Tuesday, January 25, 2011

Economic Equilibrium: A Silly Concept, Sort of

In 1775 James Watts and Matthew Bolton formed the first successful steam engine company.  At about the same time, 1776, Adam Smith was writing, An Inquiry into the Nature and Causes of the Wealth of Nations.  In that very well known treatise, one concept he wove into his theory was the concept of economic equilibrium in a competitive environment.  That these two events in economic history should occur so close together is interesting, and together with other inventions and innovations caused the "industrial revolution".

There are fundamentally two ideas interwoven into the idea of economic equilibrium.  The first is the concept of economic equilibrium itself.  Fundamentally, it is over time, the supply of a good and the requirements for a good come into balance, a steady state, and will stay in that state until and unless external changes causes a change in the amount of the good that the customer requires.  Moving to this state is caused by the "invisible hand".

At that time, Adam Smith's writing, the use of the concept of equilibrium was reasonable since in all the millenia prior to the 1800 economic progress could be measured in decades to centuries between any substantial change in technology or the ability of goods and services to travel any distance--even ideas prior to 1455 and for 50 years thereafter.  Progress moved very slowly.

In the hundred years following the publication of The Wealth of Nations, the velocity and acceleration in the growth of knowledge, of manufacturing capacity, and the increase in both the follow of information and goods, meant that the "steady state" for economic equilibrium to be reached could be measured in years and decades rather than decades and centuries. In the 1900s these trends continued.  For example, in the 1960s, manufacturers of operating systems took 2 to 5 years to release a new version of their product.  In between these releases they would release patches at a block point release every three to six months.  By the mid-1970s, software suppliers were releasing new versions every six months to a year; which accelerated by the late 1970s to every three to six months.  Today, when you purchase a new PC, the first thing that happens when you first connect it to the Internet is that it downloads a series of updates.  The reason for this is that software suppliers are releasing fixes continuously into their operating systems.  Therefore, by the time the PC is purchased its operating system and other utility software is out of date.

Alvin Toffler in his 1970 book, Future Shock, noted this acceleration in change in all aspects of technology-based societies.  He felt that the acceleration in amount of data and information, and the changes that would result would cause global civilizations an enormous amount of stress.  Part of the growth in radicalism globally is a reaction to this stress.

Another concept first denoted by Adam Smith was "The invisible hand" of economics (see http://en.wikipedia.org/wiki/Invisible_hand for more information).  This invisible hand is the economic analog of gravity in Newtonian mechanics.  It is a series of forces inherent in all human economics that it is not wise to ignore.  These are the "market forces" that cause economic equilibrium.  Adam Smith indicated that greed --in a positive sense--would cause suppliers to get into a profitable market until there was no more profit to be made.  Then the market for the good or service would be in equilibrium.  Nice but it never happens.  This makes the concept "silly", because, like Newton's model of gravity, we know the "invisible hand" is there, but don't know why.

In my book, Organizational Economics: The Creation of Wealth, I discuss an alternative model.  Integrating and synthesizing concepts from multiple disciplines, this model is based on a new concept of value (a brief description is found in the post entitled "The Concept of Value").  The forces the price/supply/demand within organizational economics are nearly the same as in Adam Smith's work, but more inclusive and process/model oriented.  This should make them a better predictor of the costs, and profit or the ability to achieve the organization's vision.

Initially, an organization creates new knowledge (see the post entitled "The Concepts of Knowledge and Wisdom" for the definition of knowledge).  At some point in the knowledge creation process the idea for a new product or service using the knowledge gained takes place.  This leads to innovation, converting the knowledge into a potential product or service.  Because the product or service is innovative (possibly disruptively innovative) it has very high knowledge value (see the post entitled The Concept of Knowledge Value--From Organizational Economics: The Creation of Wealth for a definition and description) and therefore is highly effective, which creates high profits.  As the knowledge disseminates on the product or service the type of value moves from knowledge value (invention of product and innovation of process with increased effectiveness) to capacity value (a consistently dependable product, routine process, and increased cost efficiency).  With cost efficiency the value created for each unit of a good or service increases, while at the same competition for customers forces a decrease in price, so that the marginal returns approaches zero.  This marginal rate of return on the investment wobbly because of changes in demand (with changes in the overall economy and "continuous (minor) improvements" in processes and technology).  Wall St. consider organizations with the wobbly ROI to be "cyclic"; though it seems to be like a clock with a pendulum that is constantly changing length and therefore not really predictable.

Except at the level closest to the raw material in a supply change, once the product is only producing capacity value--like the current generation of PCs--it is a commodity.  Note the even the stock markets refers to those parts of the supply chain closest to the raw materials, as commodity producers. To forstall the conversion from knowledge value to capacity value organizations will attempt to use one of three types of product differentiation.  The first is to patent some inventive or innovative function or component.  This forestalls others producing a product with identical functions or components for a long, but limited, period.  The second is to add "bells and whisles", that is, functions that other products or services done have, which may be of value to the customer.  Dell did this with its support services, and in doing so, gained brand loyality.  The third way is through advertizing to create "brand loyality".  In this, there may or may not be any extra value actually created, but there is a perspection of value in the customer's mind--which is all that counts.

However, even with raw materials, there is continously changing demand and material substitution--just asked the bronze-age warrior facing an iron-age warrior for the first time.  So that economic equilibrium is really a fiction produced by an abstraction of economic data, which can be explained in a better way by this model of value (again see the post "The Concept of Value").

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