Operating Space – First Cut

 

It has become impossible, apparently, for anyone to do a sober analysis of the torrent of fads that collectively are known as the start-ups of Silicon Valley. Instead we are given a fast paced – it has to be fast paced nowadays for fear of being disrupted five minutes later – and inevitably glowing surface-skim of the impact all these fads will have on the economy.

All we know is that the change will be total. Absolutely total.

Right.

It seems like an age ago, but there was a time when I was deeply interested in the impact that the internet and related technologies would have on business. I thought about the problem for a long time. Indeed it was the reason I re-connected with economics because I, rather foolishly in retrospect, assumed that economics would be a good source of knowledge about the fundamentals of business.

I began with the question: “why do firms exist?”.

And there I ended.

I ran into what I now call the ‘Coase Conundrum’, which is simply that economists go on endlessly about the perfection of markets and then sidestep the rather awkward issue of the presence of huge business firms lumbering about the economic landscape doing whatever they can to despoil all that perfection. The firms succeed. They proliferate. They trample the tender attributes of markets so thoroughly that the economist’s analysis looks not only quaint, but absurd when set against reality.

As Coase so neatly put it: if markets are what economists say they are, then firms cannot exist – at least not as they do. The economists have, naturally, persisted in getting around this conundrum by ignoring it and setting the extensive task of production within a stone age relic called a ‘production function’. This absurdity serves its purpose and insulates economics from  having to deal with the great economic process of creativity. After all production is a creative process. Literally. We create things from other things.

A production function vastly simplifies creativity. It eliminates any role for brainpower, thinking, innovation, or any other category of the application of knowledge, and leaps straight to the raw materials. It posits inputs as being labor, land, and capital.

Think about those three things. Labor, land, and capital. How simple. And how utterly misleading. Not one of them can be distilled into a single attribute. They are all immensely diverse categories of other stuff. Is labor really just brute force or muscle power? In which case it is better thought of as energy doing work. Is land another word for raw materials like coal or iron? In which case why not specify raw materials? Land, after all has long been associated with power and hierarchy, so why isn’t power a component of production? We all know that control is an essential ingredient of the capitalist economy, so why not admit it? And capital? Enough said: the great controversy over capital and its diversity serves us well as an indicator of the true devotion to rigor in economics. There isn’t much. Because capital is such a broad and diverse category the very notion of a single ‘capital’ has no meaning – unless we specify exactly which sub-category we are talking about – but that’s too hard to do in our usual equations. So economics ignores the problem and plods ahead with its rigor-less singularity.

One consequence of this mess is that economics has a frightful time accounting for growth. After all growth is a dynamic outcome of creativity. Since production functions are so littered with ambiguity and poor definition of the real inputs – raw materials, energy to do work, and the knowledge to extract products from a combination of work and raw materials – economics cannot track economic growth very well at all. It has to fudge. Which it does well. When it comes to the production side of an economy economics is nothing but a big brilliant fudge.

Which gets us back to breathlessness.

Because economics cannot account for the existence or function of business firms, it cannot account for the kind of change that seems to be underway as a result of the rise of digital rather than analog processes.

My original stab at an explanation went something like this:

Firms exist to concentrate and exploit information. They thus try to inhibit the perfection of the market. They do this by using their power to assert rights over information: copyrights and patents are viciously defended from encroachment and the laws are changed periodically – under pressure from business – to prolong the ability to extract excess profit from the defense of such information. Put more bluntly: business are in competition with their customers for the information used in production. Customers would ‘prefer’ to use that information directly and thus dispense with the obvious costs of having a business from act as an intermediary.

Set that aside for a moment.

Information is used to create product. Information is found everywhere in business: in the design of products, in the design of production processes, in the design of plant and equipment, in the know-how of employees and managers, and so on. Information is the lifeblood of business. It is safe to say that without information business is hard if not impossible to conduct.

Which is why businesses go to great lengths to store, protect, and develop it. Businesses can be thought of as giant stores which stand out on a landscape of much less concentrated information.

So, far from the immense landscape of flat and equally available information posited by economics, our actual landscape is punctuated and characterized by a great lumpiness. The neat and easily theorized symmetry upon which economics rests does not exist. Indeed, I would argue that it was the breaking of that symmetry and the consequent accumulation of asymmetries of various kinds that allowed the rise of our modern economies.

So what about this breathlessness?

If information is the key to business, then its movement from an analog expression to a digital expression must have implications for the way in which business can be – or will be – conducted. In a digital world the storage of information becomes much more simple. So does the transport and analysis of that information. So, therefore, does the extraction of value from creation. The pace of innovation thus ought to accelerate. Which it has. We live in an age of creativity. Indeed so much is being created that we now realize that much of what can be created is rather banal.

But, there’s a downside to this.

Firms are centers of information. They are hoards of information. In a digital world it becomes much more difficult to protect that hoard. It dissipates more easily. It is more tractable to emulation and thus propagation. Information, as we know, is not used up during production. It persists and can be copied. This allows more easy competition and replication. This implies that the life span of businesses ought to shorten. Which is what, I think we are beginning to detect in the reality of places like Silicon Valley.

A more digital world is thus, inevitably, a world of much less stability and of greater operating  risk.

Which gets us back to that competition between business and its customers. One of my ways to describe all this was to posit the existence of what I call ‘operating space’.

In older economies the space occupied by resources and resources owners was largely coterminous with that of the space occupied by consumption: there was a far greater self-sufficiency. As the division of labor fragmented this older economy and subsequent the pace of creative change accelerated we needed a space in which to to produce. This intermediate space enclosed all the emerging production processes or operations of business in what was becoming a much more come world. Hence my term ‘operating space’.

So business firms occupy this operating space which separates the two older resource and consumption spaces. Indeed it is a burden upon them since it adds cost to manage and protect that operating space and thus diminishes the value each of the others can claim for itself.

Because the activities within operating space are adding value via creativity and the production of novelty unaccessible in the two older spaces, the loss of value by the cost of creating operating space was more than offset by its value added.

Thus operating space was tolerable: as long as it added more than it cost society would benefit.

Th emergence of digital forms of storing and using information have begun to erode this balance. Operating space needs to become much smaller in order to continue to add benefit. The rise of readily accessed, deployed, and used, information is undermining the logic of operating space. Business needs to be compressed to take up less space. It has to be leaner, less intrusive, and more productive. It cannot rely on its older ability to hoard information. Not, at least, as well as in the past. So it has to rely on greater creativity to justify its existence.

One way to reduce operating space is to disassemble the logical sequence of operations needed to in production. Some of those operations can be outsourced into the consumption space. In other words businesses can involve customers on the creation of the product or service. We have seen a rapid growth of this kind of activity: the automation of many service tasks is an example (self service check-out; ATM machines and so on). Theses a way business can offload expensive aspects of operating space onto customers whilst maintaining possession of the core of value creation.

Now this core is under attack also.

An obvious example would be three-D printing, where a customer with appropriate access to information and resources can produce an ever growing variety of products previously attainable only via traditional business processes.

So to recapitulate: in older more self-sufficient economies the need for a large and expensive operating space was minimal. It became both more necessary and more easily justified as the division of labor and information proliferated. Modern business grew as a method for storing, protecting, and using this information. Businesses thus sought to defeat the perfection of the market – and continue to do so, which is why textbook economics is an inaccurate portrayal of real economies.

But the transfer of analog methods to their digital counterparts is eroding the size of the allowable operating space an economy will tolerate. This is a threat to the organization of business as we know it.

Does it imply that the perfect markets posited by economics will be revealed as operating space shrinks under the cost pressure released by digitization?

That we can talk about in the future.