prices which is thereby generated becomes an institution which greatly simplifies the comparison of values for each individual and the consequential development of more coherent patterns of consumption.  In an evolving economy, the role of prices as conventions may be no less important than their allocative function.  What we can certainly say is that a situation in which prices are changing rapidly is one in which people have to commit a substantial part of their cognitive powers to the interpretation of prices - problems which in a stable environment are effectively handled by routines - at the expense of enquiry into ways of improving their consumption patterns.

In relation to innovation, institutions are a mixed blessing.  Cognitive maps, decision premises, and external regularities are necessarily retrospective; they anchor the definition of problems and the repertoire of responses to past environments, and inhibit experimentation within their domain; in many circumstances they may be actively misleading.  But in relinquishing any claim on the scarce


resource of imagination they release it for other uses; they provide the constraints which allow people to try to follow the logic of consequence that is required by formal models of rationality, or alternatively to conceive bold conjectures.  As G.K. Chesterton once remarked, “A man must be orthodox on most things, or he will never have the time to practise his own particular heresy.”


4. Innovation

Innovation must originate with individuals (though this may be interaction between particular individuals rather than the creation of a solitary thinker.)  It therefore depends on differences between individuals, first in their perceptions of a situation as problematic, and second in the responses to that situation which arise in their imaginations.  As we have seen, the possibility of such differences is inherent in the architecture of the human brain, and the dependence of both thought arid action on making connections, most of which are not logical relationships.  Thus different situations are likely to lead to differences in behaviour, including different ideas for innovation.

This, of course, is the basic principle of Adam Smith’s (1976b) theory of economic development as a consequence of specialisation, a theory which rests precisely on the combination of wide-ranging potential but limited capacity to realise that potential which, as we have observed, characterises the human brain; by encouraging diversity, a human society can therefore achieve progress at a rate and of a kind that no single individual can even imagine.  But if diversity is to be encouraged, it is essential to avoid any universal principles of co-ordination; that is why the conception of economics as the study of efficient allocations is not appropriate to a theory of development.  But as Smith well knew, diversity requires some means of co-ordination, and so institutions are necessary, both to a developing economy and to any adequate theory of development.  In this paper I have tried to demonstrate the close connection between human institutions and human mental processes, which is a feature of Smith’s system of social science that has been little noticed by modern economists; in this final section I will sketch some ideas about consumer innovation within a framework of institutions, making further connections to eminent economists of the past.

In the standard textbook definition of economics as the science of allocation, the first of the ‘givens’ is the set of goods.  But in his attempt to establish a secure basis for economic reasoning Menger ([1871] 1976) insisted on providing an explanation for goods.  An object becomes a good only when someone perceives that it can be used for the satisfaction of human wants - or in terms of Marshall’s psychological model (which incidentally predates Menger’s Principles) makes a causal connection between the two.  To this causal connection (which we may think of as an addition to ‘knowledge that’) we should add a second connection, which links the object to the capabilities (or knowledge how’) which is necessary to put that object to use.  (The distinction between ‘knowledge that’ and ‘knowledge how’ is taken from Ryle (1949) and was used by Hayek (1952) in


The Sensory Order; it is further developed in Loasby, 1998).  For simple goods, like berries picked off a bush, no distinctive capabilities are required; but many objects can only be turned into goods by the application of skills which have to be created or redirected; thus the possessors of particular skills are likely to be especially important in the creation of new goods.

Menger went on to explain how objects which appear very remote from human wants may be turned into goods by the creation of roundabout means of production, and thereby founded the particularly Austrian interest in the specifically oriented complexity of capital structures, which we have already applied to human capital.  Specifically oriented complexity, however, need not be restricted to production systems; many modern products are also complex, and particular consumption activities even more so: indeed the total set of interrelated consumption activities may be analysed as an identifiable lifestyle, which typically draws on external organisation.  The importance of complex structures of various kinds should remind us of the contribution to innovation which Adam Smith (1976b, p. 21) attributed to “philosophers or men of speculation” who perceived relationships between “the most distant and dissimilar objects”.  Distant and dissimilar ideas and actions may both be formed into new combinations to create novelty; but we should note that what seems distant and dissimilar may depend on the connections that are formed within the human brain; philosophers and men of speculation order their ideas differently from those whose interests are more tightly specified.  As Smith observed, specialisation increases the variety of connections which can contribute to innovation.

Menger’s explanation of human progress rested primarily on the increasing knowledge which resulted in the multiplication of goods, and especially in the creation of goods of higher order which increase the efficiency of productive processes.  Though the primary concern of this paper is innovation in consumption, the language in these paragraphs has been suggestive of production rather than consumption; arid this was not accidental.  Swann (1999) has drawn attention to Marshall’s (1920, p. 90) proposition that “much that is of interest in the science of wants is borrowed from the science of efforts and activities”, and suggests that ideas about both process and product innovation may be developed in the context of the consumer as a producer of personal or household satisfactions.  The concept of household production functions is now well established, but it is used to extend the analytical scope of rational choice theory to intra-household allocations; innovation receives no more attention in the theory of household production than in choice-theoretic models of the firm.  It is a different analytical system that Swann has in mind.

Mises’ (1949) conception of economics as praxeology rested on the universal principle of purposeful action which continually stimulates the search for something better; this should not be confused with rational choice among possibilities which are already known.  Mises asserted that anyone could be an entrepreneur, and that certainly included consumers.  Kirzner (1973) deduces from Mises’ proposed universal principle the concept of entrepreneurial alertness, which depends on perception.  It is crucial to Kirzner’s argument that people differ in what they


perceive, and that entrepreneurial perception is not the consequence of thought nor subject to any principles of efficient allocation.  These features of Kirzner’s conception of entrepreneurship may be directly related to the earlier discussion of different networks of associations which are readily accessible in each person’s brain, without the intervention of conscious thought.  In Kirzner’s original exposition the perception of an opportunity was tightly linked to action, but he has since extended his notion of entrepreneurship to allow for conscious thought about the implications of what has been perceived.

Among the hitherto unrecognised opportunities identified by the alert entrepreneur, Kirzner includes the redirection of resources to meet an apparent need in a better way.  Casson (1982, 1997) has developed the concept of the entrepreneurial firm as an intermediator between resources and customers, generating both profit and consumer satisfaction through its superior capabilities in making connections between the two.  Casson usually writes about information rather than capabilities, but he makes it clear that the specific advantages of any firm lie in its ability to identify, acquire, interpret, arid use particular combinations of information.  The psychological model suggests that the connections that are produced by thinking in both Kirzner’s and Casson’s theories are not merely logical.  ‘Knowing how’ to think about particular classes of problem is itself a capability, which may be shaped like any other skill, and both the standard of performance and the range of application are consequently likely to differ among individuals.  This capability would certainly fall within Menger’s definition of a good.

Marshall’s evolutionary psychology does not readily accommodate the concept of a given preference function; and so a Marshallian version of the Mengerian process of creating goods by establishing a causal relationship between objects and wants must pay explicit attention to the generation of wants.  What Marshall had in mind in emphasising the applicability of the science of efforts and activities to the science of wants appears to have been primarily the sociological theme of preferences being changed by changes in the working environment.  We have only to recall his account of the twin benefits of the increased opportunities for working people to become managers: this would result both in greater material progress for society because less talent would be wasted, and also a better quality of life for the individuals through the development of new preferences as a consequence of higher income and of new associations.  These new associations would both stimulate new questions about consumption and provide new cognitive frameworks and new decision premises to guide the search for answers; thus Marshall’s evolutionary psychological theory is also relevant.

Swarm draws attention to Marshall’s emphasis on the different kinds of wants that consumers encounter as they climb the ‘ladder of consumption’.  Maslow (1972, pp. 35-46) has developed a psychological version of a lexicographic ordering of wants, in a sequence from physiological imperatives through needs for safety, belonging and esteem to self-actualisation.  Maslow not only argues that each person’s motivation is strongly focussed on the particular stage in the sequence that has currently been reached, but that as a person moves between

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stages “the whole philosophy of the future tends also to change” (Maslow, 1972, p. 37).  Marshall seems to have had a similar view.  This implies the need for new cognitive maps, and new ways of choosing; and the difficulties of devising these for oneself provide an obvious inducement to look for new models of behaviour in newly-appropriate reference groups.  It is not a difficult step from Marshall’s and Maslow’s conceptions to Woo’s (1992) proposition that preferences are often the outcome rather than the premises of choice processes; new regions of choice are likely to give rise to new systems of preferences.

The connection between a new category of wants and the means of satisfying them is liable to be highly problematic.  But even within a familiar category the link is not as straightforward as it appears in consumer theory.  People do not buy goods, or even bundles of objectively-defined characteristics; they construct solutions to problems.  Peter Drucker (1964, p. 87) long ago remarked that “the customer rarely buys what the business thinks it sells”, because customers and their suppliers are thinking in different ways about different problems.  Moreover there are likely to be substantial differences between customers, and perhaps suppliers too.  Bianchi (1999) argues that the ability of a good to satisfy a consumer cannot be explained by summing its attributes, but depends on the interaction between them; and what interactions are relevant is subjectively determined.  As a simple example, a lightweight folding umbrella is not, I suggest, bought as a protection from the rain, but as a solution to the dilemma of whether to carry a substantial umbrella on a day when rain, though possible, seems unlikely and the umbrella consequently merely an encumbrance, or to do without it and risk getting soaked.  The problems that people attempt to solve through buying a personal computer are extraordinarily varied.

Marshall (1920, p. 86) begins his discussion of the relationship between wants and activities by emphasising the pervasive human desire for variety and distinction, which people may seek to satisfy in many different ways.  This theme has been developed by Scitovsky (1976), who points out that preference functions of the kind which support conventional equilibria must exclude novelty.  The origination of new kinds of consumption (even if they are new only to a particular consumer) is outside the scope of rational choice theory; it is, however, readily accommodated by the concept of mental processes used in this exposition.  Scitovsky also discusses the desire to remove discomfort, which occurs at the beginning of Maslow’s sequence.  This is normally quite distinct from the attractions of new forms of consumption; but we might recall that in Smith’s (1980) psychological theory of scientific development, the search for better explanatory patterns is motivated by the desire to restore the tranquility of the imagination, but success produces substantial and lasting pleasure.  The same may sometimes be true of other remedies for discomfort.

Whatever their motivations, consumers make conjectures, using their own mental frameworks against a background of institutions.  Sometimes they just do what seems best, sometimes they deliberately experiment; but in either case it is as true for consumers as for business people that “imagination, rather than information in any ordinary sense, is what entrepreneurs require in order to


discover new ways of combining resources in order to meet consumers’ desires” (Richardson, 1960, p. 105).  This is a process of trial and error; we should note Menger’s warning that ‘goods’ may be wrongly identified, either because the supposed causal connection does not exist or because the supposed human want is not genuine.  The process is complicated by ambiguity, which extends from interpretation of information before acting to interpretation of the results, and in particular of what causes should be assigned the credit or blame for the outcome.  Consumers make plenty of mistakes, and what is observed at any time is very unlikely to be a general equilibrium.

What happens in any particular case depends - though not usually in a deterministic way - on the cognitive framework which is applied.  Just as within a large organisation an unsatisfactory situation may be interpreted as ‘a marketing problem’, a ‘production problem’, a ‘personnel problem’, or an ‘organisational problem’, and the responsibility for dealing with it allocated accordingly, so may consumers interpret a particular situation in any one of a variety of ways, each of which directs attention to a particular category of solutions.  Each consumer, however, rarely recognises more than a very few of the interpretations that are possible, and indeed usually no more than one.  Familiar routines and well-practised ways of thinking lead to familiar kinds of interpretation and action.  Thus most changes are incremental; consumers, like firms, tend to move along particular trajectories, and variations tend to follow regular patterns (Schlicht, 1997).  For an organisation and for an individual, finding a new category for an awkward problem may be the route to innovation.  Fortunately, though the developed cognitive repertoire of each person is limited, the effectiveness of human cognition is magnified by the division of cognitive labour in society, which sustains many different classification systems and ways of thinking.  The evolution of demand seems to have some way to go; and so does the analysis of this evolution.


5. Conclusion

To understand demand creation, it is necessary to replace standard choice theory, in which all action is the necessary consequence of exogenous premises, with a cognitive model which reflects not only human limitations but the distributed capacity to create, modify and apply patterns.  Patterns support individual routines and the institutions on which we all rely; in doing so they create the space for creativity.  Purposeful behaviour is guided by problems, and is thus intended to suit particular contexts - which may be widely or narrowly defined.  The solution to one problem allows attention to be focussed on another, and since human beings have a remarkable capacity to solve problems, in consumption as well as in production (in part by the application of logic, but primarily by making non-local connections) the manifestations of economic evolution extend to the generation of novel demands.

19 Index


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The Competitiveness of Nations

in a Global Knowledge-Based Economy

October  2003

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