Originally published by Don Peppers on LinkedIn: Evolution: How the Economy Actually Works

A stock broker and an economist walk down the street. Spotting a $20 bill lying on the sidewalk ahead, the broker exclaims, "Look! A $20 bill, right there on the sidewalk!" To which the economist replies, "Nonsense. If that were really a $20 bill someone would have already picked it up." At which point the broker bent down, scooped up the bill and put it in his pocket.

This is an old joke that perfectly illustrates the fallacy in traditional economic thinking. Supply-and-demand equilibrium is a bedrock principle of traditional economic thought, but in reality no economic system is ever in a state of actual equilibrium. Supply and demand are in fact always seeking equilibrium, but they never find it. In a true state of equilibrium there would be no economic activity at all, because every product supplied at the current price would have already been bought by a customer willing to pay that price.

No, economists are now coming to realize that actual economic activity is driven by constant change and discovery. New products and services are produced, while old ones fail and disappear. The only reason anyone goes into business in the first place is because they think they have a new idea or some other advantage that will allow them to sell their product in spite of the competition.  

Increasingly, therefore, economists are beginning to think of the economy as a kind of evolutionary system, in which creativity and innovation are the real drivers propelling almost all activity. And what they are finding is that the same rules that govern evolution in the biosphere also govern evolution in the economic system. Adaptation to change. Frequent variations and random mutations. Survival of the fittest. 

In evolutionary terms, innovations and new business models that make the most profit are the most "fit" for survival. They'll be imitated more often by others and have a larger impact on the overall shape of the economy. Meanwhile, innovations that make less profit or that incur losses are not as fit, and so are more likely to become extinct. 

In an evolutionary economic system, constantly changing technology and frequent innovation make it extremely difficult for any single company to survive and prosper over time. One comprehensive study examined thousands of firms in 40 industries over a 25-year period in order to understand how long the most profitable ones could maintain their superior economic performances-which the researchers defined in terms of statistically significant differences relative to their peers.  The study found that just 5% of companies were able to string together ten or more years of superior performance, while less than a half percent of their sample (32 firms out of the 6,771 analyzed) performed better than their peers for 20 years or longer.

The truly outstanding performers in this study were those able to string together a series of short-term competitive advantages, rather than maintaining some over-arching, long-term advantage.  With a good innovation you can gain a short-term advantage that differentiates your product or business model, but to continue prospering in the constantly evolving competitive environment you have to keep coming up with new advantages.

As Eric Beinhocker said in his 2006 book Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics, perennially successful firms are those that "rise into the top ranks of performance, get knocked down, but like a tough boxer, get back up to fight and win again." And this is certainly how perennially successful companies like 3M could be portrayed. Or GE. Or Netflix. Or Apple. 

And evolutionary forces operate differently than classical economic forces. Evolutionary change is first and foremost a bottom-up process, driven by a kind of trial-and-error, algorithmic efficiency, as individual actors independently seek their own advantages and compete with each other. Evolution explains why markets allocate resources so much more efficiently than even the most intelligent and well-intentioned government or business organization ever could. Rather than studying the slope of a demand curve, understanding an evolutionary economic system requires studying fitness landscapes with local optima and path-dependent outcomes.  

But note carefully: In an evolutionary economy, there really is no such thing as a "sustainable" competitive advantage. Instead, long-term success in business, as in the natural world, comes to those best able to adapt to change.

In addition to Beinhocker's excellent book, there is also Matt Ridley's more recent one, The Evolution of Everything: How New Ideas Emergein which he explores the bottom-up, relentless efficiency of evolutionary forces in virtually all human social activities. His analysis eviscerates virtually all top-down institutional mechanisms for meeting social and political needs, from public education to population control. 

Because in the end, an evolutionary model more accurately portrays how any system of independently motivated actors functions, whether they are one-celled organisms seeking access to food and energy to ensure their own survival, or complex and technologically equipped businesses seeking the resources and customers necessary to generate their own profit.