I'll be taking a break from blogging for a few weeks. I'm beginning to feel like the attenuated stream of feedback I get from blogging is starting to influence my perceptions too much -- i.e., I'm spending too much time in front my computer.
But please post suggested topics in the comments. I can commit myself to not blogging; but I won't commit to not thinking. And I'd like to know more about how and what my readers are thinking before I go back to blogging.
I had the privilege of hearing Prof. Geradin speak at a recent conference. On my view, he is one of the best academic experts on patent law. But I have to question the premise of his recent paper, Elves or Trolls? The Role of Non-practicing Patent Owners in the Innovation Economy.
I question it not because I disagree with the basic argument, which is that some patent trolls perform an important role in clearing markets by speculating on the prospective value of patent claims in litigation. Rather, I question it because I believe it falls short of a full theory of how inventions foster growth within an economy.
But today I'm feeling a little lazy. So instead of making the argument explicitly, I'm going to quote Robert Frost's excellent poem, "Mending Wall," which takes as its subject the question of why people spend time and money on defining and maintaining property rights. Note that Frost explicitly addresses the role of Elves in the allocation of property.
Something there is that doesn't love a wall,
That sends the frozen-ground-swell under it,
And spills the upper boulders in the sun,
And makes gaps even two can pass abreast.
The work of hunters is another thing:
I have come after them and made repair
Where they have left not one stone on a stone,
But they would have the rabbit out of hiding,
To please the yelping dogs. The gaps I mean,
No one has seen them made or heard them made,
But at spring mending-time we find them there.
I let my neighbor know beyond the hill;
And on a day we meet to walk the line
And set the wall between us once again.
We keep the wall between us as we go.
To each the boulders that have fallen to each.
And some are loaves and some so nearly balls
We have to use a spell to make them balance:
'Stay where you are until our backs are turned!'
We wear our fingers rough with handling them.
Oh, just another kind of out-door game,
One on a side. It comes to little more:
There where it is we do not need the wall:
He is all pine and I am apple orchard.
My apple trees will never get across
And eat the cones under his pines, I tell him.
He only says, 'Good fences make good neighbors'.
Spring is the mischief in me, and I wonder
If I could put a notion in his head:
'Why do they make good neighbors? Isn't it
Where there are cows?
But here there are no cows.
Before I built a wall I'd ask to know
What I was walling in or walling out,
And to whom I was like to give offence.
Something there is that doesn't love a wall,
That wants it down.' I could say 'Elves' to him,
But it's not elves exactly, and I'd rather
He said it for himself. I see him there
Bringing a stone grasped firmly by the top
In each hand, like an old-stone savage armed.
He moves in darkness as it seems to me~
Not of woods only and the shade of trees.
He will not go behind his father's saying,
And he likes having thought of it so well
He says again, "Good fences make good neighbors."
Freedom is a function of self-interest and timing (i.e., rationality and periodicity) for everyone... except Homer Simpson.
What Adam Smith taught us is that cooperation is the source of endogenous growth within an economy. Voluntary exchanges and divisions of labor literally create wealth within society. When it's money rather than goods or services that are exchanged, residual income (i.e., profit) is an excellent proxy for cooperation and endogenous growth. In fact, it's the best the world has ever known.
But several decades ago economist Thomas Schelling pointed out that rational self-interest alone would not determine when people cooperate. Schelling sent game theorists (and economists, political scientists, sociologists -- okay, really all of us) out into the world to watch how people interact with each other, and develop new hypotheses about how and when people cooperate.
Schelling's exhortation has had profound consequences for us. In effect, his theory of focal points has helped avoid many costly conflicts that would otherwise have resulted from plain-old, everyday misunderstandings and miscommunications.
It is puzzling therefore, that game theorists and economists have failed to move beyond where they were decades ago when Schelling gave them their task of identifying focal points. But Schelling could have guessed that this would happen. He knew that the reason that game theorists and economists had confused rational self-interest with symmetry was because symmetric problems were easier to solve. Game theory and general equilibrium theory both assume time asymmetry, an assumption that often fails, and always fails in describing growth. It's not that game theorists and economists want their theory to be irrelevant to everyday experience. It's that modeling human interactions is hard.
But some have pushed forward despite the difficulties. Amartya Sen has been pushing a capabilities approach to economics, an approach intended to add dimensionality to the uni-dimensional measure of cooperation provided by profit. The problem with this approach is that it is the uni-dimensionality of profit that has constituted cooperation. By deconstructing profit, you may gain some understanding of the mechanism underlying any voluntary exchange; but without more it won't help you to increase cooperation.
If we stop what we're doing, go out into the world and watch how people are cooperating with each other, I believe another broad hypothesis about cooperation can be identified. Specifically, it is beyond argument that the goal of profit must always be achieved through the means of a cycle of human activity. Thus, both profit and time should be considered as independent variables in a measure of human freedom or happiness.
Creative capitalism can stand for the idea of a capitalism that respects and promotes profit that is sustainable in view of the rhythms of life. Both profit and time can be measured quantitatively. By building institutions that measure and are accountable for how they handle both, we can build better institutions.
I've been searching for a good blog or online forum for discussing the current GAAP and IFRS accounting rules, but so far have been disappointed by what I've found.
Anybody have any suggestions? Please post a comment so that others can take advantage too. But email if you must.
Although it's difficult to theorize about these things in the abstract, history always provides us interesting hints. Via the Legal History Blog I found this new paper by Samuel J. Levine. Here's a money quote from the abstract:
The article contrasts Cohen's rhetoric and underlying approach to professionalism against the anti-Semitism, nativism, classism, economic protectionism, and general elitism often expressed by leaders of the early twentieth century bar who, like Cohen, promoted the notion that law is a profession rather than a business.
Could it be that all these legal ethics professors who have been preaching about how bad it is for lawyers and clients to be partners have been stooges for racists, protectionists, and moneyed elites? Whatever you happen to believe, this is going to make for some interesting discussions.
This is an important problem in jurisprudence. As Richard Epstein says in Skepticism and Freedom, "Classical liberalism requires us to maintain the distinction between liberty and coercion, to advance the former while constraining the latter."
The paradox of liberty and coercion was posed in its most salient form by Robert Lee Hale. Hale's key philosophical move was to assume radical skepticism about the merits of competing claims to scarce resources. Hale thereby demonstrates how any distinction between liberty and coercion must be one of degree. For Hale, in a world of scarcity, we are "free" only to choose among different forms of coercion, if that.
Epstein suggests that the weakness in Hale's argument originates in the lack of distinction made between individuals and groups under Hale's definition of "coercion." "When a manufacturer is unable to sell his wares," asks Epstein, "which of the millions of its potential customers is guilty of coercion and why?" On my view, Epstein is correct in his judgment that any coherent theory of liberty and coercion must stay consistent as it moves from the scale of individuals to the scale of large groups.
But Epstein appears to side-step the problem of defining liberty or coercion by taking the pragmatic route of merely observing that most refusals to deal will not, in fact, be the result of coercion. In effect, Epstein's answer is that Hale has a good philosophical point, but we shouldn't get too cute with our philosophy when we're talking about ordinary, everyday commerce. Our natural moral intuitions are often correct, regardless of whether they can be analyzed through any coherent framework of moral philosophy.
I like the pragmatic, instrumentalist strategy that Epstein follows. I can't see how we'd make it through life without it. But I want here to try to push out the edge of the philosophical theory of liberty a bit further.
The best jurisprudential definition of liberty that I know is found in Judge Richard Posner's Problems of Jurisprudence. In this book, Posner offers the theory (which he attributes to Quine) that a person's choice is "free" so long as her preferences are a link in the chain of causation that leads to an act. According to Posner then, coercion arises when a person is forced to act either before their preference can be formed or without their preference being part of causal chain that leads to the act.
Posner's definition is very useful because it suggests a judge-invariant method whereby coercion may be identified. Judges need not hesitate in condemning coercion when defendants can show that their act did not or could not reflect their rational preferences. Perhaps most importantly, there is no need to peer into the hearts or minds of plaintiff or defendant in making this judgment.
But as Posner points out this definition leads to several paradoxes, such as that of the well-supplied drug addict, the overgrown child, or animals. In each case, the preferences of these actors would seem to be a link in the causal chain that leads to their action. Yet in each case, at least some people will suspect that these are not truly free actors.
My humble suggestion is that some of these paradoxes may be resolved by considering, in addition to rationality, the periodicity of the preferences of these actors. Rationality and periodicity are orthogonal in this analysis. An act can be rational, but ill-timed; conversely, an act can be well-timed, but irrational. An actor becomes more "free" when she optimizes the fit of an act to both her self-interest and her rhythms.
For example, the drug addict indeed prefers to use drugs, and with an increasing frequency as the addiction becomes stronger. But so long as we know that the rational preference of the drug user to use more drugs is not sustainable at increasing frequencies of consumption, then we may question -- again without peering into the mind or heart of the drug user -- whether, in fact, their decision is "free." Similarly, we may ask whether an overgrown child is free who does not begin to engage in work and social activities with an increasing frequency beyond some point in time.
On the other hand, after adding considerations of periodicity to the definition of liberty, animals remain "free," because like humans, their preferences display patterns of periodicity. This observation has applicability to infants and the mentally ill as well.
Judge Posner implicitly acknowledged the importance of periodicity in his discussion of coerced confessions and the defense of duress. In each case, the rational preference of the actor is part of the causal chain that leads to the act; but the act is "forced" because it occurs before the actor would act independent of coercion. The temporal dependence of the argument hints at the role of periodicity.
These are the first film reviews I have provided on this blog, and I'm offering them up because of their interesting relevance to my earlier speculation about neuroplasticity, mirror neurons, and synchronized flow.
I wanted to recommend this film because some people might assume that it's just a gag from its synopsis alone. The protagonist Lars, in a nervous breakdown, buys an inflatable woman, and proceeds to carry her around his small town, introducing her to everyone. If this were a Farrelly Brothers movie, I wouldn't have bothered. I gave it a chance because I had nothing to expect from Craig Gillespie, who with this film establishes himself as one of the most interesting new directors to emerge in a long time.
Following a stern exhortation from the family doctor, the brother and sister-in-law go along with the delusion, and convince the whole town to join along in their conspiracy. The sensitive and nuanced portrayal of the various characters and their relationships with one-another was rivetting. The movie cements Emily Mortimer in my mind as one of the most sensitive and intelligent actresses of her generation. Don't miss her performances in 2 Brothers & a Bride or Dear Frankie.
What connection does the movie have to the neuroscience of synchronized flow? The film is a mirror image of of life. In life, groups of people will often delude themselves, and only an outsider without an iron in the fire will be able to see clearly. But the deluded group hardly ever listens to the outsider, and instead the outsider often gets sucked into the delusion.
If you don't already know of Giuseppe Tornatore, then I say, "Get thee to a film'ry." He is a lover of people and a lover of film to a degree unmatched by any director I have seen. Like Kubrick, he is in love with the medium, and lavishes every frame with significant detail. But unlike Kubrick, he has a profound compassion for the characters he portrays, which oozes off the screen. See Cinema Paradiso if you haven't already. It surpasses the Legend of 1900 in some ways. They're very different stories though, and both are worth seeing.
The protagonist in The Legend of 1900 is a man ("1900") who is born and lives out his entire life on a ship. As a boy, he discovers a gift and passion for the piano. In this way, the movie poses the question, "How would a life lived entirely through music look?" The movie succeeds because it is able to demonstrate that such a life might not, in fact, be as narrow as one might naively imagine. If anything, the story stumbles at the end when the writer and director concede to the audience that such a life is limited in important ways. It would have been a more interesting movie if they had simply taken the idea all the way through to its logical conclusion.
What is the source of growth within a society? Cooperation. What is the source of destruction? Conflict.
At this level of generality, you'd be hard-pressed to find anybody who'd disagree. Yet the mechanism for growth within an economy, or even a firm, remains mysterious. I suggest that the mechanism for growth is the phase synchronization of human activities, which occur in cycles. By communicating and reinforcing focal points, leaders and followers synchronize the phase of otherwise independent human cycles. The emergence of different institutions at different times and in different places is explained by comparative advantages to the communication and reinforcement of one focal point over another.
Growth begins at the level of individuals. Each person within an economy consumes and produces goods or services with a temporal and spatial pattern that repeats. When you count up how often each person consumes or produces within a set period of time, you get a frequency. If you look at a large group of people within the same window of time, you get a frequency distribution. This frequency distribution is mathematically equivalent to aggregate demand (for frequency of consumption) or aggregate supply (for frequency of production).
Here's an amazing fact: If, instead of the frequency-averaged picture, you look at a time-averaged picture of consumption or production for the same large group of people within the same time window, you will not usually see much fluctuation. You'd see a constant level of consumption or production with a little bit of noise around the signal. The noise would be within the range of transactions costs. This is because when the group is large enough, the cycles will be randomly distributed in phase. Thus, instead of adding up into one big cycle, many smaller cycles will cancel into a relatively smooth constant function.
Although economists use mental models of supply and demand to forecast market equilibriums, most managers and investors (at least in the United States, Japan is a little different) look only at time-averaged pictures of consumption and production in making marginal decisions. In effect, they look at the current time-averaged costs of production, the current time-averaged price, and order more widgets to be produced until the former exceeds the latter.
But as we ought to have learned by now, looking only at time-averaged measures of supply and demand is dangerous. Time-averaged measures are useful for understanding total costs. But they are terrible for measuring and forecasting changes in supply and demand. Hence, when supply or demand change suddenly (as they are apt to do in a globalized economy), managers and investors who look at time-averaged measures alone are at a disadvantage. What might show up in a time-averaged picture as a sudden decline could easily be forecast from a frequency-averaged picture that shows slowing frequencies of consumption or production.
Frequency-averaged pictures of consumption and production are more useful in measuring and forecasting value because they provide a more direct measurement of cooperation among people within an organization. Given fixed inputs, the shorter the frequency of the cycle from order to delivery, the more cooperation is taking place among workers. To borrow an analogy from chemistry, only bulk characteristics (such as temperature or pressure) can be measured with a time-averaged picture. The measurement of internal structure requires a frequency-averaged picture (such as an absorption or NMR spectrum). Some day we may be able to measure the focal points for an organization by observing the structure of its frequency spectra of activities.
What is a focal point? A focal point is a mental goal, which is shared by an organization. A focal point can be as trivial as the goal of getting a bucket from point A to point B -- a focal point that organizes bucket brigades. A focal point can be as noble and complex as life, liberty, and the pursuit of happiness -- a focal point that organized a representative democracy. A focal point need not be easily understood or articulated: market price signals are a focal point that organizes consumption and production, although nobody has succeeded in understanding or modeling market price signals (at least at a large scale). Like people, focal points are not limited to a single domain of knowledge or experience. Thus, organizations of people, which are constituted by focal points, have not been limited to a single domain of knowledge or experience.
How do focal points organize people? When two people share a focal point, the cycles that characterize each person's pattern of consumption or production will synchronize in phase to realize the focal point. Growth arises from phase synchronization. When the focal point is profit, growth arises from voluntary exchange (i.e., synchronization of consumption and production). When the focal point is happiness, growth arises from voluntary associations (e.g., synchronization of personal activities through the institutions of family or friendship). Over the long haul, particular organizational structures (e.g., outsourcing with market price signals vs. vertical integration) persist because they perform better at synchronizing cycles.
Thus, once we acknowledge that focal points are responsible for the spontaneous emergence of organizations, we can understand how and why some organizations seem to succeed and some to fail. Successful organizations have focal points that promote sustainable cycles and tight phase synchronization. Often, such focal points have many levels of abstraction, which permit for a variety of different people to relate to different facets of the same focal point. Often, such focal points have long-time horizons, which permit for more sustainable cycles of human activity -- the frequency of each person's consumption or production can only be pushed so high.
The flip side to this is that some focal points are very dangerous and destructive. In particular, when the focal point for an organization becomes its distinction from another group of people (i.e., when the focal point is racial, ethnic, or national identity), the organization will become agitated and violent when forced to interact with the group from which it perceives itself distinct. In fact, this has been the basic strategy for most dictators throughout the course of human history.
The Founding Fathers of the United States of America had an implicit understanding of focal points, and the role focal points play in organizing people. Our nation was constituted by a long, drawn-out process whereby nearly every political conflict was resolved through a voluntary agreement among equals. I say nearly because there was one issue left on the table, which wasn't formally resolved until the Civil War (and many would say remains incompletely resolved even today). Part of their genius was in recognizing the comparative advantage of various focal points.
For example, the Founding Fathers wanted religious institutions. But they didn't want religious institutions to have access to the military. So they recommended to us an establishment clause. As another example, the Founding Fathers wanted an open public discussion about government, which they knew would benefit representatives (and hence, the represented). So they recommended to us protection of speech and the press. As a final example, the Founding Fathers wanted civilians to respect and relate to the military rather than treating them either with too much or too little respect. So they put a civilian (the President) in charge of the military. They were geniuses at this.
At this moment in history, it is our task to revisit the social contracts that constitute public and private organizations. We have at our fingertips new technology and new understanding sufficient to make great leaps in how well we synchronize our activities. It is up to our generation to decide whether we will use these tools and theories to do good or evil to humanity.
From the Founding Fathers:
When in the Course of human events it becomes necessary for one people to dissolve the political bands which have connected them with another and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature's God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.
We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. — That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, — That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.
These folks understood better than most of us do today what was at stake in deciding whether to cooperate.
Here's a nice piece of history, which gives a bit of insight into the personalities at work behind the document. In the first draft by Jefferson, the "self-evident" truths were "sacred and undeniable." It was Benjamin Franklin that suggested the change to "self-evident." On my view, that cinches the fact that Franklin was the better student of "Nature."
Because private ordering happens spontaneously, that's why:
In a nutshell, agglomeration economies do exist. Their size, however, is nothing miraculous and firms internalise a substantial share of these gains when making their location choices. As a result, the observed clustering of firms in France is not obviously suboptimal, and so not obviously in need of big subsidies.
From the Vox EU blog.
Via IP Dragon I found this article by Patti Waldmeir about how a new law in China might prevent foreign inventors from obtaining protection in China unless the invention is made on Chinese soil first filed in China:
If the revisions are adopted, foreign companies would have to draft patents in Chinese for inventions made in the country. But because China’s patent regime is so new – dating only from the early years of this century – there are relatively few Chinese-literate lawyers who are experienced in this area.
Substantive IP law can harmonize all it wants. Unless ownership law harmonizes also, there won't be free-trade in IP.
I was driving on Highway 17 on my way to Santa Cruz today, and I started reflecting on the question of how we could improve traffic flow using principles of synchronized flow.
Often on the highway, one will observe a slow driver in the fast lane, holding up a line of traffic. This is particularly problematic on two-lane roads. In physics terms, lane changes increase the viscosity of flow, which in turn slows the average rate of traffic, and increases the probability of accidents.
But because humans are driving, we have the possibility of coordinating behavior through incentives. Ten years ago, this would have been impossible, because two drivers had no way to communicate efficiently (at least not safely) on the freeway. Now we do. Here's a very rough idea of how to solve the problem of highway traffic with incentives and technology:
Now obviously this is somewhat regressive as a "tax" on driving time because some people are going to be able to make much bigger tips than others, &c. But I think it's still a net benefit to society because it would decrease accidents and road rage, and probably increase the average flow of traffic by a lot. Right now, it's impossible for anybody to know whether the guy in the car behind them is just a jerk in a hurry or whether they're on their way to the hospital to save another person's life. Besides, it's also a progressive "tax" in the sense that you don't have to pay anything if you take public transportation instead.
If anybody knows of any startups working on a similar idea, I'd like to know. Because of the incentives of picking up free money and shorter commutes, I bet it wouldn't be hard to sell these devices.
In an earlier post, I pointed out that the supposed power law of "the long tail" was actually the same exponential decay that you would expect for any demand function.
Nice to see somebody else noticed this too:
That might now start to change, thanks to the article (online at tinyurl.com/3rg5gp), by Anita Elberse, a marketing professor at Harvard's business school who takes the same statistically rigorous approach to entertainment and cultural industries that sabermetricians do to baseball.
Prof. Elberse looked at data for online video rentals and song purchases, and discovered that the patterns by which people shop online are essentially the same as the ones from offline. Not only do hits and blockbusters remain every bit as important online, but the evidence suggests that the Web is actually causing their role to grow, not shrink.
As an aside, the non-power law shape of the demand function for information consumption is obvious with the periodicity of supply and demand in mind.
Why do patents end up in litigation? Typically, people answer that it is the amount of money at stake. This answer is not wrong. Since the cost of litigation is relatively constant, people should be (and in fact are) more willing to pay lawyers to litigate claims that are very large compared to the cost of litigation. But this is not a full answer to the question. For this answer does not explain why patents specifically should end up in litigation more often. In fact, trillions of dollars in legal rights are exchanged everyday around the globe without litigation. By comparison, the amount of money at stake in patent lawsuits is relatively small.
The Theory of Focal Points
Economist Thomas Schelling is famous for advancing a theory of conflict and cooperation. According to Schelling, even when communication (and hence negotiated agreement) are difficult or impossible, two people can cooperate through a shared focal point. For example, if I told you to meet me in New York City tomorrow but for some reason I couldn't tell you where and when, we might still meet by going to a famous spot at noon, such as Grand Central Station or the top of the Empire State Building. Our shared vision of these famous spots is a focal point that permits us to coordinate.
The theory of focal points explains why some groups of people fight and some cooperate. When the focal point for a first group is mutually exclusive to the focal point for a second group, conflict emerges. When the focal point is shared or non-mutually exclusive, cooperation emerges. To some extent, all conflict between people can be viewed as a costly renegotiation of focal points.
With Schelling's theory in mind, let's revisit the question of patents. What are the focal points for the various parties involved in patent litigation? To simplify the question, suppose there are only two groups involved in patent litigation: "inventors" (or their employers) and "producers" (i.e., the people who sell products or services that practice a claimed invention). Ignore for now the detail that some inventors are also producers, and that some producers are also inventors.
When patents are litigated, the focal point for inventors is on obtaining a large royalty or payment for the right to practice the invention. By contrast, the focal point for producers is on paying a small (or no) royalty or payment to practice the invention. Although both inventors and producers seek profit, at the point in time when patents are litigated, these focal points are mutually exclusive because (at worst) both have incurred costs of R&D for developing the invention. Patent litigation thus becomes a zero sum game.
The Focal Point of Profit
At first glance, therefore, one might think that inventors and producers are doomed to conflict. Before rushing to that conclusion, however, it's worth noting that in some broader sense, at least, inventors and producers share a focal point -- namely, profit.
Profit is an unusually broad focal point. As Adam Smith is famous for pointing out, the voluntary exchange of goods and services creates profit. With profit the focal point, the problem of avoiding conflict between inventors transforms into a problem of identifying and promoting the circumstances in which the voluntary exchange of inventions for cash can take place between inventors and producers.
If such voluntary exchanges never occurred, we might have reason to doubt whether conflict between inventors and producers could ever be avoided. Fortunately, such exchanges do, in fact, occur. Thus, it can be inferred that the conflict arises over how what is exchanged (services and patent rights) should be valued.
Again, this might seem puzzling at first because, at least in principle, there should be no difference in how value is measured. At least within the United States, the same rules for accounting and reporting financial statements apply to both inventors and producers. In principle, the inventors and producers should be able to compare their financial statements, and reach some agreement over the value of an invention.
But since this never seems to occur, the most reasonable inference seems to be that the conflict arises from a difference in how we interpret accounting and financial statements. In fact, it is precisely here that the focal points of inventors and producers diverge. Having had the rare opportunity of working both in patent law and accounting, it has been my privilege to be one of the first to have noticed this. In short, a better theory of accounting would help resolve conflicts over patented inventions and restore a cultural norm of cooperation within patent law. Astute readers should note that, in addition to patent law, Venice was the birthplace of double-entry accounting in the 15th century.
Problems with the Static Picture of Cost Accounting
As described by William H. Waddell and Norman Bodek in Rebirth of American Industry, the theory behind the most dominant method of accounting (which is called "cost accounting") was developed at General Motors in the early 20th century by Alfred Sloan, Pierre DuPont, and Donaldson Brown. The relevant detail about this theory is that it was designed to measure (and hence manage) return on investment (ROI). To that end, the paradigm that Sloan, DuPont, and Brown had in mind in developing their rules for accounting was a static picture. Specifically, their picture was of what the corporation would be worth in liquidation.
With the picture of the corporation in liquidation in mind, it is easier to understand why so many things that we might intuitively imagine to be costs are instead treated as assets under cost accounting. For example, under the cost accounting system, unsold inventory is reported as an asset. Cost accounting assumes that the inventory could be sold at cost in liquidation. The reporting ignores, of course, the fact that unsold inventory will incur expenses. More importantly, it ignores that what's unsold before liquidation is less likely to sell at cost in liquidation.
Under the cost accounting system, IP is called an asset on balance sheets. Again, the assumption is that patents can be sold at cost during liquidation. Again, this assumption begs several important questions. Perhaps most importantly is the question of why, if the IP is so valuable, it could not be used to attract financing or revenue, thereby avoiding liquidation. There were (and are) reasonable answers to that question when debt or equity are unavailable for reasons that have nothing to do with the demand for the patented invention. But its salience suggests that there might be better ways to measure the value of IP.
Whereas all patents cost something to procure, market demand only emerges for a handful of all patented inventions. Thus, the system of cost accounting has given managers and investors the perverse incentive to aggregate thousands of patents, inflating their balance sheets, much like we saw prior to the subprime mortgage debacle. Firms invest billions of dollars in new technology, spend millions on patent portfolios, inflating their asset accounts -- all before attracting a single customer! Not to be outdone, when the corporation fails, the cost accounting system encourages us to sell the patents at auction, and let third-parties extract whatever they can from the legal rights. On my view, the system of cost accounting, coupled with the shortage of patent lawyers who really understand technology, are responsible for the emergence of the worst kind of patent trolls.
Dynamic Accounting and the Promise of Cooperation
Fortunately, there is now a light at the end of the tunnel. In fact, many corporations have shifted away from the static picture of corporations inherent in cost accounting to a more dynamic picture. Lean accounting, in fact, was practiced at Ford Motor Company almost 100 years ago, before Ford was eclipsed by the success of General Motors. It turns out that cost accounting is a perfectly fine system of accounting when demand is basically infinite relative to the cost of supply. If the market is never cleared, then the corporations that use cost accounting will end up reporting higher return on investment (ROI) than the corporations that use lean accounting. Lean accounting is an inherently more stable mechanism for promoting growth within a corporation in part because it does not tradeoff short-term gains in income against long-term sustainable growth. But once GM started doing it, everybody else in the automobile industry, and eventually the entire economy, had to follow.
Under a dynamic theory of accounting, IP is more like equity than it is like an asset. That's because the primary value of patent rights is in promoting invention and collaboration, both of which are dynamic because people are dynamic. Elsewhere I have explained how inventors are customers. Within the cycle of growth of corporations, inventors and customers are the source of information about demand. It is no accident that unmet need was considered by Judge Learned Hand to be the most important of the secondary considerations on obviousness.
By contrast, assets are static. By adopting rules for reporting and managing the IP that are more consistent with the actual mechanism whereby it increases profit, we will in turn discourage wasteful conflicts. A very important corollary to this is that stronger patent rights would be beneficial in promoting collaboration and avoiding conflict. Strong property rights discourage people from litigating what could be solved through negotiation at an earlier point in time. As Robert Frost noted, "Good fences make good neighbors." With a change to the accounting rules, these early negotiations will happen more often.
Finally, let me emphasize that changes to financial statements need not be dramatic. For example, the simple addition of average daily debit and credit flows for each balance sheet account would permit the shift in managing and investing that I'm advocating here. Since most accounting is now done by computers, this kind of change is actually very cheap. The value of inventions could then be measured easily by comparison between the average daily debit and credit flows before and after an invention had been implemented. Suddenly, inventors and producers have a numerical way to measure the value of an invention.
Another quote from Rebirth of American Industry. See here and here for earlier installments.
To the extent that information technology improves manufacturing, it is valuable to all Americans. Information disseminated through books, newspapers, television, and the Internet may allow us to grow our knowledge and build our skills. But unless the greater knowledge and skills are put to productive use, the knowledge gained cannot enhance the long term quality of our life...
This view has been under-appreciated for the past ten years at least. But like the dream of an information economy, the dream of an agrarian or manufacturing economy can be taken too far.
Some services may, in fact, create value. This is because demand is not a static function. Utility functions, and the preference functions beneath them, are time-varying and interdependent. Services that channel demand into more sustainable directions actually do "create value" in the sense that they free up value that is wasted on less sustainable products.
For example, government servants perform an important service to society by enforcing rules that require manufacturers to accurately represent the performance of their products. Without that service, many corporations would simply redistribute wealth from customers to shareholders by spiking demand with false advertising, distributing dividends, and then declaring bankruptcy. Similarly, lawyers perform an important service to society by lubricating negotiations between parties without personal relationships. We rely on lawyers more and more for these services as cultural norms are replaced by legal norms (for example, in family law). Similarly, investors and insurers liberate value by smoothing consumption patterns over long time horizons. Last but not least, inventors liberate value by conceiving and demonstrating to the world that needs can be met better or at lower cost with an improved product or process.
But the Waddell & Bodek point about the importance of mining, agriculture, and manufacturing is under-appreciated in our current "knowledge" economy.
Regular readers know that I've been exploring an extension of the traditional economic theory of the firm. Specifically, I've been exploring the following hypothesis:
A firm will emerge when a single team of people can synchronize the flow of supply to demand at lower costs than two independent teams relying on market price signals alone.
"Flow" here means a unit quantity of goods per unit time. You can read the original post, in which I place the hypothesis in the context of earlier work by Coase, Alchian & Demsetz, and Williamson, here.
To my surprise and joy, it turns out that there have been some discoveries in biology and neuroscience over the past few decades that have some very interesting affinities with the synchronized flow hypothesis. Specifically, relatively new work on mitochondria, neuroplasticity, mirror neurons, and collaborative memory seem to fit well with the theory of synchronized flow.
The Connection between Mitochondria and the Hypothesis of Periodicity
First, the synchronized flow hypothesis was inspired by the observation that human consumption and production occur in cycles with a measurable frequency distribution. Integrated up into cumulative distribution functions, these frequency distributions can be shown to be equivalent to aggregate supply and demand for a population within a window of time. Over the past few days, I've been reading Nick Lane's recent book about mitochondria (thanks to Tyler Cowen for the recommendation), and have discovered that, over a fairly wide range, a power law applies to the basal metabolic rate of mammals. In other words, some network topology is responsible for the periodicity in our metabolism. Since mitochondria are responsible for quite a bit of our metabolism, the hypothesis of biologists is that it is the network topology of mitochondria that determines the rhythms of metabolism, at least for mammals. In other words, our network of mitochondria provides a biological mechanism for explaining the hypothesis of periodicity.
Mitochondria and Neuroplasticity
As if that weren't enough, it appears that mitochondria are also responsible, at least to some extent, for neuroplasticity. See here for a description of the function of mitochondria within the brain. Neuroplasticity is the phenomenon whereby certain neural pathways are reinforced by experience. I started reading about neuroplasticity in this book by Norman Doidge, in which he describes (among other things) how blind people have been taught to see through the use of cameras hooked up to tactile feedback transducers.
Are you with me? So far we've got a biological mechanism for explaining why we observe particular rhythms of consumption and production, which happens to be related to the mechanism that permits us to learn by repetition.
Neuroplasticity and Mirror Neurons
Another result we've gotten recently from neuroscience is that there are certain neurons in the brain that will fire both when we do things and when we see another person do the same thing. If you pair that up with neuroplasticity and the mitochondria, what you've got is a mechanism for us to teach and learn from one-another, including a mechanism for indirectly influencing one-another's rhythms of consumption or production at a biological level.
Consider this: if I perform zen meditation in front of you, because of mirror neurons, your brain is going to start firing along similar pathways to the ones that my brain is firing along while I'm in meditation. The result is that you are going to be more likely to want to do zen meditation and in fact, you may get some of the benefits even just from watching me do it. Zen meditation, of course, is a pretty benign example of the power here. Investors should see immediately how much this means.
Collaborative Memory
Has anybody looked empirically to see whether any of this neurophysiology is borne out at the level of psychology -- much less at the level of economic hypotheses (such as rationality)? In fact, yes. Here is a summary of work done on "collaborative memory." The surprising results of this work are the following: certain cognitive tasks are negatively affected by collaboration, including group brainstorming for word-list retrieval.
In an earlier post, I explored a theory of why that might be, based on the results of other neuroscience research reported in Daniel Goleman's new book, Social Intelligence. My thought is that the synchronized flow theory can be explained on a neursocientific basis as the result of comparative institutional advantages in how and what information is communicated in order to synchronize supply and demand. In particular, the thought is that integration of firms will be favored when mirror neurons and plasticity will lead to better flow synchronization.
Obviously, this is all speculation at this point. But it's really fascinating stuff, and I couldn't help throwing it out there to see whether there was anybody else who would be similarly interested in it. I realize that the connection between these various steps is fairly tenuous. Yet lots of research has been done at each step. If you simply connect the dots, you've got a fairly solid biological explanation for why groups of people choose to work together on one set of tasks, but not another.
The Harvard Law School Corporate Governance blog reports on research from Ramanna and Roychowdury:
We test whether outsourcing firms understated profits in the period leading up to the 2004 election, in circumstances where the firms’ affiliated candidates were in competitive races. Understating profits can help deflect attention away from the firms’ outsourcing activities, and thus spare the candidates considerable embarrassment. We find that outsourcing firms donating to congressional candidates in closely watched races managed their earnings downwards in the two quarters immediately preceding the 2004 election. We find no evidence of downward earnings management among outsourcing corporations donating to congressional candidates not in closely watched races.
I haven't read the paper carefully enough to have an opinion on the merits. I would like to point out, however, that requiring firms to state average daily debit and credit flows from balance sheet accounts might deter this kind of behavior.
The design of both was predicated on an unlimited supply of cheap fuel.
When SUVs were designed, the costs of fuel were low relative to the joy that people got from driving them relative to other kinds of cars. Nobody cared about miles per gallon. What they wanted to know was how big and how fast it could go. Don't get me wrong. I love cars that growl and shake when you start them. But that growl and shake come literally at the expense of fuel efficiency. The design loses its appeal when the price of fuel starts to cut into my enjoyment of other things.
Similarly, cost accounting was designed to measure and report activities within a firm at a time when "fuel" (i.e., capital, labor, and raw materials) were very cheap relative to the demand for its products. Globalization supercharged that trend, and kept the flawed model of cost accounting on life support. When labor got expensive, we simply moved to another part of the world where it was still cheap. Capital got cheaper! Only raw materials were getting more expensive.
And here we are in 2008, with the number of places in the world where labor is significantly cheaper than it is in the United States shrinking by the day, with capital getting more expensive thanks to inflationary monetary policy, and with raw materials more expensive than ever thanks to an oil shortage.
Time to rethink our theory of accounting folks. It's not how big or how fast you are anymore. It's your miles per gallon that matter.
There has been some academic controversy over the legacy of Milton Friedman of late. The University of Chicago has announced the opening of a new institute, and some left-leaning faculty are concerned that this will upset the ideological equipoise that the University of Chicago has sustained for so long. It's an important thing to be worried about. But it's too bad that these folks think of Friedman as "right-leaning" or "conservative."
Here's what Gary Becker said of his former teacher's public policy agenda shortly after his death in 2006:
I will discuss instead several ideas in his remarkable book, Capitalism and Freedom, published in 1962, that contains almost all his well-known proposals on how to improve public policy in different fields. These proposals on based on just two fundamental principles. The first is that in the vast majority of situations, individuals know their own interests and what is good for them much better than government officials and intellectuals do. The second is that competition among providers of goods and services, including among producers of ideas and seekers of political office, is the most effective way to serve the interests of individuals and families, especially of the poorer members of society.
Are these two fundamental principles conservative or liberal? I don't think so. The reason that Milton Friedman is perceived to be a conservative is because he lived and worked through the post-World War II era in which everybody in power believed that central planning, especially through government, was the answer to social problems. Anybody who has actually read Milton Friedman knows that he understood that there was a legitimate role for government. Chapter 2 of Capitalism and Freedom is entitled "The Role of Government in a Free Society." For Milton Friedman, freedom and government were not mutually exclusive!
We live in a much different era. Thanks to the Internet and globalization, there is no longer a debate about whether centrally planned or decentralized institutions are the better way to organize people. Decentralized institutions are, in fact, the only way to organize people on a global scale, over a long period of time. I believe that if Milton Friedman were alive today, he would be excited about Creative Capitalism, and interested in the idea of rethinking the way we allocate and reallocate scarce resources through property rights (like patents) and contracts (like corporate charters). On my view, he would have been against any reductionist view of the purpose of private institutions.
In this regard then, Milton Friedman was not a conservative, but a liberal. Here's what he himself had to say about his liberalism:
Beginning in the late nineteenth century, and especially after 1930 in the United States, the term liberalism came to be associated with a very different emphasis, particularly in economic policy. It came to be associated with a readiness to rely primarily on the state rather than on private voluntary arrangements to achieve objectives regarded as desirable. The catchwords became welfare and equality rather than freedom. The nineteenth century liberal regarded an extension of freedom as the most effective way to promote welfare and equality; the twentieth century liberal regards welfare and equality as either prerequisites of or alternatives to freedom. In the name of welfare and equality, the twentieth-century liberal has come to favor a revival of the very policies of state intervention and paternalism against which classical liberalism fought. In the very act of turning the clock back to seventeenth-century mercantilism, he is fond of castigating true liberals as reactionary!
If Creative Capitalism meant more freedom, Milton Friedman would have been for it.
See also the first quote describing how Ford implemented a prediction market at its Highland Park plant.
The philosophical underpinnings of much of this can be found in Sloan's "M Form" concept. One of the key ideas was to break General Motors into divisions that would operate "independently" -- decentralized, according to Sloan -- but still reporting to and controlled by the corporate headquarters. Because it was really one company, this decentralization often required the divisions to "buy" and "sell" from each other. Fisher Body, for example, sold car bodies to the Chevrolet Division and so forth. This notion of a company buying and selling from itself flowed down to the very details of the company's cost accounting scheme... The idea is that somehow, even though nobody sold anything to anybody, machining made a profit on the deal, and that profit can be used to measure the return on the company's investment in the machining department.
From Rebirth of American Industry, page 67.
Here's an interesting SSRN paper discussing a government-sponsored review of M Form theory in the Netherlands.
Reporting credit and debit flows for each balance sheet account would make it easier to keep track of how capital expenditures were either helping or hurting the ultimate goal of selling higher quality products to customers.
I've been enjoying the commentary posted at the new Creative Capitalism blog. I love it when people at the very top of their game get together and talk in open-ended terms about how things could be improved. Being able to listen in -- and even participate through comments -- is a totally earthshaking technological change.
I'm on Peter Drucker's side of the discussion about creative capitalism, and whether it has any instrumental value to investors and managers of large institutions. Here's what Mr. Drucker wrote in Management: Tasks, Responsibilities, Practices:
In modern society there is no other leadership group but managers. If the managers of our major institutions, and especially of business, do not take responsibility for the common good, no one else can or will.
Drucker knew that the managers of private institutions would have to take more responsibility for the common good because he understood the limits of centrally planned institutional design. Decentralized control through sponatenous ordering is the only sustainable form of institution over long time periods and large geographical areas. The administrative agencies of the Executive branch of federal government in the United States are an example of how central planning cannot keep up with markets (just look at how well the Federal Reserve and SEC have kept up with the markets).
But how can we improve on the model of management and investing followed in the United States? We have to go back to the fundamentals, and rearticulate why it is that we're measuring and reporting the things we do. In particular, I believe we need to make some important adjustments to how we report things on financial statements. If we were all measuring growth in the same way, then cooperation among the various stakeholders in corporations would be much easier. And competition among various corporations would be more efficient.
So here's my suggestion:
For every balance sheet account, let's include a measure of the average debit flow and the average credit flow in/out of the various accounts on a daily basis over the time period of the financial statement.
Thoughtful managers and investors may recognize how this additional measure of liquidity would help us to distinguish between a healthy corporation that is on track to grow sustainably during the next period, and a sick corporation that is being unwound slowly to generate as much cash as possible before dissolving.
Consider who within our economy is now best trained at measuring and reporting the average frequency of different economic events. With that answer in mind, is it any wonder that some of the best investors in the world generate new liquidity through insurance float?
Here are a few links to other posts I've made about how we could do accounting and management differently:
Markets can be modeled as ensembles of parametric oscillators. The parametric oscillator model is the simplest model that is useful in understanding dynamic market prices. For non-physicist readers, you've made a parametric oscillator whenever you've pumped your legs on a swing to change your frequency of oscillation. If you've ever had somebody push you, then you've made an amplified parametric oscillator, which is equivalent to a market hooked up to a time-varying external money supply.
Supply can be modeled as an ensemble of oscillators, one for each person. The cumulative frequency distribution of the supply ensemble is equivalent to the aggregate supply available to a market within a window of time. Demand can be modeled as an ensemble of oscillators, one for each person. The cumulative frequency distribution of the demand ensemble is equivalent to the aggregate demand available to a market within a window of time. See here. Elasticity is a function of the fatness of the frequency distributions at the half-maximum to their peaks. The distributions will be poissonian in shape.
Both cumulative distribution functions can be parametrized in terms of the opportunity cost of any scarce resource within an economy, or in terms of a currency that does not vary fast with respect to other currencies within the size of the time window. (Doesn't that explain why we use currency rather than bartering?)
The "temperature" of these ensembles (i.e., the shape of the distribution for a given amount of capital when scarcity and size of the ensemble are fixed) will be a function of the capital available. Similarly, other changes in the cumulative frequency distributions of supply and demand will be a function of capital (energy), scarcity (volume), and the size of the ensemble (pressure). If the changes are made slowly with respect to the time windows within which the distributions are measured, then convexities in the function of frequency with respect to increasing capital, decreasing scarcity, and increasing ensemble size may be observed. Certain ranges of capital, scarcity, and size of the population will be characterized by certain types of structures. In other words, as capital, scarcity, and size of population are tuned through different ranges, spontaneously ordered structures for the allocation of capital and resources throughout the ensembles will emerge. Thus, the parametric oscillator model is consistent with a thermodynamics of institutional design.
Thermodynamics gives us no insight into how and when change will occur. But the parametric amplifier model also permits an insight into market dynamics. According to this model, the ensemble of supply oscillators couples nonlinearly to the ensemble of demand oscillators. Mathematically, the mechanism for coupling is analogous to a damping force on each ensemble that is, in part, a function of the frequency distribution for the other ensemble. In other words, the oscillations of the two ensembles don't simply add or subtract from one-another. They can multiply or divide one-another.
In practice, the coupling mechanism might be provided by anything that causes the frequencies of the ensembles to multiply rather than add, such as transactions costs or liquidity constraints that do not vary linearly with the quantity of goods exchanged. Study of models of the coupling mechanism will be one of the most fruitful areas of research for econometricians. For the coupling mechanism is not simply a function of the frequency of the supply and demand ensembles of the market in question. Rather, it is a function of the frequency distribution for any supply or demand ensemble with non-trivial cross-elasticity with the supply and demand ensembles for the market in question. The coupling mechanism, including the phenomenon of cross-elasticity, is the dynamic mechanism that describes how and when phase transitions will occur.
Note that variations in external money supply would be a source of capital to the supply or demand ensembles that should be considered separate from the coupling mechanism. Thus, an increase in external money supply might give rise to parametric amplification. Variations in external money supply add many complications to understanding the dynamics of parametric oscillators. Having a Taylor rule that describes how the external money supply varies in time makes the model easier to solve.
Parametric oscillators exhibit many interesting dynamics. One is the phenomenon of parametric resonance, whereby the ensembles may become synchronized in phase. Phase synchronization is an implicit or explicit characteristic observable in all markets. Another is the phenomenon of parametric instability. Price bubbles can form when the resonance peak (or peaks) are too high-frequency to be sustainable.
For the Hayekians out there, given constant resources and population, as capital is removed from the system, spontaneous symmetry breaking will result in new spontaneous ordering of capital, resources, and population within the market. In other words, holding two out of three of capital, resources, or population fixed, and minimizing the other variable will lead to more spontaneous order within society.
As an end note, the wave equation necessary to the parametic oscillator model will not apply over longer time scales. Wave equations are second-order in time. For very large time windows, dissipative forces will have more noticeable effects, and a heat equation (like the Schrodinger equation) will provide a better approximation of dynamics. The difference in observable dynamics at different time-scales is part of why microeconomics and macroeconomics are not readily joined in econometric theory.
A while back, Jason Mendelson wrote a great post about his frustration with "startup lawyers," by which he means outside counsel who work on transactions relating to portfolio companies. Like many consumers of legal services, Jason is frustrated with a trend toward lower quality and higher cost.
I don't want to get into the discussion of what trends have emerged and why here. Rather, I want to ask the question of why more VC funds haven't hired outside counsel to come work in-house doing work for portfolio companies.
Benefits:
Disadvantages
Note that nobody could eliminate outside counsel because of the superior access to information about new case law, unusual market scenarios, the database of internal legal documents built up over years for use in a variety of client matters, lower cost ability to generate stock ledgers, etc.
Often, VCs invest millions of dollars into a new round of financing, only to demand that the startup company turnaround and pay outside counsel for the tens of thousands of dollars in costs of advising on the transaction. I understand why this is done from an accounting perspective. But it is not so cost efficient.
Symmetries as Schelling Points
Game theorists know that games with symmetry in payoffs are easier to solve. Appendix B of The Strategy of Conflict by Thomas Schelling is titled "For the Abandonment of Symmetry in Game Theory." In this appendix, Schelling argues that
though symmetry is consistent with the rationality of the players, it cannot be demonstrated that asymmetry is inconsistent with their rationality (page 278)
In other words, symmetry is not a necessary condition to rationality. But as Schelling documents in Appendix B, this truth was not clear to all game theorists. In particular, Harsanyi referred to the symmetry axiom as the "fundamental postulate," and said that "the assumption underlying the axiom is that a rational bargainer will not expect a rational opponent to grant him larger concessions than he would make himself under similar conditions."
Schelling goes on to ask whether the symmetry postulate can be derived from rationality. He concludes that it cannot. Thus, he observes that
we must be careful not to make symmetry part of the definition of rationality; to do so would destroy the empirical relevance of the theory and simply make symmetry an independent axiom.
In other words, we need more than the assumption of rationality to predict the outcome of any game. But what, aside from the assumption of rationality, could be as fundamental? Schelling does not give a direct answer. Rather, he observes that
a theory of strategy ... is inherently empirical; it depends on how people coordinate their expectations.
From here he goes on to make his famous hypothesis that rational people will coordinate their behavior through focal points -- i.e., the most obvious answer known by prior experience to both people. The theory of focal points resolves the paradox of symmetry and rationality by assuming that the Nash equilibrium will be the focal point for rational actors. In other words, where obvious symmetries exist in payoffs, rational actors will tend to focus on those symmetries.
How Schelling Points Led to an Attack on the Rational Hypothesis
The explanatory value of focal points in understanding conflict and cooperation has led to advances in many fields of economics and politics. Schelling later won a Nobel.
Inevitably, the theory of focal points has pushed many economists and political scientists to undertake a more serious study of psychology. If theories of strategy are inherently empirical afterall, then cognitive and behavioral limits must be important in determining focal points.
But somewhere along the way, some of the academics studying behavior forgot that the end goal was to observe and hypothesize focal points. Their focus instead fell upon the hypothesis of rationality. This isn't surprising given that the observed behavior of individual humans often seems to contradict the hypothesis of rationality. The hypothesis of rationality is not a psychology; rather, it is a prediction about how, on average, large groups of people will behave over long periods of time. It is thus an empirical hypothesis, not about individuals, but about groups -- very large groups, in fact.
Yet the attack on the hypothesis of rationality has been distracting for two reasons. First, and less importantly, in many cases the attack on the rational hypothesis has led to a misunderstanding about what, exactly, the hypothesis of rationality hypothesizes. I do not mean to impugn all research on the subject. Much of it is quite interesting and useful. But it has been misleading to non-specialists.
Second, and more importantly, the attack has distracted theorists and experimentalists from the task that Schelling gave them of identifying empirically useful focal points. In fact, theorists of econometrics have gotten so distracted that some have given up entirely on identifying focal points that could be used to model collective behavior as complicated as market prices. Their approach instead has been to substitute ad hoc models of psychology to limit the hypothesis of rationality. This, in turn, has led to intractable mathematics and insoluble debates over what approximations are reasonable as limits to rationality.
Broken Symmetries as Schelling Points
Theories of economics and political science are starved for a new focal point theory that is useful and general as an empirical observation and consistent with the hypothesis of rationality. There is such a focal point. And what should not be surprising is that it was overlooked for the same reason that Schelling points were overlooked by other academics before The Strategy of Conflict. Specifically, academics had reached a tacit agreement that symmetry would be the basis for theories of rationality. Schelling's ability to see that symmetry was only one focal point among many that could have been chosen is the reason why he is justly lauded for his deep insights into human social behavior.
And since Schelling understood how Schelling points could lead to tacit agreement, naturally he was able to identify symmetry as a Schelling point for academic economists, and ask, in effect, "Why symmetry?" The answer he suggests is that symmetric problems are easier to solve mathematically.
This is certainly true. To wit, to be soluble, mathematical models for market equilibrium (and hence price) provided by economists must assume that wealth is conserved (i.e., is not created or destroyed). Equilibrium cannot be defined when total wealth is unstable. What only few economists may realize, however, is that (under Emmy Noether's Theorem) conservation laws are mathematically equivalent to symmetry invariance. In this case, wealth conservation implies time invariance.
Given the empirical fact that symmetries are often broken, it is natural to ask, then, what hypothesis about the social behavior of large groups over long periods could be nearly as fundamental as the hypothesis of rationality -- remembering, of course, that the rules of the game are to find a hypothesis that is also consistent with the hypothesis of rationality.
My humble suggestion is the following:
The activities of people change in time according to rhythms that, averaged over a population within a period of time, have a characteristic distribution in frequency.
I call this the fundamental hypothesis of periodicity. The hypothesis can be demonstrated to be consistent with the fundamental hypothesis of rationality by observing how supply and demand curves can be integrated up from underlying frequency distributions. Nonetheless it provides new insights into how elasticity and price dynamics arise from the aggregation of rhythms in the behavior of large numbers of people over long periods of time.
Periodicity is a focal point that is unexplored by economists, political scientists, and others. It could serve as the foundation for a more complete empirical theory of the firm.
Have you ever wondered why startups are better at innovating than larger corporations?
Some people say that it's because of the culture, which promotes teamwork. Others say it's the focus on a constrained set of resources. Both are true to some extent. But I don't see either as the root cause.
Startups are often founded by people who are frustrated because their own needs have not been met by existing products or services. In other words, unmet needs are the source of inspiration to inventors.
Inventors are simply frustrated customers.
And if you think about it, this might explain why so many venture capital funds, investment banks, and large corporations have failed at promoting innovation. Innovation needs to be driven by customer needs.
Do venture capitalists know customer needs? Some do. But their incentives are driven by large corporations (on the M&A side) and investment banks (on the IPO side).
Do investment banks know customer needs? Some do. But their incentives are driven by whatever will sell at a given moment.
Do large corporations know customer needs? Some do. But their incentives to do M&A may also be driven by (misguided) attempts to increase ROI regardless of whether that will help them sell more at lower cost.
From whence in the cycle of innovation does the knowledge of customer needs arise? It's at the point in the cycle where the beginning and the end meet. Customers are the end, inventors the beginning.
Inventors are customers.
Over at PatentlyO, Dennis Crouch covers the news that McCain has proposed a publicly funded prize for developing a better battery for cars. Dennis also points out how this strategy worked historically for England in solving an important navigational problem: John Harrison solved the timing problem by miniaturization.
One can only hope that this is a symbolic gesture by McCain toward the need for patent reform. $300 million is only a drop in the bucket that has already been spent on solving this problem. Ballard Power Systems, for example, has by itself spent at least that amount developing fuel cell technology, which many scientists believe to be a more viable alternative to the battery as a non-oil alternative power plant for cars.
I point this out not because I want the government to spend more money than McCain has earmarked for this R&D, but because I want the government to spend less money. That money has to come from somewhere folks. And that somewhere is taxes. Don't bet on it coming from a higher capital gains tax if McCain were elected either. The possibility of having another "conservative" president in office, increasing spending, decreasing taxes, and increasing money supply is terrifying to me. Already it appears that the United States has indentured itself to the rest of the world for the foreseeable future thanks to our profligate spending and inflationary monetary policy over the past few decades.
There is a proper role for government "prizes," a role that the NSF and NIH have been performing quite well for decades. That role is in funding the curious exploration stage of scientific discovery. Observations of nature are often the source of inspiration for later innovations by authors and inventors. Few businesses in the history of the world have been willing to pay for curious exploration of the natural world. We still need government funding for that.
But we should limit government funding to that stage, and let the needs of industry drive funding for development of those natural observations into new products and services. The distortions in the food market that resulted from government subsidies of ethanol production are Exhibit A as to why government funding of R&D is a bad idea. Government starts with a noble plan: to reduce global warming. But it ends with people starving in the developing world. To avoid catastrophe, investing must be disciplined by market needs -- a discipline that government, by definition, lacks. Private markets and firms are a cheaper way to make things than government because they don't make money unless they match (i.e., synchronize) their outflow of things to an inflow of demand for those things. Government doesn't have to (at least not over the short-term).
The United States should follow the example of the 15th Century Venetians, who harnessed the power of market-based incentives to encourage innovation in solving the most important problems their society faced. Read this description of how inventors worked together at the Arsenal, the 16th Century equivalent of Ford's Highland Park manufacturing plant (but for boats, not cars):
Everything concerning ship-building and armament, direction of the works, purchase of wood and iron, organisation of the workshops, discipline of the workmen, commanding of the troops, training of the seamen, storekeeping, provisioning and contracts was under the provveditori. They formed themselves into a committee for testing and examining all the new inventions submitted by their fellow-countrymen or by foreigners.
Rather than $300 million for the particular purpose of batteries, why not $300 million for marketing and public education about the patent system? The provveditori are like a combination of modern day venture capitalists and patent examiners. I don't think most Americans have any idea how important the patent system is to our future. Maybe patent law is too important to be left to the patent lawyers.
Update: I can't find a good modern analogy to the provveditori. Their work is performed by a combination of people and computers today. In some ways, they are like a heijunka box. In others, they are like patent examiners, lawyers, consultants, or investors. Their role in many companies today seems largely to be filled by goods and services obtained from various markets external to the company. Have we made a step forward or a step back?
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