Saturday, June 26, 2010

Saturday Morning Musings - is economics still relevant?

In the discussion on my post, The fall of economics, KVD asked whether economics as practiced was still relevant in the internet world. He mused:  

I understand your past-tense quote “Resources were limited, so economics was also the study of the application of scarce means to alternative ends”, but am wondering how this now can be rephrased/rejigged to cover areas of activity such as the Internet?

Here we basically seem to have an abundance of resource, provided by unknown vendors/sellers, to end consumers/purchasers with little or no direct cost for that consumption or even remote connection between the various parties.

KVD didn't know it, but he actually raised issues that have been a matter of considerable concern to I and others in the past. The short answer is yes, but analysis can require changes to the concepts and tool kits used.

At the time I first became involved with the electronics, aerospace and information industries in 1983, these were very important questions. I described our overall policy approach in Case studies in public administration. There I said in part:

Wide industry definition. We developed the widest definition for the electronics, aerospace and information industries that we could get away with, combining manufacturing and services all centred on the application of systems approaches. When Barry Jones became Minister for Science and Minster Assisting in 1974 following the Department's acquisition of science and technology responsibilities, we further extended reach into information policy.

All this meant that the service sectors including telecommunications actually dominated in terms of employment and value of production. I also said that we had to develop new analytical approaches. Central to these were the application of economics to enhance our understanding of both firm and industry performance. We actually experienced considerable problems here because we were in fact challenging some of the implicit assumptions built into conventional micro economic analysis. All this is best illustrated by example.

To begin, consider the concept of investment. This is traditionally measured in terms of physical capital - plant and equipment. This worked quite well in the past. However, how do you apply the concept in, say, professional services where physical capital is only a small component of the whole? Or information services, where the same issue applies?

I make this point because investment in the sense of investment of resources now for longer term paybacks has been central to the changes that have taken place across professional services over the last thirty or so years. Capital intensity has in fact risen sharply, a rise that is only partially reflected in a rise in investment as measured by physical assets. Measuring investment by those assets is dangerously misleading.

As a second example, consider telecommunications. At the time we started work, there was a firmly embedded view that telecommunications was a non-traded service provided by monopoly, generally Government owned, carriers whose relationships were regulated by the International Telecommunications Union (ITU). In fact, it was already clear that this traditional view was breaking down under the impact of new technology, new networks and new service types. It was also clear that falling real prices of telecommunications meant that previously non-traded activities were increasingly subject to competition, leading to what came to be called foot-loose industries, support activities migrating to lower wage cost countries. Convergence was also well underway, not just between computing and communications, but also between communications and the media.

It was quite hard to get this across. To do so, we used economic analysis to tease out industry and market relationships. A key aim was to demonstrate that dynamic processes were in train that would inevitably lead to fundamental industry and market restructuring.

In our analysis, we used concepts drawn from micro-economics. Now here we faced a problem. Concepts used in macro-economics including trade theory are very important in understanding how economies work at a general sense, but can be quite misleading when applied at industry level. The concept of comparative advantage is an example. Whatever the general arguments for comparative advantage, the blind application of that concept by Treasury created a mental block that made it very hard to develop new policy approaches.

One set of economic theories that became increasingly important can be summarised as network economics. It was, in fact, a little later before we consciously realised that we were involved with this area. Still, the industries that we were dealing with forced us willy-nilly to articulate similar ideas.

Network economics developed especially in the US to aid understanding of the dynamics of the utility industries. The difference between average and marginal cost is central to network economics. Once a network is established, the cost of adding an additional customer, the marginal cost, is effectively zero up to the point at which further investment is required. As customers are added, average cost falls until the new investment point, but then rises again, starting a new cycle.

A second feature of networks is that they draw a key part of their strength from universality. The classic example of this is the early development of the telecommunications industry. So long as their were few subscribers, use was limited. As subscribers were added, the value of the network to all increased rapidly. By the 1980s, directory services were big business for all telcos.

A significant feature of network economics is a tendency to oligopoly or even monopoly. Once dominance is established, new entrants find it increasingly difficult to break in. For that reason, Governments have particular regulatory interests in these areas.

Network economics is central to the internet. Within all the froth and bubble, the single most important feature is the rise of a few dominant players. Take Skype, for example. It displays classic network features. Once its network was established, it needed customers. As it added customers, then its value to all customers increased. Google is another example, Seek an Australian example.

In undertaking the type of analysis whether in the Department or later in consulting, it is very important to deal with the actual facts of the sector being studied. Application of standard models and generalised rules can, indeed is highly liking to be, misleading. The concept of comparative advantage, for example, was useful in breaking down the old tariff regime, but had only negatives when it came to doing anything beyond this.

This is a muse, not a highly structured economic essay, so I would like to finish with a few assertions.

First, back in the 1970s, there was a lot of interest in what was called the micro-foundations of macro-economics. That is, in the creation of a unified theoretical system that would integrate economics as a whole. It took me a little while to realise that this was conceptually impossible because the different fields of economics addressed different types of problems.

Secondly, the internet itself is just as amendable to economic analysis as any other form of economic activity. I have already discussed network economics. Let me take another example, cloud computing. The currently fashionable cloud computing is no more than the offsite storage and processing of data that we were talking about thirty years ago.

Finally, I want to return to the example I began with, the concept of investment. The confusions that KDV feels about economic terms, the question of the relevance of economics as currently practiced, is directly linked to the way that many economists still use old physical concepts. This says nothing about the real relevance of economics, more about the way economists can be victims of their own forms of thinking.

In 1966 I had no problem in applying economic concepts and analysis to traditional Aboriginal economic life in Northern NSW, a non-money using, non market society. Today, I have no problems in analysing the internet in the same way. I do have problems with the way economic concepts are rendered in limited, old fashioned terms.

In the early 2000's Ndarala, the network of which I was then CEO, organised with partners seminars on the application of the new global accounting rules. These transferred old economics concepts such as tangible assets into legal requirements. We tried to make the point that the "new" rules for the treatment of intangible assets meant instability in valuations and had to be consciously planned for.

During that same time, I was trying to get professional services firms to adopt a wider definition of investment for practical management purposes even if this meant keeping two sets of books; one set met formal requirements, the second was meant to record and track the real investments on which long term performance depended. I really struggled to get this across.

Keynes wrote:

Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

I think that that's pretty right. So far as economics is concerned, the problem lies not in the discipline, but in those who practice it. They are victims of their own pasts. 

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