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To Maintain Economic Progress, We Need More Entrepreneurial Innovation.

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Each of us seeks economic progress, both individually and for society. Economic progress is different than economic growth, even though that’s what the government peddles. Economic growth is a quantitative concept, captured in government accounting as increased consumption. Economic progress is qualitative: a subjective feeling about the quality of life we lead and our anticipation for its future improvement.

America’s new democratic socialists promise more social justice and a higher level of consumption for all. They think that more government intervention, more taxation, more redistribution and more control over business can achieve their goals. The opposite is the case. In order to provide both better living standards and economic progress, entrepreneurial innovation is required.

Among other errors, the democratic socialists make the mistake of believing in a simplified productivity theory of capital: that accumulating savings and investment and a higher capital stock raises future investment yields, no matter whose hands they are in.

But without entrepreneurs, capital is dead. It takes entrepreneurs to bring capital to life and keep it alive. Capital needs to be constantly renewed, to be put to innovative uses that improve lives and achieve the progress we all seek. Our pension savings will not ensure future wealth unless they get into the hands of the entrepreneur who – motivated by profits – can find new productive applications for them. Investing in stocks does not create more real capital. Most stock trades represent merely a rotation of ownership. It is true profit-generating entrepreneurial activity that creates future wealth and income. The future environment for entrepreneurial activity will determine whether savings are put to productive use, and the democratic socialists prefer to suppress, if not destroy, economic activity.

Can we count on our large corporations to deliver the innovation that is needed for economic progress? There is certainly a case to be made that they are constantly testing and marketing new ideas, new devices, new services and new service extensions. Amazon, Google, Uber and Apple and Microsoft and the rest of them are lowering our transaction costs which is an improvement to our lives and represents economic progress.

But there are many curses of bigness, and one of them is an inevitable slowing down of innovation. Bigness tends to lead to defensiveness in the protection of high market shares; corporations become reluctant to innovate with the risk-taking bravado that took them to prominence in the first place, because they begin to fear the destabilization of their own marketplace.

M&A is one way to protect high-share and quasi-monopolistic market positions, and is often defensive in style: bring the innovators in house and control them rather than let them disrupt from outside. And if a company’s large scale was built partially or completely with debt borrowed to make acquisitions (as if often the case with private equity funded firms), then innovation will tend to be even more suppressed, because free cash is diverted from investment in R&D to debt service.

Worse, it is often the case that our large corporations get closer and closer to government, making a deal to accept greater supervision (it keeps bureaucrats in long term jobs) in return for regulation that makes it harder for upstart innovators to enter protected markets.

Tim Wu, a Columbia law professor who wrote a book called The Curse of Bigness, explains one way in which this sidling up to governments works for big corporations. Let’s say a large corporation wants to make a defensive acquisition to acquire a competitor. They submit the proposal for merger review by the government. The government, in turn, issues a consent decree, which means that permission to make the acquisition is given, with conditions. It is the administration of the conditions of the consent decree that keeps bureaucrats in a job for years, perhaps decades to come. The acquiring company meets the goal of its merger, and the government gets to write more administrative law and to load up the pubic payroll with more bureaucrats. Here’s what Wu said in an interview with ProMarket.

Overall, I think consent decrees appeal to academic economists, but they have a bad track record. One problem with consent decrees is that you have the most talented attorneys and economists negotiating these on the government side, but once they’re done, they’re given to an enforcement bureau which is typically not heavily staffed. And sometimes it can be forgotten, and certainly not enforced with any kind of vigor.

Structural separation is self-executing. The blocking of mergers is self-executing. You don’t have to have the government constantly trying to make sure the thing is working. I think Europe has really gone down the wrong path in that direction.

Capitalism is a dynamic system, alway changing, always adapting, always innovating. That’s because consumers are always changing, always demanding better lives, and insisting on economic progress. Socialism certainly can’t deliver what consumers want, and big companies have a tendency to become defensive in the face of consumers’ unrelenting insistence on improvement. It is the entrepreneur who imagines the better future that consumers wish for, and, in the pursuit of profit, finds a way to deliver it by refreshing capital and putting it to new uses. No other system has this capability.

For more like this, see Why Capital Needs Entrepreneurs at mises.org, which was a source for some of this article.

Where’s The Profit In Digital Innovation? It’s In Reduced Transaction Costs.

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Economists tend to use weird and unhelpful language. One of their terms is Transaction Costs and these things are really important. They’re the reason why firms exist at all, and they’re the reason why the new digital platforms like amazon.com and Uber get to be so big and grow so fast and assume such great prominence.

Let’s see if we can unpack the language.

When a consumer or a customer buys a service, they pay a price in money. Let’s call this the final price, after all discounts and savings and haggling, it’s the amount of cash you part with or the amount on the cheque that you write.

But the final price does not reflect the total cost to you, the buyer. There are a lot of other costs involved in many transactions, some of which we think about and try to compute, some of which we are not conscious of or don’t compute.

The High Price We Pay For Transaction Costs.

Since we have already mentioned Uber, let’s use the purchase of a taxi ride to illustrate transaction costs. If you are in the big city on a dark rainy night and you’d like to get a taxi ride to a destination several blocks away, you might compute the expected price in your head as $15 plus a tip, and decide that it represents a good value to you. You stand in the rain and the wind at the edge of the sidewalk waving at passing yellow cabs, feeling like an idiot and getting yourself and your clothes wet, thinking that there may be a visit to the dry cleaners in your future. Eventually you think you’ve snagged one, but just as it pulls to the curb a burly and brutish-looking guy runs up, pushes you out of the way, yelling “This one’s mine” and you are left disappointed and disheveled. Eventually, after waiting much longer than you had planned and worrying about being late for your appointment, you do get in the cab. It’s uncomfortable, cramped, dirty and doesn’t smell very nice. Nor does the driver. He mumbles to you in a foreign sounding accent you can’t understand. Does he recognize the address you’ve given him? He seems to be taking a long way round. Should you argue? Safer not to, probably. Eventually, you arrive. The fare is higher than you thought. You consider giving no tip but fear the confrontation this may bring on, so you demur. You take out some bills, negotiate some change, then you get out feeling wet and badly treated, and you consider a stiffer drink than you had originally planned.

These inconveniences of time, discomfort, fear and undesirable aesthetics are transaction costs. The cab ride cost $15 or $20 plus tip plus all of these transaction costs. Its value to you must be greater than the money price plus transaction costs for you to feel as though you got a good deal – that’s the essence of a voluntary market transaction, that both parties feel better for having made the exchange. Odds are that you don’t feel that way. There must be a better alternative.

Smartphones And Software Sharply Reduce Transaction Costs.

Now there is: Uber. You install the software on your smartphone. On the next similar occasion, you initiate a transaction. The software knows who you are (you’ve pre-entered the information), and it knows where you are, by the magic of GPS. It finds you a car and a driver, and gives you a rating that suggests to you that you can trust the driver and will have a good experience. The car comes to you, and you can track its incoming progress. No-one pushes you out of the way, asserting they have a prior claim. After minimum time in the rain (perhaps you have to run from the doorway to the car, but no standing), you are safely ensconced, feeling good, and on your way. You pay with one tap (you’ve already entered your payment information and the system has verified it). You arrive on time. You are unstressed, happy to be at your destination, and can get by on a regular sized alcoholic beverage.

Uber has saved you a significant amount of transaction cost. The money price of the ride may be higher, yet you feel you received good value and you’d repeat the experience.

Triangulation, Transfer And Trust.

In his new book, Tomorrow 3.0, Transaction Costs And The Sharing Economy, Michael Munger tries to wrap up these transaction costs in a catchy alliterative expression of three T’s: triangulation, transfer and trust. The affectation is a bit forced, but let’s go with it.

Triangulation refers to information about who you are, who the Uber driver is, the location of the pick-up and of the destination (and the car’s location as it makes its way to you). It’s about getting two parties to the exchange together. Munger also includes making an agreement on a price in his definition of triangulation, which you can also do with the software. All of this is easier / better / more comfortable with Uber.

Transfer refers to the way of transferring the service and the payment for it that is immediate, convenient and as invisible as possible. Software, and the pre-registration of a payment mechanism (your credit card) and the in-built processing capability make transfer easy and safe.

Trust is the way the software creates a feeling of assurance, anticipating honest dealing, with both sides living up to expectations, and performance of the terms of the contract. Both parties can anticipate that their expectations will be met by a trustworthy service provider and a trustworthy customer.

When all of the potential transaction costs are eliminated or highly reduced, the value received for the final price plus transaction costs is much higher in the consumer’s perception.

The Entrepreneurial Opportunity.

Munger’s major point is that there are tremendous amounts of entrepreneurial value creation available in the reduction of transaction costs. He refers to the sharing economy and paints the picture of  future where, if transaction costs are sufficiently reduced, no-one will need to own anything, and we’ll all get by on entrepreneurially-facilitated sharing. Need an electric drill to make a hole to hang a picture? Click on an app, have the drone or robot deliver the drill in a secure package to which you have the unlocking software code, use it for a couple of minutes, and send it back. Same with cars (don’t own one, borrow or rent one for a while), lawnmowers, perhaps even some clothes (like specialized formalwear).

Who is creating these low transaction cost experiences? Entrepreneurs. They see consumers saying, “I wish it were easier to ……..” or “I wish I had XXXX here right now” or “I really disliked my last experience with YYYY”, and they immediately think of ways to solve those problems and meet those needs. They can design an app, assembling the code from Github or by hiring an app developer on Upwork, go to market, and quickly find out whether they can sell the low transaction service improvement.

The new era of low transaction cost digital service provision is, in Munger’s telling, a revolution, as significant as the Industrial Revolution in the nineteenth century. Each of us as consumers will have the opportunity to lead more convenient, more efficient, and safer lives. And each of us as entrepreneurs – from Uber drivers to coders – will thrive by delivering new value creation through transaction cost reduction.

Entrepreneurs Bring Economic Progress – Which Is Far More Important To People Than GDP Growth.

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Economists tend to represent economic growth as growth in the level of income and of GDP. But economic progress is far broader than that, and to focus on GDP growth is to ignore the most important elements of economic progress – the elements that improve people’s lives.

Why do economists miss this point? Because they don’t understand entrepreneurship, and the role of entrepreneurs in economic progress. In economists’ models, firms are run by managers who choose low cost resources and manage processes in order to achieve greater efficiency. In a competitive economy, this would drive companies out of business. Continuous improvement and innovation are the drivers of economic progress, and they come from entrepreneurs not managers.

We invented economic progress only recently. It began in the late eighteenth century with the industrial revolution. Before that, the standard of living and the quality of life was much the same in 1750 as it was in 1650, and it was much the same in 1650 as it was in 1550 and, indeed, as it was in 550.

Since then, economic progress has been greater in the nineteenth century than the eighteenth, greater in the twentieth century than the nineteenth, and every indication is that the progress will continue to accelerate in the twenty-first century.

In the United States, per capita GDP was nearly seven times greater at the end of the twentieth century than it was at the beginning. But looking at only growth numbers seriously misrepresents the nature of the economic progress that took place in that century.

At the beginning of the twentieth century only about 1 percent of American households had cars; by the end of the century 91 percent of households had them. Largely because of advances in medical technology, life expectancy rose from 47 years at the beginning of the century to 77 years by the century’s end. Telephones were rare at the beginning of the century, but commonplace by the end of the century. Information acquisition and entertainment were completely transformed in the twentieth century. At the beginning of the century there were no movie theaters, no radio broadcasts, and no television. By 1900 electricity was available to some, and was used mainly for lighting, but by 1950, electricity powered radios, electric washing machines, and refrigerators.

By 2000, most people classified as poor in the United States had indoor plumbing, air conditioning, telephones, and automobiles. The Internet revolutionized communication and allowed business ventures to span the globe. While only a few computers existed in the world in 1950, many people had more than one computer in their homes by 2000. Computers did not become common until the 1980s, and the World Wide Web did not exist until the 1990s. The first airplane had not yet flown at the beginning of the twentieth century, but by the end of the century travel throughout the world in jet aircraft was commonplace. Despite the tremendous GDP growth over the twentieth century, when one reflects on economic progress over the century, it is apparent that the primary component of economic progress is not the amount of income growth, as impressive as it was, but rather the substantial change in the qualitative nature of the economy’s output, and the extent to which people enjoyed consuming it.

They were also able to enjoy producing progress. At the beginning of the twentieth century the average work week in the United States was about 50 hours, and by the end of the century it had fallen to about 35 hours. Again, this quantitative change in hours worked, while impressive, does not reflect the changing nature of work, which became less dangerous and less physically demanding. People worked more with their minds and less with their bodies by the end of the century, and this is reflected in the fact that at the beginning of the century only 22 percent of adults had completed high school, while by the end of the century 88 percent had at least a high school degree. Accidental deaths, including those on the job, fell from 88 per 100,000 to 34 per 100,000 over the course of the century.

While people work fewer hours for more income, the more significant element of progress in the work people do is not the quantitative reduction in work hours or increase in output, but rather the qualitative changes in the nature of work. At the beginning of the century the reward for work was money, and most jobs were mainly manual labor. While money was still a primary motivation at the end of the century, people considered the pleasantness of a job, including intellectual stimulation, challenges, and workplace amenities as significant rewards for employment. Many people enjoy the work they do: something that would have been much rarer in 1900, when work was often physically demanding, dangerous, and tedious. One can look at growth in terms of increased output per hour of work, but the progress in terms of qualitative changes at the workplace is at least as significant as the quantitative growth.

Henry Ford was the entrepreneurial innovator who brought assembly line production to the automobile industry, which enabled a substantial increase in the output of automobiles per worker. But focusing on growth in output per worker misses the much more important truths about the transformation of lifestyles that resulted. People’s transportation options were greatly enhanced, making automobile travel available to a large segment of the population. This changed many other things – such as shopping for example. Supermarkets, shopping malls and large discount stores would not be feasible if people could not drive their own cars to transport substantial quantities of goods. Because shoppers can buy more each time they shop – because they can transport more in their automobile – stores can offer a greater variety of goods at a lower cost. Entrepreneurs who supply the retailers are encouraged to think up a larger variety of new goods for sale.

Because of the introduction of low-cost long distance telephone calling – and now the internet – these entrepreneurs can contact sellers thousands of miles away to order new products immediately. Sharp declines in transportation costs make it feasible to ship individual purchases thousands of miles to buyers. The variety of goods and services offered for sale continues to expand. Progress in one area leads to progress in others. Life gets better. Progress brings economic growth with it, but growth is a minor component of economic progress.

Progress is not brought to us by managers striving for efficiency, but by entrepreneurs developing specialist knowledge about their area of expertise and thereby discovering new opportunities to serve customers better and to make a profit doing so. The profit-and-loss system amplifies progress. Profits reinforce the pursuit of ideas that are wealth-enhancing for entrepreneurs, and losses terminate the ideas that are not. As a result, the positive impact of successful entrepreneurship is much larger in magnitude than the negative impact of unsuccessful attempts. That’s how progress occurs. Specialization is an important element – something Adam Smith knew at the beginning of the Industrial Revolution.

Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object, than when it is dissipated among a great variety of things. . . . It is naturally to be expected, therefore, that some one or another of those who are employed in each particular branch of labour should soon find out easier and readier methods of performing their own particular work, whenever the nature of it admits of such improvement. (Adam Smith, Wealth Of Nations, 1776)

Entrepreneurs invest in producing the specialized knowledge that will enable them to make future entrepreneurial discoveries. Their pursuit of knowledge makes innovation and progress more likely.

To read more, see Progress And Entrepreneurship; Randall G. Holcombe; QJAE Fall 2003.

Entrepreneurial Initiative Beats Corporate Innovation Process Yet Again. When Will They Ever Learn?

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According to the Wall Street Journal, Altria, maker of Marlboro and other cigarettes, is planning to invest in Juul, maker of a cigarette alternative which vaporizes nicotine-containing liquids. These devices are often called “vapes” and the practice of using them, “vaping”. A company dedicated to addicting people to smoking burning tobacco is now adding to its portfolio a company dedicated to terminating that addiction. At the same time, Altria has made a $1.3 billion investment in Canadian cannabis company Cronos Group, Inc. It will all make for interesting portfolio management.

However, for entrepreneurs, the most important aspect of the investment combination of Juul and Marlboro is what it tells us about innovation and who is capable of delivering it. Altria has been aware for a long time of the evidence that the long term future of the cigarette market is threatened by external trends, including the subjective lifestyle preferences of consumers (and the non-consumers who dislike the “second hand smoke” problem), but also including regulation, taxation and the resultant deterioration in the price-value proposition.

Faced with such negative long term trend signals, the good and wise corporation, prompted by the business school community that has populated the executive ranks in addition to marketing its tools through consulting, seminars and books, initiated an internal innovation process. This produced the idea of so called e-cigarette products, like MarkTen and Green Smoke, devices in which tobacco is heated but not burned, which purportedly makes smoking less risky. The process also produced a device called iQOS, developed in partnership with Philip Morris International, which is a sister company spun out of Altria to sell cigarettes in international countries outside of the glare of the US legal profession and its alliance with state and federal regulators.

Philip Morris International took the lead in marketing iQOS and claimed some early success in Japan, so much so that the company diverted significant resources from conventional cigarettes to the heat-not-burn “breakthrough”. After initial growth, Motley Fool in October 2018 reported “disappointing earnings” at Philip Morris International attributable to a “significant slowdown in the e-cig’s primary market, Japan”. Motley Fool reported some early trial among a younger demographic, but “a wall of resistance among older cigarette smokers”.

It looks as though Altria has seen the warning signs as an indication of failed corporate internal innovation, and has swerved to the alternate lane of acquisition of the innovative ideas of external independent entrepreneurs.

Its investment of $12.8 billion for a 35% stake in Juul Labs Inc suggests a roughly $38 billion valuation, making Juul one of the most valuable private companies. The Juul team has created this much value in about three years, while Altria and Philip Morris international were destroying value in their failed attempts at internal innovation.

The Failure Of Centrally Planned Innovation Processes.

They should have known. Corporate innovation processes are doomed to failure. That’s because innovation is not a process. It can’t be centrally planned by executive wing geniuses, no matter how much they spend on consulting and business school seminars. Innovations like Juul are emergent results of marketplace experimentation by entrepreneurs and consumers. The consumers become dissatisfied with the current set of offerings available to them – that particular phenomenon is strikingly apparent in the cigarette market. They begin to experiment with alternatives – they might try nicotine chewing gum, or patches, or snus (tobacco pouches placed in the mouth) or even iQOS. They are not yet declaring their loyalty to a new solution, but simply looking round at alternatives.

Entrepreneurs are dissatisfied with the supply side of the market. They sense the consumer dissatisfaction and match it with their producer dissatisfaction. They, too, experiment. There have been many such producer experiments in the cigarette market, and Juul is the one that has, for the moment, risen to the top. Why? It’s usually random luck combined with a co-creation collaboration with the consumer – continuously adding and changing features and attributes and measuring consumer response until the best combination emerges. There are so many experiments among so many producers and so many consumers that one combination eventually emerges as the most preferred. The outcome can not be predicted, it can’t be modeled, and it can’t be managed. The genius of the market is that all of the failed experiments result in very small losses and a lot of learning. The one successful experiment eventually incorporates all the learning, attracts a large number of customers, creates a lot of value in a short period of time, and generates a huge amount of economic progress far in excess of the losses from the failures.

The scale and reach of this experimentation, the rapid exchange of knowledge and learning in the network of entrepreneurs and consumers, the flexible adaptiveness that allows for the rapid abandonment of the resources committed to failed paths and the agile transfer of resources to the path of success, can not be matched by a centrally planned corporate innovation process. Decision-making in hierarchical structures can’t reproduce the emergent properties of interconnected knowledge-sharing networks. Processes with their stages and gates can not compete with the spontaneous order of free experimentation. Corporate investment guidelines can not compete with entrepreneurial risk-taking.

The Future Of Innovation Lies With Interconnected Individuals.

The future of innovation lies squarely in the initiatives of the independent, interconnected entrepreneur. As new technologies like A.I. and global idea exchange platforms augment individual capacity, the trend towards individually ideated innovation will accelerate.

This does not mean that corporations will not try to suppress it rather than adopt it. Glaringly, in a follow-up report in the Wall Street Journal, we learned that one of the results of the Altria investment in Juul will be collaboration between the two companies’ regulatory teams. Speaking of cronying up to government regulators, the Altria CEO was quoted as saying, “We have years of experience” in such regulatory negotiating and another spokesperson spoke proudly of Altria’s possession of  “a level of sophistication they (Juul) need”.

This reveals a downside of capitalism. Altria has enough money to invest in Juul Labs, and enough left over to smother it in corporate process and bind it with regulatory collaboration. While there is no inherent objection to scale, it usually brings with it the insidious integration with government that is anathema to further economic progress. Not to worry; the independent entrepreneurial network will nurture new innovations through its experimentation and co-creation activities faster than incumbent corporations can capture the emergent value through M&A.

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