TCS Daily

The Economy as a Food Court

By Arnold Kling - July 27, 2005 12:00 AM

Editors note: This the second article in a series on capital markets, innovation and regulation.


2. Learning, Risk, and Time


"Certain economic quantities are so hard to estimate that I call them 'unobservables.' Two of these are the expected return on the stock market and the risk premium on bonds."
-- Fischer Black, "Unobservables," as quoted in Perry Mehrling's biography, p. 274.


This essay uses a metaphor to describe the economy and explain the function of capital markets. One of my goals is to embed capital markets within what I call the new economic paradigm of a learning economy. Fischer Black probably would have been comfortable with the new paradigm, but in describing it I prefer to stay away from the term "equilibrium," which was one of his favorites. To me, the term "equilibrium" connotes a resting place, while the new paradigm views the economy as effervescent with change, not simply moving between resting places.


The Economy as a Food Court


Think of the economy as a restaurant, or, better yet, as a Food Court. Behind the Food Court there is a farm, where plants and animals grow spontaneously in adequate but limited supplies. Bear with me, because this is a metaphor, not a literal depiction of the economy.


Coming into the Food Court each day are consumers, who want meals. At different times of the day, these same consumers work in the Food Court, earning income to pay for meals.


When the Food Court economy was relatively undeveloped, there were only a few recipes. They required a lot of work to prepare, and the meals were monotonous, low in nutrition, and not very tasty. Over time, however, people discover new recipes, which add variety, efficiency, and pleasure to the Food Court. This is the process of economic growth.


Over the years, many new recipes are tried. Only a few are successful enough to stay on the menu. The rest are discarded, either right away, or after a period of time when they are superseded by better recipes. This is the process that Joseph Schumpeter famously called "creative destruction," and what I call progress and displacement.


In a highly-developed, advanced economy, there are many recipes. In addition to making life easier and more pleasant, the large assortment of recipes helps to keep the economy elastic. It is easy for the economy to adjust to a shift in consumer tastes or in the supply of plants and animals, by using slightly different recipes.


I like to picture the Food Court economy as having two endpoints, called consumers and firms, respectively. Each recipe represents a line that can connect the two endpoints. A variety of recipes is represented by many lines that fan out from one point and converge again at the other point. A primitive economy has only a few lines. The more advanced the economy, the more recipes, and hence the more lines.


The Need for Capital


Capital markets will have emerged in the food court economy. There are a number of reasons for this.


First, some of the recipes are complicated, requiring many steps and taking several years. Some people are willing to wait, and others are less willing to wait. Those who are willing to defer consumption today in order to enjoy a better meal tomorrow make loans to those who prefer to eat more today.


New recipes do not come free. There is a price of progress. It takes time to invent and test recipes. While entrepreneurs are working on new recipes, they need to borrow from people who are willing to defer consumption.


New recipes are not without risk. Tests may reveal that the recipe fails to achieve the hoped-for combination of taste and nutritional value. Another risk is that while an entrepreneur is developing and testing a recipe, consumer preferences change or new competitors emerge that make the recipe unprofitable even if it produces the expected results in terms of taste and nutrition.


Some of the capital suppliers (people willing to eat less today in order to enjoy more tomorrow) are willing to bear the risk involved in backing projects to develop new recipes. Those investors will demand a higher return than the risk-free interest rate. However, other capital suppliers simply want a sure meal tomorrow in exchange for less to eat today. They would prefer to lend at the risk-free interest rate.


Thus, much of the job of the capital markets is to match entrepreneurs who have ideas for new recipes with consumers who are willing to bear the risk and/or defer the consumption necessary to finance the projects to develop and test new recipes. The capital markets will find a risk-free interest rate that balances supply and demand for deferred consumption. The capital markets will find a "risk premium" that balances supply and demand for bearing the risk involved in trying to discover new recipes.


Why is there just one interest rate for the capital markets to discover? Why not many rates, some for short-term projects and others for long-term projects? Why is there one risk premium, rather than different risk premiums for different types of projects? The answer to those questions will be given in subsequent essays.


Capital as Intellectual Property


The remainder of this essay is a digression. It explores the fact that the Food Court economy appears to treat capital as intellectual property.


In conventional economics, real capital means physical equipment. The financial markets mobilize funds to pay for factories, machinery, and other durable goods. There is no reason to rule out physical capital in the Food Court economy, but it could be subsumed under the concept of recipes. That is, we could have some recipes that call for the production and use of capital equipment as part of the recipe.


It is no accident that I use recipe development as a metaphor for economic growth. My reading of the economic literature of the past 50 years is that well over half of economic growth is explained by better use of ideas. Prior to that, economists tended to wrongly equate all economic growth with the accumulation of physical capital -- plant and equipment.


Fifty years ago, economists saw the economy as like the steel industry -- a collection of gigantic factories housing powerful, expensive machinery, producing output measured in tons. The new paradigm sees an economy that looks more like the pharmaceutical industry or the popular music industry. In pharmaceuticals, as in our Food Court economy, the capital needed for production facilities is relatively unimportant. Much more capital is absorbed in the process of searching for new compounds and testing their effectiveness on diseases.


Similarly, in pop music, the main cost is in finding new bands, marketing them, and testing the consumer response. The capital needed to manufacture CD's is small by comparison.


A steel company does not need intellectual property in order to survive (although patents certainly are a help). The sheer cost of building manufacturing facilities can deter competition.


In the Food Court, however, the loss of intellectual property could be fatal to innovation. Suppose that a risk-taking company tries several new recipes, and only one turns out to succeed. If a second company comes along and copies only the successful recipe, the second company saves all of the research and testing costs incurred by the first company. Without patent protection, no firm would want to play the role of leading-edge innovator.


I do not have a settled position on intellectual property. As I wrote here, I think that one can justify taking different positions on different industries. I view the pharmaceutical industry as resembling the Food Court economy pretty closely, in that some form of reward for intellectual property development is clearly needed. On the other hand, the music industry strikes me as somewhat of a hybrid between the food court economy and the steel industry. Because the music industry wants to ship CD's by the ton, and has dragged its feet about delivering bits instead (see this essay), I have much less sympathy with the music industry's cries for intellectual property protection.


I think of different industries as being arrayed across a spectrum, with some industries closely resembling the Food Court, some industries closely resembling the steel industry, and some, such as chip manufacturers like Intel, in between. The more closely an industry resembles steel, in which physical manufacturing capacity is a barrier to entry, the less crucial is the issue of intellectual property protection.


The trend as I see it is for the balance to continue to shift in most industries toward greater importance for research and testing, with relatively less importance to physical plant and equipment. In other words, I see intellectual property becoming a larger component of capital, as the economy drifts in the direction of the Food Court metaphor. As a result, intellectual property law is going to be increasingly important as we move forward.


Arnold Kling is the author of Learning Economics.


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