Notes On The Firm

When, for reasons too byzantine to recount here, I decided to re-engage with economics a couple of decades ago I did so through the prism of business. After all I had just finished a stint in banking and was thinking about the way in which the rise of digital technology would change the way in which business is conducted.

The reason for this point of re-entry was that I believed then, and still do, that economies are movements of information as much as, if not more than, anything else. So if digital technologies make information more tractable, abundant, and accessible then they must affect business. My earliest basic assumption was that a business firm is simply a system of thought whose objective is to protect and exploit its information advantage. This brings it into conflict with both its suppliers and its customers who are seeking to overcome the asymmetries of information that occur “naturally” in the landscape. I described the space that firms occupy as “operating space” that is a wedge preventing direct contact between customers [end users] and suppliers [or resources].

That was back in the mid 1990’s and, by and large, since then the disintermediation of operating space that we observe as a consequence of the “digitalization” of the economy has gathered pace.

The most obvious manifestation of this is the steady redesign of business itself. More and more business firms are reducing their operating space by jettisoning  what they consider to be “non-core” activities. The idea being to reduce their logical space only to that in which their information advantage resides, and to allow those aspects of their older form that represent no advantage to go elsewhere to be repurchased at lower cost if, and when, needed.

This, fundamentally, is what outsourcing is about. It is a recognition that the information advantage within certain activities has been eliminated by digital technology. Those activities are now better accumulated and managed outside of the firm, perhaps by other specialty firms, or even by individual workers who can act as contractors with many customer firms rather than being an employee captive within a single firm.

The greater availability of information, and its greater ease of communication is, in my opinion, the key to understanding most trends in business. It certainly underlies the radical reconstruction of our retail industry where the older model incorporating a physical presence in stores scattered around the country is being made obsolete by a more modern and more efficient digital marketing method coupled with a digitally enabled logistical infrastructure.

Key to understanding all this is having an idea of what the objective a business firm is.

In my mind a firm exists to exploit its information advantage. It must, therefore, pay particular attention to its boundaries, not in a physical sense, but in a logical and information sense.

To extract value from its information advantage a firm has to create and manage processes that produce whatever it is that it sells into the outside marketplace. And to secure the most [not the maximum since that is an impossibility] it seeks to be as efficient as it can be. Efficiency in a business sense then becomes a consequence of creating product knowledge, and making its production processes reliable, replicable, and predictable. This is why firms prefer to deploy what I call “primary knowledge” rather than “secondary knowledge”.

Primary knowledge is that which can be encoded in some form of instruction to create routines to produce a product or artifact. That artifact doesn’t have to be a physical thing, it could be something intangible, but the goal is that production is consistent and predictable. Each car, for instance, coming off a production line must conform to a plan. The plans embody the primary knowledge required to produce a car. The more rule-based the plan the more likely it is that production can be scaled to higher volumes; the more likely it is that each car will be standard; the more likely its is that errors are eliminated; and so on.

The problem with primary knowledge is that its efficacy relies on a stable environment. It is, after all, the basis of routine. Wherever a task can be made routine primary knowledge, that is codification in some form, will create the greatest value. This is why robots are superior to humans on production lines: they are less susceptible to error since their underlying code is more predictably followed. Humans have a greater tendency to err. Primary knowledge, because it is encoded, sits at the heart of the transition from the industrialization to digitization.

Let me repeat: business firms exist to exploit information. They do this by encoding what it takes to produce something. They translate knowledge into code. The more of their activities they can encode the more value they can squeeze from their information advantage. So businesses are “in the business” of creating routines. The more routine the better. Business creativity is thus almost a contradiction: it is in the discovery and implementation of routine. More particularly it in the discovery and implementation of  routines that either supplant older routines by virtue of greater efficiency, or which are novel and thus allow the production of new products.

With business firms recognized as code-making and thus efficiency-seeking devices the issues we all have with economics comes into sharper relief: economic theory is pointless in the face of the real world of information processing.

It’s the environment. Real world environments are riddled with uncertainty, emergence [you cannot predict the whole from the sum of its parts], computational intractability, and the simple fact that history is no certain guide to the future [the world is non-ergodic]. In other words, there is an ever changing context that cannot be predicted, calculated, or even easily envisioned.

Business deals with this by creating “alternative futures” called plans. These plans are simply efforts to project a modest amount of certainty into the future, knowing that such a future is unlikely to transpire exactly, but that the match between the prediction and that which transpires is sufficiently close for current decisions to be made.

Businesses need stable futures so that their codes remain relevant. The moment a business context changes the code risks becoming irrelevant. It is a question of adaptation. Even the best code can become useless if the instructions it embodies are no longer efficacious because the environment into which the product emerges is too different.

Which is why secondary knowledge exists. Secondary knowledge is best thought of as the ability to learn or adapt. It is secondary because it is vastly less efficient in stable environments. It is less efficient because it involves the maintenance of knowledge that might not be currently useful but which may be useful in some unknown future. Such knowledge is embodied not so much in code as in the persistence of sets of rules to apply to solve new problems. These rules may, of course be encoded, but their inefficiency resides in their current applicability: there is a cost in carrying around code that has no immediate application. So the ability to learn is an expensive and often unnecessary quality. It becomes vital in periods of rapid change, but is a luxury in times of relative stasis.

Thus firms prefer primary knowledge: it is less costly to maintain, more predictable, replicable, and reliable.

This leads us to another insight: business firms are devices for the translation of secondary knowledge into primary knowledge. They are not designed to, nor do they necessarily want to, learn. Learning is expensive.

This is why it is devilishly difficult for existing firms to innovate well. Innovation is a form of learning. It is an activity that sits uneasily within the codifying apparatus of a well-established business. Naturally, all businesses retain a capacity to learn by virtue of their human basis, but as logical entities they resist too much learning. Their entire reason for being is to seek efficiency through codification. Learning disrupts that efficiency seeking goal.

But, enough, these are notes to myself after all.

Summary: only in the context of an economy as the movement of/exploitation of information can we build a good theory of the firm.

Mainstream economics cannot do this because it cannot deal with radical uncertainty, non-ergodicity, emergence, or computational irreducibility. Indeed it refuses to acknowledge these facets of reality. These facets all have information in various forms as a common theme. Business, in contrast, must deal with the asymmetry of information. Indeed such asymmetry is why firms exist. So by looking at the way in which real firms behave and deal with information we can begin to understand how economies as a whole work.

Without asymmetries of information business as we know it becomes impossible to sustain. The distinction between production and consumption would blur, and the institutions of our modern economy would need radical replacement.

But that’s for another day.