What it means
Charles Darwin described the process in biology. The principle is that variation, competition and limited resources mean some forms do better than others, and the successful traits spread over time.
Economists have borrowed the logic to explain why markets reward some behaviours and punish others. The analogy was developed in economics to defend the idea of rational behaviour.
Even if managers do not calculate perfectly, the argument goes, firms that happen to price sensibly and control costs will earn profits and grow, while firms that do not will lose money and exit, so surviving firms look as though they optimise. In practice the analogy shows up in discussions of competition, innovation and bankruptcy.
A downturn clears out firms with high debt or weak products, and the survivors often gain market share, which is why economists sometimes describe recessions as a cleansing process, though a painful one. Investors use the same thinking to judge portfolios and funds.
Fund managers who underperform tend to lose clients and close, so published track records are biased towards survivors, a problem known as survivorship bias (overstating results because failures drop out of the data). The analogy has limits.
Markets are shaped by regulation, bailouts, luck and market power, so the fittest firm is not always the one that survives, and some economists prefer an adaptive view, where markets evolve as participants learn from mistakes. Managers can use the idea as a discipline inside their own organisations.
Testing several approaches on a small scale, keeping what works and dropping what does not is a deliberate form of selection, and it is usually cheaper than committing the whole budget to one untested plan.
In practice
Real-world examples.
Example
A local coffee chain with high rents and weak margins closes several outlets after a competitor opens nearby with lower costs. The surviving shops take over the customers, which illustrates a market selecting the more efficient operator. The landlord then re-lets the vacant units at lower rents, which lowers the cost base for the next entrant.
Example
An investment consultant reviews ten-year performance for a group of funds and finds that many of the weakest funds have been closed. She adjusts her conclusions because the remaining funds look better than the whole original group did. Without that adjustment, her client would have expected returns that no typical investor actually achieved.
Example
A software firm experiments with three pricing models in different regions, keeps the one that produces the highest margin and retires the others, applying a deliberate version of selection internally. Within a year, the chosen model lifts average margin by two percentage points, and the team repeats the exercise for its next product.
Case study
Seen in the real world.
Calderbrook Retail is an illustrative, fictional chain that ran fifty stores in an industry facing fast-growing online competition. Management measured every store on sales per square metre and profit margin, and allowed the lowest-ranking stores to be closed each year.
Over four years the chain shrank to thirty-five stores, but average profit per store rose strongly because the remaining shops had better locations and tighter stock control. The finance director described the process as internal natural selection, with weak stores selected out.
A later review warned that the method had its own flaws, which echoed the real-world limits of the analogy. Some closed stores were new and had simply not matured, so the measure favoured quick results, and in this illustrative story the company changed its rules to give new stores a two-year grace period before judging them against mature ones. The finance director also added a measure of customer growth so that promising young stores were not removed on first-year profit alone.
Watch out
Common mistakes.
- Assuming the surviving firm is always the best one, when luck, subsidies and market power can keep weak firms alive.
- Ignoring survivorship bias when reading fund or company performance tables that include only current survivors.
- Treating the analogy as a precise scientific law, when markets involve deliberate choices and policy and do not evolve like species. Bailouts, for instance, can keep unfit firms alive and so interrupt the selection process.
Questions
People also ask.
Is natural selection the same as the invisible hand?
They are related ideas about decentralised outcomes, but natural selection stresses survival through competition, whereas the invisible hand stresses self-interest producing wider benefits.
Why do economists use a biological idea?
It offers a simple explanation for why surviving firms tend to behave efficiently even if managers do not optimise perfectly.
How does it relate to bankruptcy?
Bankruptcy and liquidation are the mechanism through which failing firms leave the market and free resources for stronger ones.
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