The Competitiveness of Nations in a Global Knowledge-Based Economy
Brian J.
Loasby
Options and Evolution
DRUID Summer Conference 2002
He1singør 6-8 June
Content
Interconnections and Uncertainty
In 1997 the Nobel Prize in Economics was awarded for major
developments in option theory, and the use of both financial and ‘real’ options
is a notable feature of the ‘new economy’. The lectures given by the Prizewinners, which
were published in the American Economic Review for June 1998,
celebrate these theoretical and practical developments and envisage their
further extension, with a confidence equivalent to that displayed a little
later by commentators on the prospects for e-commerce.
Robert Merton begins his lecture with a declaration that “[t]he
special sphere of finance within economics is the study of allocation and
deployment of resources, both spatially and across time, in an uncertain
environment” (Merton, 1998, p. 323), and a little later asserts that “the
underlying conceptual framework originally used to derive the option-pricing
formula can be used to evaluate and price the risk in a wide array of
applications, both financial and non-financial” (Merton 1998, p. 324). Finance thus not only deals with uncertainty
but has exclusive rights to do so. Both
claims deserve comment.
Merton’s unsignalled change of terminology, from “an
uncertain environment” to “evaluating and pricing risk”, appears to treat
option theory as the modem philosopher’s stone, which transmutes uncertainty
into manageable risk. Almost 70 years
ago, Knight (1933, p. xiv) was “puzzled by the insistence of many writers on
treating the uncertainty of result in choice as if it were a gamble on a known mathematical
chance”; but this is a methodological necessity if economists desire to be
consistently orthodox, and indeed if whole realms of theory - not just option
theory - are not to collapse. However,
as Shackle (1972, p. 425) observed, “[a] training in value theory can have a
strange effect on the individual mind. It
can give rise to a fundamental scepticism concerning the reality of ‘events’. The mind which has been taught to suppose that
the norm of conduct is rational conduct... draws the tacit inference that...
the fully successful individual would encounter nothing in life that he was not
prepared for.” Such indeed appeared to
be the state of mind of Merton and Scholes in devising the operating strategy
for Long Term Capital Management.
Merton’s second claim is a separation theorem: uncertainty
is the sphere of finance, and so economists in all other branches of the
subject should make no specific allowances for it in their own work. Separation theorems play an important role in
delimiting spheres of economic analysis: it has long been assumed, for example,
that the microeconomic theory of resource allocation and monetary theory are
entirely separable, despite Martin Hellwig’s (1992, p. 232) warning that “[o]nce
we accept the fundamentally non-Walrasian nature of the organization of
exchanges in a monetary economy, we are led to question... the foundations of a
good part of microeconomic theory and welfare economics”. Since “[o]ne must introduce uncertainty,
before one can introduce money”, as Hicks (1982, p. 7) realised in 1933, there
is a common source of danger in these two particular separation theorems. If uncertainty is squeezed out of the model it
inserts itself into the gap between the model and the phenomena to which it is
applied - which is precisely what Merton and Scholes discovered.
It is not only in economics that separation theorems are
widely used. The division of knowledge
within any major academic discipline and also between disciplines assumes at
least quasi-independence; and within any large organisation the allocation of
responsibilities, the imposition of divisional, departmental or individual
targets, and the use of cost and profit centres all imply substantial
separability between classes of activity. Such assumptions are not errors, but a
consequence of human limitations; in order to develop any understanding we all
need to disentangle interconnected phenomena for separate treatment, by
creating imperfect representations of these phenomena. As Herbert Simon (1969) pointed out long ago,
decomposability is an indispensable if dangerous assumption; but it is
therefore essential to recognise what Levinthal (2000) has called ‘the
fallacies of decomposition’, both in organisational design and in academic
disciplines. The reluctance of
economists to treat decomposability as problematic, either in their own
practice or within the models that they construct, limits the content and
applicability of their models, sometimes at substantial cost to public welfare.
The space of representations does not
coincide with the space of phenomena, and may therefore have significantly
different properties. The theoretical
developments which were rewarded by the Nobel Prize are potentially valuable,
but - like any knowledge claim - they should be recognised as a set of
conjectures that “will exist by sufferance of the things which it has excluded”
(Shackle 1972, p. 354).
Merton concludes his lecture with a brief paragraph of
caution in which he appears to acknowledge this inherent problem. “The mathematics of financial models can be
applied precisely, but the models are not at all precise in their application
to the complex real world... The models should be applied in practice only
tentatively, with careful assessment of their limitations in each application”
(Merton, 1998, p. 343). This final
paragraph is in sharp contrast to the confident tone of the twenty pages that
precede it; but despite a brief reference to a few “unfortunate pathologies”
(Merton, 1998, p. 340) the chief problem that he identifies is the need for
increased training in mathematical modelling. Scholes gives a section to pathologies, but
attributes the more serious failures to unwise government guarantees to
financial institutions, and his final sentence is unqualified: “In a world of
information asymmetries, derivative instruments provide lower-cost solutions to
financial contracting in a dynamic environment and these lower-cost solutions
enhance economic efficiency” (Scholes, 1998, p. 368). Those who seek to develop useful products seem
to be significantly (though not invariably) much more conscious of the
difficulties of turning promising theoretical or experimental results into
valuable goods and services than economists are of the difficulties of turning
their own models into viable policies.
The major future development, Merton believes, is in
corporate strategy. “For example, a hypothetical
oil company with crude oil reserves and gasoline and heating-oil distribution
but no refining capability could complete the vertical integration of the firm
by using contractual agreements instead of physical acquisition of a refinery”
(Merton, 1998, pp. 342): options to deliver crude and receive refined products
avoid the uncertainty which is associated with large fixed-cost commitments. (Enron is cited as an illustration of the
possibilities.) What is surprising is
that Merton fails to pursue the simple logic of his analysis: not only does an
oil company not need to own a refinery; it does not need to own oil reserves or
distribution facilities either. Moreover, no-one needs to own a refinery;
option contracts for the use of particular
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items of
equipment and for the use of specified labour inputs deliver optimal
allocations while avoiding commitment. Productive
activities can be decomposed into individual option sets, linked by a nexus of
contracts.
This is, of course, an updated version of the Arrow-Debreu
model of general equilibrium, which was developed precisely in order to
encompass, in Merton’s phrase, “the study of allocation and deployment of
resources, both spatially and across time, in an uncertain environment”: in
this version the complete set of contingent commodities, encompassing all
possible future states of the world, is partly - or even completely - replaced
by present option contracts for corresponding contingencies. Instead of present contracts for contingent
goods, decisions are postponed until the contingencies are revealed, but the
value of an option to a potential purchaser cannot be calculated unless both
the probability of each contingency and the decision which matches it is
already known; thus the information requirements are identical. Both versions ensure allocative efficiency
with no need for managers, organisation, or social institutions of any kind. That is why Merton is strictly correct to
describe as “vertical integration” what industrial economists used to call
‘vertical disintegration’; the complete integration of contracts is essential
for Walrasian results. Scholes (1998, p.
367) is less inhibited: “I believe that the corporate form we know today will
not be long-lived”. The force of Merton
and Scholes’ argument is that the development of option theory invalidates
Coase’s ([1937] 1988, pp. 39-40) explanation of the firm - which neither of
them mention - as a contract for the performance of future activities which are
deliberately left unspecified; complete contracts are now possible, and they
will always drive out incomplete contracts because, as every neoclassical
economist knows, they are necessarily more efficient.
Knight’s distinction between risk and uncertainty was the
foundation of his theory of the firm: risk could be insured, but uncertainty
had to be continuously managed (Knight, 1921, p. 259). In his first published article, George
Richardson (1953) adapted Knight’s distinction between situations which can be
assessed by agreed procedures and those which require idiosyncratic skills, in
a fashion which directly anticipates his later emphasis on distinctive
capabilities: he even included a reference to Gilbert Ryle’s (1949) distinction
between ‘knowing that’ and ‘knowing how’. We should not therefore be surprised to find
that in claiming that all uncertainty can in principle be handled by agreed
procedures (even if those procedures are somewhat esoteric - and therefore
deservedly well-rewarded) Merton and Scholes are led to predict the
disappearance of management; they should, however, also have predicted the
disappearance of profit, even for themselves.
Soon after the publication of these articles, uncertainty inserted
itself into the gap between the models which Merton and Scholes had devised for
their profit-making enterprise and the phenomena to which they were applied,
with spectacular consequences.
It is not my purpose here to examine the usefulness of
options and derivatives as financial instruments; we all rely on them in some
form (often indirectly), and extensions of their use can often be valuable,
though, like many other useful techniques, they involve some dangers. Nor do I wish to deny Merton’s claim for the
wider importance of options or derivatives. On the contrary, I wish to enlarge it, for I
believe that they actually have much broader, and indeed more fundamental,
relevance than he has recognised. But
this broader relevance cannot be encompassed, as Merton assumes, by “the
special sphere of finance”; it requires a generous context
of
economic analysis and a larger conception of the economic system, in which the
fundamental imperfections of human knowledge are not disguised by the
imposition of probabilities, either supposedly objective or subjective, but are
directly applied to the explanation of economic phenomena. My purpose in this paper is to indicate what
is required, and what options for theory are thereby opened up. In doing so I am applying Richardson’s
conviction, formed very early in his career, that “it was precisely the
uncertainty and fragmentation of knowledge that gave to the economic system its
essential rationale” (Richardson. 1998, p. xi).
Interconnections and Uncertainty
The kind of option theory selected for honour by the Nobel
Prize Committee is part of a theoretical structure which assumes not only a
fully-specified economy but also a closed system of knowledge to which
demonstrably correct principles can be applied. It excludes the possibility of surprise - as
Merton and Scholes discovered; for surprise is a refutation not only of a
particular set of options but of the assumption of relevantly complete knowledge
on which all calculation of option values in their models is based. As we shall see, abandoning this structure and
moving from a closed to an open system does not exclude the possibility of
valuing options; but their valuation must be recognised as either a conjecture
or a convention - just like the valuation of other commodities. More importantly, it leaves ample room for the
analysis of options as a protection against genuine uncertainty instead of
misrepresenting it as risk, and even more as a means of generating novelty. As Shackle above all has reminded us,
uncertainty is the necessary price we pay for imagination; it would be a pity
to pay the price without gaining the benefits. Since uncertainty and imagination both imply
that knowledge changes overtime, this shift of perspective also requires an
analysis which, in Hicks’s phrase, is “in time”, and options in this sense may
be incorporated into evolutionary theory.
The conceptual basis for such an analysis has been set out
by Jason Potts (2000). Any system
consists of a set of elements and a set of connections between them. The Walrasian model requires both sets to be
complete: thus the demand for any commodity depends on the preferences of all
consumers for all commodities, the supply of any commodity depends on the total
supply of resources and the technologies available for all commodities, and the
consumer incomes which influence demand are themselves derived from supply. Every element directly influences every other
element. This is essential to standard
Walrasian analysis; and so, though connections are crucial they have no role in
the comparison of Walrasian systems, which depends solely on differences
between the elements. (There is a
flourishing fringe of subsidiary analyses which focus on supposedly missing
connections - principal-agent models and efficiency wage theories, for example -
but they all rely on embedding these local difficulties in an otherwise
completely-connected system.) An obvious
limitation of this conceptual basis is that all change is exogenous, and
attributable to some change in the elements.
Now suppose that we relax both requirements; neither the
set of elements nor the set of connections is assumed to be complete. Endogenous changes may now be produced by rearranging
some of the connections within a system, and new connections may give rise to
subsystems which may constitute new elements within a higher-level system - for
decomposition is inherently problematic, both as threat and
5
opportunity.
Possible rearrangements of connections
from any given starting point may now be thought of as options; and each
starting point will have its own set of feasible options, though this set is
most unlikely to be accurately known by anyone. A variety of starting points then entails a
variety of option sets, and each option that is taken will generate an amended
option set: history matters, because each choice changes the basis for
subsequent choices. Options may still be
valued by making assumptions about of uncertain futures (perhaps using Nobel
Prizewinning methods), but these valuations are conjectures, and are often
wrong. Thus a range of assumptions,
perhaps developed through alternative scenarios, giving a range of values may
provide useful knowledge. The result is
a continuing process of purposeful trial and error, often but not always
resulting in cumulative movement in particular directions. Research may often be designed to create
options for future exploitation, but the ordinary course of business, or of
life, is also a common source of new options. The creation of real options, intended or
unintended, is a source of variety for evolutionary selection.
This perspective on options is closely linked with Carl
Menger’s (1976 [1871]) recognition of the importance of preparing for an
uncertain future by acquiring or developing reserves, each of which allows for
responses to a range of threats or opportunities. Menger understood that money, or financial
reserves in general, and non-financial reserves, such as fire-extinguishers and
medicine chests, were differentiated examples of a broad range of options for
coping with particular kinds of threats and opportunities. This link is reinforced by Menger’s use of the
concept of derivatives as the fundamental connecting principle of his causal
analysis of value. Instead of assuming a
set of goods, as in modern microeconomics, Menger begins by arguing that an
object becomes a good only when someone discovers how to use it to satisfy some
human need. Goods are endogenous,
created by new connections between human need and physical or human resources;
and their value is derived from the need which each of them serves and - crucially
for this paper - from the knowledge that it can serve this need and also the
knowledge of how it can be made to do so. (Both of Ryle’s categories are important.) The creation of goods, and of technology,
rests on the creation of knowledge, and therefore on previous uncertainty - or
indeed sheer ignorance (Kirzner 1999, p. 7). Menger traced the sequence from first-order
goods which are directly useful, through second-order goods which can be used
to produce first-order goods, third-order goods which can be used to produce
second-order goods, and so onto increasingly indirect means of producing
satisfaction, including market institutions and money. The value of a good of any order is derived
from the value of the good which it helps to produce in the order immediately
below, and thus eventually from the need which is ultimately met. Value therefore depends on knowledge, and new
knowledge can both create and destroy value, including the value of options.
Instead of derivatives being a special class of prices,
which are the particular concern of finance theorists, the general theory of
price, according to Menger, is a theory of derivatives. This is potentially a much more useful
conception than Walrasian general equilibrium, not least because it endows
every economy with a distinctive structure, and thus provides a basis for
explaining how and why prices may change: whereas a Walrasian model gives no
clues about the impact of any external shock, the specific structure of a
Mengerian model allows one to trace the likely pathways through which the
effects of that shock may be disseminated, using, creating and destroying
options
in the
process. Moreover, since many goods,
especially goods of higher order, can be used to meet more than one need, they
provide options; and so any choice between uses is a choice between option
values, as these are perceived by the chooser. Thus all choice theory is option theory, which
should not be “the special sphere of finance”. We do not, however, need to assume that all
valuations are correct, or that there is a precise method of imputing value,
such as modern option theory claims to provide. Menger made no such general assumption. On the contrary, by insisting that every
connection within this system depends on human knowledge, which is incomplete
but augmentable, Menger not only makes every price dependent on human
knowledge, but also incorporates uncertainty in his system - and therefore, as
Knight demonstrated, makes room for innovation and entrepreneurship. Differences of knowledge may give rise to
differences of valuation which, as Shackle pointed out, are the basis of
profit.
It is the combination of time and uncertainty that makes
the creation and preservation of options potentially so valuable. Shackle (1972, p. 160) once defined money as “the
means by which decisions can be deferred until a later and better informed
time”; and Coase (1937) explained the creation of a firm as a device for
postponing decisions while simultaneously assembling the resources with which
to implement those decisions at the appropriate time, without the costs of
arranging market transactions before setting to work. Both are means of avoiding precisely-specified
contracts, and are preferred precisely because of their imprecision. Options as defined in finance theory cannot
cover all possibilities - especially those that are not yet perceived, and most
of the options on which we rely are not of this kind. Because of the uncertainty and fragmentation
of our knowledge, every economic system is a network of different kinds of
options, or, to use Menger’s term, reserves. Just as monetary theory is incomplete without
reference to at least the more obvious alternatives to money, so the
restriction of option theory to financial instruments is inadequate; we should
consider a portfolio of options.
Among the resources which may be adapted to a range of
uses, sometimes wide, sometimes narrow, we may include particular skills, the
capacity to acquire new skills, equipment and physical plant, formal
organisations, alliances and networks, reputation and goodwill. Indeed we may find it salutary to consider
life as a process of creating, forgoing, preserving, modifying, relinquishing,
and using options, at the level of the individual, groups, organisations, and
economic systems. Every option is
appropriately valued by the future possibilities to which it gives access,
though determining that value is rarely easy. Because it is the nature of options to change
overtime, in content, in their connection to other options, and in the
perceptions (usually divergent) of their value, a comprehensive treatment
requires a context of process, which economists typically try to avoid. An inherent obstacle to conventional analysis
lies in the purpose of options, which is the selective enlargement of
discretion; for the individual’s freedom to choose impairs the analyst’s
ability to predict. Patterns, however,
such as reliance on particular combinations of options and particular kinds of
institutions, may be more predictable than individual behaviour.
In the remainder of this paper we will explore a little
further this view of options. It is
essential to recognise that the conceptual basis for our exploration is not the
integral
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space, or
fully-connected system, that is assumed in most economic modelling; instead the
assumption is that the internal connections within the systems that we study
are incomplete, and often only a fraction (sometimes zero) of the possible
connections across the boundaries of these systems currently operational. In other words, systems are typically ‘open’
to unrecognised influences, both internally and externally. In particular, the connections between the
representations that constitute our knowledge and the phenomena that each
purports to represent are always incomplete. Now an obvious implication of partial
connections is the potential for adding to or rearranging the present set:
there are always, in principle, options for change. It also seems plausible to argue that the
options that are most likely to be perceived, and the easiest to exploit, are
transitions to ‘adjacent states’ (Potts 2000), in other words those that
involve marginal adjustments, or possibly moves to other systems that are similarly
configured although they may bear different labels, such as fixed-point
theorems for proofs of equilibrium or neo-Darwinian models of evolution for
modelling economic change - or, as a striking example that I recently
encountered from corporate strategy, thinking of airport slots for airlines in
terms of shelf-space for consumer goods manufacturers. If this is so, then the possibility of making
new connections will be substantially influenced by the starting configuration,
and since each new connection implies a new starting configuration, and thereby
changes the set of adjacent states, the sequence of new connections is likely
to be substantially path-dependent - though not path-determined.
It is within this context that we can begin to consider
the central issues of knowledge, learning and flexibility; these give a new
dimension to the problem of co-ordination, because what has to be co-ordinated
is a process in which greater coherence may suppress potentially valuable
variety. Though reason is important,
‘rational choice’ in the sense of modern economics is inappropriate; instead
the emphasis is on the connectionist character of human cognition, as
recognised by, for example, Adam Smith, Alfred Marshall, and Friedrich Hayek,
and on knowledge as structured relationships (for example of similarity or
causality). Knowledge begins with
uncertainty, and grows by trial and error in making connections, for knowledge
is constituted not by elements but by the selective (and therefore
non-Walrasian) connections between them; and these ‘connecting principles’, as
Adam Smith ([1795] 1980) argued in his psychological theory of the growth of
knowledge, are formed in the imagination. We are therefore using scientifically precise
language when we talk of ‘making sense’ of phenomena or situations, for sense
has to be made rather than revealed. We
make sense by making patterns, and we stick to apparently successful patterns
and seek to enlarge their scope, perhaps with modifications to a few
connections at the periphery; sometimes we perceive apparently significant
similarities with apparently successful patterns in another business or another
discipline, and try to import them; and sometimes we create a link between two
patterns and produce an innovation - remember Schumpeter’s definition of
innovation as ‘new combinations’.
In a recent paper Armand Hatchuel (2001) distinguishes
between well-defined ‘problems’ which have countable solutions and open-ended
‘projects’ in which the solution set is non-countable. Projects require what he calls expandable
rationality, which I interpret as the ability to make connections which were
not included in the original specification of the project, thereby creating new
patterns. Options have to be created
before they can be evaluated. As others
have done, Hatchuel (2001, p. 270)
observes
that “human agents are limited decision-makers but ‘good’ natural designers
(including social interaction as a design area)”.
What is true of knowledge seems, not surprisingly, to be true
of human cognition, and indeed of the human brain, and this seems to be
compatible with current biological models of evolution. It is easy to understand why genetic
programming of behaviour (which is still powerful in all of us) long preceded
the more complex genetic programming of a brain that is capable of developing
connections which support novel behaviours within individuals; and it easy to
suggest that the selection of a brain structure with this creative potential
may be an evolutionary adaptation to cope with changes which are too rapid or
transitory for genetic modification (Schlicht 2000). The human brain thus becomes an option set
for the generation of option sets. The
evolutionary fitness of this novel potential naturally depends on the readiness
to put it to good use, and Schlicht, like Smith, suggests that emotions serve
an essential function in motivating our attempts to ‘make sense’ and that
aesthetic sensibility impels us to make sense by making patterns. The influence of aesthetic considerations on
the evaluation of scientific ideas has often been noted by scientists
reflecting on the development of their discipline. It is worth noting that there is no reason to
expect new behaviours produced in this way to be encoded in genetic modifications.
Thus Lamarckism is kept at bay; but the
consequence is that the study of such behaviours, their transmission and
adaptation, goes substantially beyond the biological model (Loasby 2002b).
In a famous paper, Cohen and Levinthal (1989) pointed out
that in addition to generating innovations, R & D departments have a
‘second face’ as absorbers of other people’s innovations, and that a
substantial part of their activities, such as basic research and work outside
the company’s technological range, is primarily intended to improve their
absorptive capacity. Absorptive capacity
is multi-specific rather than general, for it depends on appropriate receptors,
which can easily connect to knowledge that has been developed by others. But creative ability is also multi-specific,
depending on the formation of linkages from some part of existing knowledge
structures. This duality between
creation and absorption is not peculiar to R & D: any department in a firm
may use particular connections within their own patterns of knowledge either as
a basis for new ideas or as links to other people’s ideas. Indeed, the formation of new connections for
the creation or importation of knowledge is a basic principle of human
learning: our existing knowledge provides the options for increasing our
knowledge, in response either to internal prompting or internal initiative.
Only a small proportion of these options for further
connections is likely to be perceived, and the potential value of those that
are perceived may be highly uncertain. Ambiguity is a natural consequence of
knowledge as open-ended connections. “It
is difficult to put boundaries around an idea” (Fleck 2000, p. 255); but
though, as Fleck points out, this makes them very slippery elements in any
analytical system, it also makes them an ideal source of options which may
create new knowledge or new artefacts. There
is always an entrepreneurial element in new applications of present knowledge
or in experimenting with variations of that knowledge; imagination is a condition
for the perception or the creation of the kinds of options that we are now
discussing. The pathway to valuable new
ideas, technologies or products may be obvious in retrospect, when the
appropriate destination is revealed and the problem
9
therefore
well-defined, but which of many paths is worth following is an open-system
problem for which there are no demonstrably correct procedures.
For every individual, however, and for every organisation,
there will at any time be some framework, usually ill-defined and therefore in
some respects permeable (Kelly, 1963, p. 79), within which new ideas will be
sought and new phenomena accommodated if at all possible. Frameworks organise the opportunities for
choice, and for the creation and perception of options; thinking, even
innovative thinking, requires “cognitively tractable local spaces” (Porac and
Shapira 2001, p. 207). The substantial
energy requirements of the brain provide an explanation that should be readily
absorbed by economists, and this explanation provides a more secure foundation
for the study of institutions than the current focus on co-ordination; but
though the importance of institutions is implicit in this discussion, they must
be reserved for separate treatment. Though
frameworks of thought may change progressively over time - and such progressive
change seems to be the process which in retrospect may seem to have delivered a
new paradigm - there are substantial costs of major changes of framework, not
least in the difficulty of forgetting, which requires the breaking of
connections which have become automatic. Thus the options that are even conceivable for
a single individual, or a single organisation are a minor subset of the options
that would be available to an unlimited intelligence. However, the options available to a community
may be increased by orders of magnitude if the members of that community
operate in diverse local spaces; the variety of contexts then generates a
variety of problems which prompt the formation of somewhat different
connections. This diversity, as Adam
Smith saw, may be most readily achieved by the division of labour. The division of labour generates options, and
from these options comes economic growth.
Coase’s (1937) characterisation of the firm is implicitly
a definition of an option set, in which the willingness to restrict the set of
future decisions reduces uncertainty about the availability of the capabilities
needed to implement these decisions. Since
any list of relevant possibilities that can be defined, even within this
restricted set, is liable to be incomplete, these advantages can be obtained
only if the contracts by which a firm is constituted are imperfectly specified;
completing the set of contracts in the way that Merton and Scholes propose is
not possible if the set of options is not countable. Economists are well aware that this imperfect
specification may give rise to problems; they are less willing to recognise
that it is a solution to a prior problem. Its purpose is to reduce the costs and delays
in responding to future threats, and also, let us not forget, the costs and
delays in responding to opportunities - for, as Shackle continued to remind us,
the imperfections of our knowledge gives us the perpetual hope of improvement
through the development of new skills and the discovery of ways hitherto
unimagined of meeting human needs. The
realisation of these hopes requires us to keep our list of possibilities open
to novel thoughts; but the elimination of the incentive problems which form the
subject-matter of principal-agent, property rights, and transaction cost
theories (except for Coase’s theory) requires unquestioned closures which may
frustrate these logically prior purposes. Whether, in any particular circumstance, the
disadvantages outweigh the benefits may be an appropriate question for
investigation; the standard assumption (against a background of hypothetically
complete information), that the more completely specified is any contract the
better,
simply
suppresses that question, and, as Coase (1991, p. 65) complained, prevents
economists from saying anything about what firms actually do.
In exploring the rationale of corporate planning 35 years
ago, I came to the conclusion that a well-designed planning process supplied a
procedure for examining both the future possible implications of present
decisions and the present implications of future possibilities, and thus
facilitated timely provision for possible future actions (Loasby 1967). Though not so expressed, it was, in the
language of this paper, a justification of planning as a means of preparing
appropriate option sets; planning processes are an important aspect of the role
of the firm as an instrument for creating options. Another important aspect is the development of
firm-specific skills in its workforce, for capabilities are option sets also. Firm-specific skills, very appropriately, have
become a substantial interest of labour economists; but there is a danger (as
with the assignment of option theory to finance specialists) that the neglect
of the relationship between firm-specific skills and other forms of options may
obscure some theoretical dangers, and also some theoretical opportunities. In particular, what may be specific to a firm
may be, not the component skills of its members, but the interconnections which
allow them to be oriented towards a range of purposes, including the
development of new products and new methods of production, in ways which no
single member of that firm is able to specify - and which, therefore, may be
difficult for any other firm to emulate. I shall not attempt to discuss firm-specific
skills, but will simply point to an obvious but unexplored connection to
Penrose’s (1959, 1995) Theory of the Growth of the FFirm.
The major conceptual innovation that makes Penrose’s
analysis possible is her sharp distinction between resources and the services
which they can provide. A Penrosian firm
is a mechanism for generating options, in the form of capabilities, which are
then transmuted into options in the form of productive opportunities by the
perception of valuable applications. This is her own summary.
A firm is basically a collection of resources. Consequently, if we can assume that
businessmen believe that there is more to know about the resources they are
working with than they do know at any given time, and that more knowledge would
be likely to improve the efficiency and profitability of their firm, then
unknown and unused productive services immediately become of considerable
importance, not only because the belief that they exist acts as an incentive to
acquire new knowledge, but also because they shape the scope and direction of
the search for knowledge. (Penrose 1959, p. 77)
The application of the options that are generated by this
search is guided by the entrepreneur’s belief that “demand [is] something he
ought to be able to do something about” (Penrose 1959, p. 80): there are
options for creating demand, often by creating, or modifying, market
institutions. Peter Dmcker (1955, p. 35)
declared that the purpose of business was to create a customer; an established
relationship between a business and its customers provides options for the
business to gain income by offering value in new forms, and options for the
customer to obtain value at relatively low transaction costs. To maintain such a relationship it is
important not only to
11
understand
what options each customer finds attractive, but also not to underestimate the
customers’ access to ‘outside options’, which are inherent in any competitive
market.
Capabilities are inherently multi-specific, and because
they change over time the range of their specificity changes. This modification of capabilities is the basis
for Penrose’s theory of endogenous growth; what makes it also the basis for a
theory of the firm is that the particular patterns of modification, and in
particular the clustering of modifications, tend to be specific to each firm -
not least because so much depends on entrepreneurial imagination which may
change strategy. In choosing between
productive opportunities managers are necessarily choosing between pathways of
development; some capabilities will develop further, giving rise to new
options, while others will cease to grow, and even if they do not decay are
likely to become outclassed by the improving capabilities of other
organisations which have made different choices. Despite the invocation of her name by some
writers on corporate strategy, Penrose’s theory is not about “sustainable
competitive advantage”, which is a version of equilibrium theorising that
assumes a stable knowledge set (Foss 2002), but about the continuous search for
temporary distinctiveness through the creation of novel capabilities and the imagination
of novel possibilities.
Each firm is a complex structure of complementary capital
goods, including human and organisational capital, which embodies its capacity
to meet human needs, directly or indirectly. The course of each firm’s development depends
on both this structure and its orientation (a theme pursued by both Lachmmm and
Shackle), which is the consequence, not always intended, of human perception
and human action; and competition between firms derives from the interlinked
differences between them in resources and perception. The firm is an institution of constrained
flexibility, in which organisational structure and corporate strategy (whether
prescribed or emergent) are instruments for organising the growth of knowledge,
and thereby creating and limiting its option space and thus the scope of its
future activities. Organisations have a
cognitive basis because cognition has an organisational basis (Loasby 2002a);
both bases provide the options for certain kinds of novelty.
The ‘administrative framework’ is an essential feature of
Penrose’s analysis; it supplies patterns and procedures for dealing with
problems and seeking opportunities: as in Simon’s organisational analysis “firms
provide a comprehensive repertoire of authority relations, and motivational
foundations and coordinative mechanisms that help people make good decisions”
(Osterloh, Frey and Frost 2000, p. 232). At each level and in each department within
the firm managers set the constraints within which flexibility is encouraged:
Richardson (1998, p. xvii) draws on his 15 years’ experience as chief executive
of Oxford University Press in remarking that “management is less to do with
giving orders than with establishing the roles and rules according to which
those working for a firm co-operate”. These
roles and rules prescribe the set of (intendedly) compatible local frameworks
within which existing options are exercised and new options developed.
The identity of a firm is defined by its commitments to
the continued development of particular skills and, even more, to the
relationships between them - what is sometimes called its architecture. Because these relationships cannot be
specified in any detail, and often cannot be adequately expressed even by the
participants, they
may be
difficult to replicate by competitors, and sometimes even by the firm itself in
a new location with new managers and a new workforce; they may also be hard to
transform if they seem to be responsible for poor performance. Corporate identities do change gradually, but
attempts at rapid and substantial change typically create great difficulties
and often achieve very imperfect success. A major source of difficulty, as noted in the
previous section, is the need to forget the old ways - to dismantle familiar
connections which have become embedded not only in conscious practice but in
neural networks - and to do this in a way which is compatible with the
processes of forgetting as well as learning among other members of the
organisation.
Every investment implies a commitment to a range of
possible futures. As Keynes appreciated,
it implies a willingness to limit the range of options, for any such commitment
implies forgoing some future productive possibilities, and also some future
finance-based deals. Where there is no
confidence in the valuation of any such restricted set of options, a firm will
not invest, as GEC repeatedly declined to commit its own funds to substantial
research and development programmes, preferring to accumulate a ‘cash mountain’
which, it was hoped, would give the company access to other people’s successful
research. That the value of their
financial option depended on the development of relevant absorptive capacity
seems to have been inadequately appreciated. The options represented by this cash mountain,
together with the options inherent in their established lines of business, were
recently exchanged for a set of options in telecommunications which, after
initial enthusiasm, are currently assigned a very low value on the stock market.
The value of any option tends to degrade overtime, both
because the dates and circumstances to which it applies steadily move from the
future to the past and because changes in the environment (which include the
creation of capabilities and options within other organisations) reduce its
relevance. Innovations which are
‘competence-destroying’ destroy the value of options which rest on the
competence which is destroyed. It is
possible that particular developments may enhance the value of particular
options, but in general and over time it is true that the value of any firm’s
option set can be maintained only by continued investment in new or enhanced
capabilities, just as maintaining capital intact can hardly ever be achieved by
like-for-like replacement (Lachmann 1986, pp. 67-70). Penrose recognised that such continued
investment is necessary in every line of business, and noted that firms may
feel compelled to relinquish some capabilities (and therefore some options) in
order to make adequate provision for developing those that are retained. Merton and Scholes claim that options can
remove uncertainty; but the options that we are discussing simply allow one to
choose which uncertainties to embrace.
The outstanding well-documented example of the purposeful creation
of options is the fundamental research programme instituted in the Central
Research Department of Du Pont by Research Director Charles Stine in the 1920s
(Hounshell and Smith 1988). Stine was
careful to explain that the value of this programme derived directly from
uncertainty, in the sense of an uncompletable list of possible futures, which
made research targeting of the conventional sort unattractive. The company’s diversification programme had
created substantial capabilities in product development, which as a consequence
of organisational redesign were located within product divisions that possessed
considerable autonomy. The Central
Research Department had developed close contacts with the operating divisions,
and recognised that these capabilities
13
rested on
a few technologies which were common to two or more divisions; it was therefore
well placed to investigate the principles underlying these technologies, which
were not well understood. Stine argued
that such investigations would generate a range of options for developing
as-yet-undiscovered products which were related to the company’s present
activities; and if any such products resulted directly from this research the
company would have substantial advantages in developing them. As we now know, the programme delivered nylon
and neoprene; what is rarely noted is that it also delivered Du Pont’s unique
capabilities for turning them into profit.
This illustration of the constrained flexibility which
characterises the firms of Penrose’s theory is counterpointed by a later
episode in which the Company President directed the Central Research Department
to look for major new product lines that were unrelated to the company’s
business. He called this a search for
‘new nylons’; but since he failed to understand the strategy that had produced
nylon his directive ensured that the research capabilities were not linked to
capabilities in development, production and marketing. It is not therefore surprising that this
commitment of distinctive resources, though generating much first-class
science, yielded almost nothing in options of value to the company.
As economists correctly recognise, decisions require
closure, of both the set of actions and the set of outcomes to be considered. Incomplete contracts preserve a choice of
closure, but restrict that choice. These
restrictions may be thought of as decision premises, which, as Simon (1957, p.
xii) suggested many years ago, provide appropriate units of analysis for the
study of decisions, especially a sequence of decisions within an organisation. Decision premises are necessary in order to
guide decision-makers in completing their models; since closures are always
artificial, but may be decisive in choice, it is obviously desirable to close
models in ways that turn out to be appropriate, and though there is no way to
ensure this, decision premises which are based on accumulated experience often
provide good guidance to sense-making. They
also help to ensure shared sense-making, which is an obvious requirement for organisational
success, though it certainly cannot guarantee it. Compatability of interpretations takes
priority over compatability of incentives, and may also contribute to
compatability of incentives, for our bounded rationality often makes us grateful
for guidance on how to decide what to do.
The growth of knowledge, within any firm as in any
academic discipline, requires a substantial degree of closure, or agreement on
a set of decision premises, which we might even call a paradigm. But different closures, decision premises or
paradigms are appropriate for different kinds of knowledge. The overall growth of knowledge, in an
economy, in academia, or in society, therefore requires the kind of variety
which is necessarily a property of a system, and not of the units within it. That it requires a system which is tolerant of
variety ought not to require mention, but the apparent attractions of imposing
uniform ‘best practice’ suggest that frequent reminders may be necessary. It was the foundation of Adam Smith’s theory
of development that the division of labour was the source of continuing
developments of productive knowledge - of better ways, in Menger’s terms, of
meeting human needs. What Alfred
Marshall added to Adam Smith was a Darwinian recognition of the importance of
variation within each industry. As
Herbert Simon (1992, p. 21) remarked, any
particular
direction that is taken is likely to be wrong, and so it is better if people
take different directions. That, we
should note, is hardly possible within any economy in which resources are
concentrated on a ‘national champion’.
It is here, above all, where the attractions of perfect
competition have led economists astray. From
a detached perspective it is astonishing as well as unhelpful that active
competition is relatively little discussed, and when discussed is almost
invariably condemned. This would hardly
be possible if more economists took seriously the pervasiveness of uncertainty,
and its implications. “Surely it is the
essence of competition that the participants hold uncertain and divergent
beliefs about their chances of success” (Richardson, 1975, p. 359); to which
one should add divergent imaginations of what is possible. A competitive economy, in the normal instead
of the economists’ sense, is a system for generating variety, and then selecting
from the variety that has been generated. Competition is an evolutionary process. To enquire whether either generation or
selection within a particular system is optimal is meaningless; but that does
not mean that either process does not deserve examination, or is not subject to
improvement by human intervention - provided that any intervention is
recognised to be based on a fallible conjecture, as is any competitive action.
It is not my intention to conduct such an examination in
this paper. But it is important to draw
attention to the relationship between firms and markets in this evolutionary
perspective. To say that markets provide
the environment in which firms provide options from which customers select is
not wrong, but it is incomplete, even when we note that in many markets the
customers are other firms. As Menger
recognised, markets are goods which may be used for meeting both present and
future wants; the prospect of continuing markets supplies options for making
contracts in the future. These options
are a necessary complement to money as a means of postponing decisions, for
without markets, money is of little value; they are also a necessary complement
to any firm’s capabilities in developing productive opportunities, and if the
relevant market options are not already available then the firm will have to
deploy resources in order to create them. That entrepreneurial firms may have to make
markets has been a theme of Mark Casson’s work since 1982 (Casson 1982, 1997).
Inter-firm trade is of particular interest. It has become the focus of (non-Coasean)
transaction cost theory, which is a particular application of the effects of
incentives on allocative efficiency; but Marshall recognised that it could also
provide each firm with an ‘external organisation’ which connected distinctive
frameworks in a way that facilitated the transfer of knowledge and the creation
of new capabilities and new options. As
Richardson (1972) pointed out, some of the most valuable options can be created
only by the development of close working relationships; for some activities
which are sufficiently different to be assigned to distinct businesses may
nevertheless need to be carefully integrated in order to meet particular needs.
These relationships may extend through a
network which may sometimes merit the label of a competence block.
Two features of such relationships should be noted. First, handling cognitive transactions which
are neither those of internal organisation, both formal and informal, nor those
of arm’s-length market transactions, requires a distinctive kind of capability,
which may be special to each relationship. The creation of such
15
capabilities
may involve substantial investment of time and skill, but it may create
valuable options within the relationship. The kind of options portfolio that Merton and
Scholes believed sufficient to co-ordinate separate businesses will not
suffice, just as information technology is insufficient to ensure relevant
knowledge. (‘Insufficient’ does not
imply ‘irrelevant’.) The second feature
is the need to create trust. “Closely
complementary” activities, as Richardson (1972) called them, are likely to
exhibit precisely those characteristics which, in transaction cost theory, seem
to mandate internal governance; but internal governance is of no value without
an understanding of what is to be governed, and the division of labour is also
a division of knowledge. The
co-ordination, and above all the interactive development of divided knowledge,
depends on willingness to rely on both the skills and goodwill of one’s
collaborators. Trust is a means to the
creation of options, sometimes of great value, because it is a means to
distinctive new combinations of capabilities. Relational proximity is often an important
basis for ensuring that the cognitive distance which is large enough to sustain
the development of differentiated knowledge is nevertheless small enough to
support shared understanding. Even ‘new
economy’ techniques must be embodied in relationships, such as networking,
which are of ancient lineage.
“The question at the end is how we look at the world”
(Kay, 1997, p. 282). This is a question
for managers, and also (as Kay intended it) for the members of any discipline;
for the way that we look at the world controls the options that we can
generate. The prize-winning (and
loss-making) theory of option value appeared as a viable and attractive option
within neoclassical economics; a substantially different theory of option value
is inherent in Menger’s conception of the principles of economics. Not much attention is paid by most economists
to such broad theoretical options, though there are some notable exceptions. Much of the apparent confusion that later
commentators claim to have observed in Marshall’s Principles (1920) may
be attributed to his prolonged effort to keep open the very different options
of ‘mechanical’ equilibrium theorising and ‘biological’ evolutionary theory. His successors lost no time in abandoning the
evolutionary option (in what we might regard as a classic example of
‘short-termism’) and have recently been struggling to produce a theory of
development within the inappropriate option set to which their predecessors -
and, in most cases, it appears, their own predilections - have restricted them.
Economists, like GEC, and many other
organisations, have lost options, and all are faced with substantial switching
costs if something of value is to be created to replace them. But whereas biological processes can never
recover an extinct species, it is possible to recover once-rejected ideas,
although we can never know whether we have recovered the original
interpretations. n any event, we must
construct the cognitive options which we judge to be of value in our present
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