Arnold Kling  

Unstable Information Economy

Academic Self-Selection... Social Security Reform...

Eli Noam says that an economy where the key input is research will be unstable. In industries where up-front costs are high but production and distribution costs approach zero,

the main strategy will be to consolidate and cartelise in order to maintain pricing power. As a result, prices and profits rise (as well as media concentration), which will lead again to expansion, entry, and by the same economic logic, to a new price collapse, with a general downward trend in prices.

...Thus, the information economy is likely to be a volatile, cyclical, unstable mess. The problem is not the "creative destruction" one would expect in an innovative economy, but the structural instability of an economy whose major products have very low marginal costs and hence prices, but are not low-cost to produce.

Even if this research-intensive industries exhibit this behavior, I am not convinced that they will all experience booms and busts simultaneously. Biotechnology does not have to be highly correlated with the communications industry.

For Discussion. Is it more risky for the general public to invest in stocks when there is rapid creative destruction involving difficult-to-understand technological developments?

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CATEGORIES: Growth: Consequences

COMMENTS (9 to date)
david foster writes:

A thought-provoking article, but some of the logic is questionable. "Even cable TV, at 20,000 programme hours a week, is available to viewers at a cost of a 1/10 of 1 cent per hour." No individual viewer can watch 20,000 hours a week, so this is a meaningless number. Given his whole fixed cost/variable cost analysis, one would think the author would see that "per hour" is not a particularly helpful metric here.

Randall Parker writes:

While the booms and busts will not always happen together it seems inevitable that eventually some will and at some points many will. Just run a bunch of wave forms out that are at different frequencies and eventually many troughs or peaks will coincide.

Scott M. Harris writes:

A Toyota production adage states that finding a problem is like finding a diamond. Without a problem to solve there can be no improvement. Economic turbulence -- the uneven flow of economic resources -- is inherently inefficient. What Eli fails to recognize is that this inefficiency represents an opportunity for those who can figure out how to reduce it. Entrepreneurs will figure out ways to restructure industries in ways that we cannot imagine. Consider how generalized integrated circuit design tools and silicon foundries are restructuring the integrated circuit industry. Also consider how exceedingly complex technology sharing partnerships are restructuring the pharmaceutical industry. (We too often ignore innovations in trading relationships.)

What Eli sees as a market failure requiring government intervention is actually Eli’s failure to select the right intellectual tool for the job at hand. Eli is using marginalist economics not to predict what will happen in markets but rather to explain what happens in economies. He is driving in screws with a hammer.

Bruce Cleaver writes:

I dunno - looks like he is pretty much on the mark for the pharmaceutical industry (I used to work there, and my wife still does). The gossip is always about who is acquiring whom, and it is driven by talk such as 'weak pipelines' or 'strong pipelines.' Those firms that are pipeline-poor but cash rich want to acquire a smaller firm's pipeline.

Mr. Kling's description, "..up-front costs are high but production and distribution costs approach zero" describes pharma very well. Consolidation is a way of evening out the risk.

Lawrance George Lux writes:

It is actually much safer to invest in such industry, if you are a major player. The poorer Stockholder will suffer all the costs of getting in and getting out like always, with great loss of profitability. These industries are particularly good, because of the planned obsolecense of technologies which introduce incompatability. Such industries claim there is not planned strategy for this incompatability, but Investors flock to the firms indicating such a strategy. lgl

Scott M. Harris writes:

Innovative means of trade allow firms to acquire technology and/or products without acquiring the entire company. Ideally, one wants the high risk, high reward information intensive part of the industrial structure to be separate from the far less risky, less information intensive. (Successful "intrapreneuring" is more difficult than the popular business literature makes it out to be.)

Those familiar with Coase’s theory of the firm might want to consider a slightly more sophisticated model, one that considers the costs of establishing (and ending) relationships for trading sensitive information, e.g., technology. In general, low transaction cost trading relationships require a great deal of trust. They are expensive to establish. They also tend to be expensive to terminate amicably, which is important in keeping the cost of future high trust trading relationships down. Conversely, high transaction cost trading relationships tend to have minimal relationship building and dissolving costs – the “building trust problem” is “solved” in the transaction contract.

Now consider an industry in which the commercial culture has advanced sufficiently to permit low transaction cost, low relationship cost trading of sensitive information. The industry starts looking more like a single, complex firm. I argue that such an industry structure would be more efficient and effective than either a collection of traditional firms or a single large firm.

I might add that many of our ideas about what constitutes a “firm” are out of date. How “firm” is a “firm” when extraordinary events have become ordinary?

Scott M. Harris writes:

Another example of a creative way to avoid economic turbulence is the exchange of technology among manufacturers practicing pricing-down-the-learning-curve strategies.

In the early stages of product life cycles, firms pursuing a pricing-down-the-learning-curve strategy aggressively price below cost in order to learn faster than the competition. If several firms follow this strategy, it creates a winner-take-all race to product maturity. In the mature stages, the company that grew fastest, hence learned fasted, reaped most of the profits. Losers ended up with large amounts of high cost excess manufacturing capacity.

Over time firms practicing this strategy learned how to mitigate the worst turbulence caused by such "winner take all" races. One way they did so was to build more flexible production capacity. Another way was to enter into agreements to exchange technology. In effect, they committed to learn together. The Japanese were particularly good at this early on, which is one reason why American and European competitors felt that they were competing not against single Japanese firms but rather against "Japan, Inc."

I should add that Japanese bureaucrats (METI) tried to mitigate these effects by picking national champions. It's been over fifteen years since I studied this, so I can't remember exact details. What I do remember is that their guidance was not very good. (Encouraging Honda to keep out of the car business??)

Monte writes:

"Is it more risky for the general public to invest in stocks when there is rapid creative destruction involving difficult-to-understand technological developments?"

It really shouldn't matter. The risk-return tradeoff would automatically adjust to any stock market turbulence resulting from such developments, offering willing investors an opportunity to earn higher profits. Those with lower risk thresholds would simply stay out of the market.

Bernard Yomtov writes:

No. It is not more risky. The general public should do the same thing as always - maintain a diversified portfolio with overall risk level that matches the particular individual's risk tolerances.

I see no reason why the growing importance of technology should increase systematic risk.

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