Platt Perspective on Business and Technology

Open markets, captive markets and the assumptions of supply and demand dynamics 6

Posted in macroeconomics by Timothy Platt on November 6, 2015

This is the sixth installment to a brief series on underlying assumptions as they arise and play out in economic systems, and in production and marketplace systems (see Macroeconomics and Business 2, postings 230 and loosely following for Parts 1-5.)

I began explicitly discussing friction as it arises in business and economic systems, at least in the context of this series, in Part 5. And one of the key points that I raised and at least briefly discussed there, was that real world stakeholders and actor participants in business and economic systems, always face friction and its consequences as they decide and act; they always face information and communications gaps and challenges that collectively comprise friction there.

• Business and economic transaction participants always have to make their decisions and act upon them from a position of at least partial uncertainty, as created by only holding part of the information that they would have if they were to make ideal-world, fully informed choices.
• And transaction participants who hold more accurate, timely and complete information relevant to the decision points at hand, hold a great deal of competitive advantage over their less-informed counterparts when addressing those transactions and making their decisions for them.

At the end of Part 5, I stated that I would continue its discussion by taking “a game theoretic approach to business strategy in that, where friction and its attendant uncertainties can be and often are the driving factors in determining which strategies (e.g. win-win or zero-sum oriented), differing stakeholders would each variously seek to employ in pursuing their own goals.” I also stated that I would discuss this in terms of timing. I am going to at least start to delve into those issues here. And then after considering those issues I am going to discuss how politicians market economic theories and economics-based agendas when they campaign for office, and how that translates into legislation and enacted law, and into marketplace and economic realities.

I begin addressing all of that, with an at least selective further discussion of friction, or rather of its costs and impact and on both individual business stakeholders and on the overall systems that they participate in. And I begin that with the absolute fundamentals:

• Friction creates uncertainty and that translates directly into creation of risk. And added risk always increases overall transaction costs.
• There are a number of ways to measure this cost increment, but to cite an actuarially oriented single business-defined approach that I find particularly useful, and in its simplest case format with a single point of risk that is either fully realized or fully avoided:
• The risk cost that at minimum has to be allowed for in any viable long-term due diligence calculations and systems modeling, is the product of the likelihood of the risk-predictive bad outcome occurring and the total cost that would be incurred specifically and consequentially if it does.
• So if for example, there is a one chance in one million of some specific unfavorable event occurring, that can be accurately predicted for likelihood of occurrence,
• And cost calculations indicate that it would cost ten million dollars to correct from this development if it were to occur,
• Then the ongoing risk costs from this particular event possibility would be ten dollars, as a set liability cost that has to be calculated into the overall cost of doing business going forward.
• And if this risk were more complex for likelihood of occurrence and for cost faced if it does (e.g. where it might partly or fully arise, or where it might fully arise but with a range of possible different costs incurred from it depending on timing or other factors),
• Then the overall aggregate risk liability cost for this event category as a whole, going forward for it, would be represented at least conceptually as a sum of weighted average costs, with weighting factors determined by specific likelihoods of that risk event occurring, for each of the various “event possibility” outcomes that would qualify as realizations of at least some form of it happening. This is a conditional probability calculation, where it is assumed that at least some form of this type of overall risk category event does occur, and each weighing factor is a fraction that is greater than zero, and less than or at largest equal to one. And the sum of all such weighing factors here is precisely one.
• And the overall risk faced across all recognized and considered variations on this one basic deleterious event would be represented by a sum of the overall risk liability costs for all of the event-occurrence possibilities that individually rise to a sufficient level of likelihood and cost to merit consideration in due diligence and risk management calculations – with nonlinearities added in here as appropriate too – where for example it would not be possible for event A to happen as a realized risk if B were happening, due to the context and occurrence requirements that each would call for, being incompatible (e.g. a store’s basement storage area for inventory in stock that is awaiting shelf space, is unlikely to catch fire if it is already flooded with water.)

Note that together this means a business decision might carry significant risk because one very high potential cost event type, would have an unacceptably high likelihood of occurring and at an unacceptable cost if it does. But on the other hand a business decision might carry essentially the same overall risk because each of a seeming myriad of individually low cost but vexing and time consuming complicating events are all likely to arise and each with a high enough probability of doing so, that it is certain the business would have to face a succession of them happening – creating a death by a thousand paper cuts effect, rather than death to that transaction’s viability from one large excessively likely and costly hemorrhage.

This, so far, addresses risk costs for the individual business. But individual businesses rarely if ever operate entirely in a vacuum with regard to other businesses; most businesses purchase resources from other businesses, supply their products or services to others (e.g. wholesalers or retailers, or to other manufacturers or providers), or both. And it is increasingly common for businesses to enter into and participate in supply chain systems and even complex ones. And risk-based costs in any one business in these systems create impact effects that radiate out. Risk in participating businesses shapes their operational processes and their more strategic decision making and their priorities and even the precise terms of their business goals, and all of that influences and certainly collectively, fundamentally shapes the positions from which they would interact with other businesses in these systems.

• How interconnected businesses behave, influences and can at least cumulatively even significantly shapes both operations and even underlying strategies for all participants – impacting on how partner businesses can and do and will act and interact and collaboratively function.
• And competitors have to be included here as businesses respond to and develop and operation in response to other businesses that they fight for market share with, at least as much as they do to businesses that they more positively interact with.
• And competitive advantage is often and even usually shaped by differences in raw data and processed knowledge held and by timing and positioning differences as to when it is known and where in these involved businesses – the raw material of friction as a whole here.

Regulatory and related outside-imposed frameworks enter into this here, but I will delve into that complex of issues later when I add a political and legislative dimension to this discussion – which I will delve into relatively soon. I will simply note that this directly impacts upon both collaborative and competitive business-to-business interactions and impacts.

• It is, or at least should be a goal of any overarching economic theory that it accurately describe and predict the impact of risk as it expands out from individual businesses in place, to include patterns of interactions that connect together entire business sectors and industries, with their markets and market spaces.

And this up to here addresses one fundamental form of friction and of risk based cost that businesses, and higher level organizational systems of businesses and marketplaces face.

• I have been addressing how risk that arises from incomplete information and related friction sources, increases overall costs faced, and both on an individual transaction basis and cumulatively across a business as a whole. And I have at least briefly sketched out how this set of phenomena influence groups of businesses and even, at least potentially, entire economies.
• I will discuss the readily apparent gaps that arise when going from the level of individual businesses and groups of businesses to the level of entire macroeconomic systems, when I address political and legislative actions as they are at least in part, economically based. But setting that line of discussion aside for now, I add that there is a second fundamental form of cost that friction imposes on business and on larger economic systems:
• Friction also influences the maximum possible positive return on investment for participating in a transaction that might be possible as a realistic maximum value attainable.
• And friction, as a combined metric of lack of crucial information for making informed decisions, also means loss of fully informed understanding as to what overall cost/benefits ratios would be, as well as reducing the maximum return on investment and the maximum profitability that might be possible.

The point of distinction that I am making here is crucial. Friction reduces the prize that might be gained as overall profit-creating value, that is received from entering into a transaction. And it also clouds your vision in being able to calibrate costs and benefits, and cost/benefits ratios. And this brings me directly and specifically to game theory strategizing, and transaction and business model determinations, and how those approaches fit into this overall discussion.

I am going to explicitly turn to and discuss game theory approaches to business strategy, as they would apply to and help clarify this discussion, in my next series installment. Then after that, I will discuss how politicians market economic theories and economics-based agendas when they campaign for office, and how that translates into legislation and enacted law, and into marketplace and economic realities. And as noted above, I will discuss this in regulatory and legislative terms. And that will bring me back to the first installment to this series, and its line of discussion.

Meanwhile, you can find this and related postings at Macroeconomics and Business and its Page 2 continuation.

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