tag:blogger.com,1999:blog-27661895760509772402024-03-13T09:56:56.619-07:00Change My WorldviewAll week we are bombarded with information. The newspapers we read, the conversations we have, the thoughts that fleetingly appear in our heads. Most of it filters through without much impact – after all, it’s just information – I could always go and find more on the web if I needed it. The aim of this blog is to filter what's genuinely interesting from the background noise...David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.comBlogger91125tag:blogger.com,1999:blog-2766189576050977240.post-57006760876866290392020-12-31T14:18:00.002-08:002020-12-31T14:18:38.367-08:00Value Creation and Value Capture: An Introduction and Simple Framework<p><span style="font-family: georgia;"><span style="font-size: small;">The shift towards a digital, <a href="http://www.changemyworldview.com/2019/12/the-book-machine-platform-crowd-by.html">platform-based economy </a>has major implications for how value is created in the economy and who captures that value. In my writing I regularly invoke these two concepts—value creation and value capture—but I realize that not everyone will be familiar with them.<sup>1</sup> The concepts are well defined and are taught in many business schools. However, to newcomers to the field the terms might seem rather opaque. Given how central they are to thinking about economics, strategy, and entrepreneurship, I am writing this blog post to introduce the two concepts and offer a simple 2-by-2 framework that illustrates how I think about the relationship between the concepts and the distinctive domains of economics, entrepreneurship, and strategy. </span></span></p><p><b><span style="font-family: georgia;"><span style="font-size: small;">Value creation and value capture </span></span></b></p><p><span style="font-family: georgia;"><span style="font-size: small;">When we say that economic activity <i>creates value</i>, the “value” we are referring to is the sum of the benefits that flow to all the participants in the system. The “benefits” here are subjective and are sometimes referred to as “<a href="https://en.wikipedia.org/wiki/Utility">utility</a>.” Economic transactions between buyers and sellers shed light on some of these benefits, but not all of it. When a consumer buys a product, we can infer that the consumer’s “<a href="https://en.wikipedia.org/wiki/Willingness_to_pay">willingness-to-pay</a>” for the product (i.e. the utility they derive from it) is higher than the price they paid for the product—if it wasn’t, they wouldn’t have bought it! </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
A useful metaphor for value creation is that it represents the <i>size of the pie </i>created by the actors (workers, entrepreneurs, managers, and consumers) undertaking some economic activity. The concept of value creation is very general and applicable at different scales: we can talk about the value created by a single transaction (which is the buyer’s willingness-to-pay minus certain costs related to the goods bought), the value created by a firm, the value created by an industry, or the value created by the entire economy. It is hard to know what a consumer’s “willingness-to-pay” for a product actually is, so when we wish to measure the “size” of the economy we fall back on measures that simply sum up all the transactions in the economy that represent end purchases of goods and services (one definition of <a href="http://www.changemyworldview.com/2012/09/the-perils-of-relying-on-gdp-in.html">Gross Domestic Product</a>, GDP). </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
If value creation is about determining the size of the pie, then value capture is about determining <i>how the pie is divided</i>. The price system is central to defining who captures value from a given economic transaction. When a consumer purchases a good, their <i>value capture </i>is defined as the difference between their willingness-to-pay and the price they paid (i.e. if they buy something they value a lot at a low price—hurray, a bargain!—they get more value capture). The seller’s value capture from the transaction will equal the price received minus some measure of the costs that went into providing the good (measuring those costs becomes complicated quickly, so I’ll set it aside in this blog post). Key here is that as long as the price is less than the buyer’s willingness-to-pay, <i>the price doesn’t affect the total value created</i>, it just affects the how much value is captured by each participant in the transaction. </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
<b>Are these just different labels for concepts I already know? </b></span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">Quite possibly. The field of business strategy uses the terms value creation and value capture to discuss managerial decisions about what a company should do. A common synonym for value capture is value appropriation. The two terms also have analogous concepts in the field of microeconomics: the total value creation in a system is sometimes referred to as <a href="https://en.wikipedia.org/wiki/Welfare_economics">social welfare</a>. Economics also has labels for value captured by particular sets of actors: value captured by the consumers (or buyers) is <i>consumer surplus </i>and value captured by firms (or sellers) is <i>producer surplus</i>.<sup>2</sup> </span></span></p><table border="1" cellpadding="0" cellspacing="0" class="MsoTableGrid" style="border-collapse: collapse; border: medium none; mso-border-alt: solid windowtext .5pt; mso-padding-alt: 0cm 5.4pt 0cm 5.4pt; mso-yfti-tbllook: 1184;">
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><b><span>Key concepts in
value-based strategy</span></b></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><b><span>Pie-based metaphor</span></b></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><b><span>Alternative labels in
strategy</span></b></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><b><span>Alternative labels in
economics</span></b></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><span>Value creation</span></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><span>Size of pie</span><br /><i><span>“How big is the pie?”</span></i></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><span> </span></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><span>Social welfare</span></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><span>Value capture</span></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><span>Division of pie</span><br /><i><span>“How big is each
player’s slice of the pie?”</span></i></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><span>Value appropriation</span></span></span></p>
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<p class="MsoNoSpacing"><span style="font-family: georgia;"><span style="font-size: small;"><span>Consumer surplus (size
of buyer’s slice) and producer surplus (size of seller’s slice)</span></span></span></p>
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<p><span style="font-family: georgia;"><span style="font-size: small;">
<b>Economics, entrepreneurship, and strategy: A simple framework </b></span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
Drawing a conceptual distinction between value creation and value capture is surprisingly useful. In some economic activities, value creation and value capture are tightly coupled. For example, if I run bakery, I create value when I make a cupcake for a customer; I capture value when the customer pays me for the cupcake. <b>However, in many important economic activities there is either a weak link—or no inherent link—between value creation and value capture</b>. For example, basic research activity leads to novel scientific breakthroughs; product development activities invent <a href="http://www.changemyworldview.com/2014/08/the-essence-of-innovation-when-needs.html">useful new products and services</a>. Both these have potential for enormous value creation. But the route to capture value from those activities is rarely obvious. That is why basic research is often funded by national governments through universities and research institutes: the “positive externalities” created by the new knowledge being widely distributed more than justifies the expenditure of public funds on the basic research.
</span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;"> Research and innovation might create value without capturing it. On the flip side, there is a large set of activities in the economy directed toward capturing value, not creating it. Which activities fall into this set is hotly debated. One unambiguous example would be theft or fraud: illegal activity that simply <i>transfers </i>value from the victim to the fraudster is 100% about value capture (in fact, value creation is generally negative in these instances). A less clear-cut example is intermediation in the financial system. There is <a href="https://web.stanford.edu/~wfsharpe/art/active/active.htm">a strong argument</a> that active mutual fund managers do not create value (as, on average, <a href="https://www.ft.com/content/e555d83a-ed28-11e5-888e-2eadd5fbc4a4">they do not outperform the market</a> index) and yet they receive substantial management fees, thus they capture large quantities of value. Relatedly, <a href="https://en.wikipedia.org/wiki/Flash_Boys">high-frequency traders</a> capture value by receiving information about large orders to buy or sell stock before other market participants and “front-running” those orders; it is hard to see any value creation in their activities. Critics of modern finance argue that it directs a huge portion of our collective intellectual capabilities towards value capture rather than value creation activities.
</span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;"> Hence, I find it useful to think about value creation and value capture as two separable axes in a two-by-two matrix (see Figure 1). </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;"></span></span></p><span style="font-family: georgia;"><table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto;"><tbody><tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjZVAVL0SNFgkV-zPd0ilwKoxxaieoAlFqUpYzZDqhxI1VuiAQpEnC2rypOqh0Q0Dbmjh86JnES7Nu1QUeYqSjfrxFZuh5DaRsuXgZNhWFWbJDC9smV8tAhemGbG2D16Ak0WRWThyphenhyphenTJeoZO/s1138/Value+creation+and+value+capture+v2.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="985" data-original-width="1138" height="346" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjZVAVL0SNFgkV-zPd0ilwKoxxaieoAlFqUpYzZDqhxI1VuiAQpEnC2rypOqh0Q0Dbmjh86JnES7Nu1QUeYqSjfrxFZuh5DaRsuXgZNhWFWbJDC9smV8tAhemGbG2D16Ak0WRWThyphenhyphenTJeoZO/w400-h346/Value+creation+and+value+capture+v2.png" width="400" /></a></td></tr><tr><td class="tr-caption" style="text-align: center;"><i>Figure 1: Value creation and value capture as separable dimensions</i><br /></td></tr></tbody></table><br /></span><span style="font-family: georgia;"><span style="font-size: small;">In the upper right quadrant, value creation and capture coincide; the upper left represents value creation without value capture; the lower right represents value capture without value creation.<sup>3</sup> When I think of <i>entrepreneurship</i>, I think of the upper two quadrants: entrepreneurship is about finding new ways to create value for people. Not all entrepreneurship is directed toward making profit. Thus, much social entrepreneurship activity would fall into the upper left quadrant in the 2-by-2. When I think of <i>economics</i>, I mainly think of the right hand two quadrants. Economics is primarily about models of rational, self-interested actors—in other words, actors who care only about how much value they will capture. In economic models of firms, managers make decisions with a view to maximizing their firm’s profits. </span></span><p><span style="font-family: georgia;"><span style="font-size: small;">
When I think of <i>strategy </i>as field of practice and research, it lies at intersection of value creation and value capture. Strategy, to me, is in the upper right quadrant in the 2-by-2. <i>Strategic thinking </i>is about understanding the interplay—the tension—between value creation and value capture. Competent strategists ought to understand both the economics of value capture and the entrepreneurial mechanisms that drive value creation. </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
In conversations with (profit-oriented) founders about their business model, I probe both how they will create value and how they will (at some stage) capture some of it. Many entrepreneurs fixate on one or the other. Focusing narrowly on value creation may be a good starting point for a venture but scaling up the value creation takes <a href="https://journals.aom.org/doi/10.5465/annals.2016.0132">resources </a>(people, dollars, etc.) and those resource providers need to get something in return. Focusing narrowly on value capture leads some entrepreneurs to be overly cautious about discussing their ideas for fear they will be stolen. </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
As you can tell, I could write at greater length on the interplay between value creation and value capture (and maybe in later blog posts I will!). I hope this acts as a helpful primer on two core concepts at the heart of entrepreneurial strategy. If more people comprehend the distinction, my hope is that more effort will be directed toward value creation, and less energy will be expended in the lower right quadrant where many talented people spend their days playing value capture games. </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
<br /></span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;"><u><i>Further reading</i></u><i> </i></span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
My strong recommendation for reading more on this topic is Brandenburger and Nalebuff’s 1996 book <a href="https://en.wikipedia.org/wiki/Co-opetition_(book)">Co-opetition</a>. For a scholarly introduction to value-based strategy, see Brandenburger and Stuart’s article, “<a href="http://pages.stern.nyu.edu/~hstuart/VBBS.pdf">Value-Based Business Strategy.</a>” If you are new to my blog, some related blog posts are <a href="http://www.changemyworldview.com/2014/04/co-opetition-complementarity-and-sixth.html">here</a>, <a href="http://www.changemyworldview.com/2014/08/the-essence-of-innovation-when-needs.html">here</a>, and <a href="http://www.changemyworldview.com/2019/07/the-edison-conjecture-why-successful.html">here</a>.
</span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">_____________________________ <br /></span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;"> <u>Footnotes </u></span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
<sup>1</sup> My co-author Andy Wu and I recently published a Dialogue paper in the <a href="https://journals.aom.org/doi/10.5465/amr.2020.0222">Academy of Management Review</a> on the topic of AI and data-driven learning by platforms. Value capture is a central topic in that piece, so this blog post functions partly as a primer to that paper, and a complement to my other writings on value capture. </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
<sup>2</sup> In the latter part of this blog post I suggest that economics focuses on value capture. This is true of the assumptions that economists make about the actors in their models. But economists themselves also study whether policy interventions (such as taxes, subsidies, or regulations) can improve overall value created, i.e. social welfare. Economists care about value creation! They just assume that everyone else only cares about value capture. </span></span></p><p><span style="font-family: georgia;"><span style="font-size: small;">
<sup>3</sup> One could straightforwardly extend the matrix to a 3-by-2 where negative value creation (i.e. value destruction) is a new row in the Figure or a 3-by-3 where negative value capture (i.e. value subsidization) is a new column. Subsidization is an important element in platform strategy as it is often used to catalyze the <a href="https://onlinelibrary.wiley.com/doi/10.1002/smj.3230">adoption of new platforms</a> and is sometimes also needed in the long run to retain the most valued side of platform joiners in a <a href="https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1756-2171.2006.tb00036.x">multi-sided market</a>.<br /></span></span></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjvCk0ErzwcaK6QwHFxkYneuh0FIKW_mXva6-ABBa3y3KcpBTDdXM5mmqpg6Fd4KS_EsOYBqG6yvghze6qK4x-tmnwPqI1lrD_C7lD3bn87YdKZFzUP-4zb8Vdn1FJ02j9kxXHjZkhPNGHQ/s1138/Value+creation+and+value+capture+v2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="985" data-original-width="1138" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjvCk0ErzwcaK6QwHFxkYneuh0FIKW_mXva6-ABBa3y3KcpBTDdXM5mmqpg6Fd4KS_EsOYBqG6yvghze6qK4x-tmnwPqI1lrD_C7lD3bn87YdKZFzUP-4zb8Vdn1FJ02j9kxXHjZkhPNGHQ/s320/Value+creation+and+value+capture+v2.png" width="320" /></a></div><br />David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-33781612221084772042019-12-31T13:59:00.002-08:002019-12-31T14:16:04.620-08:00Machines, Platforms, Crowds, and the Synergies Between Them<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiunIC1xBQcxhq6gPm_N3JjPxWLePih7SUYyXDUi1njBIOaB3lq0OTYPK7NMo8RiZ2XMrrGhpegbK__WlBCGznifYU68D4TtEoAJbTSEWk53zOa7ns_5eMfmCs1iRs61rrZ7zNwQ8SoEHXS/s1600/Machine+Platform+Crowd+cover.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" data-original-height="1600" data-original-width="1062" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiunIC1xBQcxhq6gPm_N3JjPxWLePih7SUYyXDUi1njBIOaB3lq0OTYPK7NMo8RiZ2XMrrGhpegbK__WlBCGznifYU68D4TtEoAJbTSEWk53zOa7ns_5eMfmCs1iRs61rrZ7zNwQ8SoEHXS/s200/Machine+Platform+Crowd+cover.jpg" width="132" /></a><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The book <a href="https://wwnorton.com/books/Machine-Platform-Crowd/">Machine Platform Crowd</a> by Andrew McAfee and Erik Brynjolfsson provides a superb overview of three of the most important current trends in technology. The authors expand on ideas they introduced in The Second Machine Age (which I wrote about <a href="http://www.changemyworldview.com/2015/10/let-them-eat-microchips-second-machine.html">here</a>), discussing which tasks are likely to be automated and how platforms bring about complementarities between people and algorithms. They outline how certain tools enabled by <a href="http://www.changemyworldview.com/2017/11/how-fast-will-platform-revolution.html">digital platforms</a>—including crowdsourcing and blockchain—are being adopted by businesses or could impact them in future. In this blog post I point out one highlight of the book, then expand on a topic that intrigues me: how positive feedback loops between machines, platforms, and crowds might set up a virtuous cycle of expanding technological capabilities.</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">One especially valuable passage in the book is the accessible introduction to one of the most powerful economic theories of organization, Transaction Cost Economics (TCE). TCE emerged in the 1970s and its originator, <a href="https://en.wikipedia.org/wiki/Oliver_E._Williamson">Oliver Williamson</a>, received the 2009 Nobel Prize in Economics, yet I have seen relatively little coverage of the theory in popular social science books. Put succinctly, TCE helps explain why organizations exist. It explains why some transactions are governed by market mechanisms (i.e. contracts) and others are governed by hierarchies (i.e. organizations), by analyzing how the relative costs of these competing forms of governance vary depending on the nature of the transaction. The large academic literature on TCE helps explain why firms shift toward or away from vertically integrated structures over time. Integration is favored when contracts are harder to write, for example when monitoring of effort or output is trickier or when rapid change generates uncertainty about the future.
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">Brynjolfsson and McAfee bring this theory to bear to examine what the emergence of digital platforms means for the size of organizations. The rise of Big Data reduces our uncertainty about transaction partners, as we know more about their track record. In addition, transaction platforms can incorporate tools to reduce the likelihood we get defrauded by counterparts we transact with over the platform. These factors lower the cost of using market mechanisms to govern transactions. More transactions can be governed by markets rather than hierarchies. As a result, digitization can drive down the size of organizations, and mean workers are increasingly treated as contractors rather than employees (a source of considerable <a href="https://abovethelaw.com/2019/10/in-the-gig-economy-who-is-an-employee-and-who-is-an-independent-contractor/">controversy</a>!).
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The book is arranged in three sections each devoted to one of the phenomena mentioned in the title. (<i>Machine </i>here refers to machine learning technology and <i>Crowd</i> refers to decentralized modes of organizing). To expand on the book, one could undertake a structured analysis of how the three phenomena mutually interact and (potentially) reinforce one another. I’ve sketched out the beginnings of such an analysis in the Figure below. There are at least seven mechanisms generating synergies between machines, platforms, and crowds, several of which are mentioned in the book, and several of which I’ve added:
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbzI7ADyjBo-Ha8_PgGqxvizIActraJ5XNexaao7b3qrFzQS19cr2VRL4lbYNPk5M1_rksNqp2ZapYg3-ThRklELSHgVgWOPROODPJIV53EyvoUbglKcEc90swR9Bn3UM35p-0UcNMWjGv/s1600/Synergies+machines+platforms+and+crowds.PNG" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img alt="" border="0" data-original-height="541" data-original-width="721" height="300" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbzI7ADyjBo-Ha8_PgGqxvizIActraJ5XNexaao7b3qrFzQS19cr2VRL4lbYNPk5M1_rksNqp2ZapYg3-ThRklELSHgVgWOPROODPJIV53EyvoUbglKcEc90swR9Bn3UM35p-0UcNMWjGv/s400/Synergies+machines+platforms+and+crowds.PNG" title="Synergies between machines, platforms, and crowds" width="400" /></a><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
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<li><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><b>Machine learning improves digital platforms </b>through two main mechanisms. First, it improves the quality of search tools which allow digital platforms to make better quality matches between users and complements. This helps users access the <a href="https://www.wired.com/2004/10/tail/">long tail </a>of products that are hard to provide in offline settings. Example: Amazon’s recommendation algorithm helps users find items they want to buy.<br /> </span></span></li>
<li><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">Second, <b>machine learning tools reduce costs </b>related to processing transactions over platforms. Machine learning helps platforms verify identities and detect fraud.*</span></span></li>
<li><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><b>Crowds contribute to the effectiveness of platforms. </b>User generated feedback is an important basis for establishing the trust that allows transactions to happen on digital platforms. For example, users rate their Uber drivers—and drivers rate passengers. User feedback weeds out bad actors, thereby improving users’ confidence in the platform.</span></span></li>
<li><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><b>Platforms, in turn, enable machine learning. </b>McAfee and Brynjolfsson identify the five critical inputs of machine learning as (i) data, (ii) algorithms, (iii) networks, (iv) the cloud, and (v) hardware. Platforms directly improve machine learning tools by generating masses of data on user interactions. This data can be used to train algorithms to make predictions, which can feed into automated decisions made by the algorithm. For example, Google uses past data on who tends to clicks on what in order to optimize its ad-serving algorithms.</span></span></li>
<li><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><b>Platforms can be used to run innovation contests, </b>which employ the “wisdom of the crowd” to solve difficult technical problems. Innovation contests may be used for many types of problems but have proven particularly effective for firms searching for better algorithms. In this way, platforms and crowds jointly contribute a key input to machine learning. For example, Netflix used an innovation contest to find a better user recommendation algorithm.</span></span></li>
<li><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><b>Machines and platforms empower crowds. </b>Machines and platforms democratize entrepreneurship by providing tools for anyone to go about building their own business. Machine learning tools are not exclusively used by large firms: powerful tools such as <a href="https://ai.google/tools/">TensorFlow </a>have been made open source, meaning anyone may adopt them for free. Other tools, such as IBM’s Watson or Microsoft’s Azure, are available to entrepreneurs to incorporate as modules in their enterprise via an API.</span></span></li>
<li><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">And, finally, <b>crowdfunding platforms allow entrepreneurs to raise financial capital </b>to support their business. Some <a href="http://www.changemyworldview.com/2014/08/the-essence-of-innovation-when-needs.html">crowdfunding</a> is “reward-based” (e.g. Kickstarter) allowing the entrepreneur to effectively make pre-sales which then fund production, while other platforms exist for founders to raise equity or debt finance from a broad pool of small investors.</span></span></li>
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">These inherent complementarities represent a positive feedback loop which could generate change at an accelerating pace. This is, at once, both exciting and intimidating. With the world struggling to keep up with past technological changes, it is tempting to wish for things to slow down a little. But if the ever-expanding technological frontier can be used to solve problems and create value—rather than merely help a few people capture a larger share of value—then this positive feedback loop is cause for tremendous optimism.
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"> ___________ </span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><u>Footnote</u> </span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">*Machine learning to improve fraud detection is discussed in some detail in the book <a href="https://www.predictionmachines.ai/">Prediction Machines </a>by Agrawal, Goldfarb, and Gans.
</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-57976507832864999282019-07-22T16:33:00.001-07:002019-07-22T16:33:50.521-07:00The Edison Conjecture: Why Successful New Technologies Offer Unfamiliar Solutions to Familiar Needs<span style="font-family: "georgia" , "times new roman" , serif;">The <a href="https://en.wikipedia.org/wiki/Google_Glass">Google Glass</a> and <a href="https://en.wikipedia.org/wiki/Apple_Watch">Apple Watch</a> were launched in 2014 and 2015 respectively. Both devices were “wearable tech,” both embodied leading-edge technology, and both were launched to much fanfare with sophisticated marketing campaigns. But while the Apple Watch sold millions of units in its first quarter on the market, Google’s Glass flopped. <i>What led to such different outcomes for these two innovative technologies?</i></span><br />
<span style="font-family: "georgia" , "times new roman" , serif;"><br /></span>
<span style="font-family: "georgia" , "times new roman" , serif;">To provide a thoughtful answer to this question, let me wind back the clock to 1878 when <a href="https://en.wikipedia.org/wiki/Thomas_Edison">Thomas Edison</a> and his employees were conducting pioneering experiments into electricity.<sup>1</sup> Edison faced a tremendous challenge, described in a <a href="https://journals.sagepub.com/doi/abs/10.2307/3094872">classic research article</a> by Andrew Hargadon and Yellowlees Douglas:<sup>2</sup> electricity had the potential to be put to numerous possible uses, but it was deeply unfamiliar to the general public at the time. It was regarded with a mix of curiosity and fear. The risk of death by electrocution was salient in the public’s mind after some high-profile incidents. Why should people let electricity’s mysterious, ghost-like presence into their home or workplace?</span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">Part of what underlay Edison’s success in commercializing electricity was in how he framed it as a solution to familiar needs. Rather than launch with an immediate wave of electricity-powered domestic gadgets (which, indeed, came later), he focused on the familiar problem of providing light after the sun has set. There was an existing solution for this: natural gas was piped under streets to feed gas lamps which created light as a by-product of combustion. Rich people’s houses had gas lines in the walls feeding lamps on the walls and ceiling. </span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">Edison’s success came partially from the pioneering inventions of his laboratory, which created the first carbon incandescent light bulb in 1879. But Edison’s success was also due to his savvy commercialization strategy. He organized the Edison Electric Light company under existing statutes that applied to gas companies. This allowed him to install underground lines and compete directly with gas companies, many of which would have happily seen him fail. Electric lightbulbs were launched as a direct substitute for gas lamps. Electric light fixtures were designed to resemble gas lamps, including the installation of lamp shades, which are not functionally needed for electric bulbs, but retaining them increased the sense of familiarity to the users.</span><br />
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<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjKdAdVomlcPeqLIXJQenhVKUhaGE4rG4KY0S9exNHkFXZSxquzpPBjXhG3wlYZU0Cc8tv-CiT8Umm10mUbk2MC6Vq71krTtEz49tr4gxBCrBJ9gdVPnpxGA8PPdzsAMuat0KjmIihZElQ0/s1600/Gas+lamps.jpg" imageanchor="1" style="clear: right; margin-bottom: 1em; margin-left: auto; margin-right: auto;"><img border="0" data-original-height="340" data-original-width="451" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjKdAdVomlcPeqLIXJQenhVKUhaGE4rG4KY0S9exNHkFXZSxquzpPBjXhG3wlYZU0Cc8tv-CiT8Umm10mUbk2MC6Vq71krTtEz49tr4gxBCrBJ9gdVPnpxGA8PPdzsAMuat0KjmIihZElQ0/s320/Gas+lamps.jpg" width="320" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><span style="font-size: small;">A lamp shade's original function was to prevent </span><br />
<span style="font-size: small;">soot from gas lamps ruining the ceiling and walls</span></td></tr>
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<span style="font-family: "georgia" , "times new roman" , serif;">Edison’s success in commercializing his laboratory’s ideas is one reason we revere him as one of the most influential innovators in history.</span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">What else can we learn from Edison’s success? I have previously written about how innovation can be viewed as a matching process in which needs are matched up with solutions (see <a href="http://www.changemyworldview.com/2014/08/the-essence-of-innovation-when-needs.html">here</a>). The stories of Edison and Apple and Google point towards a powerful lesson for would-be innovators. When innovators match up needs and solutions, the general public may be more or less familiar with the needs they tackle and the solutions they proffer. The general public also have only a limited tolerance for things that are unfamiliar. For this reason, an innovator offering an <i>unfamiliar </i>solution to an <i>unfamiliar </i>need—even if it is a very real need—is unlikely to succeed. I refer to this as ‘The Edison Conjecture.’<span style="font-size: x-small;"><sup>3</sup></span></span><br />
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<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTsBcpLfotnHDePVywiBNAplPWcY2rNw7xrLwIvdb63hkV7hykPaoeyRDUXC3yLtEKG65JTWPWDRb3Nn8hNH13gCM16IahBENv-lxf8eSyHC7_uC8jyl7BhNFhrzOIBfWlu8q6ZQYE55Kc/s1600/Edison+Conjecture+2by2.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="679" data-original-width="903" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTsBcpLfotnHDePVywiBNAplPWcY2rNw7xrLwIvdb63hkV7hykPaoeyRDUXC3yLtEKG65JTWPWDRb3Nn8hNH13gCM16IahBENv-lxf8eSyHC7_uC8jyl7BhNFhrzOIBfWlu8q6ZQYE55Kc/s320/Edison+Conjecture+2by2.png" width="320" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><span style="font-family: "georgia" , "times new roman" , serif; font-size: small;">In
this two-by-two matrix, the sweet spot is applying an unfamiliar
solution to a familiar need. Applying a familiar solution to an
unfamiliar need can also work. Applying an unfamiliar solution to an
unfamiliar need is a ‘bridge too far’ for most potential adopters.</span><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></td></tr>
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<span style="font-family: "georgia" , "times new roman" , serif;"><br /></span>
<span style="font-family: "georgia" , "times new roman" , serif;">Returning to the Apple versus Google example: both companies launched technologically pioneering consumer electronic products that fall in the category we now call “wearable tech.” Both solutions were unfamiliar at the time they were launched. The biggest difference, I suggest, is that Apple’s Watch is couched in the familiar, much as Edison’s electric light bulbs were launched as a replacement for (familiar) gas lamps. The Apple Watch solves two familiar problems: telling the time (for which we’ve used watches for over a century) and receiving notifications (for which we had used pagers since the 1980s and mobile phones since the early 2000s). Google’s Glass, on the other hand, holds potential for numerous hypothetical applications, but did not solve any clear, familiar problem for the user.</span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">As always, there are other important factors that helped the Apple Watch succeed and other factors that led the Google Glass to fail (e.g. <a href="http://www.changemyworldview.com/2015/01/notes-from-cutting-room-floor-google.html">Google</a> underestimated the seriousness of <a href="https://www.cnn.com/2013/12/10/tech/mobile/negative-google-glass-reactions/index.html">privacy concerns</a> relating to the Glass’s integrated camera<span style="font-size: x-small;"><sup>4</sup></span>). But the analysis of the (un)familiarity of needs and solutions carries what I think is a valuable message for managers aspiring to introduce ground-breaking innovations. If you want to introduce an unfamiliar solution, it better be matched up with a familiar need, otherwise resistance to it will simply be too great. </span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">_________
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<span style="font-family: "georgia" , "times new roman" , serif;"><u>Footnotes</u></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>1</sup> Edison was not a lone genius; rather he ran a successful organization which churned out inventions. It has been said that “Edison is in reality a collective noun” (see the article referenced below).</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>2</sup> Reference: Hargadon, A. B.; Douglas, Y. (2001). When innovations meet institutions: Edison and the design of the electric light. <i>Administrative Science Quarterly</i>, 46(3), 476-501. (<a href="https://www.psychologytoday.com/sites/default/files/Edison_ASQ.pdf">link</a>)</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>3</sup> I refer to it as a conjecture because it has not, to my knowledge, been tested in a large sample study.
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>4</sup> An interesting post-script in the story of Google Glass: the concept has been pivoted to address a market in which privacy is less of a concern. The <a href="https://www.google.com/glass/start/">Glass</a> has been relaunched as an B2B service for enterprise productivity applications.
</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-18950975456409907122017-11-10T18:18:00.001-08:002017-11-10T18:18:39.715-08:00How Fast will the Platform Revolution Proceed? Why Digital Platforms Don’t Work in Education and Healthcare (Yet)<br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The past two decades have seen the dramatic rise of digital platforms as a revolutionary business model for creating value in a connected world. However,</span></span><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"> platforms </span></span>have failed, as of yet, to make inroads into the education and healthcare industries. In this post I explore why.</span></span><br />
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">In economics, a “<a href="https://en.wikipedia.org/wiki/Two-sided_market">platform</a>” is any kind of intermediary that brings a large number of others together for a mutually beneficial interaction. Often, but <a href="https://en.wikipedia.org/wiki/Online_dating_service">not always</a>, this involves a monetary transaction. For example, an <a href="https://en.wikipedia.org/wiki/Auction">auction </a>house is a platform bringing together buyers and sellers; a taxi company brings together drivers and riders; a newspaper brings together readers and advertisers. Platforms have been around since the birth of trade in ancient village marketplaces. The advent of digitization, the internet, and, more recently, <a href="http://www.changemyworldview.com/2010/07/how-long-until-there-is-smartphone-for.html">smartphones </a>has allowed a new breed of digital platforms to upend traditional industries. They do this by dramatically lowering the cost of intermediation, and by aggregating large volumes of information to improve the <a href="https://en.wikipedia.org/wiki/Matching_theory_(economics)">quality of the matches</a> made on the platform. For example, eBay can offer a vastly bigger variety of goods than a physical auction house, along with tools to search through them. Uber can match a rider with a driver dropping off a passenger nearby, and then provide precise directions to the rider’s location based on GPS. Google and Facebook can provide targeted advertisements that increase the odds you will discover goods and services you want. Digital platforms provide such big advantages over traditional business models that they underlie the success all of the “internet giants,” the top five of which are now collectively valued at over $3 trillion.<sup>1</sup></span></span><br />
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeZVb1uH3aQj3HFdsRSPxsfrgQvwxN3-9IM1FUFZu2lE0lF-PvRGA-PshoST95uKiO_gSQmTpRWbtzx624IgZaYyHEQcGtqlEdXf1Lsq2ULm7YUbNQgffN7U_n3mpSNhZrLacmLjQlEAoB/s1600/PlatformRevolution+cover.png" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" data-original-height="911" data-original-width="600" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgeZVb1uH3aQj3HFdsRSPxsfrgQvwxN3-9IM1FUFZu2lE0lF-PvRGA-PshoST95uKiO_gSQmTpRWbtzx624IgZaYyHEQcGtqlEdXf1Lsq2ULm7YUbNQgffN7U_n3mpSNhZrLacmLjQlEAoB/s320/PlatformRevolution+cover.png" width="210" /></a><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">In their 2016 book <a href="https://platformrevolution.com/">“Platform Revolution,”</a> Geoffrey <a href="https://ggparker.net/">Parker</a>, Marshall <a href="http://web.mit.edu/marshall/www/home.html">Van Alstyne</a>, and Sangeet Paul <a href="http://platformthinkinglabs.com/about/sangeet-choudary/">Choudary </a>provide a detailed and accessible overview of the strategic decisions firms face when trying to enact a digital platform business model. As a primer in understanding how digitization affects business strategy, it is hard to beat. Over twelve chapters the authors step through the theory of platforms—including the importance of “network effects,” the economic term for the increasing value that platform users gain the more other users there are on the platform—and the practical challenges of building a successful platform, such as the “chicken and egg” problem of getting an initial critical mass of users on board.
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The book’s final chapter discusses “the future of the platform revolution.” Why have some industries adopted digital platforms faster than others? Which industries will be revolutionized next? The authors identify four factors that stimulate platform adoption in an industry: information intensity, non-scalable gatekeepers, fragmentation, and extreme information asymmetries. Three factors slowing “platformization” are strong regulatory control, high failure cost, and physical resource intensity. In light of these factors, the authors analyze education, healthcare, energy, finance, and other industries. Why isn’t there (yet) an “Uber for Doctors” with the same level of success as Uber for drivers? The authors argue that the positive drivers are very strong in education and healthcare, and that it is mainly the power of regulators and incumbent suppliers that holds back the transformation of these industries to platforms.
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">I suggest a further reason why education and healthcare are fundamentally problematic to move onto platforms. It is grounded in a subtle but important distinction made in the economic subfield of industrial organization (IO) between different types of goods. IO economists distinguish between ‘<a href="https://en.wikipedia.org/wiki/Experience_good">experience goods</a>’ and ‘<a href="https://en.wikipedia.org/wiki/Credence_good">credence goods</a>.’ Both types of goods are subject to asymmetric information, in the sense that the buyer cannot observe the goods’ quality prior to buying it. The distinction is that with experience goods, the quality is revealed to the buyer after they use the goods—examples include eating at a restaurant or staying at a hotel in a new city. We are uncertain how good the service will be when we make the reservation, but after having experienced the goods we know exactly what the service was like. In contrast, with credence goods we cannot tell the quality even after we’ve experienced the goods. We can only take it on faith that the service was good or the advice was correct. This is a deep form of informational uncertainty. An example would be strategy consulting advice that McKinsey provides to a Fortune 500 CEO. The CEO might follow McKinsey’s recommendation to slim its product line; maybe sales decline slightly but costs decline a lot and profits improve. This could be interpreted as meaning the advice was good. But there are numerous other factors that affect sales and costs. It’s impossible to precisely attribute the outcome to the consultants’ advice.
</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">Platforms work well for experience goods. Very well, in fact. Nowadays I rarely reserve a restaurant or hotel without checking its aggregate reviews on a platform such as Opentable or Tripadvisor. Since other customers have experienced these goods and reported on their experiences, I have a wealth of information to help me make my choices. Importantly, because these are experience goods (and not credence goods), the information in those reports is meaningful. Ratings that platform users make about their past transaction partners are an essential input to platforms such as eBay, Uber, and Airbnb. The ratings create an intermediated system of trust. They make possible interactions with complete strangers, without any other form of accreditation—getting in their cars, staying in their homes, sending them cash—all because past transaction partners can rate past interactions, and thus weed out incompetent and ill-intentioned platform participants.
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">Critically, platforms don’t work well for credence goods. Users cannot leave informed ratings of the service they received, because they do not know how good it was, even <i>ex post</i>.
</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><a href="http://www.changemyworldview.com/2010/08/both-us-and-uk-are-preparing-dramatic.html">The trouble with healthcare</a> and education, then, is that these are credence goods. They rely on such deep tacit knowledge and are surrounded by such uncertainty that even after interacting with healthcare professionals or teachers, we cannot say with any certainty whether they did their job correctly. Of course, we can rate how much we enjoyed the interaction. We can rate how friendly they were. But these things bare little relation to whether they cured our illness or taught us valuable knowledge. Grumpy doctors and stern teachers may nevertheless be effective! A sick person who visits a doctor and gets prescribed medicine may get better or may get worse; in either case it’s unlikely to be possible for the sick person to know whether they would have been better or worse without the medicine, or with a different medicine. A child in school has little sense at that precise moment of whether what they’re learning will be useful to them in later life. Using online platforms to collect ratings in these settings could be worse than useless<sup>2</sup>—it could lead to service providers prioritizing customers’ subjective sense of customer service over their actual well-being.
</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">This sets up a major limitation to the use of digital platforms in the contexts of education and healthcare. Where Parker, Van Alstyne and Choudary note that platforms can help industries overcome information asymmetries, this should come with a caveat that aggregated consumer ratings work well for experience goods, but not for credence goods. Platforms in healthcare and education may yet be able to overcome information asymmetries in other ways, such as building on existing systems of certification and legitimacy that these industries are built on. In the mean time we should be wary of prescribing the platform pill in cases where it might have harmful side-effects.
</span></span><br />
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">_________________</span></span><br />
<span style="font-family: "georgia" , "times new roman" , serif;"><span style="font-size: x-small;">Further reading: I have previously written some reflections on platforms, from a technological angle, which can be found <a href="http://www.changemyworldview.com/2016/05/alternatives-to-growth-platforms_14.html">here</a>. The definition of platform used in that essay was different, but the concepts of a technological platform and an economic platform are highly related (e.g. see <a href="https://static1.squarespace.com/static/50d63bc4e4b0e383f5b2a05a/t/51a826e2e4b05f6bb2434446/1369974498554/Piezunka+-+Technological+Platforms+-+An+assessment+of+the+primary+types+of+technological+platforms%2C+their+strategic+issues+and+their+linkages+to+org+theory.pdf">here </a>for a review).</span></span><br />
<span style="font-family: "georgia" , "times new roman" , serif;"><span style="font-size: x-small;"><sup>1</sup> This assertion is based on the following market caps as of 11th November 2017: Apple 897b, Alphabet 720b, Microsoft 647b, Amazon 542b, Facebook 520b. I haven’t exhaustively checked <a href="https://en.wikipedia.org/wiki/List_of_public_corporations_by_market_capitalization#Publicly_traded_companies">all firms</a>, and note that Alibaba and Tencent could be alternate members of the top 5 (and probably feature in the top seven).</span></span><br />
<span style="font-family: "georgia" , "times new roman" , serif;"><span style="font-size: x-small;"><sup>2</sup> Further to the deep uncertainty around quality, there is also a potential selection bias in what ratings are observable. Dead patients don’t leave negative reviews.
</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-50229156526674431422017-07-17T15:35:00.000-07:002017-07-17T15:35:06.084-07:00On Schell, Schelling, and Nuclear War<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">As a mathematical tool, <a href="https://en.wikipedia.org/wiki/Game_theory">game theory</a> is useful for formalizing our intuitions so we can analyze them systematically. Game theory is most powerful, however, when it shows us that rigorous thinking can lead to counter-intuitive results. In this post I juxtapose two writers—<a href="https://en.wikipedia.org/wiki/Jonathan_Schell">Jonathan Schell</a>, a journalist, and <a href="https://en.wikipedia.org/wiki/Thomas_Schelling">Thomas Schelling</a>, a game theorist—who have thought in incredible depth about one of the gravest threats to mankind’s existence: the possibility of nuclear war.</span></span><br />
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLSSoa7URYfvqfVUP47SEjn0qR0gBNw1YGQCKcIuzhmUFbuF6d5SBMIaZ2QKRJdlMoOxw3a9CMiVnQh8p4_mSfcFq-RX2rISeMXTI9aCk4P7eBhTpW8iv-q0KiN0pcE5AI-akDAEp-v-T2/s1600/FateOfTheEarth+cover.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" data-original-height="475" data-original-width="288" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLSSoa7URYfvqfVUP47SEjn0qR0gBNw1YGQCKcIuzhmUFbuF6d5SBMIaZ2QKRJdlMoOxw3a9CMiVnQh8p4_mSfcFq-RX2rISeMXTI9aCk4P7eBhTpW8iv-q0KiN0pcE5AI-akDAEp-v-T2/s200/FateOfTheEarth+cover.jpg" width="121" /></a><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">I first learned about Jonathan Schell by reading <a href="https://www.nytimes.com/2014/03/27/us/jonathan-schell-author-who-explored-war-dies-at-70.html">his obituary in March 2014</a>.<sup>1</sup> Schell authored ‘<a href="https://en.wikipedia.org/wiki/The_Fate_of_the_Earth">The Fate of the Earth</a>’ which is, at once, a visceral, historical account of the atomic bombing of Hiroshima and a scientific and philosophical meditation on the possibility of human extinction by nuclear war. The book draws its power by opening with actual accounts of the horrifying effects of an atomic weapon—the fire spread through the city, outpacing its fleeing populace, masses more dying of radiation sickness—then shifting fluidly to hypotheticals in which New York City is attacked with a nuclear weapon. It discusses the predicted sky-scorching effects of all-out nuclear war and dwells on the bleak prospect of a extinction, of an infinite future in which humans are absent from the Universe. Schell’s position—his conclusion—was that the only way to prevent nuclear holocaust was a worldwide movement of nuclear disarmament. As long as nuclear weapons are in existence, the risk of them being used, however infinitesimal, is too high.</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">If we agree that complete disarmament is a desirable end point (a hotly debated topic), can we actually get there in practice? This is where Schelling comes in. Schelling is known within social science for breakthrough contributions to the analysis of coordination, a thorny corner of game theory where the standard Nash Equilibrium solution concept gives rise to a proliferation of equilibria, and for pioneering the use of computational models to show that small shifts in individual-level preferences can cause <a href="https://en.wikipedia.org/wiki/Tipping_point_(sociology)">large changes</a> in society-scale outcomes.<sup>2</sup>
</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The interplay of game theory as a scholarly field and nuclear strategy as a matter of applied international relations <a href="https://en.wikipedia.org/wiki/John_von_Neumann#Mutual_assured_destruction">goes back a long way</a>. The concept of ‘<a href="https://en.wikipedia.org/wiki/Mutual_assured_destruction">mutually assured destruction,</a>’ often going by the acronym, MAD, is a game-theoretic one. It basically says neither adversary in a nuclear conflict will employ a first-strike strategy if it knows that the other side will retain the capability to wipe it out through retaliation. The doctrine of has MAD entered the popular discourse, and was parodied perfectly by Kubrick’s <a href="http://www.imdb.com/title/tt0057012/">Dr. Strangelove</a>.
</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">An interesting—and very practical—corollary of MAD reasoning is explored by Schelling in the Appendix to his 1960 classic ‘<a href="http://www.hup.harvard.edu/catalog.php?isbn=9780674840317&content=reviews">The Strategy of Conflict.</a>’ He argues, and shows mathematically, that partial nuclear disarmament is extremely risky. The capability to wipe out an opponent even <a href="https://en.wikipedia.org/wiki/Second_strike">after one has suffered a pre-emptive strike</a> is what lends the mutually assured destruction set-up its stability. An opponent who fears they will have no capability left with which to retaliate if they are attacked has greater reason to take the risk of initiating the first strike. The upshot of the game-theoretic analysis is the rather counter-intuitive result that partial disarmament is worse than no disarmament at all.
</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The von Neumann / Schelling / MAD reasoning was based on the Cold War context which basically entailed two largely-symmetric, competing nuclear powers. Game theory also assumes actors behave ‘rationally,’ i.e. each actor is self-interested and forward-looking and assumes that other actors are too. This seems to have been a reasonable assumption for that era.<sup>3</sup> As of 2017 it is not clear these same assumptions apply, which is a cause for concern. The ‘players’ in today’s nuclear ‘game’ are not so symmetric, nor is it clear that they will behave as predictably as economists’ rational actors do. It seems that it is for this reason that the <a href="http://thebulletin.org/">Bulletin of the Atomic Scientists</a> has moved its Doomsday Clock to ‘two and a half minutes to midnight,’ its <a href="http://thebulletin.org/timeline">riskiest point since 1953</a>. It is a wise time to revisit the writings of both Schell and Schelling, take seriously this existential threat, and hope that cool heads will prevail.</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">____________________________
</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>1</sup> Another post on this blog that was first inspired by an obituary is the one discussing the work of <a href="https://www.theguardian.com/technology/2013/jun/28/james-martin">James Martin</a>, who passed away in 2013. The following summer I read both Schell’s and Martin’s landmark books. Some of my thoughts on Martin’s ‘<a href="http://www.jamesmartin.com/book/">The Meaning of the 21st Century</a>’ are recorded <a href="http://www.changemyworldview.com/2014/10/the-meaning-of-21st-century-by-james_18.html">here</a>.
</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>2</sup> An excellent analysis of the organizational apparatus underlying the military strategy during the Cuban missile crisis is provided by Graham Allison in his classic, ‘<a href="https://en.wikipedia.org/wiki/Essence_of_Decision">Essence of Decision</a>.’</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>3</sup> Other posts I've written drawing on Schelling's ideas can be found <a href="http://www.changemyworldview.com/2013/04/strategic-delegation-and-cypriot.html">here</a> and <a href="http://www.changemyworldview.com/2013/05/schelling-focal-points-and-problem-with.html">here</a>.</span></span><br />
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-86876756610678882052016-05-14T01:02:00.000-07:002017-07-17T16:32:44.771-07:00Alternatives to Growth? Platforms, Modularity and the Circular Economy<style>@font-face {
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";"><i>The following is an essay I submitted to the <a href="http://symposium.org/">St. Gallen Symposium's</a> '<a href="http://symposium.org/competition">Wings of Excellence</a>' Award; it was selected as a finalist for the award: </i></span></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The St.
Gallen Symposium Leaders of Tomorrow have posed the question, <i style="mso-bidi-font-style: normal;">What are alternatives to economic growth? </i>In
this essay I draw on ideas from technology strategy and systems theory to put
forward a vision for sustainable improvement in human well-being which does not
depend on economic growth, as it is currently measured. First, I discuss just
why we need a new approach to progress. Then I will describe a new way of
thinking about ‘progress’ which transcends the traditional growth-orientation.
Three key concepts—platforms, modularity, and the circular economy—suggest ways
to <i style="mso-bidi-font-style: normal;">create value</i> without transactions,
to <i style="mso-bidi-font-style: normal;">stimulate innovation</i> at low cost,
and to inject sustainability as a design feature of the economy, not an
afterthought. After introducing each concept in turn, I discuss the synergies
between all three which mean that together they offer a compelling alternative
to the present narrow focus on economic growth.</span></div>
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<b style="mso-bidi-font-weight: normal;"><u><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The Challenge</span></u></b></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The
prevailing paradigm of growth-oriented capitalism has several intrinsic flaws.
Here I highlight two.</span></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">First, there
is the issue of resource sustainability. Much of today’s economic activity is
generated roughly as follows: we unearth some raw material from the ground,
process it through a multitude of steps, use the finished product, and then
throw it away at which point it gets put into landfill. Before the industrial
revolution, this system worked because the quantities of materials and waste
were miniscule compared to the overall system. Nowadays, due to population
growth and rising living standards, we face the very real possibility of finding
key resources in short supply.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn1" name="_ftnref1" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[1]</span></span></span></a></span>
Our waste outputs—in the form of greenhouse gases—are now having geologically
significant effects on the planet.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn2" name="_ftnref2" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[2]</span></span></span></a></span> As
many have observed, perpetual growth is a physical impossibility because of the
limitations of the planetary system.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn3" name="_ftnref3" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[3]</span></span></span></a></span>
Hence, we require an alternative.</span></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Second, there
is the issue of poverty. Growth-oriented capitalism has failed to solve the
problem that hundreds of millions of people cannot afford many things which
those of us in developed countries take for granted—such as food, clean water,
housing and household comforts, access to education. ‘Trickle-down economics’ has
failed; growth has increasingly benefited those who are already wealthy.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn4" name="_ftnref4" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[4]</span></span></span></a>
</span>Moreover, innovation is directed towards things people or governments in the
rich world will pay for, such as smartphones, medical devices, and military
hardware. The spending on so-called <i style="mso-bidi-font-style: normal;">frugal
innovation</i>, to create novel products for the world’s poor, is a fraction of
what is spent on high-end innovation. To benefit the majority of mankind,
innovations in the future will need to be dramatically lower cost than those of
today.</span></div>
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<b style="mso-bidi-font-weight: normal;"><u><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Platforms</span></u></b></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The concept
of a ‘platform’ has emerged in the last two decades from studies on the
economics of technology. In a technological system, a platform is a central
component which other complementary components can attach to. For example, in
the software world, an operating system (OS) is a platform on which individual
pieces of software can be installed; it is the joint package of OS plus
software that creates value for users. More abstractly, in market systems a
platform may be a central organization with which other individuals and/or
organizations interact. For example, eBay is a ‘two-sided’ platform which
brings together sellers and buyers of physical goods. In the words of
management professor Annabelle Gawer, a platform ‘acts as a foundation upon
which other firms can develop complementary products, technologies or services.’<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn5" name="_ftnref5" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[5]</span></span></span></a></span></span></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The power of
platforms is that they bring together people to allow mutually valued
interactions. Some of these may entail transactions—such as a good being sold
on eBay—in which case they show up as contributing to economic growth. But much
of the time the interactions that platforms facilitate involve no money
changing hands. For example the website ‘Quora’ is a platform on which people
can post questions or <span style="mso-spacerun: yes;"> </span>answers, exchanging
valuable knowledge, without any price attached. This can create tremendous
value, but does not generate economic growth as measured by GDP.</span></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Platforms
benefit from a phenomenon that economists call ‘network externalities:’ the
value of joining a platform rises the more other people there are already using
it. For example, social media platforms are more attractive to use if they have
an active community of users to interact with. This results in dramatically
increasing returns to scale, captured by ‘Metcalfe’s law,’ which states that
‘the value of a network goes up as the square of the number of users.’<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn6" name="_ftnref6" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[6]</span></span></span></a></span> In
many cases only a small fraction of this value is accounted for as ‘economic
growth’ in national statistics. </span></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Platforms
are especially well suited to digital technology, which enables fast, cheap
information flows, and makes a platform easy to scale up. Digital platforms
make efficient use of raw materials: once a fixed investment is made in
hardware, the only ongoing resource a digital platform uses is the electricity
to run its servers. Digital platforms therefore create tremendous value with
very few natural resources. This makes them an essential pillar in a future
that transcends growth-oriented capitalism.</span><span style="font-family: "georgia"; font-size: 12.0pt; line-height: 150%;"></span></div>
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<b style="mso-bidi-font-weight: normal;"><u><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Modularity</span></u></b></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The concept
of modularity is closely related to the idea of a platform. Modularity is a
property of a system that means it is partitioned into constituent parts that
have clearly defined interfaces. A product system is modular if its components
can be easily swapped out and interchanged with others. For example the
traditional PC has a modular architecture: its internal components (e.g.
graphics card, sound card) and peripheral components (e.g. keyboard, monitor,
mouse) all plug in through standard interfaces and can be individually upgraded.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn7" name="_ftnref7" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[7]</span></span></span></a></span> An
organization can be said to be modular if it is made up of subdivisions that
operate in a relatively self-contained manner, such as the academic departments
of a university. </span></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The essence
and importance of modularity was first articulated by Herbert Simon in his
seminal essay, ‘The Architecture of Complexity.’<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn8" name="_ftnref8" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[8]</span></span></span></a></span>
His observation: a modular architecture allows a system to evolve, through
trial-and-error experimentation with alternate components. When a new component
enhances the value of the system, it can be retained, and if it detracts from
the system it gets discarded. This general observation reads across directly to
modularity and evolution of technological products; the modular architecture of
the PC is credited with catalyzing innovation in the computer industry.</span></div>
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<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">In a recent
essay, Carliss Baldwin and Jason Woodward observe that by their nature
platform-based industries exhibit a modular architecture: ‘In essence, a “platform
architecture” is a modularization that partitions the system into (1) a set of
components whose design is stable and (2) a complementary set of components
that are allowed – indeed encouraged – to vary.’<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn9" name="_ftnref9" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[9]</span></span></span></a></span>
Platforms therefore have the potential to be highly ‘evolvable’ systems. They
allow new designs and product permutations to be tried out at low cost, with
little waste. In other words, platforms can facilitate efficient innovation,
enhancing value creation without entailing massive resource expenditures.</span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<b style="mso-bidi-font-weight: normal;"><u><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The Circular Economy</span></u></b><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";"></span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">A third key
concept I wish to highlight is the notion of the circular economy. As noted
above, our present economic paradigm entails extracting natural resources from
the ground, and burying our waste products, which in systems dynamics terms
creates an ‘open loop.’ Proponents of a circular economy, such as the Ellen
MacArthur Foundation, argue we need to close this loop. In the first instance,
we should recycle waste as a source of raw materials. More deeply, we need to
redesign our products and our industries to close the resource loop. When a product
is decommissioned at the end of its lifespan, not all its components are
useless. Many, in fact, may be in a good enough condition to use in a new
product, but under the present system they can end up in landfill or in an
incinerator. If the original product were designed with disassembly in mind,
then retrieving reusable components becomes a real possibility.</span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The building
industry provides an exemplary case study. Construction accounts for around 15%
of global greenhouse gas emissions.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn10" name="_ftnref10" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[10]</span></span></span></a></span>
Construction is carbon intensive because the chemical process for manufacturing
cement, an ingredient of concrete, releases large quantities of carbon dioxide.
When a concrete structure is demolished—either at the end of its lifespan, or
(more commonly) to make space for a newer building—the rubble is typically
shipped to landfill. New concrete is then poured, meaning new cement is used
and new emissions are generated.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn11" name="_ftnref11" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[11]</span></span></span></a></span> Efforts
to close this wasteful loop are vitally important, given the need to build
quality housing in the rapidly growing urban centers of the world’s emerging
economies. One step will be increasing the degree of recycling of old concrete
rubble, which can be used as an input to building processes, thereby diverting
it from landfill. But the truly ‘circular economy’ approach will entail
designing building materials with re-use in mind. Reinforced concrete slabs
will be treated as components that can be recovered and reconfigured, instead
of scrapped, when a building needs to be replaced. This has been an architectural
dream at least since the ‘Metabolist’ movement in post-war Japan, and modern
researchers are getting nearer to creating it as a reality.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn12" name="_ftnref12" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[12]</span></span></span></a></span></span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<b style="mso-bidi-font-weight: normal;"><u><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Synthesis</span></u></b><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";"></span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Individually,
these three concepts are each powerful levers to improve quality of life.
Together, the complementarity between them makes for an even more potent
recipe.</span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">The aim of
this essay is to advocate that we move towards a model of capitalism based on
circular resource flows and rising quality of life driven by modular
innovation. By itself, a circular economy may imply stagnation in living
standards. It has echoes of Schumpeter’s ‘circular flow’ in which every year industrial
activity looks much like the last.<span style="font-size: x-small;"><a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftn13" name="_ftnref13" title=""><span class="MsoFootnoteReference"><span class="MsoFootnoteReference"><span style="font-family: "georgia";">[13]</span></span></span></a></span>
And by itself, evolutionary innovation based on experimentation with modules
can be highly resource intensive; we can waste a lot of resources to produce
modules we don’t use, and there is a strong temptation to throw out a module
once we find a better one. This is clearly visible in the huge amount of
electronic waste that developed countries pump out every year. </span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">We need to
move towards an industrial infrastructure based on stable long-lasting
platforms and interchangeable modular components that can attach to the
platform but which themselves conform to a closed-loop production process. This
abstract idea can apply in numerous realms, from the now-familiar electronics
and software platforms, through manufacturing—using technologies such as 3D
printing as the base platform—and built-environment, in which modular
skyscrapers could provide a housing solution to the world’s growing urban
population. The synergies between platforms, modularity, and a circular economy
are several; I enumerate four here:</span></div>
<div class="MsoListParagraphCxSpFirst" style="line-height: 150%; margin-bottom: 12.0pt; mso-add-space: auto; mso-list: l0 level1 lfo1; text-indent: -18.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: Georgia; mso-fareast-font-family: Georgia;"><span style="mso-list: Ignore;">1.<span style="font: 7.0pt "Times New Roman";">
</span></span></span><b style="mso-bidi-font-weight: normal;"><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Economies in
design. </span></b><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">By
letting a common platform underlie a variety of modules, we can avoid wasting
the effort of replicating something that has been designed elsewhere. In other
words, platforms allow us to converge on a set of common standards, which makes
design much more efficient.</span></div>
<div class="MsoListParagraphCxSpMiddle" style="line-height: 150%; margin-bottom: 12.0pt; mso-add-space: auto; mso-list: l0 level1 lfo1; text-indent: -18.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: Georgia; mso-fareast-font-family: Georgia;"><span style="mso-list: Ignore;">2.<span style="font: 7.0pt "Times New Roman";">
</span></span></span><b style="mso-bidi-font-weight: normal;"><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Economies in
production.</span></b><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";"> With a common underlying platform we obtain economies of
scale in the production process for both the platform and the modules. This
will play a big role in making innovations accessible to the world’s poor.</span></div>
<div class="MsoListParagraphCxSpMiddle" style="line-height: 150%; margin-bottom: 12.0pt; mso-add-space: auto; mso-list: l0 level1 lfo1; text-indent: -18.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: Georgia; mso-fareast-font-family: Georgia;"><span style="mso-list: Ignore;">3.<span style="font: 7.0pt "Times New Roman";">
</span></span></span><b style="mso-bidi-font-weight: normal;"><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Rapid
scalability of improvements.</span></b><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";"> When a better design for a module is
invented, the use of a common underlying platform will allow the new design to
be diffused and adopted widely with great ease. Many new designs will be
distributed royalty-free under an ‘open source’ license. </span></div>
<div class="MsoListParagraphCxSpLast" style="line-height: 150%; margin-bottom: 12.0pt; mso-add-space: auto; mso-list: l0 level1 lfo1; text-indent: -18.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: Georgia; mso-fareast-font-family: Georgia;"><span style="mso-list: Ignore;">4.<span style="font: 7.0pt "Times New Roman";">
</span></span></span><b style="mso-bidi-font-weight: normal;"><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Re-use of
modules.</span></b><span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">
Modules can be designed such that they can be disassembled and altered, rather
than disposed of, if a better design for that module is developed. This is also
a process that benefits from economies of scale in the infrastructure for
module renewal.</span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Consider, by
way of illustration, a world with a commonly agreed upon standard for 3D
printing, with widely available devices that can print with a small number of specified
materials. The material feedstock for the printer would be derived by
disassembling used products. The printer is the platform, and the products it
makes are the modules. Creative designers anywhere in the world would post
designs online that others could download and use: there would be rapid,
evolutionary innovation in the modules. Replacing a physical good with the
latest, updated model would become much like updating a piece of software today.
</span></div>
<div class="MsoNormal" style="line-height: 150%; margin-bottom: 12.0pt;">
<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";">Together,
platforms, modularity, and the circular economy work in synthesis to make
economic activity more environmentally sustainable, and make innovations
accessible to the lowest income people on the planet. They offer a compelling
alternative to the narrow focus on economic growth that prevails today.</span></div>
<div class="MsoNormal" style="line-height: 150%;">
<span style="font-family: "georgia"; mso-bidi-font-family: "Times New Roman";"> </span><span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;"> </span>
</div>
<div align="center" style="line-height: 150%; text-align: center;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">References</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Bajželj, B., Allwood, J. M., & Cullen, J. M. 2013.
Designing climate change mitigation plans that add up. <b><i>Environmental
science & technology</i></b>, 47(14): 8062-8069.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Baldwin, C. Y., & Woodard, C. J. 2009. The
architecture of platforms: A unified view. In A. Gawer (Ed.), <b><i>Platforms,
markets and innovation</i></b>. Cheltenham, UK: Edward Elgar Publishing.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Bresnahan, T. F., & Greenstein, S. 1999. Technological
competition and the structure of the computer industry. <b><i>The Journal of
Industrial Economics</i></b>, 47(1): 1-40.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Gawer, A. 2009. Platforms, markets and innovation: An
introduction. In A. Gawer (Ed.), <b><i>Platforms, markets and innovation</i></b>.
Cheltenham, UK: Edward Elgar Publishing.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Graedel, T. E., Harper, E. M., Nassar, N. T., Nuss, P.,
& Reck, B. K. 2015. Criticality of metals and metalloids. <b><i>Proceedings
of the National Academy of Sciences of the United States of America</i></b>,
112(14): 4257-4262.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Meadows, D., Randers, J., & Meadows, D. 2004. <b><i>Limits
to growth: The 30-year update </i></b>Chelsea Green Publishing.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Rios, F. C., Chong, W. K., & Grau, D. 2015. Design for
disassembly and deconstruction-challenges and opportunities. <b><i>Procedia
Engineering</i></b>, 118: 1296-1304.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Saez, E., & Zucman, G. 2016. Wealth inequality in the
united states since 1913: Evidence from capitalized income tax data. <b><i>Quarterly
Journal of Economics</i></b>, (forthcoming).</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Schumpeter, J. A. 1934. <b style="mso-bidi-font-weight: normal;"><i style="mso-bidi-font-style: normal;">The theory of economic
development: An inquiry into profits, capital, credit, interest, and the
business cycle.</i></b> <span style="mso-bidi-font-style: italic; mso-bidi-font-weight: bold;">Cambridge, MA: Harvard University Press</span>.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Shapiro, C., & Varian, H. 1999. <b><i>Information rules
</i></b><span style="mso-bidi-font-style: italic; mso-bidi-font-weight: bold;">Cambridge,
MA: </span>Harvard Business School Press.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Simon, H. A. 1962. The architecture of complexity. <b><i>Proceedings
of the American Philosophical Society</i></b>, 106(6): 467-482.</span></div>
<div style="line-height: 150%;">
<span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">Waters, C. N., Zalasiewicz, J., Summerhayes, C., Barnosky,
A. D., Poirier, C., Ga</span><span style="font-family: "times new roman"; font-size: 11.0pt; line-height: 150%;">ł</span><span style="font-family: "georgia"; font-size: 11.0pt; line-height: 150%;">uszka, A., Cearreta, A., Edgeworth, M.,
Ellis, E. C., & Ellis, M. 2016. The anthropocene is functionally and
stratigraphically distinct from the holocene. <b><i>Science</i></b>, 351(6269).</span></div>
<div align="center" style="line-height: 150%; text-align: center;">
<br /></div>
<div style="mso-element: footnote-list;">
<br clear="all" />
<hr align="left" size="1" width="33%" />
<div id="ftn1" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref1" name="_ftn1" style="mso-footnote-id: ftn1;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[1]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> See, for example,
Graedel et al. </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(2015)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"> on metals criticality.</span></div>
</div>
<div id="ftn2" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref2" name="_ftn2" style="mso-footnote-id: ftn2;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[2]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> See Waters et al. </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(2016)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
</div>
<div id="ftn3" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref3" name="_ftn3" style="mso-footnote-id: ftn3;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[3]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> See Meadows, Randers,
and Meadows </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(2004)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
</div>
<div id="ftn4" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref4" name="_ftn4" style="mso-footnote-id: ftn4;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[4]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> For example, since the
financial crisis wealth gains in the United States have predominantly gone to
the top 0.1% of households in the wealth distribution; average wealth of the
bottom 90% of households has fallen </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(Saez & Zucman, 2016)</span><span style="font-family: "times new roman"; font-size: 11.0pt;">.</span></div>
</div>
<div id="ftn5" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref5" name="_ftn5" style="mso-footnote-id: ftn5;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[5]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> Gawer </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(2009: 2)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
</div>
<div id="ftn6" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref6" name="_ftn6" style="mso-footnote-id: ftn6;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[6]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> Shapiro and Varian </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(1998: 184)</span></div>
</div>
<div id="ftn7" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref7" name="_ftn7" style="mso-footnote-id: ftn7;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[7]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> See Bresnahan and
Greenstein </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(1999)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
</div>
<div id="ftn8" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref8" name="_ftn8" style="mso-footnote-id: ftn8;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[8]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> Simon </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(1962)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
</div>
<div id="ftn9" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref9" name="_ftn9" style="mso-footnote-id: ftn9;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[9]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> Baldwin and Woodard </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(2009)</span></div>
</div>
<div id="ftn10" style="mso-element: footnote;">
<div class="MsoNormal">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref10" name="_ftn10" style="mso-footnote-id: ftn10;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[10]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> 7.7 Gt of a total 50.6
Gt CO<sub>2</sub> equivalent in 2010, see Bajželj, Allwood, and Cullen </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(2013)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
</div>
<div id="ftn11" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref11" name="_ftn11" style="mso-footnote-id: ftn11;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[11]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> Concrete production has
been accelerating, and the scale of production is immense. Geologist Colin
Waters and colleagues point out that concrete is now a geologically significant
material in the stratigraphy of the planet: ‘The past 20 years (1995–2015)
account for more than half of the 50,000 Tg of concrete ever produced,
equivalent to ~1 kg m<sup>−2</sup> of the planet surface.’<span style="mso-spacerun: yes;"> </span></span><span style="font-family: "times new roman"; font-size: 11.0pt;">(Waters et al., 2016)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
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<div id="ftn12" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref12" name="_ftn12" style="mso-footnote-id: ftn12;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[12]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> See, for example, Rios,
Chong, and Grau </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(2015)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
</div>
<div id="ftn13" style="mso-element: footnote;">
<div class="MsoFootnoteText">
<a href="https://www.blogger.com/blogger.g?blogID=2766189576050977240#_ftnref13" name="_ftn13" style="mso-footnote-id: ftn13;" title=""><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;"><span style="mso-special-character: footnote;"><span class="MsoFootnoteReference"><span style="font-family: "times new roman"; font-size: 11.0pt;">[13]</span></span></span></span></span></a><span style="font-family: "times new roman"; font-size: 11.0pt;"> See chapter 1 of
Schumpeter </span><span style="font-family: "times new roman"; font-size: 11.0pt;">(1934)</span><span style="font-family: "times new roman"; font-size: 11.0pt;"></span></div>
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David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-10501940341596908302016-03-26T01:55:00.000-07:002016-05-09T17:07:43.472-07:00“X-Contingent Loans:” Valuable Innovation or Inevitable Temptation?<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The path to hell is paved with good intentions. The best of intentions seem to lie behind <a href="http://stm.sciencemag.org/content/8/327/327ps6">a proposal by Montazerhodjat, Weinstock, and Lo</a> that chronically sick people should be able to take out health-contingent loans to finance curative treatments instead of paying repeatedly for short term medicine. The logic behind the suggestion is undeniable: the patient’s financial outcome and health outcomes look better under the hypothetical loan-based model. Just like a renter who prefers to take out a mortgage to buy a home than rent indefinitely, the patient exchanges a perpetual stream of payments for a lump sum of debt that they can eventually pay off. In addition, the loan they propose is contingent on the person’s continued health—if the cure doesn’t work the loan is written off. This aligns the incentives of the pharmaceutical vendor with that of the patient: both want to see the patient permanently cured. In the long-run, if these loans were widely available, more R&D would be directed towards curative medicine rather than temporary or partial treatments.</span></span><br />
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjxadZ3DJP_-GYM_kD2fOcV8lGPF0YrS2ZUry83n7RknIWnzBP8tiq48OHnVY-FRVEMUmAedZQihCaJb8UeSoHWG7u0YnszR-PalvaLAimHZQD02MBLTBB0ZYVedRMvDXW0Uhse3WmgaTRn/s1600/Investing+in+human+capital.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjxadZ3DJP_-GYM_kD2fOcV8lGPF0YrS2ZUry83n7RknIWnzBP8tiq48OHnVY-FRVEMUmAedZQihCaJb8UeSoHWG7u0YnszR-PalvaLAimHZQD02MBLTBB0ZYVedRMvDXW0Uhse3WmgaTRn/s1600/Investing+in+human+capital.jpg" /></a><span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">Similar rumblings can be heard in the discussion around <a href="http://www.aei.org/publication/students-futures-as-investments-the-promise-and-challenges-of-income-share-agreements/">financing higher education</a>. The idea of a “<a href="https://en.wikipedia.org/wiki/Human_Capital_Contract">human capital contract</a>” is that a prospective student might agree to pay a percentage of their future income in exchange for having their tuition fees paid up front. It is a financial model that replaces the concept of student debt with one of student equity: by sponsoring my university studies you are “buying shares” in my future prospects. The idea is analysed in depth by <a href="http://www2.owen.vanderbilt.edu/miguel.palacios/">Miguel Palacios</a> in his 2004 book “<a href="http://www.cambridge.org/sg/academic/subjects/economics/labour-economics/investing-human-capital-capital-markets-approach-student-funding">Investing in Human Capital</a>.” Palacios rightly points out that there are ethical and practical dilemmas involved. On the ethical side, the concept of equity in a human being has echoes of slavery or indentured servitude, and no matter what guarantees the sponsor makes to preserve the recipients’ freedom, there will be a risk of exploitative or coercive behavior by sponsors to ensure the recipient takes a higher paying job. Also, the idea of indefinite contracts is rather unpalatable. On the practical side, the proposed contracts suffer from severe problems of <a href="https://en.wikipedia.org/wiki/Adverse_selection">adverse selection</a> and <a href="https://en.wikipedia.org/wiki/Moral_hazard">moral hazard</a>.<sup>1</sup> A more palatable half-way house between plain vanilla loans and human capital contracts is the “<a href="https://en.wikipedia.org/wiki/Income-contingent_repayment">income-contingent loan,</a>” which you pay back with some percentage of salary over a given threshold. Income-contingent loans typically include a capped repayment period, after which the remaining balance is written off. </span></span><br />
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The health-contingent loans to pay for medical treatment and the income-contingent loans to pay for education are part of a broader class of “human capital loans,” which are used to build up the intangible value embodied in the person themselves rather than their tangible assets. They also belong to a category I am calling “<b>X-contingent loans</b>” since the amount that gets repaid depends on how future events unfold. As the two examples suggest, X-contingent loans might provide a route to finance things that increase quality of life but which traditional financial products don’t work for. They may be one of the defining financial innovations of the 21st century, which unlock tremendous value for poor people, whose <span style="font-family: "georgia" , "times new roman" , serif;">"</span><a href="https://en.wikipedia.org/wiki/Liquidity_constraint">liquidity constraint</a><span style="font-family: "georgia" , "times new roman" , serif;">"</span> prevents them from accessing healthcare or higher education. They also pose substantial risks, which are not always acknowledged by their proponents. I will highlight two.</span></span><br />
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">First, we consumers are not good at judging the costs and benefits of complicated financial products. The concept of compound interest is not intuitive, meaning we struggle to deal with our long-run finances, even when consumer financial products have deterministic payment profiles. Once you add “contingencies” into the mix, we become pretty hopeless at judging what is a good deal. Corporations have statisticians on staff to compute probabilities of myriad events occurring, and even they were caught out by the correlated decline in house prices that precipitated the financial crisis of 2008. As everyday consumers we have only the coarsest sense of what the future holds; we make decisions based on gut feel, not on probabilities. When it comes to complicated financial products we are easily misled, and even when a vendor is being transparent (the exception, not the rule these days), we tend to make poor choices. When we make poor choices, we lose out, and ultimately markets may fall apart completely.</span></span><br />
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">To emphasize this point, consider two different consumer financial products with “embedded options.” In the US, in contrast to many other developed nations, <a href="https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci16-8.pdf">most mortgages are fixed-rate</a>. However, mortgage borrowers are typically allowed <a href="https://en.wikipedia.org/wiki/Prepayment_of_loan">prepay</a> on their loan. If the prevailing interest rates goes down, it becomes attractive to refinance a mortgage at a lower rate. Mortgages have an implicit call-option on the part of the borrower, which creates “<a href="http://www.investopedia.com/exam-guide/cfa-level-1/fixed-income-investments/call-prepayment-risk.asp">prepayment risk</a>” for lender, vastly complicating the valuation of pools of mortgages that make up <a href="https://www.youtube.com/watch?v=GWMemC0AArs">mortgage-backed securities</a>. Mortgage providers enlarged the level of complexity by issuing mortgages with attractive starting rates, but <a href="https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#High-risk_mortgage_loans_and_lending.2Fborrowing_practices">complicated tiers of future payments</a> (and some mortgage issuers simply engaged in outright fraud). The widespread, correlated defaults on mortgage payments from 2007 were an unforeseen consequence of the products’ complexity. The US market for automotive leasing also has options embedded by law in the leases: at the end of the lease the lessee can decide to either purchase the car at its pre-specified residual value, or to return it to the lessor.<sup>2</sup> Monthly lease payments amortize the difference between the purchase price and the residual value, so lessors can offer attractive deals by using optimistic estimates of residual values. In the early 2000s, this market fell into dysfunction because lessors had systematically overestimated the residual values of vehicles, and far more vehicles were returned to lessors than anticipated. Many banks exited the industry, sustaining hundreds of millions of dollars in losses.</span></span><br />
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">The second big problem with X-contingent loans is that prices respond to the quantity of money available to buy something. This is a fairly intuitive result of the forces of demand and supply; when buyers have more money available, this raises the <a href="https://en.wikipedia.org/wiki/IS%E2%80%93LM_model">effective level of demand</a>. This is why central banks lower interest rates to stimulate aggregate demand in the economy, but raise interest rates if excess demand is causing inflation. When we consider introducing a form of credit that is specific one particular consumer good, we should expect a high rate of inflation in the prices for that good. The clearest real-life example is (again) the <a href="http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0297.2011.02424.x/full">market for property</a>, with the expansion of credit in the form of larger and easier-to-obtain mortgages. The long-run trend to allow people to borrow increasingly larger multiples of their income has sent property prices skyrocketing. This effect is already in evidence in the US market for higher education, in which tuition fees have risen <a href="https://en.wikipedia.org/wiki/College_tuition_in_the_United_States#Growth_of_college_costs">at roughly three times</a> the rate of inflation, hand-in-hand with the expansion of student loans to pay these fees.<sup>3</sup> We can clearly anticipate that if health-contingent loans expand the credit available to pay for treatments, their prices (if left unregulated) will likely rise. This is compounded by the highly <a href="http://www.changemyworldview.com/2010/08/both-us-and-uk-are-preparing-dramatic.html">inelastic demand for health</a>: people will pay for health at whatever price is asked—it is, after all, a matter of life or death.</span></span><br />
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<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">All this considered, what can we do? My inclination is to treat X-contingent loans very cautiously. We should move forward slowly rather than rush to welcome this tempting looking new market. And we should consider centralized government control. If we compare the situation with student loans in the US and the UK, <a href="http://www.changemyworldview.com/2010/11/debt-free-aged-73-how-9000-tuition-fees.html">neither is perfect</a>, but the presence of private student debt in the US makes for a far more dysfunctional system than in the UK, which already runs on income-contingent loans. Mortgages have made home-ownership a realistic possibility for millions, but have also come close to sinking the global financial system. If we can learn from past mistakes, maybe with X-contingent loans we can expand the benefits of access to healthcare and education, in a humanistic rather than an exploitative way.</span></span><br />
<span style="font-size: small;"><span style="font-family: "georgia" , "times new roman" , serif;">_________________________________</span></span><br />
<span style="font-size: x-small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>1</sup> In this context, adverse selection occurs because people who expect to earn a lot in future will prefer to take out loans to finance their education, while people who expect to earn less will opt for HCCs. Moral hazard occurs because a person has a lower incentive to take a higher paying job if some percentage of that extra income gets paid to their sponsor.</span></span><br />
<span style="font-size: x-small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>2</sup> This example is taken from the academic article "Big Losses in Ecosystem Niches: How Core Firm Decisions Drive Complementary Product Shakeouts" by <a href="http://onlinelibrary.wiley.com/doi/10.1002/smj.736/abstract">Lamar Pierce (2009)</a>.</span></span><br />
<span style="font-size: x-small;"><span style="font-family: "georgia" , "times new roman" , serif;"><sup>3</sup> We should not be surprised that bad actors arise to exploit the system, a story that <a href="https://www.youtube.com/watch?v=P8pjd1QEA0c">John Oliver recounts with aplomb</a>.
</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-6253484661156733502015-12-21T04:18:00.000-08:002015-12-21T04:18:21.680-08:00Can Prospect Theory Explain High Start-up Valuations?<br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Human beings are not particularly good at thinking about probabilities. The last several decades of research in psychology and <a href="https://en.wikipedia.org/wiki/Behavioral_economics#Applied_issues">behavioral economics</a> have unearthed an array of cognitive biases in how we reason about uncertain events. For example, we are prone to misinterpret the results of <a href="http://www.yudkowsky.net/rational/bayes">diagnostic tests</a>, by failing to account for the <a href="https://en.wikipedia.org/wiki/Base_rate_fallacy">base rate</a> of a disease in the population. This has enormous implications in the medical field, and may be leading us to over-diagnose and over-prescribe treatments for a variety of illnesses.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">One of the foundational theories in behavioral economics is <a href="https://en.wikipedia.org/wiki/Prospect_theory"><i>prospect theory</i></a>, formulated by <a href="https://en.wikipedia.org/wiki/Daniel_Kahneman">Daniel Kahneman</a> and <a href="https://en.wikipedia.org/wiki/Amos_Tversky">Amos Tversky</a>. This theory is most well known for the observation that humans interpret losses as more consequential than gains of the same magnitude. Thus, simply changing the framing of a decision from a ‘gain frame’ to a ‘loss frame’ can make people much more averse to taking risks. In this blog post I want to focus on another prong of prospect theory: the over-weighting of rare events.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Prospect theory suggests—and experimental evidence supports—the idea that people ‘filter’ probabilities: we act as though very low probability events are more likely than they really are (and as though high probability events are less likely than they really are). This helps explain why people fret so much over low probability dangers such as shark attacks and ignore more mundane risks such as <a href="https://www.flmnh.ufl.edu/fish/sharks/attacks/relarisklifetime.html">accidental falls</a>. It also helps explain why people gamble money on lotteries even when the odds of winning are very slim, and<i> </i>the <i>expected</i> return is negative. </span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">What has this got to do with valuing a start-up? The conventional way to value a company is to make a forecast of its future cash flows, then discount these back to find the ‘net present value’ of its future income. Alternatively, as a heuristic we can apply a multiplier to its earnings based on accepted valuations of other companies. Neither of these works for an emerging venture with a novel business proposition (i.e. your typical Silicon Valley start-up). The future prospects of such a company are shrouded in uncertainty.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Instead of trying to establish the likely path of a given venture’s future cash flows, investors—usually venture capitalists—take a portfolio approach. They pick companies they think will have a chance at becoming massively successful, but realize that many will fail to do so. Each investment is a bit like a lottery ticket. In the classical VC portfolio model, roughly one investment in ten would need to exit at a blockbuster valuation for the overall fund to make a decent return on investment. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">In the present wave of technology venture activity, three key things are being done differently to the past. First, the definition of a ‘massively successful exit’ has inflated: ventures now aspire to be ‘unicorns’ with a billion-dollar valuation. Second, investors are spreading their money out, investing in a larger number of ventures. This is most visibly true in <a href="http://arstechnica.com/business/2012/09/how-startup-sausage-gets-made-the-launch-pad-reviewed/">accelerator programs</a>, which provide large numbers of nascent ventures with seed funding and mentoring in return for a small equity stake: they explicitly rely on a scattershot approach. Instead of a VC picking ten investments and hoping for two or three large exits, the accelerator approach is to invest in a hundred startup teams and hope for one unicorn. Third, more ventures are staying private for longer, rather than go public through an IPO. As described <a href="http://www.ft.com/cms/s/2/6ad992e6-8792-11e5-9f8c-a8d619fa707c.html">in this FT article</a>, this allows them to effectively manage their headline valuation figure by giving new investors guaranteed financial returns (risking, in the process, the equity of preceding investors). This prevents negative opinions of the venture’s prospects from being incorporated in its valuation. </span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">And so we have a perfect storm in which valuations are based on someone’s estimate that a given venture will become a unicorn, and—according to prospect theory—they are biased to overestimate how likely this is. For every thousand startups, maybe one of them will be hugely successful, but all of them might be valued as if they have a one-in-a-hundred chance of this success. This is a problem. More fundamentally, we are dealing with such small probabilities that we can easily get them very wrong.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Earlier in the year I considered a few possible mechanisms by which a hypothetical <a href="http://www.changemyworldview.com/2015/02/how-might-tech-bubble-burst.html">technology bubble might burst</a>. Here, I’ve described one psychological factor that might be behind high startup valuations in the first place. It’s also worth noting that prospect theory can explain rapid changes in investor sentiment. If prices start falling—for example if a bubble shows signs of bursting—investors can switch from a gain mindset to a loss mindset, and immediately become much more risk averse. I hope this doesn’t happen, because the present wave of entrepreneurial activity is generating a lot of innovation. But a wise investor or entrepreneur should be aware that the tide might turn in the near future, and plan accordingly—or risk getting swept away when it does.</span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com1tag:blogger.com,1999:blog-2766189576050977240.post-22835319803885876552015-10-31T02:08:00.000-07:002015-10-31T03:42:54.527-07:00Let Them Eat (Micro)Chips: The Second Machine Age and the Spectre of Technological Unemployment<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><i>We are in the midst of the greatest economic upheaval since the industrial revolution.</i> This is the premise of <a href="http://secondmachineage.com/">The Second Machine Age</a> by Erik Brynjolfsson and Andrew McAfee, a book discussing the economic implications of present day technological trends. It is an excellent piece, which touches on several topics I have previously explored in this blog, from the trends towards <a href="http://www.changemyworldview.com/2011/01/how-scalability-principle-can-lead-to.html">scalability and the consequent ‘winner takes all’</a> market dynamics, to the deep challenges the information age poses to the <a href="http://www.changemyworldview.com/2012/09/the-perils-of-relying-on-gdp-in.html">measurement of economic growth</a>.</span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">The book has a compelling overarching theme: technology is driving two forces, one positive </span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUHOc_vfSW2NWLpL_lg7g3T1hnsF3S41yeUTUSwM34Vps-DEkyo1n5J5At29CWjIuN9rAHefOZ8caFXjxOPxZpcLG3XnrllHTK27UCfBiYt5sEkz3zypMtJi03Q-ZWEeaFKBGZ2SJFBjOE/s1600/secondmachineage.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUHOc_vfSW2NWLpL_lg7g3T1hnsF3S41yeUTUSwM34Vps-DEkyo1n5J5At29CWjIuN9rAHefOZ8caFXjxOPxZpcLG3XnrllHTK27UCfBiYt5sEkz3zypMtJi03Q-ZWEeaFKBGZ2SJFBjOE/s320/secondmachineage.jpg" width="210" /></a></span></span></div>
<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">for society and one negative. On the one hand technological change is generating an enormous <i>bounty</i> of economic growth. On the other hand, it is also driving increasing <i>spread</i> between rich and poor, and these economic faultlines could undermine the basic fabric of society. </span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Behind both bounty and spread is the rise of machine intelligence. Machines can take on ever more tasks, even ones that a decade ago we thought would be impossible to automate. The poster child for this is driverless cars. Technology experts used to think driving is so complex that humans would always have an advantage over computers, but the exponential progress of technology has rendered this prediction wrong. Google has been testing <a href="http://www.bbc.com/news/technology-34423292">driverless cars</a> for several years and <a href="https://www.youtube.com/watch?v=9X-5fKzmy38">Tesla’s Autopilot</a> mode has already made automated vehicles a commercial reality.</span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">One of the discussions in the book I find most compelling is on the subject of technological unemployment. At least since the days of the <a href="https://en.wikipedia.org/wiki/Luddite">Luddites</a>, the spectre of machines taking our jobs has worried generations of workers and commanded much attention in social and political science. The prevailing wisdom in the contemporary economics establishment is that technological unemployment is, indeed, a phantom, one we need not worry too much about. The argument goes as follows: while technological change may tear down old industries, it opens up new possibilities, and through the process of entrepreneurial action old ‘factors of production’ can be redeployed to productive uses. People whose skills become obsolete can learn new skills, they just need to be flexible about the type of work they are willing to do.</span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Brynjolfsson and McAfee make a compelling case that technological unemployment is a legitimate concern. They point to three main reasons:</span></span><br />
<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br /></span></span>
<b><span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">1.) Rates of change</span></span></b><br />
<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">The argument against technological unemployment rests on the idea that people can adapt and find employment in growth industries. This reasoning holds as long as the rate of adaptation is faster than the rate of technological change. Historically this has been the case: despite <a href="https://en.wikipedia.org/wiki/Joseph_Schumpeter"><i>the gales of creative destruction</i></a> blowing strongly, society has adapted.* However, Brynjolfsson and McAfee point out that just because a trend held for 200 years doesn’t mean it holds forever. The rate of technological change has been increasing; can we expect that individuals and the institutions of society will adapt at an ever increasing rate as well? </span></span><br />
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<b><span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">2.) Elasticity of consumption</span></span></b><br />
<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Another part of the argument against technological unemployment is that gains in productivity lead to lower prices, which in turn stimulate a higher volume of consumption. This assumption – that in aggregate the long-run “elasticity of demand” is approximately one – would provide an adjustment mechanism if technology continues to raise productivity. The authors point out that if this assumption is wrong, then economic growth would eventually come grinding to a halt.</span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">A corollary of the elasticity of consumption argument, not addressed by the authors, is that it relies on prices going through periods of <a href="https://en.wikipedia.org/wiki/Deflation">deflation</a>. Deflation occurred in <a href="https://en.wikipedia.org/wiki/Great_Depression">1930s US</a> and <a href="https://en.wikipedia.org/wiki/Lost_Decade_%28Japan%29">1990s Japan</a>, and might have occurred in the 2008-2012 Great Recession if it were not for the <a href="https://en.wikipedia.org/wiki/Quantitative_easing">unconventional monetary policy</a> of central banks around the world. Avoiding deflation has been celebrated for averting a potentially disastrous depression. But if prices are never allowed to fall, we lose one of the economic mechanisms for adjusting to technological change. I don’t have a clear cut answer to this dilemma, but I would like to see a few more economists discussing this issue.</span></span><br />
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<b><span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">3.) Floor on wages </span></span></b><br />
<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">This argument is presented with a thought experiment: </span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">“Imagine that tomorrow a company introduced androids that could do absolutely everything a human worker could do, including building more androids. There’s an endless supply of these robots, and they’re extremely cheap to buy and virtually free to run over time.” </span></span></blockquote>
<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">In this hypothetical end-game scenario, the equilibrium wage for human labor falls to zero. Managed well, we’d be in a Utopia, managed poorly – dystopia.</span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">This is no mere parlor game. The authors also point out that in a digital economy, in which the output of superstars can be freely reproduced, the equilibrium wage for non-superstars is already zero, or close to it. These non-superstars look for work in other sectors, pushing wages down there. Eventually, “If neither the worker nor any entrepreneur can think of a profitable task that requires the worker’s skills and capabilities, then that worker will go unemployed indefinitely.”</span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Something implicit and horrifying in this last mechanism is that the free market’s solution to an oversupply of workers is starvation. When demand for a typical material good shrinks, its price falls. The supply side of the market adjusts by producing less of it. But when demand for labor shrinks, its price (i.e. the wage rate) may fall, but this doesn’t translate to a lower supply of labor (i.e. a lower population), except through violent means.</span></span>
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">The book concludes that governments need to take action in order to make the most of technology’s bounty while minimizing the spread, or at least mitigating some of its worst consequences. Amongst other things, the authors advise greater investment in education (“higher teacher salaries and more accountability”), more support for entrepreneurship, more investment in science, and more progressive taxation, especially raising taxes on those with superstar levels of income.</span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">The authors join a <a href="http://www.vice.com/read/something-for-everyone-0000546-v22n1">growing minority of commentators</a> who view a <a href="https://en.wikipedia.org/wiki/Basic_income">Basic Income</a> – a guaranteed minimum income paid by the government – as the best solution to rising inequality.** In the long run this might be the only feasible way to organize an economy which only requires a small, skilled minority to generate most of its economic output. </span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Technological change bears the potential to benefit everyone, but it also has the potential impoverish the majority while enriching a few. This is not some <a href="https://en.wikipedia.org/wiki/Nine_Tomorrows">science fiction future</a> – this is starting to happen today. The warning bells are sounding and now some wise leadership will be needed to steer the ship through the coming storm.</span></span><br />
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<span style="font-size: x-small;"><span style="font-family: Georgia,"Times New Roman",serif;">* Though not without spells of pain and suffering along the way.</span></span><br />
<span style="font-size: x-small;"><span style="font-family: Georgia,"Times New Roman",serif;">** I find it quite noteworthy that this possibility is now part of mainstream discourse, and I found it even more surprising to learn that it almost became a reality under the Nixon administration
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<br />David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-76331031680637334502015-02-04T01:57:00.000-08:002015-02-04T02:06:30.904-08:00How Might the Tech Bubble Burst?<span style="font-family: Georgia,"Times New Roman",serif;">Tech company valuations are through the roof right now, and <a href="http://www.economist.com/debate/overview/206">many people have been questioning</a> whether we are presently <a href="http://fortune.com/2014/10/24/are-we-in-a-tech-bubble-silicon-valley-says-yes-and-no/">living through a tech bubble</a>. In this blog post I set to one side the thorny question of <i>whether </i>we are in a bubble or not. Instead, I go through a thought experiment: I assume that we <i>are </i>in bubble, and play out a few scenarios for ways in which it might burst. Here are my top three:</span><br />
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<b><span style="font-family: Georgia,"Times New Roman",serif;">Scenario 1: A Rising Star Falls</span></b><br />
<span style="font-family: Georgia,"Times New Roman",serif;">Present tech valuations are only warranted if you believe in the fundamental quality of their management teams. A high level of future growth is already priced into current valuations. This will only be attainable if they can expand their horizons, for example by expanding internationally. Such expansion puts a lot of pressure on organizational infrastructure. It is hard for a Silicon Valley-based headquarters to ensure that every local subsidiary maintains the quality standards they aspire to globally. Businesses who scale up slowly often have problems; those doing it at an accelerated pace (such as Uber) are even more likely to trip up. If <a href="http://www.salon.com/2014/12/24/the_year_in_uber_scandals_a_surge_priced_cruise_through_the_companys_biggest_controversies/">too many local scandals</a> mount, the managerial quality of the whole enterprise will get called into question, as will its valuation. The bold, <a href="http://pando.com/2014/02/27/we-call-that-boob-er-the-four-most-awful-things-travis-kalanick-said-in-his-gq-profile/">fresh-faced management team</a> will suddenly look <a href="http://www.washingtonpost.com/business/technology/uber-executive-stirs-up-privacy-controversy/2014/11/18/d0607836-6f61-11e4-ad12-3734c461eab6_story.html">hapless and inexperienced</a>, flailing in the midst of a crisis, or riven by internal politics.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">We only need look at Enron to see the risks that free-wheeling growth can expose an organization to. Now I am categorically <i>not </i>saying that <i>every </i>tech start-up is an Enron. waiting to happen. What I am saying is that it could take <b>just one</b> high-tech corporate implosion to cast doubt on all the others. And once investors start to doubt the fundamental managerial quality of these tech ventures <i>the game is up for the whole pack</i>. Let me be totally clear: this line of argument is about perceptions. In the context of venture capital investments ‘risk’ is highly subjective, in other words it is a matter of perceptions. One <b>dramatic fallen star</b> could change the perceptions of investors about the risk of all the other stars, leading to the tech bubble deflating.</span><br />
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<b><span style="font-family: Georgia,"Times New Roman",serif;">Scenario 2: The Advertising Pyramid Collapses</span></b><br />
<span style="font-family: Georgia,"Times New Roman",serif;">Many tech ventures rely on advertising as their main (or sole) source of revenue. <a href="http://en.wikipedia.org/wiki/Online_advertising">Advertising</a> is the bedrock of the tech sector, worth an estimated $43bn in 2013. It has allowed the industry to evolve in such a way that consumers expect services to be free. Take it away and those apps and websites suddenly don’t look like such appealing investments anymore.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">Where do the pressure points lie when it comes to advertising? I see two potential sources of strain. First is the question of the proportion of advertising accounted for by tech companies and websites themselves. Apps tend to display adverts for other apps; websites display adverts for other websites. Webmasters buy ads to drive eyeballs to their site, where they hope people will click on ads. When this kind of behavior occurs, the online sector is feeding on itself – it is <a href="http://www.merriam-webster.com/dictionary/autophagous">autophagous</a>. Here we are in classic bubble or pyramid territory. The pyramid is sustained as long as it draws more people in to play the game, but once it is revealed to be hollow, it vanishes at once. I don’t have data on how much advertising is of this nature – so I can’t truly judge the extent to which this is a problem. However, just from my personal experience of browsing the web it appears that a lot of advertising is of this autophagous nature.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">The second pressure point is the difficulty of measuring the return on investment (ROI) of online advertising. Web-based advertising platforms throw off a lot of data. The funnel from views-to-clicks-to-purchases can be tracked, so in principle a marketing manager can attribute a given online sale to a given online advert. However, things are far from simple. A customer who clicked through a pay-per-click advert may have still made exactly the same purchase even if the advert hadn’t been there. And a lot of online advertising is bought primarily to promote offline sales (think of, e.g., car adverts). However the effects on offline sales are <a href="http://mashable.com/2014/07/21/ad-analysts-job-impossible/?geo=GB">much harder to track</a>. Interestingly, while online advertising opens up the possibility of using randomized experiments to measure the effect of adverts, <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2367103">research so far has found</a> that the effect size is so small it is hard to reliably measure from a statistical standpoint.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">The upshot of this: the online advertising industry, while huge, is not yet in a long-term, stable equilibrium, and it’s not clear whether the stable market size will be larger or smaller than the market that exists now.</span><br />
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<b><span style="font-family: Georgia,"Times New Roman",serif;">Scenario 3: Silicon Valley Disrupts Itself</span></b><br />
<span style="font-family: Georgia,"Times New Roman",serif;">To <i>disrupt </i>an industry is the bold aim of many of Silicon Valley’s start ups. It typically entails finding a way to deliver the same service the industry presently delivers but at a fraction of the cost or at a step-change improvement in quality or convenience.* It is often said that to disrupt you need to offer something <a href="http://joshlinkner.com/2012/the-10x-factor/">10x better</a> than what presently exists, in order to overcome people’s inertia and lock-in with present systems.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">The industries targeted for disruption are typically of the staid, old-school variety, perhaps dominated by some entrenched rentiers – think of <a href="https://hbr.org/2014/12/making-sense-of-ubers-40-billion-valuation">Uber disrupting</a> the taxi / car industry, or TransferWise disrupting the foreign remittance industry. The narrative of disruption underlies the massive valuations these companies receive. To take Uber, for example, in debates about its valuation have moved from comparisons with the <a href="http://fivethirtyeight.com/features/uber-isnt-worth-17-billion/">entire global market for taxi services</a> to discussion about how it might act as a <a href="http://www.washingtonpost.com/blogs/the-switch/wp/2014/12/05/ubers-not-a-40-billion-start-up-its-a-mid-sized-car-company/">subtitute for car ownership</a>.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">But there's no particular reason only old industries are vulnerable to disruption. It is perfectly conceivable that one of the current tech giants itself gets disrupted. People appear pretty locked-in to social media platforms such as Facebook, but if a company were to come along with an offer 10x better than one of these, it is easy to see customers switching. And, in fact, <a href="http://business.time.com/2014/01/15/more-than-11-million-young-people-have-fled-facebook-since-2011/">many already did</a>: in the last few years plenty of people switched from Facebook to Twitter or Instagram as their primary social media feed, and in future something even better than either of these may come along. Well aware of this fact, Facebook paid <a href="http://www.wsj.com/articles/SB10001424052702303815404577333840377381670">a billion dollars for Instagram</a> and <a href="http://dealbook.nytimes.com/2014/10/28/facebooks-21-8-billion-acquisition-lost-138-million-last-year/">$22bn for WhatsApp</a> primarily because of the threat that these businesses posed to its dominance. </span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">I can’t predict what a social media platform 10x better than Facebook would look like, but then neither could I have predicted Facebook’s creation before it existed. And, as with Scenario 1, it only takes one giant to fall asunder for many of the others to lose their appeal to investors.</span><br />
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<i><span style="font-family: Georgia,"Times New Roman",serif;">So, there we have it, three scenarios for how the tech bubble might burst. Which do you find the most plausible? What other scenarios sounds realistic? Answers in the comments below! </span></i><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: x-small;">*Note: this is a fairly colloquial definition of disruption. It is a somewhat warped version of its original academic usage by Clay Christensen, which referred to creation of new performance dimensions for emerging market sub-segments that eventually become large markets in their own right. Here, the colloquial meaning is the one I intend.</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com2tag:blogger.com,1999:blog-2766189576050977240.post-60147598569420992402015-01-16T23:21:00.000-08:002015-01-16T23:22:06.180-08:00Notes from the cutting room floor: "Google has mastered technology, but they need to better understand people"<span style="font-family: Georgia,"Times New Roman",serif;"><i>I wrote the following paragraph on 3rd November, 2013, shortly after a big rise in Google's share price. I never got round to expanding it into a full post. This week the Google Glass developer program was <a href="http://www.bbc.com/news/technology-30831128">put on hiatus</a> so it seemed like an apt point to dig it up.</i> </span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">Google has made the news this week for its share price reaching record highs. I’ve been observing the company keenly for many years and greatly admire the technical prowess and creativity of its employees and the vision of its founders and leaders. In the past the company has pioneered a vast array of internet services and is one of the chief reasons why much of what is online is available for free (including this blog). Now it looks as though they plan to be a pioneer in the hardware world, and this is likely to be the greatest challenge they will ever face. There are numerous possible miss-steps, and above all I want to highlight the risk that, while they have mastered technology, they lack an understanding of how it is socially adopted and accepted. This will leave some of their greatest innovations – Google Glass and driverless cars – down a rocky path, with a real chance of outright rejection by society.</span><br />
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David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-60803287959190472832014-10-18T09:34:00.001-07:002014-10-18T10:04:55.866-07:00The Meaning of the 21st Century by James Martin: Review part 1 - Humanity’s Greatest Challenges<blockquote class="tr_bq">
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><i>“There’s a reason for the 21st century. Not too sure, but I know that it’s meant to be.”</i> - The <a href="https://www.youtube.com/watch?v=GN3zBlsu8p4">Red Hot Chili Peppers</a></span></span></blockquote>
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">The work of James Martin was brought to my attention when I read <a href="http://www.nytimes.com/2013/07/03/technology/business-computing/james-martin-technology-consultant-and-author-dies-at-79.html?_r=0">his obituary</a> after his passing on 24th June, 2013. One of the UK’s most influential computer scientists, and probably its foremost futurologist, his early work<sup>1</sup> foresaw much of what would unfold as IT evolved and revolutionized society. He helped to create the digital revolution through his work on information engineering at IBM, as well as through several companies he founded, amassing considerable personal wealth along the way. His fascination with the future led him to deploy this wealth by founding <a href="http://www.oxfordmartin.ox.ac.uk/">The James Martin 21st Century School</a> at the University of Oxford and dedicating the latter part of his life to understanding and communicating the challenges facing humanity.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjndL99_vTZaBxU6wwvs1l6NaAZb7acO0khM2YOlIW2QTI2IgEA5MyqZAwWvcucEHRGqUZZO417DjX_GDliBwfOFQPuuSMu60lOLG4Bh2SshWGWDpOMjNLV-rymrl2O35j5B0rExWEc3F4q/s1600/James+Martin+The+Meaning+of+the+21st+Century.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjndL99_vTZaBxU6wwvs1l6NaAZb7acO0khM2YOlIW2QTI2IgEA5MyqZAwWvcucEHRGqUZZO417DjX_GDliBwfOFQPuuSMu60lOLG4Bh2SshWGWDpOMjNLV-rymrl2O35j5B0rExWEc3F4q/s1600/James+Martin+The+Meaning+of+the+21st+Century.jpg" /></a></span></span></div>
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><a href="http://www.jamesmartin.com/book/">'The Meaning of the 21st Century'</a> contains his reflections on the challenges facing humanity over the next hundred years, and some of the possible solutions. Published in 2006, it is unabashedly subtitled 'A vital blueprint for ensuring our future.' It weighs in at over 500 pages, and I read it gradually over the summer of 2014. Its expansive themes make it sometimes heavy going. I have come to agree with many of the <a href="http://www.jamesmartin.com/book/reviews.cfm">accolades </a>it receives on the inside cover (‘A wonderful book… a privilege to read.’ ‘A fire bell warning.’ ‘ a short course on the most pressing mega-problems of the new century.’) It is somewhat daunting to try and distill the book into a blog post sized text. In this post I focus on the Grand Challenges he identifies facing humanity<sup>2</sup>. Martin touches on a great many over the course of the book, which I find helpful to arrange in three broad categories: (1) ecological and environmental challenges; (2) social and institutional challenges, and (3) technological challenges.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><b>Ecological / environmental challenges</b></span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Ecological / environmental challenges are now broadly recognized and <a href="http://www.theguardian.com/environment">widely discussed</a>. Our ecological / environmental challenges include: water scarcity, deforestation, topsoil erosion, soil salination, loss of biodiversity, depletion of marine life, and global warming (with its sub-problems of: ice caps melting, ocean current perturbation, sea level rising, extreme weather events). Many of these contribute to the possibility that we will reach our agricultural limit, a thesis famously put forward by <a href="http://en.wikipedia.org/wiki/Malthusianism">Malthus</a>. Many would say it has since been discredited, but just because it hasn’t happened yet, that doesn’t mean it never will. Some of the ecological problems receive more attention than others; ultimately any of them could spell disaster for the functioning of society. Also, the degree to which these problems are inter-related is probably underestimated. For example <a href="http://en.wikipedia.org/wiki/Deforestation">deforestation</a> has a cluster of knock-on effects, it (i) reduces biodiversity, (ii) releases greenhouse gases, (iii) reduces the rate at which CO2 is absorbed, (iv) leads to topsoil erosion, (v) contributes to desertification. When we realize that tackling one cause can stem many effects, the rationale for taking action increases considerably.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><b>Social / institutional challenges</b></span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Social / institutional challenges are beginning to receive attention, but mostly to their symptoms, i.e. the latest <a href="http://edition.cnn.com/2014/10/16/world/asia/hong-kong-protests/index.html">flare-up of unrest</a> or the latest act of <a href="http://en.wikipedia.org/wiki/2014_ISIL_beheading_incidents">terrorism</a>. Relatively little attention is paid to their root causes. Social challenges include: population growth, poverty, religious extremism, terrorism, social unrest, rising inequality, illiteracy, bureaucratic paralysis, regulatory capture, public service mismanagement, and institutionalized short-termism. Again, these are intertwined in various ways, for example rising inequality is a catalyst of social unrest, extremism and terrorism, and also leads to regulatory capture and political stasis due to the concentration of power in the hands of an entrenched plutocracy. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><b>Technological challenges</b></span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Thirdly, technological challenges are probably the ones most overlooked in the mainstream discourse, and it is here that Martin’s insight adds the most to the conversation. He takes a critical eye and looks at technology not as an unalloyed benefit but also as a threat – potentially a grave one – to the wellbeing of humanity. Technological challenges include: ease of access to weapons of mass destruction (in particular nuclear or biological weapons), computer intelligence, risky scientific experiments, <a href="http://en.wikipedia.org/wiki/Endocrine_disruptor">hormone disruptors</a> in the water supply, ethics of transhumanism and genetic engineering, new destructive weaponry (e.g. nanotechnology, robotics, and new bio-weapons), and rising scalability contributing to unemployment and inequality. Martin stresses that computer intelligence is ‘non-human-like’ so we should not expect computers to suddenly gain consciousness in the conventional sense. However, <a href="http://en.wikipedia.org/wiki/Technological_singularity">the Singularity</a> still poses a threat, as intelligent computers would be inherently unpredictable: </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><i>‘Technical controls will be needed for computing, perhaps in the form of hardware design, to ensure that when computers become incomparably more intelligent than we are, they act in our best interests.’ (</i>p.287<i>)</i></span></span></blockquote>
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><b>Relationships between the three areas</b></span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">One of the book’s great strengths is that it looks at how all three forces interact. For example, Martin (correctly) predicted a rise in Islamic extremism facilitated by the spread of internet technologies for recruitment purposes. Long before the rise of ISIS, he framed these comments in terms of Al Qaeda:</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><i>'Al Qaeda’s recruiting video is on the Web… Osama bin Laden’s rhetoric is highly persuasive to many young Muslims, telling them that God want them to help end Islam’s humiliation. Right now [i.e. 2006], most of the vast target audience for this message doesn’t yet have the ability to see Web-delivered TV. As the technology spreads, this means of recruitment will reach far more potential volunteers.'</i> (p.342-343) </span></span></blockquote>
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Martin feared that technological advances will make weapons of mass destruction accessible to terrorists. Drawing on the work of <a href="http://www.nuclearterror.org/bio.html">Graham Allison</a>, he saw a high probability that we will see nuclear terrorism sometime in the 21st Century.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Another highly inter-connected challenge is <a href="http://en.wikipedia.org/wiki/World_population">population growth</a>. At its heart, population growth is a social issue, with fertility rates highly dependent on a country’s level of economic development. But population growth has enormous consequences for the environmental and ecological problems (including the ultimate question of whether the planet can sustain the world’s population). </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">A third example is the rising scalability in production technology (a <a href="http://www.changemyworldview.com/2011/01/how-scalability-principle-can-lead-to.html">recurring</a> <a href="http://www.changemyworldview.com/2014/06/the-downside-of-scalability-piracy.html">theme</a> on this blog). Scalability is facilitated by technological advances. It can increase economic output, but it also contributes to inequality, which in turn stimulates social unrest and terrorism. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">A key dilemma that Martin does not really address, but which became apparent to me while reading the book, is whether ending poverty and saving the environment are compatible goals. If we could raise the living standards of the world’s population to a Western level, the damage to the environment would be <a href="http://en.wikipedia.org/wiki/Human_overpopulation#Carrying_capacity">untenable</a>. Realistically, we have to find ways to make the Western lifestyle ecologically neutral (what Martin terms ‘eco-affluence’) before the rest of the world catches up to our level of development. Anything else will spell environmental disaster for all of us.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><i>The opening chapter of the book is available at <a href="http://www.jamesmartin.com/book/chapter_one.cfm">JamesMartin.com</a></i></span></span> <br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><i>You can follow me on Twitter: @David_Clough1</i></span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">___________________</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><sup>1</sup> Including 'The Wired Society' in 1977 and 'Technology's Crucible' in 1987</span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><sup>2</sup> In chapter 13, Martin presents a list of 17 challenges, but these are not exhaustive of the many challenges he covers elsewhere in the book; my three-bucket structure is hopefully more digestible. In future I plan to write a separate post about the solutions or avenues for progress that Martin identifies.</span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-16799237926575331622014-08-21T09:28:00.000-07:002014-11-17T01:40:59.758-08:00The Essence of Innovation? When Needs and Solutions Meet<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;"><i>“Innovate!”</i> is the imperative that today’s managers most often seem to hear. So often, in fact, that it’s easy to lose sight of what that actually means. <i>“Innovate or die”</i> and <i>“Disrupt or be disrupted”</i> have become the reigning slogans in tech circles. As <a href="http://www.ft.com/cms/s/2/3961d5a8-233d-11e4-a424-00144feabdc0.html">Gillian Tett describes</a> in this weekend’s Financial Times, there seems to be a race on to uncover the secret recipe that can spark creativity in any organization.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">In this blog post I boil down innovation to its fundamentals. The thesis is simple: innovation occurs when needs and solutions meet. In a world obsessed with technology, it is easy to overlook this simple fact. Technology puts the focus on solutions. It has raced ahead at such a pace that we have far more solutions than we know what to do with. And the needs – often the most dire, urgent needs of humanity – are going overlooked, because their solutions are not technological. The gap between our present needs and solutions is a massive deadweight loss to society, and to close it we need much more innovation to be ‘pull-driven.’ If we can transform the ‘innovation production line’ to work on <a href="http://en.wikipedia.org/wiki/Toyota_Production_System">Toyota-style</a>, demand-driven principles, we might be able to solve far more of humanity’s pressing problems<sup>1</sup>.</span><br />
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<span style="font-size: small;"><b><span style="font-family: Georgia,"Times New Roman",serif;">When do Needs and Solutions Meet?</span></b></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">I’ll start off with two success cases. The first is borrowed from <a href="http://www.ft.com/cms/s/2/3961d5a8-233d-11e4-a424-00144feabdc0.html">Gillian Tett’s article</a>. Delos Cosgrove was a heart surgeon in Ohio in the early days of open heart surgery. One of the challenges he faced day-to-day was installing a ring onto the valve in a human heart to keep it in shape. The prevailing design was a rigid ring, which didn’t work very well. To quote Tett:</span><span style="font-size: small;">
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<br />
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<span style="font-size: small;"><i><span style="font-family: Georgia,"Times New Roman",serif;">“Then, some years later, Cosgrove happened to spot a kind of flexible hoop that 19th-century American women used for embroidering pieces of cloth. That’s when he had his “aha!” moment: why not utilise the sewing device and apply it to human hearts to create a valve that could move with human tissue?”</span></i></span></blockquote>
<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">As you may guess, the invention worked, the flexible hoop replaced the rigid one and became dominant. There’s doubtless a lot more subtlety to the full story, but the principle is this: a person with detailed knowledge about a particular need came across a potential solution. Once the need and solution were ‘in the same head’ as it were, the invention could come about.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">The same narrative is visible in the invention of the CamelBak hydration device (an example I learned of from <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2355735">Eric von Hippel</a>). The CamelBak is essentially a backpack with a polymer bag inside, filled with water, with a tube and a valve on so that you can drink from it while exercising. It has become highly popular with runners, trekkers, and cyclists (and I’ve used it myself on many occasions). It was <a href="http://www.camelbak.com/en/International/Sports-Recreation/About-Us/Our-Story.aspx">invented by Michael Eidson</a>, who in 1988 was a keen cyclist trying to find an easy way to stay hydrated during long-distance races. He also happened to be an Emergency Medical Technician. He improvised a device made from an IV bag in a tube sock, and it worked. The invention was possible because the need – easy hands-free hydration – and the solution – the flexible plastic ‘bladder’ of an IV bag – were known to the same person.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">Organizations which specialize in product development have systematic ways to encourage needs and solutions to meet. In a typical product development process consumers’ needs are elicited using interviews, focus groups, or <a href="http://www.slideshare.net/sladner/using-ethnography-in-product-design">ethnographic</a> methods, and then a team works on novel ways to solve the problem. The team is inter-disciplinary, so that they can combine knowledge from different domains to come up with a solution. Companies such as <a href="http://en.wikipedia.org/wiki/IDEO">IDEO</a> have carefully honed these practices and they are on the whole effective – but the types of innovations they provide tend to be those that make life <i>a bit easier</i> for consumers who already have <i>pretty comfortable lives</i>.</span><br />
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<span style="font-size: small;"><b><span style="font-family: Georgia,"Times New Roman",serif;">When do Solutions fail to match up to Needs?</span></b></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">Due to the innate human fascination with science and technology, we quest after new discoveries. We often make inventions first, then later figure out what to do with them. It can take decades for the uses of a new technology to become clear, and for the ‘gale of Creative Destruction’ to blow<sup>2</sup>. A great historic example is the <a href="http://en.wikipedia.org/wiki/Laser#History">laser</a>: it was discovered in the 1950s by quantum physicists investigating atomic emission spectra. Its many practical <a href="http://en.wikipedia.org/wiki/Laser#Uses">applications</a> only became apparent later, when scientists familiar with the laser noticed and acted on the connections to possible uses<sup>3</sup>. Lasers are now ubiquitous, used in barcode scanners, printers, DVD drives and hundreds of other devices. At any given time, then, there will be a stock of technologies we don’t yet know what to do with.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">Technological progress adds to that stock, while the process of ‘matching’ technologies to needs depletes it. What if technological progress accelerates? Unless the matching process also speeds up, the result is a ballooning stockpile of unused solutions. This is exactly the situation I think we are facing now.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">Let me provide two contemporary examples. The first is <a href="http://en.wikipedia.org/wiki/3D_printing">3D printing</a>. The technological know-how for this has been around since the 1980s. There have been commercial uses for it since the 1990s, though the sector has only taken off in the last 5-10 years. Most experts agree that the scope of 3D printing is limitless, that it will hasten in ‘The New Industrial Revolution<sup>4</sup>.’ But we are only just <a href="http://www.cnet.com/news/3d-printing-still-years-away-for-most-consumers-gartner/">figuring out how to use it</a>. Many of the early ventures in this space arose when someone with a particular need first came across a 3D printer and noticed that it might solve the need<sup>5</sup>. There is so much more to be done with 3D printers and I am genuinely excited to find out what imaginative uses people will find for them.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">Another example is drones, of the tabletop <a href="http://en.wikipedia.org/wiki/Quadcopter">‘quadcopter’</a> variety. These hit the mainstream relatively recently, relying, as they do, on miniaturized electronics and lightweight materials that have only become available in the last few years. They are a solution that is begging out for a need. So far their widest use seems to be to take breath-taking videos and <a href="http://www.dronestagr.am/">photographs. </a>This is great, but there is so much more that these devices make possible, especially if we recombine them with other technologies in imaginative ways. It would seem a waste if the best we come up with is <a href="http://www.businessinsider.com/amazon-testing-delivery-drones-in-india-2014-8">delivering parcels for Amazon</a>.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg1c3oA7kp9fxJQ6AI3o_fhZHjz82fEDoHq4pa9BC-we4ol3TW1-mnGTOoKaESCL-4uEZYg6gGxRuOpijhBBAkBZNLFAkkrWyH9SQdzG7DXt9fjLSUw1HAfQ_jpcHKfZA-opjx8SxPxbpS3/s1600/Eagle+in+Flight.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg1c3oA7kp9fxJQ6AI3o_fhZHjz82fEDoHq4pa9BC-we4ol3TW1-mnGTOoKaESCL-4uEZYg6gGxRuOpijhBBAkBZNLFAkkrWyH9SQdzG7DXt9fjLSUw1HAfQ_jpcHKfZA-opjx8SxPxbpS3/s1600/Eagle+in+Flight.jpg" height="250" width="400" /></a></div>
<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;"><span style="font-size: x-small;"><i>Winning image in a National Geographic / Dronestagram <a href="http://www.bbc.co.uk/news/technology-28262942">photography competition</a></i></span></span><br />
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<span style="font-size: small;"><b><span style="font-family: Georgia,"Times New Roman",serif;">The World is Full of Unsolved Needs</span></b></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">A surfeit of solutions might seem like a great thing. And it would be, except for the fact that we also have an abundance of needs, needs which these technological wonders aren’t solving. I will leave it to a future post to detail the world’s challenges, when I review <a href="http://www.jamesmartin.com/">James Martin’s</a> book ‘<a href="http://www.jamesmartin.com/book/">The Meaning of the 21st Century.</a>’ For now I’ll make two observations: (1) Even the most basic technologies for the bare minimum of living standards are failing to diffuse to the third world. Simple life-support mechanisms like <a href="http://www.who.int/water_sanitation_health/monitoring/fast_facts/en/">running water and sanitation</a> are only available to the richer half of the world’s population. (2) The world is facing <a href="http://www.changemyworldview.com/2012/05/learning-from-our-mistakes-review-of.html">environmental / ecological catastrophe</a> due to over-use of finite resources and our tendency to over-pollute. Both of these look like enormous needs, or clusters of inter-related needs. </span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">In recent history we’ve relied upon capitalist market processes to match needs and solutions. These have been enormously successful in generating the kinds of innovations that make life easier and better for rich people. But unfettered capitalism provides little economic incentive to solve problems for poor people<sup>6</sup>. Similarly, it provides no economic incentive to solve <a href="http://en.wikipedia.org/wiki/Tragedy_of_the_commons">‘tragedies of the commons’</a> such as our environmental problems. These needs require a different approach. They also, most likely, require innovations of a social variety rather than a technological variety. Other mechanisms exist to match needs and solutions, such as innovation contests, and latterly crowdsourcing. But new ones may need to be invented.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">And thus I conclude by re-iterating my main points. Innovation occurs when needs meet solutions, and this requires them to be in the same place. Most often, in the same head. There are structured ways to try and ensure this occurs, call it ‘<a href="http://www.nytimes.com/2013/04/07/opinion/sunday/engineering-serendipity.html?_r=0">engineered serendipity.</a>’ There is also a tendency for technology to be viewed as an end in itself, so that we generate myriad solutions, and bumble around in the dark until we find needs that they meet. This is a great opportunity for aspiring entrepreneurs who are familiar with an under-utilized technology. But it is also, in a sense, a waste, because right now the world has so many needs that are not being met. If we could re-engineer the production line of innovation, so that it was pull-driven instead of push-driven, we might just be able to overcome the world’s greatest challenges. </span><br />
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<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;">____________________________</span><br />
<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;"><sup>1</sup> We might term this ‘Lean Innovation’ but I wish to avoid confusion with the term ‘<a href="http://theleanstartup.com/">Lean Start-up</a>’ which is rather different.</span><br />
<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;"><sup>2</sup> This insight led Schumpeter to theorize about technological causes of <a href="http://en.wikipedia.org/wiki/Joseph_Schumpeter#Business_cycles">business cycles</a>, an often-overlooked aspect of his work.</span><br />
<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;"><sup>3</sup> One of the laser's inventor's, Charles Townes, recalls it as "<a href="http://en.wikipedia.org/wiki/Laser#cite_ref-34">a solution looking for a problem.</a>"</span><br />
<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;"><sup>4</sup> Subtitle of the book 'Makers' by Chris Anderson [the WIRED one, not the TED one].</span><br />
<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;"><sup>5</sup> See <a href="http://pubsonline.informs.org/doi/abs/10.1287/orsc.11.4.448.14602">research by Scott Shane</a> on 'Prior Knowledge and the Discovery of Entrepreneurial Opportunities'.</span><br />
<span style="font-family: Georgia,"Times New Roman",serif; font-size: small;"><sup>6</sup> As pointed out to me by a friend, there are some notable cases of profitable ventures serving the poor by engaging in <a href="http://en.wikipedia.org/wiki/Frugal_innovation">frugal</a> or <a href="http://jugaadinnovation.com/">jugaad</a> innovation, for example the <a href="http://en.wikipedia.org/wiki/Aravind_Eye_Hospital">Aravind Eye Care Hospital</a>. There is, therefore, some reason for optimism.</span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-21834277144300313952014-06-09T07:40:00.000-07:002014-06-09T07:40:30.456-07:00The Downside of Scalability: The Piracy Problem - and the Business Model Solution<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">I have written previously about how <a href="http://www.changemyworldview.com/2011/01/how-scalability-principle-can-lead-to.html">scalability is allowing enormous rewards</a> to accrue to top performers across a range of industries. This phenomenon is behind large bankers’ bonuses as well as soccer players’ and movie stars’ outsize paychecks. At first glance, scalability seems to be an attractive property of an industry to be in, if you are amongst the most capable in that industry. However, I’ve recently been considering one big downside of scalability: the way that imitation, or piracy, can erode your position. The gains to be had from scalability are fragile.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Scalability applies when the <a href="http://en.wikipedia.org/wiki/Marginal_cost">marginal cost</a> of reproducing a product or service is low-to-<a href="http://www.thezeromarginalcostsociety.com/">zero</a>*. In these circumstances, some fixed cost is expended to create a product, but then it can be distributed widely very easily. This creates a ‘<a href="http://www.changemyworldview.com/2011/05/richard-kochs-star-principle-business.html">winner-takes-all</a>’ dynamic in an industry, where customers gravitate towards the best offerings in the field. The movie industry makes most its money from a few blockbuster hits, the book publishing industry earns its profits from a handful of bestsellers, and top selling singers sell millions of records, while the majority of musicians scrape by.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Digitization means more and more industries are showing this scalability property, as digital delivery of has close-to-zero marginal cost. What used to be delivered in person can now, sometimes, be done online. For example, in the higher education industry, online courses (MOOCs) are threatening to disrupt the traditional lecturer-based pedagogical model. In finance, <a href="http://en.wikipedia.org/wiki/Exchange-traded_fund">exchange traded funds</a> (ETFs – often marketed over online trading platforms) are highly scalable and low-cost alternatives to traditional stock broking or mutual fund investments, and have already captured substantial market share.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">However, the very nature of low-to-zero-cost replication means that scalable products are the most vulnerable to piracy and imitation. The most obvious manifestation of this is digital piracy: the peer-to-peer sharing of music, movies, TV shows and software over the internet**. Piracy has led to a dramatic decline in some industries, for example the market for (legal) recorded music has been shrinking for some time. Scalability is therefore a mixed blessing, even for top performers in a given industry. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Examining the economics of piracy is rather interesting. To provide a simplified sketch: copyright holders are essentially trying to take the role of a <a href="http://en.wikipedia.org/wiki/Monopoly">monopolist</a>, arbitrarily restricting the supply of a good. They try to pick a price that maximizes their profit. The introduction of piracy creates a parallel market, with a structure resembling <a href="http://en.wikipedia.org/wiki/Perfect_competition">perfect competition</a>, in which price falls to marginal cost – which in this case is essentially zero. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">In this light, an industry becoming scalable looks destined for decline. However the erosion of profitability is not inevitable. It depends a lot on how the industry responds, and in particular on what business model the firms choose to adopt. The TV industry has weathered the digital storm far better than the music industry, with channels such as HBO going from strength to strength. This may have a lot to do with their subscription-based business model, which provides viewers unlimited usage once the fixed fee is paid.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">The music industry was amazingly slow to respond to the transition to digital media, and in fact it was new entrants such as Spotify who successfully marketed unlimited-use subscription based services. These services are far more appropriate for a digital age than the outdated notion of buying individual <a href="http://en.wikipedia.org/wiki/List_of_best-selling_albums">albums</a>. The record labels’ attempt to sustain high album prices in a digital world was misguided and hastened the album’s decline. Musicians have had to adapt by concentrating more on generating <a href="http://www.musictimes.com/articles/2591/20131202/study-shows-copyright-brings-little-revenue-musicians-live-performances-music.htm">revenue from live shows</a>, a distinctly unscalable service, now that the scalable <a href="http://en.wikipedia.org/wiki/Music_industry#Total_revenue_by_year">recorded-music revenues</a> are evaporating***. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Having praised the TV industry’s subscription based models, I should also point out that not all is well here. Many people are driven to illegally download TV shows for the simple reason that the legal ways of obtaining the shows are either inconvenient or don’t even exist at all. I would love to subscribe to Netflix, as they have some <a href="http://www.imdb.com/title/tt0367279/">great shows</a>, but they are not available in France where I’m presently based.</span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Furthermore, illegal content can be higher quality than the legitimate offerings. When I was in the US last year, I paid for and watched <a href="http://www.imdb.com/title/tt0903747/">Breaking Bad’s</a> final season using Amazon Instant Video. The first problem was that the checkout process was painful, just because I was using a British credit card. Then, having purchased the episodes, my enjoyment of the streaming video was harmed by a poor internet connection, and there was no option to download the shows. If I had downloaded whole episodes using BitTorrent instead, my viewing experience would have been, quite simply, better. </span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">In summary, scalability can be a route to massive rewards, but it can also be a path to major disappointment, when piracy or imitation prevents a top-performer from appropriating a slice of the enormous value they can create. The careful crafting of a business model can mitigate that risk, but it requires foresight and an ability to change the standard ways of doing things. Entrepreneurs have an opportunity to experiment with new ‘scalability-robust’ business models when incumbents fail to adapt – and those that succeed can transform an entire industry.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">_________________________________________________ </span></span><br />
<br />
<span style="font-size: x-small;"><span style="font-family: Georgia,"Times New Roman",serif;">* It is actually highly relevant whether the cost is low or zero. Piracy is much easier when the replication cost is zero than when it is some small but non-zero amount.</span></span><br />
<span style="font-size: x-small;"><span style="font-family: Georgia,"Times New Roman",serif;">** There are other manifestations that don’t rely on internet technology, such as taping songs playing on the radio or photocopying pages from a book.</span></span><br />
<span style="font-size: x-small;"><span style="font-family: Georgia,"Times New Roman",serif;">*** Academics concerned about the rise of MOOCs might want to take note: a demand for live tuition will likely remain, as long as (like live music) it offers a superior experience to the recorded version.
</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-69755048578318742632014-04-26T13:47:00.000-07:002016-04-20T07:04:40.704-07:00Co-opetition, Complementarity and the 'Sixth Force' of Competitive Strategy<span style="font-family: "georgia" , "times new roman" , serif;">What’s the most powerful force in the economy? If you’ve studied some basic microeconomics, you might suggest it is <a href="http://en.wikipedia.org/wiki/Perfect_competition">competition</a>, which (in theory) drives prices down to marginal cost, and maximizes social welfare. You might be drawn to a similar conclusion if you’ve studied business strategy or marketing, and learned about the importance of differentiating your offer from your competitors to prevent profits being competed away.</span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">The central thesis of <a href="http://www.stern.nyu.edu/faculty/bio/adam-brandenburger">Adam Brandenburger</a> and <a href="http://som.yale.edu/barry-nalebuff">Barry Nalebuff’s</a> 1996 book ‘<a href="http://mayet.som.yale.edu/coopetition/">Co-opetition</a>’ is that this singular focus on competition is misguided – and that co-operation is at least as important. In fact, they argue, competition and co-operation are inextricably linked, two sides of the same coin, so when they combine these words in their book title they mean it literally.</span><br />
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<i><span style="font-family: "georgia" , "times new roman" , serif;">Co-opetition along the supply chain</span></i><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">A typical firm procures some inputs – materials and services – from a set of suppliers. It adds value to those inputs, then sells the product or service on to some customer. A long <a href="http://en.wikipedia.org/wiki/Value_chain">chain </a>of many of these value-adding activities, in many different firms, will stretch from the extraction of raw materials at one end to the consumer market at the other. Brandenburger and Nalebuff point out that a firm’s relationship with its suppliers and customer has a <a href="http://en.wikipedia.org/wiki/Cooperative_game">co-operative</a> flavor, because they are working to jointly create value for the end customer at the end of the supply chain. However the relation is also competitive, because they need to bargain over how the value is distributed between them. In other words, they need to co-operate to ‘grow the size of the pie’ but then they are in conflict over ‘how to split the pie.’</span><br />
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<i><span style="font-family: "georgia" , "times new roman" , serif;">Co-opetition within an industry</span></i><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">The idea that firms within an industry are in competition with each other is well-known. Firms compete for market share, which by definition is a ‘pie’ that adds up to 100%. Firms also compete over input resources, such as ‘star’ talent and capital investment. Competition in these arenas is often fierce – so where does co-operation come into the equation? Collusion is clearly possible, but illegal. Brandenburger and Nalebuff do not advocate collusion, but they also question the need to act in a highly competitive manner all of the time. For example, they advise against aggressively pursuing a competitor’s customers with low-priced offers, as the competitor will only go on to reciprocate, stealing away your customers further down the road.</span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">Moreover, there are legitimate ways for firms within an industry to engage in <a href="http://en.wikipedia.org/wiki/Strategic_alliance">mutually-beneficial co-operation</a>. They can pool resources in a joint venture when engaging in a risky initiative, such as pioneering research and development or expansion into a frontier market. They can support 3rd party trade associations which represent the industry to the government and the press. They can sit on standards-setting organizations, and back common certification standards so that consumers are better assured about the quality of the goods and services they are buying. These co-operative strategies can benefit all the firms involved, and the end consumer, and are an increasingly important part of a corporation’s portfolio of strategic initiatives.</span><br />
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<i><span style="font-family: "georgia" , "times new roman" , serif;">The power of complementors</span></i><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">To me the single most powerful idea in the book is the concept of complementors. To quote their definition: </span><br />
<blockquote class="tr_bq">
<span style="font-family: "georgia" , "times new roman" , serif;">“A player is your complementor if customers value your product more when they have the other player’s product than when they have your product alone.”</span></blockquote>
<span style="font-family: "georgia" , "times new roman" , serif;">So essentially any pair of products or services which are typically consumed together are <a href="http://en.wikipedia.org/wiki/Complementors">complementors</a>: hot dogs and mustard, games consoles and video game software, airplanes and airports, iPods and MP3s, <a href="http://www.ft.com/cms/s/0/1a9716ce-c550-11e3-89a9-00144feabdc0.html?siteedition=intl#axzz301PgQ7Ze">cognac and karaoke bars</a>… the list is endless. Complementarity creates a form of strategic interdependence which means a co-operative strategy can be enormously effective. </span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">Brandenburger and Nalebuff use the example of Nintendo, which managed to dominate the market for <a href="http://en.wikipedia.org/wiki/Nintendo_Entertainment_System">8-bit videogame consoles</a> in the late 1980s, largely because of its control over the complementary goods – the games. It had a strong capability to design games in house, based on its history making arcade games machines, but it also cultivated a set of external suppliers, none of which was permitted to become too powerful in its own right.</span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;"><a href="http://en.wikipedia.org/wiki/Intel_Corporation">Intel </a>is another classic case example of a firm which invests in complementary technology. By helping external firms to develop applications which put high demands on the computer processor, they stimulate demand for new generations of their CPU chips. Intel’s <a href="http://www.intelcapital.com/">corporate venture capital</a> program is legendary, and while successes are rare they have hit <a href="http://www.cbinsights.com/blog/corporate-venture-capital-ipos">a few home runs</a> (the typical venture capital ‘portfolio’ approach). Unfortunately, one example which the authors dwell on in this book is, nowadays, looked back upon as a failure: Intel’s foray into video conferencing, with its ‘ProShare’ software in the early 1990s. They invested $750m in developing this technology, but never gained a critical mass of uptake*. (The irony is that when we analyze this case now, we can trace the failure of video conferencing to take off to an absence of complementary services: high speed internet connections were very rare at the time). </span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">When I came across Michael Porter’s <a href="http://en.wikipedia.org/wiki/Porter_five_forces_analysis">Five Forces framework</a> in my undergraduate course, it seemed elegant, all-encompassing and, therefore, close to perfect. From time to time, in unashamedly nerdy discussions with my colleagues we might speculate about what might be missing from this framework, how it might be improved. We never settled on a firm answer. Having read Brandenburger and Nalebuff’s book, I can now answer with conviction: that <a href="http://en.wikipedia.org/wiki/Six_forces_model">elusive ‘Sixth Force’</a> in business strategy is the presence of Complementors. </span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">A great 21st Century illustration of this is <a href="http://en.wikipedia.org/wiki/Apple_Inc.">Apple</a>. The success of Apple has not so much rested on its market power with respect to suppliers and customers (although this plays a part). The really critical success factor, the magic essence, is the large <a href="http://en.wikipedia.org/wiki/Business_ecosystem">ecosystem </a>of complementary products and services it has created around its core offerings. The music for its iPods, and the Apps for its iPhones, sold through proprietary platforms; the mobile network infrastructure and Wi-Fi hotspots on which it relies for mobile data delivery; the broad range of peripherals for its hardware which helps establish them as quintessential lifestyle devices. Apple has not just one set of complementors (which would be easy for other firms to imitate) but a whole array of them.</span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">Brandenburger and Nalebuff’s book may be approaching twenty years old, but it is still well worth a read. Their game theoretic approach to strategy is grounded in timeless principles of mathematics, so it is unsurprising that it remains relevant today. If anything the technological trend towards an ever-more interconnected world makes their message of considering complementors ever-more valuable as time goes on. </span><br />
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<span style="font-family: "georgia" , "times new roman" , serif;">_____________________</span><br />
<br />
<span style="font-family: "georgia" , "times new roman" , serif;">*For a detailed account of Intel's strategy during the 1990s - including its errors - I can recommend <a href="http://www.imperial.ac.uk/AP/faces/pages/read/Home.jsp?person=a.gawer&_adf.ctrl-state=42nff4m6u_3&_afrRedirect=2460276491958230">Annabelle Gawer</a> and <a href="http://web.mit.edu/cusumano/www/">Michael Cusumano's</a> excellent book <a href="http://www.platformleadership.com/">Platform Leadership</a></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-51989367377449265462014-03-12T05:39:00.003-07:002014-03-12T05:42:23.292-07:00We Need to Talk About Robocop<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0A4Rba5K9T5jt7fB5R0ofgWevOYCjWhRebG9MJy8TMojOQvZZeSDXxKyqwdObdJM6PkCGvDBKvGY2ZQ0KdwCE4QLsg3Aa_HGIjIdjKFQNh9XtJxLYrgPv_UGDRpTzCxlu6abuIqOCAmvX/s1600/robocop_poster_p_2013.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0A4Rba5K9T5jt7fB5R0ofgWevOYCjWhRebG9MJy8TMojOQvZZeSDXxKyqwdObdJM6PkCGvDBKvGY2ZQ0KdwCE4QLsg3Aa_HGIjIdjKFQNh9XtJxLYrgPv_UGDRpTzCxlu6abuIqOCAmvX/s1600/robocop_poster_p_2013.jpg" height="320" width="213" /></a><span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">I’ve recently seen the 2014 version of <a href="http://en.wikipedia.org/wiki/RoboCop_%282014_film%29">Robocop</a>. As an action movie, it is somewhat disappointing, but as a piece of social commentary it is extremely thought provoking. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Set in the not-too-distant-future, the film opens with a scene in a Middle Eastern town where US troops are ‘peacekeeping’ with the assistance of militarized robots. These are depicted in the film as <a href="http://www.omnicorp.com/products/ed-209.php">two-legged vehicles with in-built AI brains</a>, an array of scanners, and a variety of deadly weapons. The public relations arm of the <a href="http://www.omnicorp.com/">defense company</a> which supplies the robots is broadcasting the patrol live, to prove how effective robotic peacekeepers are. Their aim – to have the law in the United States changed to permit the use of robots for law enforcement there – a market worth many billions of dollars. Their attempted propaganda backfires when a group of rebels attacks the patrol, and one of the robots guns down a young child that it identifies as a ‘threat.’<br />
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While the movie is pitched as science fiction, this particular scene had more than a touch of present-day reality to it. The only two differences are that today’s military drones are <a href="http://en.wikipedia.org/wiki/Combat_drone">aircraft</a> (not walkers), and they are piloted remotely by humans on the ground (rather than onboard AI). They are still used with impunity across the <a href="http://www.theguardian.com/world/2014/mar/10/uk-reaper-drones-africa-middle-east-mod-afghan">Middle East</a> for the targeted killing of (suspected) rebels, with <a href="http://www.livingunderdrones.org/">substantial collateral damage</a>. The justification for their use – to ‘save lives of American servicemen and women’ – is the same as in the film. While the President finds it unproblematic to deploy them abroad, the concept of using them on home turf is far more controversial. In the film, the harassment by robots breeds discontent and rebellion amongst the occupied population. Similarly, in the real world, drones have been described as <a href="http://www.businessinsider.com/obamas-covert-drone-war-in-yemen-prompting-more-terror-2012-5">“Al Qaeda's best recruitment tool ever”</a>.<br />
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The technological trends point towards computers being in the driving seat in future. The movie puts the spotlight on two central moral dilemmas of using computer algorithms to make life-or-death decisions. Firstly, the great strength of algorithms – that they have no emotion, so are prone to neither biases nor fear – is also a key weakness. The absence of empathy means that a computer will be unable to replicate the nuances of human judgment. Secondly, algorithms are touted as removing scope for ‘human error’. But if a computer algorithm takes a human life it is not meant to, who is responsible? Presumably if artificial intelligence becomes sufficiently sophisticated, the artificial entity itself has moral culpability. But discounting full AI, could we hold an individual programmer responsible? Or the company that manufactures the robot? This is, as yet, far from clear, and these questions are just as relevant when we <a href="http://www.theguardian.com/technology/2013/oct/20/artificial-intelligence-impact-lives">consider civilian applications of robotics</a> e.g. in factories, or in self-driving cars, which are very much present-day concerns.<br />
<br />
We also need to debate the legitimate use of technology by the State. We have seen from <a href="http://www.theguardian.com/world/edward-snowden">Edward Snowden</a>’s leaks that the State (at least, US and UK governments) is willing to use every technological tool possible to enhance its own power and entrench its position. Civil servants and security contractors assume a pragmatic mindset and swat away any concerns they might have about morality. The very phrase ‘National Security’ seems to obliterate any civil rights of the Individual. This is something we must bear in mind if we think the idea of robotic policemen or ‘search and destroy’ drones deployed one home turf seems implausible. <br />
<br />
A final remark is that there is a very real chance that robots may soon constitute a new class of <a href="http://en.wikipedia.org/wiki/Weapon_of_mass_destruction">Weapon of Mass Destruction</a>. The pattern of the 20th Century was for scientists to create lethal weapons (nuclear, chemical, biological), national governments to use them on some enemy, then later, upon realizing their potential to devastate entire populations, to <a href="http://en.wikipedia.org/wiki/List_of_weapons_of_mass_destruction_treaties">declare them illegal</a>. The potential problem with declaring something illegal after using it is that it might not work next time – the weapon might be sufficiently destructive that it annihilates its creator. This has long been explored in science fiction – from <a href="http://en.wikipedia.org/wiki/John_Wyndham">John Wyndham</a>’s <a href="http://en.wikipedia.org/wiki/The_Day_of_the_Triffids">Day of the Triffids</a>, to Michael Crichton’s Prey; from James Cameron’s <a href="http://en.wikipedia.org/wiki/The_Terminator">Terminator</a>, to Danny Boyle’s <a href="http://en.wikipedia.org/wiki/28_Days_Later">28 Days Later</a>. Now it is something we must take seriously as a future scientific reality.
</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-59205619366531083362013-12-13T11:09:00.000-08:002013-12-13T11:09:00.975-08:00How Much Debt is Good Debt?<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Debt is now one of the most talked about issues in current affairs. Debt seems to be everywhere. Governments are borrowing to finance their spending. House buyers are taking on mortgages to 'get on the housing ladder,' and millions of young people are borrowing to <a href="http://www.theguardian.com/money/student-debt-us">put themselves through college</a>. The slightest sign that interest rates might change can send shockwaves through financial markets.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">But debt has got a bad name. Excessive mortgage lending lay behind the <a href="http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308">2008 financial crisis</a>, inflating a house price bubble while parceling out financial risk to investors distant from the original loans. National governments around the world, from the <a href="http://en.wikipedia.org/wiki/List_of_countries_by_public_debt">US to the UK, Greece to Japan</a>, are struggling under piles of debt; many countries have received bail-outs and others are on the brink of default. And student loans have created a higher education bubble, with so many students graduating from Universities that many now struggle to find ‘graduate-level’ employment [the Financial Times has run <a href="http://www.ft.com/indepth/class-of-the-crunch">some fascinating analysis</a> of the situation in the UK - helping confirm <a href="http://www.changemyworldview.com/2010/11/correction-debt-free-aged-fifty-three.html">my earlier conclusion</a> that the new tuition fees regime is hopelessly unsustainable].</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">As a result we see much talk of 'deleveraging,' meaning a reduction in the overall level of debt in the economy. This process is inevitably a source of economic stress, at least in the short run. If people slow down their spending, in order to pay off their debts, the economy stops growing and may go into recession. This phenomenon lay behind Japan's economic stagnation since the early 1990s, and seems highly likely to take hold in Europe.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">All this begs the question, how much debt is good debt? We could moralize about the issue, and say no debt is good, a position taken by some religions and political ideologies*. At the opposite end of the spectrum, the <i>laissez faire</i> view would suggest any debt is acceptable so long as both parties are happy to enter in to it. However, it was this attitude that led to the financial crisis. The structure of the financial system was set up in such a way that there were huge problems of incentive misalignment, information asymmetry and misjudged risks.</span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">To answer the question 'how much debt is good debt' we need to go back to some straightforward economic fundamentals. Taking out a loan is good so long as we invest the money we receive in something that yields a return greater than the interest payments required. The archetypal example is someone purchasing a car on credit. Owning a car means greater mobility, thus a greater range of employment opportunities and higher future wages. The extra wages can then pay off the debt. This cost-benefit calculus is the best way to assess whether a loan is wise, whether you are a government minister looking to borrow <a href="http://en.wikipedia.org/wiki/High_Speed_2">$50bn for rail investment</a>, or a young person borrowing $200k to go to college.</span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Seems simple, so what's the problem? The problem is that we rarely know with any precision whether what the future return is on our invested cash. For government infrastructure projects, <a href="http://pwc.blogs.com/files/hs2---delivering-a-return-on-government39s-investment.pdf">teams of consultants</a> are hired to make projections 30 years into the future - but in truth their estimates are little better than guesswork. No one can possibly foresee how the transportation market will progress in the next 30 years. Likewise, it is fruitless for a young person to try and guess how much a University degree will be worth over the course of their career. The UK government is keen to highlight statistics such as 'Graduates earn an <a href="http://news.bbc.co.uk/2/hi/uk_news/education/8401267.stm">average of £100k more</a> than non-graduates over their career,' but this is disingenuous, in fact it is <a href="http://www.timeshighereducation.co.uk/420403.article">dangerously misleading</a>. While the statistical methods used to calculate this are <a href="https://www.gov.uk/government/publications/university-degrees-impact-on-lifecycle-of-earnings">quite sophisticated</a>, and take into account that it is more able students who choose university, the analysis faces the fundamental difficulty that it uses historical data. It is therefore inappropriate to draw the inference that this 'graduate premium' will continue to apply, since far more young people are now going to University.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">One economist who understood the risks of debt and its role in financial crises was <a href="http://en.wikipedia.org/wiki/Hyman_Minsky">Hyman Minsky</a>. Minsky identified <a href="http://en.wikipedia.org/wiki/Hyman_Minsky#Minsky.27s_theories_and_the_subprime_mortgage_crisis">three types</a> of borrowers. The first are genuinely creditworthy, the ‘hedge borrowers,’ able to pay back both principle and interest from incoming cash flows. The second are ‘speculative borrowers,’ able to keep up their interest payments, but not to pay back capital. The third are 'Ponzi' borrowers, who can pay back neither capital nor interest from their cash flows, and rely on asset values appreciating indefinitely – which they clearly cannot.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Minsky saw that in a booming economy, more and more credit is extended until it is eventually offered to the Ponzi borrowers. When it becomes clear that much of the capital will never be repaid, the boom turns into bust, and falling asset values can drive all three types of borrowers to default, even creditworthy hedge borrowers. As the economist <a href="http://www.economonitor.com/nouriel/2007/07/30/are-we-at-the-peak-of-a-minsky-credit-cycle/">Nouriel Roubini foresaw</a>, this cycle describes well what played out in the 2008 financial crisis.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Unfortunately Minsky’s work still lies <a href="http://www.economist.com/blogs/freeexchange/2010/01/the_fed_discovers_hyman_minsky">outside of the mainstream</a> of economic education. Until more economists take the <a href="http://www.changemyworldview.com/2013/07/is-economics-on-verge-of-paradigm-shift.html">vicissitudes of human behavior</a> into account, and take Minsky’s work more seriously, I fear we won’t learn from history, and so we are <a href="http://en.wikiquote.org/wiki/George_Santayana">condemned to repeat it</a>.</span></span><br />
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<span style="font-size: x-small;"><span style="font-family: Georgia,"Times New Roman",serif;">*Sharia law, for example, forbids interest payments and requires any loan to be backed by a physical asset with an associated income stream; it is telling that Sharia-compliant investment products fared better than Western funds during the recent crisis.
</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-57252905570162836542013-08-18T10:01:00.003-07:002013-08-19T12:51:38.185-07:00Nassim Nicholas Taleb's Antifragile in 1000 Words (not 500 Pages)<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPNGvelBc3mneim-HJPSiFXElB0EdbuD7hp3B979YuwFmm_m4r_MbzbKeHO7vOoHopdq31M0rcgcH-pt6WgG9J4AfEgzF4vHFK6B91tWu30Eu197_jbHCFD3nOELtjgbloUUHK-lXKDUYw/s1600/Antifragile+cover.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPNGvelBc3mneim-HJPSiFXElB0EdbuD7hp3B979YuwFmm_m4r_MbzbKeHO7vOoHopdq31M0rcgcH-pt6WgG9J4AfEgzF4vHFK6B91tWu30Eu197_jbHCFD3nOELtjgbloUUHK-lXKDUYw/s320/Antifragile+cover.jpg" width="208" /></a><span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">What is the opposite of ‘fragile’? Most of us would naturally give the answer ‘robust’ or ‘resilient.’ <a href="http://en.wikipedia.org/wiki/Nassim_Nicholas_Taleb">Nassim Nicholas Taleb</a>, however, points out that this is incorrect. An object is fragile if it suffers <b>negative </b>consequences from volatility or stress, he reasons. The direct opposite, then, is not a <b>lack </b>of consequences, as robustness implies, but rather <b>positive</b> consequences from volatility or stress. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Thus Taleb introduces the concept of <b>‘<a href="http://en.wikipedia.org/wiki/Antifragile:_Things_That_Gain_from_Disorder">antifragility,</a>’</b> the central idea to which everything else in his book is tied back. He argues that antifragility is a very general concept, but one that has been pretty much overlooked in science and philosophy up until…his book. He provides examples of things-that-are-antifragile in a wide range of domains. In physiology, muscles strengthen after being stressed; in finance options become more valuable when markets are volatile; in the media an attempt to supress information leads to its wider dissemination (the <a href="http://en.wikipedia.org/wiki/Streisand_effect">Streisand effect</a>). Evolutionary processes lead to antifragility at the system level as environmental volatility kills off weaker members of the population.
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Once you get beyond the enticing prologue, the rest of Taleb’s tome is a rather painful read. It contains many interesting ideas but they are wrapped into an exposition that seems designed to alienate. Taleb expresses a disdain for most other human beings, and comes across as an arrogant know-it-all. To give an example, even though Taleb lauds the efforts of entrepreneurs in taking risks and pushing forward technological progress, he gives obnoxiously unflattering descriptions of the few technology practitioners he has actually met:
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“Technothinkers tend to have an ‘engineering mind’ – to put it less politely, they have autistic tendencies. While they don’t usually wear ties, these types tend, of course, to exhibit all the textbook characteristics of nerdiness – mostly lack of charm, interest in objects instead of persons, causing them to neglect their looks. They love precision at the expense of applicability. And they typically share an absence of literary culture.” [p.314]
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As an <a href="http://www.changemyworldview.com/2011/01/how-scalability-principle-can-lead-to.html">ardent fan</a> of Taleb’s earlier books, “<a href="http://en.wikipedia.org/wiki/Fooled_by_Randomness">Fooled by Randomness</a>” and “<a href="http://en.wikipedia.org/wiki/The_Black_Swan_%282007_book%29">The Black Swan</a>” I made the effort of seeing this one through to the end<sup>1</sup>. As such, I shall try to summarize three of its core concepts, which in addition to the notion of antifragility, make up the meat of the book.
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<b>1.) Non-linear Effects
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The human mind deals quite easily with linear effects. Double an input and, as a first approximation, we tend to expect output to roughly double. If you drive twice as fast you get to the destination in half the time. If you put in 10% more effort you expect a result 10% better, and perhaps to end up 10% more tired afterwards. </span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjGGBVHYzcMGw4l5TAPO-oZHCvEHQmfC33cn167ZfErTKzqj9wX5QyKFQF4kwQ40CeRVWXPk_V6mEkpjHY-RelvSAoMM0-GMahTrsTGOJT6ykU6ipnlnZXft486y72o9OXhI4tVT8bKRk84/s1600/Graph.jpg" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" height="347" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjGGBVHYzcMGw4l5TAPO-oZHCvEHQmfC33cn167ZfErTKzqj9wX5QyKFQF4kwQ40CeRVWXPk_V6mEkpjHY-RelvSAoMM0-GMahTrsTGOJT6ykU6ipnlnZXft486y72o9OXhI4tVT8bKRk84/s400/Graph.jpg" width="400" /></a><span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br />
We find non-linear effects less intuitive. For example if you drive twice as fast you use up four times as much energy, so your fuel costs will be four times higher. And in some circumstances, being 10% better than average at something can earn a payoff 100x the average. In reality, non-linear effects abound.
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In Taleb’s earlier books he looks at our poor understanding of probability, and so in this book he combines this with the concept of non-linear effects. Fragility, for example is a non-linear response to a shock, where small shocks have no effect but large shocks have a catastrophic effect. This changes our interpretation of variance<sup>2</sup>: an increase in variance makes large shocks, and thus catastrophic impacts, more likely. A high variance regime is therefore qualitatively different from a low one. We observed this in the financial markets in 2007-08 when the above-normal volatility brought us close to financial Armageddon.
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<b>2.) Causal Opacity
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Uncertainty is one of Taleb’s favourite topics, and in this book he focuses a lot on the uncertainty that surrounds causal relationships. He is extremely sceptical of theories about causal mechanisms. Many systems in the world are highly complex, so our attempts to rationalize them are often futile. It is wiser to be honest about our ignorance and focus instead on empirical regularities and phenomena than abstract theories.
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A key field in which this philosophy has practical implications is medicine. Taleb believes we should rely on medical intervention a lot less than we presently do. His key insight here is that the negative side-effects of interventions are potentially large, and intrinsically opaque. Some side effects take decades, or generations, to manifest. The risks inherent in any medical treatment are impossible to quantify, so the wise approach is to be conservative and only intervene for very serious conditions.
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Taleb further points out that doctors and pharmaceutical firms have skewed incentives in favour of providing treatments. Doctors want to be seen to be doing something – and Pharma companies want to make a profit. Taleb urges readers to be resilient to minor problems, letting the immune system do its job; after all, the immune system is the result of millennia of evolution which has given us a degree of antifragility.
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<b>3.) The Ethics of Transfers of Fragility
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It is clear throughout the book the Taleb harbours a visceral anger towards the Western elite, firstly for promoting a culture of competitive materialism, and secondly for fixing the system so the dominance of the elite is perpetuated.
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Taleb identifies that transfers of fragility (and antifragility) are a key method by which those with power prosper. A transfer of fragility means we make ourselves antifragile (i.e. susceptible to large gains) by making others more fragile (i.e. vulnerable to large losses). Many examples of this exist in the asymmetries of the financial system. For example fund managers take a large proportion of their fund’s profits but do not pay up if the fund make a loss. A bond trader who makes a large profit gets a bonus, but the worst-case if he or she makes a large loss is to get fired, while the loss is borne by the bank. Even the banking system as a whole has an asymmetric incentive to take risks as it can be bailed out by the government if it loses.
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The more fundamental insight is that while we tend to notice first order monetary transfers (e.g. taxes and welfare payments), we also need to think probabilistically about such transfers. Any conditional cash transfer can been viewed as a probability distribution, so we must consider the higher order moments, for example the variance and skewness, of these distributions when we consider the ethics of such transfers. A transfer that seems equitable and ethical if we look at the ‘expected’ payoff may be quite biased once we take the whole probability distribution into account.
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Taleb is clearly an intelligent guy, so I can only conclude that the abrasive presentation in much of his book is a result of his disdain for copy editors and an attempt to cause controversy. I could easily have written an entire blog post about the things I dislike about the book. However it does contain many ideas of value, of which I hope I have given you a flavour here. </span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">1 If you do decide to pick up a copy of Antifragile, my suggested reading plan would be the prologue and Book 1, then skip directly to Books 5, 6 and 7.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">2 And not just variance: the interpretations of the other higher moments change, with skewness and kurtosis also important.</span></span><br />
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David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com1tag:blogger.com,1999:blog-2766189576050977240.post-92127884107344339322013-07-23T10:52:00.000-07:002013-07-23T10:57:12.521-07:00Is Economics On the Verge of a Paradigm Shift? David Orrell's Economyths and the Perils of Financial Engineering<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOO_rnsuosJNj6YvrwbD2AQaG_CBBLR56Ks5iVNsTwcPkRD9mU2BhNlZisI9nK1Q0bL0-gYmzZXtOWgVNCb2i0QSk-__O-kSNk3-zi637dRZDUET2gCuGWriDCOsdaqhxJWhH1VEqpbZEk/s1600/Economyths+Cover2.jpg" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOO_rnsuosJNj6YvrwbD2AQaG_CBBLR56Ks5iVNsTwcPkRD9mU2BhNlZisI9nK1Q0bL0-gYmzZXtOWgVNCb2i0QSk-__O-kSNk3-zi637dRZDUET2gCuGWriDCOsdaqhxJWhH1VEqpbZEk/s200/Economyths+Cover2.jpg" width="131" /></a><span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Is economics on the verge of a paradigm shift? This is the question raised by <a href="http://www.postpythagorean.com/">David Orrell’s</a> excellent book <a href="https://www.facebook.com/Economyths">Economyths</a>, in which he dissects the flaws at the heart of neoclassical economics and argues <i>not only</i> that it is not fit for purpose, but that it is responsible for many of society’s current problems. As a book that sets out to ‘change your world view’ it really fits the theme of this blog. While I had <a href="http://www.changemyworldview.com/2012/09/the-perils-of-relying-on-gdp-in.html">an existing scepticism</a> of the state of economics when I began reading it, the book has really opened my eyes to the breadth and depth of the problems, and did so in a rigorous but also highly readable way.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">The book is neatly structured in ten chapters, each of which is focused on different problem with economics. Orrell re-visits the early thinkers from the <a href="http://en.wikipedia.org/wiki/Classical_economics">classical school</a> of economics to tease out where the foundational assumptions of the field came from. It turns out that many of the problems of modern economics can be traced back to the influence of physics, which led to an atomistic and deterministic view of human behavior. This paradigm served us well initially, and led to some useful insights about the nature of markets. But economics has become elevated to the status of mathematics, in which any theorem is deemed to be true as long as it can be derived from the accepted axioms. Few academics at the heart of the economics establishment outwardly question these axioms, and those that do are often marginalized and labeled as ‘<a href="http://en.wikipedia.org/wiki/Heterodox_economics">heterodox</a>’ <sup>1</sup>. In trying to become more like a science, economics has ended up becoming more like an ideology.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Orrell describes a wealth of data that should lead us to doubt the axioms and theorems of neoclassical economics. People are not rational; markets are not efficient; the policy prescriptions drawn from economics aren’t working. He deftly draws on some of the alternative schools of economics (e.g. behavioral economics, ecological economics) and brings in the work of some allied fields that could have major implications for the way we think about the economy (e.g. neuroscience, psychology). Far from being a pessimist, he points towards some areas of scholarship that could be the basis for a paradigm shift in economics, highlighting in particular the fields of network theory and complexity theory<sup>2</sup>.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Having attempted to summarize the book, I would like to highlight one idea in particular which plays a small role in the book but made a big impression on me. Dwelling on the modern job title of ‘financial engineer’ (people who develop new financial products, such as <a href="http://en.wikipedia.org/wiki/Collateralized_debt_obligation">CDOs</a>, <a href="http://en.wikipedia.org/wiki/Credit_default_swap">CDSs</a>, etc.) Orrell observes that in every traditional engineering discipline there is a formalized code of practice and a requirement to build a ‘<a href="http://en.wikipedia.org/wiki/Factor_of_safety">factor of safety</a>’ into the system<sup>3</sup>. In fact safety-critical mechanical and structural products typically have a safety margin of over 100% (i.e. they can withstand double the load or stress they are designed for before they break). This extra layer of redundancy means that even when the products (whether cars, airplanes, or buildings) encounter extraordinary conditions, outside of their design specification, they will still function. When a product fails, the firm that built it is legally liable for losses and the engineer who designed it can be personally held responsible.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">One could well imagine that the effective functioning of the economy might be deemed safety-critical. A malfunctioning economy leads not just to discomfort but to starvation, deprivation and a <a href="http://www.nytimes.com/2012/11/05/health/us-suicide-rate-rose-during-recession-study-finds.html?_r=0">rise in the suicide rate</a>. And yet there is no formalized code of practice for modern financial engineers<sup>4</sup>. They do not have to build in margins of safety into their products. They are not held accountable when the products they develop fail. This observation is not just based on the 2008 financial crisis, in which financial engineering playing a massive part, but in many previous crises such as the <a href="http://en.wikipedia.org/wiki/Den_of_Thieves_%28Book%29">junk bond debacle</a> in the 1980s and the bankruptcy of Enron in 2001.</span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Prompted by Orrell’s comparison, I’ve begun thinking about other sectors in which unorthodox types of ‘engineer’ are involved in developing mass market, safety-critical products. <a href="http://en.wikipedia.org/wiki/Food_engineering">Food engineering</a> is an interesting one: a majority of food we eat in the West has been processed by a big corporation and has been mathematically optimized to be as appealing as possible for the least possible cost to the producer. This is why the foods contain so much <a href="http://michaelmossbooks.com/books/salt-sugar-fat/">Salt, Sugar and Fat</a> (the title of another book I want to read, by Michael Moss). To the companies, the long-term health effects of these products are a secondary concern, and if we get ill it isn't the food companies that will be held liable. How would things be different if food engineers were held to the standards of traditional engineers? Could they build in a ‘margin of safety’ to make it hard for us to over-consume unhealthy ingredients, and easy for us to get the nutritional sustenance that we need?</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Economyths is far from the only book out offering a penetrating critique of the financial system, but it is one of the best<sup>5</sup>. Moreover, by pointing towards possible paths forward it goes further than many other books in the ‘crisis economics’ genre. Orrell shows that the crisis isn’t just with the financial system, but with the intellectual system that underwrites it, and as <a href="http://en.wikipedia.org/wiki/Thomas_Kuhn">Thomas Kuhn </a>pointed out, it is a sense of intellectual crisis which acts as a catalyst of ‘<a href="http://en.wikipedia.org/wiki/The_Structure_of_Scientific_Revolutions">scientific revolutions</a>.’ If Orrell is correct, a scientific revolution in economics is already underway.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">1 Interestingly Orrell suggests that many economists are unhappy with the current state of affairs, but don’t question it in public for the sake of their careers and credibility.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">2 I was pleased to read this as both these fields are close my own interests.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">3 Upon Googling '<a href="http://en.wikipedia.org/wiki/Margin_of_safety_%28financial%29">margin of safety</a>' the first reference I find is to an appropriation of the term in the field of value investing, so while the concept clearly exists in finance it is not part of a financial engineer’s design responsibility.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">4 The CFA Institute's Code of Ethics is probably the nearest equivalent, but it is rather narrowly applicable to fund managers, who by all accounts seem to routinely flout it anyway.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">5 Another one which I’ve just begun reading is Nassim Nicholas Taleb’s polemic Antifragile – I look forward to reporting on it shortly.</span></span><br />
<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><br /></span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com4tag:blogger.com,1999:blog-2766189576050977240.post-74375638677856089582013-07-04T14:15:00.001-07:002013-07-04T14:15:19.474-07:00Why David Cameron's Foreign Trade Claims are Flawed<span style="font-family: Georgia,"Times New Roman",serif;">I don’t tend to pick on individual politicians to criticize, but David Cameron’s piece in today’s London Evening Standard newspaper is worthy of some commentary. You can find the article <a href="http://www.standard.co.uk/comment/comment/david-cameron-battersea-is-a-symbol-of-britains-renewal-8687882.html">here</a>.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">Let’s analyze what he says:
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<span style="font-family: Georgia,"Times New Roman",serif;"><i>“This country is in a tough global race to succeed… the world does not owe us a living, we have to earn it.”</i> – this much I agree with. We are, indeed, part of a global economy in which countries compete for economic activity.
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<span style="font-family: Georgia,"Times New Roman",serif;">But the message of Mr. Cameron’s piece is that we are being successful at <b>attracting foreign investment</b>. He trumpets major capital investments from abroad in the UK telecoms and energy industries and in real estate development. He seems to entirely miss <a href="https://en.wikipedia.org/wiki/Balance_of_trade">the point</a> that the kind of economic competitiveness that matters most is the ability to produce exports.
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<span style="font-family: Georgia,"Times New Roman",serif;">As a nation, the UK consumes vast amounts of imported goods, mostly paid for on credit, and as long as the country fails to increase its own exports, it will be increasingly indebted to the countries that supply these goods. Imports help people live wealthy-seeming lifestyles today, but then the debts are left over for future generations to pay off.
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<span style="font-family: Georgia,"Times New Roman",serif;">The three industries mentioned above, telecoms, energy and real estate, are all services sold back to the people within the country. No exports there, I’m afraid. Just highly inflated housing prices in London, as a direct result of foreign investment in the capital’s real estate. Well done, Mr. Cameron, for attracting all of that investment. Kudos.
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<span style="font-family: Georgia,"Times New Roman",serif;">Something that might benefit the country, and lead to products and services we can export, is innovation activity. And a good way to stimulate innovation is by supporting entrepreneurship.
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<span style="font-family: Georgia,"Times New Roman",serif;">Maybe Mr. Cameron realizes this, as he says, <i>“the red carpet is rolled out for entrepreneurs.”</i> But for some reason that doesn’t ring true, for example if the would-be entrepreneurs are from outside the EEA and have to jump through laborious hurdles just to get a visa. Last week Theresa May <a href="http://www.ft.com/cms/s/0/f7a0d960-dcfd-11e2-b52b-00144feab7de.html">announced a new policy</a> clearly tailor-made to attract thousands of foreign entrepreneurs: a £3,000 bond that must be deposited before visitors from some select countries are even allowed in the country. Cameron, to his credit, had the good sense to quash this one, but in generating so much uncertainty and confusion much damage has already been done. The sudden and arbitrary changes that are regularly being made to the Byzantine student visa and post-study work visa regulations also exemplify the country’s enthusiasm for attracting talented foreigners.
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<span style="font-family: Georgia,"Times New Roman",serif;">The third thing that irritated me in the article is Cameron’s joke about his most recent trade mission, <i>“Just last weekend <a href="http://www.guardian.co.uk/politics/2013/jul/01/david-cameron-business-amnesty-kazakhstan-deal-nazarbayev">I was in Kazakhstan</a> (but I missed out on the camel’s milk).”</i>
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<span style="font-family: Georgia,"Times New Roman",serif;">I will leave critiques of his sense of humour for another time. Why, I ask, is our Prime Minister visiting Kazakhstan to attract investment, a country that ranks <a href="http://www.transparency.org/country#KAZ">133rd out of 176 </a>in Transparency International’s corruption perceptions index, and in the bottom 15% of the World Bank’s control of corruption measure? A country that <a href="https://en.wikipedia.org/wiki/2011_Mangystau_riots">shoots dead protesters</a> who dare to oppose the oil and gas industry? Is it because these <a href="http://www.guardian.co.uk/world/2013/may/20/uk-approved-arms-exports-saudi-arabia">unstable, autocratic, petrodollar-backed regimes</a> are the only ones who both need and can afford one of our biggest actual exports, namely weapons?
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<span style="font-family: Georgia,"Times New Roman",serif;">Cameron has the gall, two paragraphs later, to trumpet the UK’s <i>“stable democracy, where there are property rights and the rule of law.”</i> He clearly cares very dearly about these things. We may as well put out a sign saying, “Billionaire oligarchs from despotic backwaters welcome here!”
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<span style="font-family: Georgia,"Times New Roman",serif;">Then, finally, comes the Battersea Power Station project, the <i>“jewel in the crown”</i> of the infrastructure investments Cameron cites. This will be backed by an £8bn investment and will <i>“create 15,000 jobs.”</i> Never mind the fact that jobs created on building projects are only ever temporary, and no substitute for sustainable job-creation. The thing that struck me here was the irony of it. The source of the funding – <span id="goog_1942257591"></span>Malaysia<span id="goog_1942257592"></span>.
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<span style="font-family: Georgia,"Times New Roman",serif;">Maybe Mr. Cameron is not familiar with the history of economic crises, but if he were he would surely stop boasting about foreign investment being the route to riches. Malaysia, Thailand, Indonesia and their neighbours know this well, from their experience of a <a href="http://en.wikipedia.org/wiki/1997_Asian_financial_crisis">financial crisis in 1997</a>. Long before the credit crunch showed the Western world that laissez-faire capitalism has its risks, South East Asia experienced a severe currency crisis and long recession due to the aggressive inflow and then flight of foreign capital. Foreign investment is neither a stable nor a sustainable route to economic growth.
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<span style="font-family: Georgia,"Times New Roman",serif;">Whether the Battersea project will come to fruition remains to be seen, and I don’t have strong opinions either way (I give its odds of success maybe 1 in 3). But its use by Mr. Cameron as a piece of propaganda is entirely disappointing. Economic growth is important (though not nearly as important as most politicians think) and if the UK wants to pursue it the country needs to look for competitive industries inside its borders that create value for customers elsewhere. There is, perhaps, one investment referenced in the article that involves exports: the Tata group’s purchase and expansion of <a href="http://en.wikipedia.org/wiki/Jaguar_Land_Rover">Jaguar-Land Rover</a>. This investment has helped re-juvenate British manufacturing and create long-term jobs. When Mr. Cameron comes back with more of these type of investments to shout about, it might be worth getting excited about.
</span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-49665292030992337712013-05-26T09:47:00.000-07:002013-05-26T09:52:36.816-07:00What is the Half Life of a Social Network? The Problems of Digital Baggage and a ‘Move Fast and Break Things’ Philosophy<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">It is a little over a year since Facebook went public in <a href="http://en.wikipedia.org/wiki/Initial_public_offering_of_Facebook">a c.$90bn IPO</a>, and I find myself amongst a growing group of people questioning what the future holds for ‘The Social Network’. Social media is a new industry and the rules of competition are being discovered as we go along. And the same things that caused Facebook’s meteoric rise may end up making it irrelevant.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Online technology companies (by which I mean social media as well as services such as search, email, blogging, etc…) face the unenviable situation of being violently pulled in <a href="http://en.wikipedia.org/wiki/Ambidextrous_organization">two directions at once. </a>On the one hand is the imperative for constant change: that constant struggle to capture the attention of the general public while hundreds of competitors are trying to do a similar thing. In this light we see firms as locked in an arms race, repeatedly adding features and revising designs in a bid to stay fresh. On the other hand, there is the need to provide consistency and reliability in the service being provided. Users become accustomed to the current set of features, so any changes will tend to cause discomfort and lead to inevitable outcries.
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">In a way this tension is faced, in some form, by all businesses. But in the online tech industry it is particularly acute, because there are such low barriers to entry, and thus there are so many entrants trying to displace whoever is leading at any point in time. There is also an implicit premium on mere ‘newness’ as trend-setting users like to explore new services in order to be ‘at the forefront.’
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">In most industries, the most common problem is resistance to change, an inability to adapt to changing user needs and changing social pressures. It’s my strong feeling that in social media, the opposite problem holds. Companies like Google and Facebook are pioneers at experimentation, trialing possible changes with randomized subsets of users, and implementing the ones that appear to work on a wider scale. This is epitomized in Mark Zuckerberg’s famous management philosophy: “<a href="http://blog.sfgate.com/techchron/2012/02/01/facebooks-hacker-way-move-fast-and-break-things/">Move Fast and Break Things.</a>”
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">The problem is that while this philosophy may be suitable for a small or mid-sized start-up, it suddenly becomes a lot more dangerous for a large corporation. With every change that is pushed through, Facebook risks alienating some fraction of its users, and of those, some fraction is likely to disengage (see my <a href="http://www.changemyworldview.com/2010/05/facebook-big-new-story-that-was.html">comments on community pages in 2010</a>). Take, for example, <a href="http://mashable.com/2013/05/07/facebook-edgerank-infographic/">Facebook’s algorithm</a> for deciding what gets put on your Newsfeed. This is one of its most important pieces of technology, as it determines both how users interact with each other, and how advertisers interact with users. When this algorithm is changed, it will always have the effect of giving some posts more attention and other posts less attention – and the people or businesses getting less attention will be irritated. I noticed this last year, when Facebook changed the algorithm at the same time as it introduced paid-for “promote this post” options, earning the moniker '</span></span><span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><a href="http://dangerousminds.net/comments/facebook_i_want_my_friends_back">The Biggest ‘Bait N’ Switch’ </a><a href="http://dangerousminds.net/comments/facebook_i_want_my_friends_back">in History</a><i>'</i></span>. I’ve also noticed <a href="http://bits.blogs.nytimes.com/2013/03/03/disruptions-when-sharing-on-facebook-comes-at-a-cost/">another change</a> in the last few months, which has led to my newsfeed being filled with less relevant posts (and more advertising than before) and my own posts getting less attention than they used to. I am already changing my Facebook engagement habits as a result, and using Twitter more as a source of interesting links.
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">This excess of change is far from the only risk. Two others are worth highlighting. <a href="http://www.ft.com/cms/s/0/8b7ab90e-bc91-11e2-b344-00144feab7de.html">An article in the Financial Times last week</a> focused on investor disquiet over FB losing its ‘coolness’ as a result of people’s parents joining. Young people are the key audience for social network, and tend to direct posts to their friends, and the growing presence of older relatives is reducing the perceived freedom of the space. I’ve seen an example of this myself, when one of my friends posted about having a ‘too many drinks’ – and minutes later their father making a rather embarrassing comment on the post, along the lines of ‘I thought you were more sensible than that.’ This is all just <a href="http://www.happyplace.com/3511/the7-best-examples-of-horrific-and-embarrassing-parenting-on-facebook">rather off-putting</a>, given that the original appeal of Facebook in its early years was based around it being restricted to peers at the same university. Private social networks, such as Microsoft’s <a href="http://en.wikipedia.org/wiki/Yammer">Yammer</a>, could begin to capture the attention of users looking for a more exclusive forum.
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Then finally there is the issue of <a href="http://blogs.avg.com/news-threats/check-digital-baggage-harming-career/"><i>digital baggage</i></a>. This is something I’ve realized recently: much of my activity on Facebook in the early years after I joined in 2005 has left a very large, quite personal digital trail. Furthermore, since I created the content, joined groups etc., the architecture of FB has changed, as has its <a href="https://www.eff.org/deeplinks/2010/04/facebook-timeline">privacy policies</a>. This makes it rather difficult to see who has access to what. And even if I correctly manage my privacy settings today, there is no guarantee that privacy policies won’t be <a href="http://socialmediatoday.com/maddiegrant/1418286/facebook-privacy-policy-changes-infographic">changed in the future</a>. To give concrete examples, I discovered several photo albums which I thought were ‘friends only’ were actually reachable by the general public with a simple google search. Also there was a set of ‘groups’ that I set up for University colleagues (which are now years out-of-date) but were visible to the general public. These examples struck me as disconcerting, and I realize now that the only way to ‘leave that baggage behind’ would be a make a fresh start with a new social network – for example Google+. I’m not going to do that just yet, but I expect other people will. The Facebook timeline was famously glorified <a href="http://www.youtube.com/watch?v=hzPEPfJHfKU">in this video</a> as a way of having a record of your entire life in one place. But that idea is actually quite scary. I, personally, do not want that record in the (potentially) public domain, and I doubt that I’m the only one.
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">During its initial rise, the trend of Facebook’s subscriber figures was exponential growth. To <a href="http://www.benphoster.com/facebook-user-growth-chart-2004-2010/">look at the graph</a>, if it referred to a share price it would definitely look like a bubble. Of course it is not a share price, and so I don't <a href="http://diegobasch.com/social-networks-implode-quickly">expect it to ‘pop.’</a> But I think user engagement with <a href="http://en.wikipedia.org/wiki/Half-life">FB will decay</a>. However much effort it puts in to try and stay relevant, it is nevertheless likely to be displaced by newer start-ups offering cool new services. The proportion of cognitive real-estate it can command will decline as other services manage to win more. My message to Facebook investors is therefore, get out while you can.</span></span><br />
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<i><span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Agree? Disagree? Please leave comments below</span></span></i><br />
<br />David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com4tag:blogger.com,1999:blog-2766189576050977240.post-40443115119099042592013-05-06T13:21:00.000-07:002013-05-06T13:21:32.724-07:00Schelling, Focal Points and the Problem with Partial Vegetarianism<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Following <a href="http://www.changemyworldview.com/2013/04/strategic-delegation-and-cypriot.html">my previous post</a> on Thomas <a href="http://en.wikipedia.org/wiki/Thomas_Schelling">Schelling’s</a> contributions to Game Theory, I have been reflecting on another key idea from his 1960 book ‘The Strategy of Conflict’. Schelling introduced the concept of <a href="http://en.wikipedia.org/wiki/Focal_point_%28game_theory%29">‘focal points’</a> in situations where two parties have to coordinate. The idea is that when faced with several options, people often have a sense of which is the ‘most obvious,’ and when coordination is required they are likely to pick this obvious solution, in the knowledge that the other party is also likely to pick it.</span></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"> The classic (abstract) example of such a coordination problem is when and where you would go to meet somebody in New York City, if you had not agreed this ahead of time and communication was, for some reason, cut off. What do you think? When and where would you show up? (see below for the solution*)
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">The idea of the focal point is important for several reasons, of which I will highlight two.
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Firstly, focal points do not fit well with standard ideas in economics. Most modern microeconomic theory deals with curvilinear relationships between variables: equilibrium is defined by the utility-maximizing point on a curve. We find this point using calculus and marginal analysis, and so we assume the curve is continuous. The focal point concept throws continuity out of the window. Even when we introduce game theory – a critical implement in the modern economist’s toolkit – this only tells us that <a href="http://en.wikipedia.org/wiki/Nash_equilibrium">Nash Equilibrium</a> outcomes are stable, not which Nash Equilibrium is most likely. Somehow focal points allow people to efficiently choose between different equilibrium positions, even without communicating.
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">This leads onto the second, deeper, point. Focal points challenge the economist’s mechanistic idea of ‘rationality.’ It is very hard to specify what constitutes an ‘obvious’ choice. Often the cues that lead to particular choices are idiosyncratic to that particular context. Given a number of different equilibrium positions, standard models of rational behavior might suggest picking randomly between them, or undertaking exploratory search to see what the other players pick. It is difficult, if not impossible, to identify focal points using a mechanistic or analytical solution, the best we can do is identify heuristics for finding them. Yet gravitating towards focal points tends to lead to better outcomes for individuals than a strictly ‘rational’ behavior, and so behavior is in some sense ‘hyper-’ or ‘<a href="http://en.wikipedia.org/wiki/Superrationality">super-’ rational</a>.
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">The idea of focal points has been broadened from Schelling’s original coordination-game context, to the general tendency for people to fixate on certain ‘obvious’ equilibrium points of behavior. The tendency to do this seems to be deeply rooted in human psychology. This has major consequences for self-control and our inability to ‘do things by halves.’ It is much easier to give up a certain behavior outright than to stop doing it half the time – for example, I am fully aware that meat production is environmentally very damaging. Vegetarianism would therefore be an ethical behavior for me to adopt – but I love eating meat so much that I can’t bear the thought of giving it up entirely. Now, I could halve the environmental damage my meat consumption does by halving my consumption. However, as I have found (upon trying to limit my meat consumption), it <a href="http://answers.yahoo.com/question/index?qid=20101220215050AAdaqEm">simply does not work like that</a>. A plan to only eat meat on Fridays falls apart when there is a delicious steak on the cafeteria menu on Wednesday!
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<span style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">______________________________</span></span><br />
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<span style="font-size: x-small;"><span style="font-family: Georgia,"Times New Roman",serif;">*This example, <span style="font-size: x-small;">conceived by Schelling, </span>has been used many times by researchers as a quiz questio<span style="font-size: x-small;">n.</span> <span style="font-size: x-small;">O</span>verwhelmingly people opt for 12 noon as the most ‘obvious’ time to meet. The place chosen varies between two obvious locations: New York residents tend to pick Grand Central Station, whereas out-of-towners choose the top of the Empire State Building.
</span></span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-52621070702347570432013-04-07T12:14:00.000-07:002013-04-07T12:14:51.652-07:00Strategic Delegation and the Cypriot Financial Crisis<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">An interesting thing happened in the eight days between the <a href="http://www.telegraph.co.uk/finance/9934565/Cypriot-savers-hit-as-eurozone-agrees-10-billion-bail-out.html">‘first’ Cypriot rescue plan</a> was announced on Saturday 16th of March and <a href="http://www.telegraph.co.uk/finance/financialcrisis/9951680/Cyprus-agrees-10bn-bail-out-deal-with-eurozone.html">the ‘second’ plan</a> was announced on Monday 25th March. The Cypriot parliament <a href="http://www.ft.com/intl/cms/s/0/eeff4c98-9080-11e2-862b-00144feabdc0.html#axzz2PnsKhMSv">voted down the first plan</a>, rejecting the levy on deposits and sending the President back to the negotiating table. But it also voted to allow the President to make a new agreement, <span style="font-size: small;">which could </span>include a <span style="font-size: small;">bank levy <a href="http://www.guardian.co.uk/business/2013/mar/22/eurozone-crisis-cyprus-bailout-russia-vote">(renamed as a 'restructuring'</a>), and </span>which would <a href="http://www.businessinsider.com/why-the-cypriot-parliament-doesnt-have-to-vote-on-the-deal-this-time-2013-3">not need further Parliamentary approval</a>. This is a noteworthy event: the Parliament relinquished its own decision-making ability. In a situation where the stakes are so high, for a powerful actor to give up its own power is, on the surface, quite shocking.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Why did it happen? It seems to be a textbook case of <i>strategic delegation</i>. The idea of strategic delegation was introduced by <a href="http://en.wikipedia.org/wiki/Thomas_Schelling">Thomas Schelling</a> in his seminal 1960 book, <a href="http://en.wikipedia.org/wiki/Thomas_Schelling#The_Strategy_of_Conflict_.281960.29">The Strategy of Conflict</a>. Schelling’s work highlights something that, from the perspective of economics, is paradoxical: having one’s choices restricted is sometimes a good thing. In <a href="http://en.wikipedia.org/wiki/Rational_choice_theory">traditional economics</a>, freedom to choose between more options is never a bad thing, as each option may lead to a better outcome. Schelling shows that in multi-agent negotiations, less choice is sometimes better.
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">When our negotiating opponent makes their choice based on what they expect us to do, it can be an advantage to have very limited options. As a result, it can be beneficial to commit oneself to a particular course of action before the strategic interaction even begins – and let the opponent react. The classic example of this is set in a military conflict: a defensive force ‘burns its bridges’ to cut off its means of retreat. Realizing that the defensive force cannot retreat, and preferring to avoid a fight to the death, the attacking force does not advance. In Schelling’s terminology, the defensive force has made a <i>credible commitment</i> to stand and fight, and this in itself is enough to win the day.
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">Schelling identifies two uses of a bargaining agent. The first is to pre-commit oneself to a course of action, as in the burning of bridges strategy above. The second is to gain from using an agent whose incentives differ from one’s own.
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">When the Cypriot Parliament delegated power to the President, it was a highly strategic maneuver. They knew that the resolution of the crisis would require accepting a bailout, and that negotiating the bailout would require painful sacrifices be made on behalf of the Cypriot people. They realized that while they might privately support an agreement that causes pain, there is a high chance that in a public vote a painful agreement would, again, be rejected. The Parliamentarian’s objective is to make a decision that is popular, so they have an incentive to not be seen to support a bank levy. They chose to ‘bind their hands’ to prevent themselves from interfering in the future. The President, by contrast, had the overwhelming incentive to resolve the crisis, so he was appointed as an agent, and, ultimately, a scapegoat who could take the blame for an unpopular agreement.
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<span style="font-size: small;"><span style="font-family: Georgia,"Times New Roman",serif;">To some, <a href="http://en.wikipedia.org/wiki/Game_theory">Game Theory</a> is easy to dismiss as a parlor trick, a mathematical abstraction with little relevance for the real world. However the work of Thomas Schelling illustrates just how relevant it is to every moment of every day – hence why he won the Nobel Memorial Prize in Economics in 2005. Much of his work was inspired by the tension of the nuclear arms race and potential for Mutually Assured Destruction. In a world once again <a href="http://www.ctvnews.ca/politics/will-north-korea-s-anticipated-missile-launch-lead-to-military-confrontation-1.1227781">threatened by nuclear conflict</a>, we could do worse than to revisit Schelling’s classic work to help us make sense of the situation. </span></span><br />
David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-84152721155234460392013-03-21T16:42:00.000-07:002013-03-21T16:47:30.390-07:0072 Hours to Decide the Fate of Cyprus: Will it Go Down Like Lehman Brothers?<span style="font-family: Georgia,"Times New Roman",serif;">The financial crisis in Cyprus is presently at a critical juncture. Having rejected a tax on bank deposits early this week, the government needs to come up with another option for financing, or face a liquidity crisis in the next 72 hours that renders the country effectively bankrupt.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">From here there are several things that could happen, of which I list three in the order of relative likelihood that I would assign them.</span><br />
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<b><span style="font-family: Georgia,"Times New Roman",serif;"> 1.) The Russian government contributes to a bailout</span></b><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">The reason for proposing the bank levy initially was that the EU and IMF are unwilling to completely bailout Cyprus themselves. The EU and IMF funding is structured as loans. Despite the fact that the extra sum required is small compared to bailouts in other Eurozone countries, the Cypriot economy cannot support any greater level of debt than is currently being planned. What is needed is more 'equity' rather than debt, either from a direct fiscal transfer, or an internal source such as a bank levy. </span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">A fiscal transfer would be untenable to the EU, and Germany in particular, for two reasons. Firstly, this would set up a 'moral hazard' problem, such that other countries lose the incentive to be financially responsible. The impetus for austerity measures in Greece and elsewhere would be severely weakened. Secondly, a key beneficiary of the transfer would be Russian depositors, who were outspoken opponents of the bank levy as originally proposed. A bailout that transfers EU funds directly to wealthy Russians is rather unpalatable, both ethically and politically.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">This leaves the Russians themselves the most likely participants in a bailout agreement. It is their own citizens that stand to lose out from default, and the Russian leaders have already shown their solidarity with the depositors, even if they are using Cyprus as a tax haven. </span><br />
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<b><span style="font-family: Georgia,"Times New Roman",serif;"> 2.) A bank levy is reinstated on large deposits</span></b><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">Having observed the outcry at taxing deposits universally, the Cypriot leaders probably wish they had limited it to large deposits in the first place. It is far more politically palatable to place a windfall tax on the wealthy than on the poor. They even amended the proposed bank levy before the vote in parliament, but by that time it was too late as it had already lost all support. However, since Cyprus is so low on outside options, a resurrection of a tax on larger deposits is a real possibility.</span><br />
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<b><span style="font-family: Georgia,"Times New Roman",serif;"> 3.) Default</span></b><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">There are many commentators arguing that default will not be allowed to occur, and EU authorities will relent and cave in to a larger bailout. In my view, default is a very real possibility. I outlined above why the EU is unlikely to provide a direct fiscal transfer; such a transfer is beyond the remit of the IMF and anything less than an equity injection will leave the Cypriot banks insolvent. This means the European Central Bank will cease providing them with cash, and they will be bankrupt.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">In this case the likely consequence would be a Cypriot exit from the Euro. The mechanics of how this might be conducted were closely examined in case it were needed in Greece. The banking system would be put on hiatus while the currency is switched to Cypriot Pounds. Bank assets and liabilities, including customers' deposits, would be re-denominated. The new Pounds would instantly depreciate against all the major currencies. Simultaneously the government would probably default on its external debts, either directly (by ceasing payments) or indirectly (by denominating the debts in Pounds and printing money, leading to hyper-inflation.) In short a lot of people would lose a lot of money, and they would end up wishing they had accepted the bank tax originally proposed.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">From the perspective of the rest of the Eurozone, the great big unknown in this situation is the knock-on effects. </span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">A very good parallel here is the Lehman Brothers bankruptcy at the peak of the credit crunch in 2008. This was allowed to happen by the US authorities on precisely the 'moral hazard' grounds that make the EU reluctant to completely bail out Cyprus. The Lehman bankruptcy had devastating consequences, which were unanticipated largely due to the opaqueness and intrinsic complexity of connections in the financial system. Small details, like where assets were parked overnight, went on to have major ramifications as it led to different bankruptcy laws being applied. With a national economy we are faced with a whole different set of opaque connections, complex dynamics and ambiguous legal territory.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">The EU leaders know all this, and yet may still allow it to happen. If nothing else (and assuming the Euro survives the contagion), a Cypriot exit would provide a test case for how a bigger Eurozone nation might later conduct an exit.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">My thoughts go out to the leaders currently negotiating the future of a nation. I hope you bring us back from the edge.</span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0tag:blogger.com,1999:blog-2766189576050977240.post-50653380338163404832013-01-20T03:35:00.000-08:002013-01-21T07:38:50.345-08:00When the Music Stops: The Past, Present, and Future, of HMV<span style="font-family: Georgia,"Times New Roman",serif;"><br />There are a two big myths circulating about HMV, the last-music-retailer standing on the British high street, which recently went into administration. Myth #1: HMV was killed by iTunes and downloaded music. Myth #2: HMV is, indeed, dead.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"> <b>1. HMV was killed by iTunes and downloaded music </b></span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">This is a convincing narrative being propagated in much of the business press, but I don’t buy into it. There was, is, and will continue to be a market for hard-copy CDs and DVDs. Many people have not switched to downloading music, preferring the tangible feel of a disc in their hands.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">No, from the product side, HMV’s competition comes from Amazon.com on the one hand, and from the supermarkets on the other. When it comes to buying the <b>mass market, top charting</b> movie release or pop record, it is simply easier to bung it in the trolley at Tescos instead of make a special trip to HMV. When it comes to buying <b>niche, specialized </b>albums and movies it was a safer bet that you would find it on Amazon. HMV has neither convenience nor range: it is <a href="http://blogs.telegraph.co.uk/technology/willardfoxton2/100008690/who-killed-hmv-we-all-did-we-may-live-to-regret-it/">stuck between a rock and a hard place</a>.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;"> <b>2. HMV is, indeed, dead</b></span> <br />
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<span style="font-family: Georgia,"Times New Roman",serif;">Reports of HMV's demise have been greatly exaggerated. As I write this, HMV has gone into administration, which means that it will be run as a going concern until <a href="http://news.sky.com/story/1038715/hmv-collapse-early-interest-in-retailer">a buyer can be found</a>. Only if this proves impossible will it be wound down. <br /> </span><br />
<span style="font-family: Georgia,"Times New Roman",serif;">Most media commentators seem to miss the crucial point that on a going-concern basis HMV has still been <b>reasonably profitable</b>. It has been caught out because for years it relied on rising sales to support its working capital base. As I pointed out in this blog two years ago, its sales growth had halted, and it has been caught in a <a href="http://www.changemyworldview.com/2011/04/retail-sector-has-made-headlines-for.html"><b>working capital trap</b></a>. The administration process will wipe out its equity holders, allow a restructuring of debts and closure of unprofitable stores, but then the remaining assets should be able to continue running as a viable business.<br /> </span><br />
<span style="font-family: Georgia,"Times New Roman",serif;">One big risk factor here is the inexplicable decision of administrators to <a href="http://www.guardian.co.uk/business/2013/jan/16/hmv-accused-of-theft-over-gift-vouchers">stop accepting HMV gift cards</a> at the stores that remain open. This will have caused HMV’s credibility and <a href="http://www.telegraph.co.uk/comment/9812776/HMV-fell-victim-to-our-temperamental-love-affair-with-brands.html">brand value</a> to plummet. In theory, as the last remaining record store on the high street it should have a reliable stream of customers. But the messy handling of the administration has caused much of its remaining value to evaporate. I would not be surprised if its future sale was accompanied by a complete re-branding to distance the firm from the current disarray.</span><br />
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<span style="font-family: Georgia,"Times New Roman",serif;">Update (21st Jan): Administrators have announced that HMV <a href="http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/9815074/HMV-will-honour-gift-vouchers.html">will accept gift cards</a>. An eminently sensible decision, although much reputational damage has already been done. </span>David R. Cloughhttp://www.blogger.com/profile/01537969781945041673noreply@blogger.com0