Broken Symmetry

Elves or Trolls? According to Robert Frost, it's Neither

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."

Creative capitalism accounts for both money and time

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.

Bleg: Where to find the best online discussion of accounting rules?

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.

Why is the legal profession so regulated?

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.

What does it mean to be free? Both rationality and periodicity should be considered.

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.

Focal Points Constitute Organizations by Synchronizing the Phase of Human Rhythms

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.

Why France should join the Hayek club

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.

The Long Tail Revisited

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.

Reigniting the Engine of Growth with the Sparkplug of Invention

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.

A Neuroscientific Explanation for the Hypothesis of Periodicity and the Synchronized Flow Theory of the Firm?

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.

Accounting Information as Political Currency

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.

What the Design of SUVs and Cost Accounting have in common

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.

Milton Friedman the Liberal

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.

Another Waddell & Bodek Quote

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.

Creative Capitalism = Sustainable Capitalism

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:

• Inventors are customers
• Markets and firms maximize profit by synchronizing the flow of supply to demand.
  • The neuroscientific mechanism for synchronized flow.
  • Relationship to Coase, Alchian & Demsetz, and Williamson.
• Could Bear Sterns have avoided disaster were debit and credit flows reported to its management?
• Cost accounting and lean accounting are both needed as views of firm financial health.
• Why Wall Street ignores balance sheets
• Response to Summers on Regulatory System Design

The Ensemble of Parametric Oscillators Model of the Economy

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.

Why don't VC funds employ in-house lawyers to do work for portfolio companies?

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:

• Lower fees from outside counsel, probably more than offsetting the salary cost
• Better quality services from outside counsel (higher bandwidth communication, especially when it's with a former colleague)
• Less worry about the billable hour clock by the in-house lawyer, which means more efficient allocation of time to various legal problems
• Lower cost to lawyer spending time on-site with portfolio companies to proactively avoid legal problems
• Lawyer also available for consulting on fund-related issues when not needed at portfolio companies

Disadvantages

• Requires outlay of cash-flow from management fees to cover salary
• Agency costs that could result from soft kickbacks between in-house lawyer and outside counsel (relatively easy to reduce with monitoring)
• Misalignment of incentives between lawyer and portfolio companies because salary is paid by VC fund (but this one is shared with the VCs!)

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.

Inventors are Customers

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.

Why the Venetians didn't invent a Prize system for Inventions

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?

Evidence for the Synchronized Flow Theory of the Firm

Following the lead of my favorite VC blogger Fred Wilson, who has been posting quotes from books he's been reading.  I'm going to start posting some quotes from an extraordinary book I found through Kevin Carson at the Mutualist blog (the purveyor of "free market anti-capitalism").  The book is called Rebirth of American Industry, and was authored by William Waddell and Norman Bodek.

The Shortage Chaser was the man charged with keeping on top of it all. He held forth in an office on the shop floor called the Clearinghouse, and he had a small gang of Checkers and Counters working for him. The Checkers and Counters constantly (as their job titles suggest) checked production volumes and counted parts and subassemblies throughout the plant and reported back to him.  The Shortage Chaser kept tally on blackboards in the Clearinghouse...

That's a description of the inner workings of Ford's Highland Park plant.  The book is chock full of these on-the-ground insights.

The question of how that blackboard and the people using it are different from a public market price and the people using it is at the core of understanding how M&A or outsourcing can either create or destroy value.

The Neuroscience of Synchronization

Today I got my hands on a copy of the newest Daniel Goleman (author of Emotional Intelligence) book, titled Social Intelligence.

Goleman summarizes research showing that there are "high road" and "low road" channels of communication operating most of the time in social interactions.  The high road corresponds roughly to processing of ideas.  The low road to emotional signals, which are exchanged through facial expressions, tone of voice, and language including body language.

Interestingly, the low road can function smoothly even as the high road is disrupted, but the converse is not true.  In other words, most people, if distracted with math questions while playing chess, won't play chess as well; but the same people will usually be able to detect whether the voice asking the math questions sounded happy or sad.  By contrast, the high road gets disrupted when the low road is disrupted -- if I shout angrily or sob while I'm asking you complicated questions, you'll most likely show less accuracy in answering them.

Assuming I'm understanding the summary of research correctly, this has fascinating implications for the synchronized flow theory of the firm.

• When low road information is likely to be disruptive (e.g., in buying and selling securities because of the powerful herd instincts triggered by mirror neurons), market signals may be the best means for synchronizing the flow of supply and demand.
• When low road information is likely to be important (e.g., in supplying specialized services, such as legal advice or psychiatry), market signals may be a poor means for synchronizing the flow of supply and demand.

Another finding summarized in the book is that low road communication tends to improve through repeated cooperative interactions.  A firm that has success with internal flow synchronization will thus tend to build on its strength, whereas a firm that tries and fails may disintegrate -- even when a second or third try might be successful.

A New Kind of Firm for the R&D Market

Having articulated an improved theory for the firm, one which makes explicit the value of matching supply and demand cycles, I can now say why, in accordance with that theory, a new kind of firm would be beneficial to the market for R&D.

For at least three reasons, market price signals have failed as a means for coordinating the supply cycles with the demand cycles for R&D.

1. Most basic science is now funded by the government.  R&D therefore tends to be supplied much earlier than the demand for it by large firms.  Thus, there is a funding gap between research and venture-capital backed startups.  This funding gap is part of the cause for the observation by many R&D buyers that "ideas are cheap."
2. Even when supply and demand can be matched in time, sensitive ownership and trade secret issues raise the transactions costs for transferring technology from one large entity to another
3. There is a shortage of service professionals (especially patent lawyers) who understand R&D and can assist in negotiating technology transfers.  This shortage has hit the inventors the hardest.

Some inventors have given up on finding proof-of-concept financing for their work, only later to watch a venture-capital backed startup make millions or billions, with very little (if any) flowing back to the pioneering inventors.  Some large firms have gotten tired of paying millions or billions for startup companies, only later to layoff the employees who do similar work to what is already done by top-quality teams within the large firm.

Since the Bayh-Dole Act was passed in 1980, our best scientists and engineers have been less concerned with industrial R&D needs, instead being content to turn their published papers in to the technology transfer office so that a patent application can be churned out.  Every once in a while, a graduate student drops out to start a new company with a new idea.  In technology corridors like Silicon Valley and Boston, that every once in a while has been often enough to make a few professors rich.  But the rest of the time and at most universities, if an idea turns out to be valuable enough for industry to commercialize, the university ends up negotiating a license for patent rights alone.  Often and at an increasing rate, that negotiation comes at the end of a long litigation.

Venetian Capital Management provides a new way to meet the R&D needs of large firms with the best R&D teams available for those needs.  Inventors or large firms interested in learning more about Venetian Capital Management services should contact me by email.

The Synchronized Flow Theory of the Firm

The Past

• Ronald Coase argued in 1937 that firms emerge when the costs of discovering relevant prices and closing contracts for outsourcing a job are higher than the administrative overhead costs of managing the job in-house.
• Armen Alchian and Harold Demsetz in 1972 extended the Coase argument by observing and describing how monitoring costs could be reduced by managers who work in exchange for the residual income from team production (i.e., equity).
• Oliver E. Williamson in 1975 extended the work of Alchian and Demsetz by observing and describing how "asset specificity" affects the residual income of the firm.  Whereas Alchian and Demsetz analyzed how specific structures of people within the firm affect profitability, Williamson analyzed how specific structures of things possessed by the firm affect profitability.

All of these theories are based on a time-averaged picture of production within the firm.  All of these models ignore the rhythms of supply and demand for production and consumption within our economy.

The Present

Despite the challenges of a rapidly evolving global economy, investors are frustrated by the repeated failures of managers at maintaining consistent levels of profitability.  Some investors and politicians identify problems with corporate governance as the root of the problem.  But many managers and directors have acted in good faith and failed because they were without the information or theories needed to guide decisionmaking in a dynamic world.

At the same time, a few managers and investors have rediscovered the dynamic lessons learned during the industrial era, but forgotten thereafter.  Lean accounting and management and the Toyota Production System have moved in the right direction by taking advantage of a frequency-averaged picture of production within the firm to increase residual income by making more efficient and sustainable use of the people and things associated with the firm.  Benjamin Grapham and his students have been taking advantage of a frequency-averaged picture of the firm for decades.

The Future

The dynamic, global economy calls for an improved theory of the firm:

• 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.

Some thoughtful readers will understand how this theory is consistent with Coase, Alchian & Demsetz, and Williamson.  By looking under the hood of the time-averaged picture of supply and demand and discovering beneath them the cycles of supply and demand at work within the engine of the firm, we can understand the function of price signals within the market.  The relationship between time and frequency (i.e., in accounting, the relationship between average cost and average liquidity) is fundamental to an understanding of dynamics.

Self-organized Criticality and Commerce Clause Jurisprudence

Consider the description of the natural phenomenon of self-organized criticality (SOC) offered by Jensen:

"What kind of systems will evolve into a SOC dynamical state?  A separation of time scales is required.  The process connected with the external driving of the system needs to be much slower than the internal relaxation processes.  The prototypical example is an earthquake.  The stress in the earth's crust is built up on the scale of years owing to the motion of the tectonic plates.  The stress is subsequently released in a few seconds or minutes during an earthquake."

This called to mind the famous metaphor for markets offered by Judge Learned Hand in the Schecter Poultry case:

"In an industrial society bound together by means of transport and communication as rapid and certain as ours, it is idle to seek for any transaction, however apparently isolated, which may not have an effect elsewhere; such a society is an elastic medium which transmits all tremors throughout its territory; the only question is of their size."

Judge Hand here is describing SOC dynamics.  The metaphor may be more literal than he imagined.  For there is some evidence of SOC dynamics in markets.

The implication is that the firms interact with one-another in the market the same way that tectonic plates rub against one-another under the crust of the earth.  Most of the time, we're not even aware of the tension building.  But every once in a while, our whole economy gets a good shake.

Incidentally, the Schecter Poultry case was the last in a line of Supreme Court cases stretching back to Lochner v. New York (1905) in which the Supreme Court ruled unconstitutional various restraints of contract (such as minimum wage and maximum hour laws) enacted by Congress.  The end of the line came in West Coast Hotel Co. v. Parish (1937), when the Supreme Court upheld a minimum wage law in the shadow of threats by President Franklin Roosevelt to "pack the court" with additional justices who would be more favorable to his desire for a more powerful administrative state.  At the time, the President and Congress felt that expanded Executive and Legislative authority were necessary to avoid the market failures of the Great Depression.  Does this sound familiar?  We should attend to these details of history, since good intentions like these often lead to unanticipated consequences.

Fortunately, unanticipated consequences are both good and bad.  One uanticipated consequence of the expansion of Congressional authority under the Commerce Clause was the Civil Rights Act of 1964, which was probably the most important step toward reconciliation of racial conflicts in the United States since the end of the Civil War almost 100 years earlier.  But the opaque and labyrinthine bureaucracies of Federal administrative agency authority is net a more negative consequence.

How Bear Sterns is like Easter Island

Yesterday I got my hands on a copy of the latest book by Jared Diamond (author of Guns, Germs, and Steel).  His newer book, Collapse, is an anthropological study of how various societies around the world have failed through lack of coordination.  I couldn't help blogging the thought that some of the disasters he describes in this book could have been avoided had more information been available about the relative frequency of supply and demand.

In the book, Diamond describes how the resident of Easter Island disappeared after failing to coordinate consumption of the trees growing on the island.  They used them all up before new ones had time to grow.  The society collapsed afterward.

Imagine that everybody on Easter island could easily access the following information:

• the number of trees
• how many trees were cut down per day (or month, or year)
• how many new trees grow per day (or month, or year)

Even the worst mathematician could have recognized at a glance that the trees were going to be used up faster than they were being grown.

But are we really any smarter or better coordinated than the residents of Easter Island?  I say no.  For what's the difference between keeping track of the amount of subprime mortgage assets you have on your books without keeping track of influx (i.e., number of new subprime mortgage assets added per unit time) and outflux (i.e., the number of subprime mortgage assets sold per unit time).  In this sense, managers at investment banks like Bear Sterns didn't do much better than the residents of Easter Island.  Bear Sterns did do better at least in the sense that there are a few people left at Bear Sterns.  But that's cold comfort.

The moral of the story is that bad things happen when you don't keep the rhythms of supply and demand locked in phase and frequency.  Requiring companies to report turnover rates for each balance sheet account would be a good start in that direction.

Does the long tail result from a power law?

No. Wired's Chris Anderson published an article and later book on the "long tail" that characterizes demand for information.

The hypothesis advanced by Anderson and others is that this long tail results from a power law in demand -- i.e., that the slope of the demand curve declines algebraically rather than exponentially, even at high levels of quantity.  Others have noted how this would be a major coup in economics, since the law of demand from economics predicts a faster than algebraic decay.

Let me suggest how this paradox might be resolved.  In fact, the distribution of consumption for information is not governed by a power law.  Rather, the distribution is poissonian in shape.  The poisson distribution can be approximated with power laws when the mean frequency of events is close to zero.  But unlike the power law distribution, the poisson distribution approaches zero at zero frequency.

The effect of these differences is that the cumulative distribution function -- i.e., the aggregate demand, still has a well-defined peak in quantity.  The fat-head is finite.

This mistake is easy to forgive since people confuse local trends with power laws all the time.  I may blog more at some point about how the notion that a power law applies to demand for information is misleading.

Cost Accounting and Lean Accounting as a Fourier Pair

Time and frequency have a mathematical relationship, which Joseph Fourier is famous for analyzing.  For example, a spike in time is a constant in frequency, a switch on and off in time is a squiggly Bessel function in frequency, a sinusoidal wave in time is a spike in frequency, and a comb of spikes in time is a comb of spikes in frequency.  This is true because waves of different frequency add.

Cost accounting is about presenting a time-integrated picture of cash-flow (the income statement) and a snapshot in time (the balance sheet).  As advertised, cost accounting is very useful in calculating time-averaged costs, such as the raw goods, labor, and overhead required for selling products over a period of time.

By contrast, lean accounting is focused on frequency-averaged costs, such as value-stream efficiency, scrap rate, lead time, and inventory turnover.  As advertised, lean accounting is very useful in identifying and removing bottlenecks in production that increase costs of sales.

Can you see how cost accounting is a time