Brian J. Loasby
Options and Evolution
DRUID Summer Conference 2002
He1singør 6-8 June
In 1997 the Nobel Prize in Economics was awarded for major developments in option theory, and the use of both financial and ‘real’ options is a notable feature of the ‘new economy’. The lectures given by the Prizewinners, which were published in the American Economic Review for June 1998, celebrate these theoretical and practical developments and envisage their further extension, with a confidence equivalent to that displayed a little later by commentators on the prospects for e-commerce.
Robert Merton begins his lecture with a declaration that “[t]he special sphere of finance within economics is the study of allocation and deployment of resources, both spatially and across time, in an uncertain environment” (Merton, 1998, p. 323), and a little later asserts that “the underlying conceptual framework originally used to derive the option-pricing formula can be used to evaluate and price the risk in a wide array of applications, both financial and non-financial” (Merton 1998, p. 324). Finance thus not only deals with uncertainty but has exclusive rights to do so. Both claims deserve comment.
Merton’s unsignalled change of terminology, from “an uncertain environment” to “evaluating and pricing risk”, appears to treat option theory as the modem philosopher’s stone, which transmutes uncertainty into manageable risk. Almost 70 years ago, Knight (1933, p. xiv) was “puzzled by the insistence of many writers on treating the uncertainty of result in choice as if it were a gamble on a known mathematical chance”; but this is a methodological necessity if economists desire to be consistently orthodox, and indeed if whole realms of theory - not just option theory - are not to collapse. However, as Shackle (1972, p. 425) observed, “[a] training in value theory can have a strange effect on the individual mind. It can give rise to a fundamental scepticism concerning the reality of ‘events’. The mind which has been taught to suppose that the norm of conduct is rational conduct... draws the tacit inference that... the fully successful individual would encounter nothing in life that he was not prepared for.” Such indeed appeared to be the state of mind of Merton and Scholes in devising the operating strategy for Long Term Capital Management.
Merton’s second claim is a separation theorem: uncertainty is the sphere of finance, and so economists in all other branches of the subject should make no specific allowances for it in their own work. Separation theorems play an important role in delimiting spheres of economic analysis: it has long been assumed, for example, that the microeconomic theory of resource allocation and monetary theory are entirely separable, despite Martin Hellwig’s (1992, p. 232) warning that “[o]nce we accept the fundamentally non-Walrasian nature of the organization of exchanges in a monetary economy, we are led to question... the foundations of a good part of microeconomic theory and welfare economics”. Since “[o]ne must introduce uncertainty, before one can introduce money”, as Hicks (1982, p. 7) realised in 1933, there is a common source of danger in these two particular separation theorems. If uncertainty is squeezed out of the model it inserts itself into the gap between the model and the phenomena to which it is applied - which is precisely what Merton and Scholes discovered.
It is not only in economics that separation theorems are widely used. The division of knowledge within any major academic discipline and also between disciplines assumes at least quasi-independence; and within any large organisation the allocation of responsibilities, the imposition of divisional, departmental or individual targets, and the use of cost and profit centres all imply substantial separability between classes of activity. Such assumptions are not errors, but a consequence of human limitations; in order to develop any understanding we all need to disentangle interconnected phenomena for separate treatment, by creating imperfect representations of these phenomena. As Herbert Simon (1969) pointed out long ago, decomposability is an indispensable if dangerous assumption; but it is therefore essential to recognise what Levinthal (2000) has called ‘the fallacies of decomposition’, both in organisational design and in academic disciplines. The reluctance of economists to treat decomposability as problematic, either in their own practice or within the models that they construct, limits the content and applicability of their models, sometimes at substantial cost to public welfare. The space of representations does not coincide with the space of phenomena, and may therefore have significantly different properties. The theoretical developments which were rewarded by the Nobel Prize are potentially valuable, but - like any knowledge claim - they should be recognised as a set of conjectures that “will exist by sufferance of the things which it has excluded” (Shackle 1972, p. 354).
Merton concludes his lecture with a brief paragraph of caution in which he appears to acknowledge this inherent problem. “The mathematics of financial models can be applied precisely, but the models are not at all precise in their application to the complex real world... The models should be applied in practice only tentatively, with careful assessment of their limitations in each application” (Merton, 1998, p. 343). This final paragraph is in sharp contrast to the confident tone of the twenty pages that precede it; but despite a brief reference to a few “unfortunate pathologies” (Merton, 1998, p. 340) the chief problem that he identifies is the need for increased training in mathematical modelling. Scholes gives a section to pathologies, but attributes the more serious failures to unwise government guarantees to financial institutions, and his final sentence is unqualified: “In a world of information asymmetries, derivative instruments provide lower-cost solutions to financial contracting in a dynamic environment and these lower-cost solutions enhance economic efficiency” (Scholes, 1998, p. 368). Those who seek to develop useful products seem to be significantly (though not invariably) much more conscious of the difficulties of turning promising theoretical or experimental results into valuable goods and services than economists are of the difficulties of turning their own models into viable policies.
The major future development, Merton believes, is in corporate strategy. “For example, a hypothetical oil company with crude oil reserves and gasoline and heating-oil distribution but no refining capability could complete the vertical integration of the firm by using contractual agreements instead of physical acquisition of a refinery” (Merton, 1998, pp. 342): options to deliver crude and receive refined products avoid the uncertainty which is associated with large fixed-cost commitments. (Enron is cited as an illustration of the possibilities.) What is surprising is that Merton fails to pursue the simple logic of his analysis: not only does an oil company not need to own a refinery; it does not need to own oil reserves or distribution facilities either. Moreover, no-one needs to own a refinery; option contracts for the use of particular
items of equipment and for the use of specified labour inputs deliver optimal allocations while avoiding commitment. Productive activities can be decomposed into individual option sets, linked by a nexus of contracts.
This is, of course, an updated version of the Arrow-Debreu model of general equilibrium, which was developed precisely in order to encompass, in Merton’s phrase, “the study of allocation and deployment of resources, both spatially and across time, in an uncertain environment”: in this version the complete set of contingent commodities, encompassing all possible future states of the world, is partly - or even completely - replaced by present option contracts for corresponding contingencies. Instead of present contracts for contingent goods, decisions are postponed until the contingencies are revealed, but the value of an option to a potential purchaser cannot be calculated unless both the probability of each contingency and the decision which matches it is already known; thus the information requirements are identical. Both versions ensure allocative efficiency with no need for managers, organisation, or social institutions of any kind. That is why Merton is strictly correct to describe as “vertical integration” what industrial economists used to call ‘vertical disintegration’; the complete integration of contracts is essential for Walrasian results. Scholes (1998, p. 367) is less inhibited: “I believe that the corporate form we know today will not be long-lived”. The force of Merton and Scholes’ argument is that the development of option theory invalidates Coase’s ( 1988, pp. 39-40) explanation of the firm - which neither of them mention - as a contract for the performance of future activities which are deliberately left unspecified; complete contracts are now possible, and they will always drive out incomplete contracts because, as every neoclassical economist knows, they are necessarily more efficient.
Knight’s distinction between risk and uncertainty was the foundation of his theory of the firm: risk could be insured, but uncertainty had to be continuously managed (Knight, 1921, p. 259). In his first published article, George Richardson (1953) adapted Knight’s distinction between situations which can be assessed by agreed procedures and those which require idiosyncratic skills, in a fashion which directly anticipates his later emphasis on distinctive capabilities: he even included a reference to Gilbert Ryle’s (1949) distinction between ‘knowing that’ and ‘knowing how’. We should not therefore be surprised to find that in claiming that all uncertainty can in principle be handled by agreed procedures (even if those procedures are somewhat esoteric - and therefore deservedly well-rewarded) Merton and Scholes are led to predict the disappearance of management; they should, however, also have predicted the disappearance of profit, even for themselves. Soon after the publication of these articles, uncertainty inserted itself into the gap between the models which Merton and Scholes had devised for their profit-making enterprise and the phenomena to which they were applied, with spectacular consequences.
It is not my purpose here to examine the usefulness of options and derivatives as financial instruments; we all rely on them in some form (often indirectly), and extensions of their use can often be valuable, though, like many other useful techniques, they involve some dangers. Nor do I wish to deny Merton’s claim for the wider importance of options or derivatives. On the contrary, I wish to enlarge it, for I believe that they actually have much broader, and indeed more fundamental, relevance than he has recognised. But this broader relevance cannot be encompassed, as Merton assumes, by “the special sphere of finance”; it requires a generous context
of economic analysis and a larger conception of the economic system, in which the fundamental imperfections of human knowledge are not disguised by the imposition of probabilities, either supposedly objective or subjective, but are directly applied to the explanation of economic phenomena. My purpose in this paper is to indicate what is required, and what options for theory are thereby opened up. In doing so I am applying Richardson’s conviction, formed very early in his career, that “it was precisely the uncertainty and fragmentation of knowledge that gave to the economic system its essential rationale” (Richardson. 1998, p. xi).
The kind of option theory selected for honour by the Nobel Prize Committee is part of a theoretical structure which assumes not only a fully-specified economy but also a closed system of knowledge to which demonstrably correct principles can be applied. It excludes the possibility of surprise - as Merton and Scholes discovered; for surprise is a refutation not only of a particular set of options but of the assumption of relevantly complete knowledge on which all calculation of option values in their models is based. As we shall see, abandoning this structure and moving from a closed to an open system does not exclude the possibility of valuing options; but their valuation must be recognised as either a conjecture or a convention - just like the valuation of other commodities. More importantly, it leaves ample room for the analysis of options as a protection against genuine uncertainty instead of misrepresenting it as risk, and even more as a means of generating novelty. As Shackle above all has reminded us, uncertainty is the necessary price we pay for imagination; it would be a pity to pay the price without gaining the benefits. Since uncertainty and imagination both imply that knowledge changes overtime, this shift of perspective also requires an analysis which, in Hicks’s phrase, is “in time”, and options in this sense may be incorporated into evolutionary theory.
The conceptual basis for such an analysis has been set out by Jason Potts (2000). Any system consists of a set of elements and a set of connections between them. The Walrasian model requires both sets to be complete: thus the demand for any commodity depends on the preferences of all consumers for all commodities, the supply of any commodity depends on the total supply of resources and the technologies available for all commodities, and the consumer incomes which influence demand are themselves derived from supply. Every element directly influences every other element. This is essential to standard Walrasian analysis; and so, though connections are crucial they have no role in the comparison of Walrasian systems, which depends solely on differences between the elements. (There is a flourishing fringe of subsidiary analyses which focus on supposedly missing connections - principal-agent models and efficiency wage theories, for example - but they all rely on embedding these local difficulties in an otherwise completely-connected system.) An obvious limitation of this conceptual basis is that all change is exogenous, and attributable to some change in the elements.
Now suppose that we relax both requirements; neither the set of elements nor the set of connections is assumed to be complete. Endogenous changes may now be produced by rearranging some of the connections within a system, and new connections may give rise to subsystems which may constitute new elements within a higher-level system - for decomposition is inherently problematic, both as threat and
opportunity. Possible rearrangements of connections from any given starting point may now be thought of as options; and each starting point will have its own set of feasible options, though this set is most unlikely to be accurately known by anyone. A variety of starting points then entails a variety of option sets, and each option that is taken will generate an amended option set: history matters, because each choice changes the basis for subsequent choices. Options may still be valued by making assumptions about of uncertain futures (perhaps using Nobel Prizewinning methods), but these valuations are conjectures, and are often wrong. Thus a range of assumptions, perhaps developed through alternative scenarios, giving a range of values may provide useful knowledge. The result is a continuing process of purposeful trial and error, often but not always resulting in cumulative movement in particular directions. Research may often be designed to create options for future exploitation, but the ordinary course of business, or of life, is also a common source of new options. The creation of real options, intended or unintended, is a source of variety for evolutionary selection.
This perspective on options is closely linked with Carl Menger’s (1976 ) recognition of the importance of preparing for an uncertain future by acquiring or developing reserves, each of which allows for responses to a range of threats or opportunities. Menger understood that money, or financial reserves in general, and non-financial reserves, such as fire-extinguishers and medicine chests, were differentiated examples of a broad range of options for coping with particular kinds of threats and opportunities. This link is reinforced by Menger’s use of the concept of derivatives as the fundamental connecting principle of his causal analysis of value. Instead of assuming a set of goods, as in modern microeconomics, Menger begins by arguing that an object becomes a good only when someone discovers how to use it to satisfy some human need. Goods are endogenous, created by new connections between human need and physical or human resources; and their value is derived from the need which each of them serves and - crucially for this paper - from the knowledge that it can serve this need and also the knowledge of how it can be made to do so. (Both of Ryle’s categories are important.) The creation of goods, and of technology, rests on the creation of knowledge, and therefore on previous uncertainty - or indeed sheer ignorance (Kirzner 1999, p. 7). Menger traced the sequence from first-order goods which are directly useful, through second-order goods which can be used to produce first-order goods, third-order goods which can be used to produce second-order goods, and so onto increasingly indirect means of producing satisfaction, including market institutions and money. The value of a good of any order is derived from the value of the good which it helps to produce in the order immediately below, and thus eventually from the need which is ultimately met. Value therefore depends on knowledge, and new knowledge can both create and destroy value, including the value of options.
Instead of derivatives being a special class of prices, which are the particular concern of finance theorists, the general theory of price, according to Menger, is a theory of derivatives. This is potentially a much more useful conception than Walrasian general equilibrium, not least because it endows every economy with a distinctive structure, and thus provides a basis for explaining how and why prices may change: whereas a Walrasian model gives no clues about the impact of any external shock, the specific structure of a Mengerian model allows one to trace the likely pathways through which the effects of that shock may be disseminated, using, creating and destroying options
in the process. Moreover, since many goods, especially goods of higher order, can be used to meet more than one need, they provide options; and so any choice between uses is a choice between option values, as these are perceived by the chooser. Thus all choice theory is option theory, which should not be “the special sphere of finance”. We do not, however, need to assume that all valuations are correct, or that there is a precise method of imputing value, such as modern option theory claims to provide. Menger made no such general assumption. On the contrary, by insisting that every connection within this system depends on human knowledge, which is incomplete but augmentable, Menger not only makes every price dependent on human knowledge, but also incorporates uncertainty in his system - and therefore, as Knight demonstrated, makes room for innovation and entrepreneurship. Differences of knowledge may give rise to differences of valuation which, as Shackle pointed out, are the basis of profit.
It is the combination of time and uncertainty that makes the creation and preservation of options potentially so valuable. Shackle (1972, p. 160) once defined money as “the means by which decisions can be deferred until a later and better informed time”; and Coase (1937) explained the creation of a firm as a device for postponing decisions while simultaneously assembling the resources with which to implement those decisions at the appropriate time, without the costs of arranging market transactions before setting to work. Both are means of avoiding precisely-specified contracts, and are preferred precisely because of their imprecision. Options as defined in finance theory cannot cover all possibilities - especially those that are not yet perceived, and most of the options on which we rely are not of this kind. Because of the uncertainty and fragmentation of our knowledge, every economic system is a network of different kinds of options, or, to use Menger’s term, reserves. Just as monetary theory is incomplete without reference to at least the more obvious alternatives to money, so the restriction of option theory to financial instruments is inadequate; we should consider a portfolio of options.
Among the resources which may be adapted to a range of uses, sometimes wide, sometimes narrow, we may include particular skills, the capacity to acquire new skills, equipment and physical plant, formal organisations, alliances and networks, reputation and goodwill. Indeed we may find it salutary to consider life as a process of creating, forgoing, preserving, modifying, relinquishing, and using options, at the level of the individual, groups, organisations, and economic systems. Every option is appropriately valued by the future possibilities to which it gives access, though determining that value is rarely easy. Because it is the nature of options to change overtime, in content, in their connection to other options, and in the perceptions (usually divergent) of their value, a comprehensive treatment requires a context of process, which economists typically try to avoid. An inherent obstacle to conventional analysis lies in the purpose of options, which is the selective enlargement of discretion; for the individual’s freedom to choose impairs the analyst’s ability to predict. Patterns, however, such as reliance on particular combinations of options and particular kinds of institutions, may be more predictable than individual behaviour.
In the remainder of this paper we will explore a little further this view of options. It is essential to recognise that the conceptual basis for our exploration is not the integral
space, or fully-connected system, that is assumed in most economic modelling; instead the assumption is that the internal connections within the systems that we study are incomplete, and often only a fraction (sometimes zero) of the possible connections across the boundaries of these systems currently operational. In other words, systems are typically ‘open’ to unrecognised influences, both internally and externally. In particular, the connections between the representations that constitute our knowledge and the phenomena that each purports to represent are always incomplete. Now an obvious implication of partial connections is the potential for adding to or rearranging the present set: there are always, in principle, options for change. It also seems plausible to argue that the options that are most likely to be perceived, and the easiest to exploit, are transitions to ‘adjacent states’ (Potts 2000), in other words those that involve marginal adjustments, or possibly moves to other systems that are similarly configured although they may bear different labels, such as fixed-point theorems for proofs of equilibrium or neo-Darwinian models of evolution for modelling economic change - or, as a striking example that I recently encountered from corporate strategy, thinking of airport slots for airlines in terms of shelf-space for consumer goods manufacturers. If this is so, then the possibility of making new connections will be substantially influenced by the starting configuration, and since each new connection implies a new starting configuration, and thereby changes the set of adjacent states, the sequence of new connections is likely to be substantially path-dependent - though not path-determined.
It is within this context that we can begin to consider the central issues of knowledge, learning and flexibility; these give a new dimension to the problem of co-ordination, because what has to be co-ordinated is a process in which greater coherence may suppress potentially valuable variety. Though reason is important, ‘rational choice’ in the sense of modern economics is inappropriate; instead the emphasis is on the connectionist character of human cognition, as recognised by, for example, Adam Smith, Alfred Marshall, and Friedrich Hayek, and on knowledge as structured relationships (for example of similarity or causality). Knowledge begins with uncertainty, and grows by trial and error in making connections, for knowledge is constituted not by elements but by the selective (and therefore non-Walrasian) connections between them; and these ‘connecting principles’, as Adam Smith ( 1980) argued in his psychological theory of the growth of knowledge, are formed in the imagination. We are therefore using scientifically precise language when we talk of ‘making sense’ of phenomena or situations, for sense has to be made rather than revealed. We make sense by making patterns, and we stick to apparently successful patterns and seek to enlarge their scope, perhaps with modifications to a few connections at the periphery; sometimes we perceive apparently significant similarities with apparently successful patterns in another business or another discipline, and try to import them; and sometimes we create a link between two patterns and produce an innovation - remember Schumpeter’s definition of innovation as ‘new combinations’.
In a recent paper Armand Hatchuel (2001) distinguishes between well-defined ‘problems’ which have countable solutions and open-ended ‘projects’ in which the solution set is non-countable. Projects require what he calls expandable rationality, which I interpret as the ability to make connections which were not included in the original specification of the project, thereby creating new patterns. Options have to be created before they can be evaluated. As others have done, Hatchuel (2001, p. 270)
observes that “human agents are limited decision-makers but ‘good’ natural designers (including social interaction as a design area)”.
What is true of knowledge seems, not surprisingly, to be true of human cognition, and indeed of the human brain, and this seems to be compatible with current biological models of evolution. It is easy to understand why genetic programming of behaviour (which is still powerful in all of us) long preceded the more complex genetic programming of a brain that is capable of developing connections which support novel behaviours within individuals; and it easy to suggest that the selection of a brain structure with this creative potential may be an evolutionary adaptation to cope with changes which are too rapid or transitory for genetic modification (Schlicht 2000). The human brain thus becomes an option set for the generation of option sets. The evolutionary fitness of this novel potential naturally depends on the readiness to put it to good use, and Schlicht, like Smith, suggests that emotions serve an essential function in motivating our attempts to ‘make sense’ and that aesthetic sensibility impels us to make sense by making patterns. The influence of aesthetic considerations on the evaluation of scientific ideas has often been noted by scientists reflecting on the development of their discipline. It is worth noting that there is no reason to expect new behaviours produced in this way to be encoded in genetic modifications. Thus Lamarckism is kept at bay; but the consequence is that the study of such behaviours, their transmission and adaptation, goes substantially beyond the biological model (Loasby 2002b).
In a famous paper, Cohen and Levinthal (1989) pointed out that in addition to generating innovations, R & D departments have a ‘second face’ as absorbers of other people’s innovations, and that a substantial part of their activities, such as basic research and work outside the company’s technological range, is primarily intended to improve their absorptive capacity. Absorptive capacity is multi-specific rather than general, for it depends on appropriate receptors, which can easily connect to knowledge that has been developed by others. But creative ability is also multi-specific, depending on the formation of linkages from some part of existing knowledge structures. This duality between creation and absorption is not peculiar to R & D: any department in a firm may use particular connections within their own patterns of knowledge either as a basis for new ideas or as links to other people’s ideas. Indeed, the formation of new connections for the creation or importation of knowledge is a basic principle of human learning: our existing knowledge provides the options for increasing our knowledge, in response either to internal prompting or internal initiative.
Only a small proportion of these options for further connections is likely to be perceived, and the potential value of those that are perceived may be highly uncertain. Ambiguity is a natural consequence of knowledge as open-ended connections. “It is difficult to put boundaries around an idea” (Fleck 2000, p. 255); but though, as Fleck points out, this makes them very slippery elements in any analytical system, it also makes them an ideal source of options which may create new knowledge or new artefacts. There is always an entrepreneurial element in new applications of present knowledge or in experimenting with variations of that knowledge; imagination is a condition for the perception or the creation of the kinds of options that we are now discussing. The pathway to valuable new ideas, technologies or products may be obvious in retrospect, when the appropriate destination is revealed and the problem
therefore well-defined, but which of many paths is worth following is an open-system problem for which there are no demonstrably correct procedures.
For every individual, however, and for every organisation, there will at any time be some framework, usually ill-defined and therefore in some respects permeable (Kelly, 1963, p. 79), within which new ideas will be sought and new phenomena accommodated if at all possible. Frameworks organise the opportunities for choice, and for the creation and perception of options; thinking, even innovative thinking, requires “cognitively tractable local spaces” (Porac and Shapira 2001, p. 207). The substantial energy requirements of the brain provide an explanation that should be readily absorbed by economists, and this explanation provides a more secure foundation for the study of institutions than the current focus on co-ordination; but though the importance of institutions is implicit in this discussion, they must be reserved for separate treatment. Though frameworks of thought may change progressively over time - and such progressive change seems to be the process which in retrospect may seem to have delivered a new paradigm - there are substantial costs of major changes of framework, not least in the difficulty of forgetting, which requires the breaking of connections which have become automatic. Thus the options that are even conceivable for a single individual, or a single organisation are a minor subset of the options that would be available to an unlimited intelligence. However, the options available to a community may be increased by orders of magnitude if the members of that community operate in diverse local spaces; the variety of contexts then generates a variety of problems which prompt the formation of somewhat different connections. This diversity, as Adam Smith saw, may be most readily achieved by the division of labour. The division of labour generates options, and from these options comes economic growth.
Coase’s (1937) characterisation of the firm is implicitly a definition of an option set, in which the willingness to restrict the set of future decisions reduces uncertainty about the availability of the capabilities needed to implement these decisions. Since any list of relevant possibilities that can be defined, even within this restricted set, is liable to be incomplete, these advantages can be obtained only if the contracts by which a firm is constituted are imperfectly specified; completing the set of contracts in the way that Merton and Scholes propose is not possible if the set of options is not countable. Economists are well aware that this imperfect specification may give rise to problems; they are less willing to recognise that it is a solution to a prior problem. Its purpose is to reduce the costs and delays in responding to future threats, and also, let us not forget, the costs and delays in responding to opportunities - for, as Shackle continued to remind us, the imperfections of our knowledge gives us the perpetual hope of improvement through the development of new skills and the discovery of ways hitherto unimagined of meeting human needs. The realisation of these hopes requires us to keep our list of possibilities open to novel thoughts; but the elimination of the incentive problems which form the subject-matter of principal-agent, property rights, and transaction cost theories (except for Coase’s theory) requires unquestioned closures which may frustrate these logically prior purposes. Whether, in any particular circumstance, the disadvantages outweigh the benefits may be an appropriate question for investigation; the standard assumption (against a background of hypothetically complete information), that the more completely specified is any contract the better,
simply suppresses that question, and, as Coase (1991, p. 65) complained, prevents economists from saying anything about what firms actually do.
In exploring the rationale of corporate planning 35 years ago, I came to the conclusion that a well-designed planning process supplied a procedure for examining both the future possible implications of present decisions and the present implications of future possibilities, and thus facilitated timely provision for possible future actions (Loasby 1967). Though not so expressed, it was, in the language of this paper, a justification of planning as a means of preparing appropriate option sets; planning processes are an important aspect of the role of the firm as an instrument for creating options. Another important aspect is the development of firm-specific skills in its workforce, for capabilities are option sets also. Firm-specific skills, very appropriately, have become a substantial interest of labour economists; but there is a danger (as with the assignment of option theory to finance specialists) that the neglect of the relationship between firm-specific skills and other forms of options may obscure some theoretical dangers, and also some theoretical opportunities. In particular, what may be specific to a firm may be, not the component skills of its members, but the interconnections which allow them to be oriented towards a range of purposes, including the development of new products and new methods of production, in ways which no single member of that firm is able to specify - and which, therefore, may be difficult for any other firm to emulate. I shall not attempt to discuss firm-specific skills, but will simply point to an obvious but unexplored connection to Penrose’s (1959, 1995) Theory of the Growth of the FFirm.
The major conceptual innovation that makes Penrose’s analysis possible is her sharp distinction between resources and the services which they can provide. A Penrosian firm is a mechanism for generating options, in the form of capabilities, which are then transmuted into options in the form of productive opportunities by the perception of valuable applications. This is her own summary.
A firm is basically a collection of resources. Consequently, if we can assume that businessmen believe that there is more to know about the resources they are working with than they do know at any given time, and that more knowledge would be likely to improve the efficiency and profitability of their firm, then unknown and unused productive services immediately become of considerable importance, not only because the belief that they exist acts as an incentive to acquire new knowledge, but also because they shape the scope and direction of the search for knowledge. (Penrose 1959, p. 77)
The application of the options that are generated by this search is guided by the entrepreneur’s belief that “demand [is] something he ought to be able to do something about” (Penrose 1959, p. 80): there are options for creating demand, often by creating, or modifying, market institutions. Peter Dmcker (1955, p. 35) declared that the purpose of business was to create a customer; an established relationship between a business and its customers provides options for the business to gain income by offering value in new forms, and options for the customer to obtain value at relatively low transaction costs. To maintain such a relationship it is important not only to
understand what options each customer finds attractive, but also not to underestimate the customers’ access to ‘outside options’, which are inherent in any competitive market.
Capabilities are inherently multi-specific, and because they change over time the range of their specificity changes. This modification of capabilities is the basis for Penrose’s theory of endogenous growth; what makes it also the basis for a theory of the firm is that the particular patterns of modification, and in particular the clustering of modifications, tend to be specific to each firm - not least because so much depends on entrepreneurial imagination which may change strategy. In choosing between productive opportunities managers are necessarily choosing between pathways of development; some capabilities will develop further, giving rise to new options, while others will cease to grow, and even if they do not decay are likely to become outclassed by the improving capabilities of other organisations which have made different choices. Despite the invocation of her name by some writers on corporate strategy, Penrose’s theory is not about “sustainable competitive advantage”, which is a version of equilibrium theorising that assumes a stable knowledge set (Foss 2002), but about the continuous search for temporary distinctiveness through the creation of novel capabilities and the imagination of novel possibilities.
Each firm is a complex structure of complementary capital goods, including human and organisational capital, which embodies its capacity to meet human needs, directly or indirectly. The course of each firm’s development depends on both this structure and its orientation (a theme pursued by both Lachmmm and Shackle), which is the consequence, not always intended, of human perception and human action; and competition between firms derives from the interlinked differences between them in resources and perception. The firm is an institution of constrained flexibility, in which organisational structure and corporate strategy (whether prescribed or emergent) are instruments for organising the growth of knowledge, and thereby creating and limiting its option space and thus the scope of its future activities. Organisations have a cognitive basis because cognition has an organisational basis (Loasby 2002a); both bases provide the options for certain kinds of novelty.
The ‘administrative framework’ is an essential feature of Penrose’s analysis; it supplies patterns and procedures for dealing with problems and seeking opportunities: as in Simon’s organisational analysis “firms provide a comprehensive repertoire of authority relations, and motivational foundations and coordinative mechanisms that help people make good decisions” (Osterloh, Frey and Frost 2000, p. 232). At each level and in each department within the firm managers set the constraints within which flexibility is encouraged: Richardson (1998, p. xvii) draws on his 15 years’ experience as chief executive of Oxford University Press in remarking that “management is less to do with giving orders than with establishing the roles and rules according to which those working for a firm co-operate”. These roles and rules prescribe the set of (intendedly) compatible local frameworks within which existing options are exercised and new options developed.
The identity of a firm is defined by its commitments to the continued development of particular skills and, even more, to the relationships between them - what is sometimes called its architecture. Because these relationships cannot be specified in any detail, and often cannot be adequately expressed even by the participants, they
may be difficult to replicate by competitors, and sometimes even by the firm itself in a new location with new managers and a new workforce; they may also be hard to transform if they seem to be responsible for poor performance. Corporate identities do change gradually, but attempts at rapid and substantial change typically create great difficulties and often achieve very imperfect success. A major source of difficulty, as noted in the previous section, is the need to forget the old ways - to dismantle familiar connections which have become embedded not only in conscious practice but in neural networks - and to do this in a way which is compatible with the processes of forgetting as well as learning among other members of the organisation.
Every investment implies a commitment to a range of possible futures. As Keynes appreciated, it implies a willingness to limit the range of options, for any such commitment implies forgoing some future productive possibilities, and also some future finance-based deals. Where there is no confidence in the valuation of any such restricted set of options, a firm will not invest, as GEC repeatedly declined to commit its own funds to substantial research and development programmes, preferring to accumulate a ‘cash mountain’ which, it was hoped, would give the company access to other people’s successful research. That the value of their financial option depended on the development of relevant absorptive capacity seems to have been inadequately appreciated. The options represented by this cash mountain, together with the options inherent in their established lines of business, were recently exchanged for a set of options in telecommunications which, after initial enthusiasm, are currently assigned a very low value on the stock market.
The value of any option tends to degrade overtime, both because the dates and circumstances to which it applies steadily move from the future to the past and because changes in the environment (which include the creation of capabilities and options within other organisations) reduce its relevance. Innovations which are ‘competence-destroying’ destroy the value of options which rest on the competence which is destroyed. It is possible that particular developments may enhance the value of particular options, but in general and over time it is true that the value of any firm’s option set can be maintained only by continued investment in new or enhanced capabilities, just as maintaining capital intact can hardly ever be achieved by like-for-like replacement (Lachmann 1986, pp. 67-70). Penrose recognised that such continued investment is necessary in every line of business, and noted that firms may feel compelled to relinquish some capabilities (and therefore some options) in order to make adequate provision for developing those that are retained. Merton and Scholes claim that options can remove uncertainty; but the options that we are discussing simply allow one to choose which uncertainties to embrace.
The outstanding well-documented example of the purposeful creation of options is the fundamental research programme instituted in the Central Research Department of Du Pont by Research Director Charles Stine in the 1920s (Hounshell and Smith 1988). Stine was careful to explain that the value of this programme derived directly from uncertainty, in the sense of an uncompletable list of possible futures, which made research targeting of the conventional sort unattractive. The company’s diversification programme had created substantial capabilities in product development, which as a consequence of organisational redesign were located within product divisions that possessed considerable autonomy. The Central Research Department had developed close contacts with the operating divisions, and recognised that these capabilities
rested on a few technologies which were common to two or more divisions; it was therefore well placed to investigate the principles underlying these technologies, which were not well understood. Stine argued that such investigations would generate a range of options for developing as-yet-undiscovered products which were related to the company’s present activities; and if any such products resulted directly from this research the company would have substantial advantages in developing them. As we now know, the programme delivered nylon and neoprene; what is rarely noted is that it also delivered Du Pont’s unique capabilities for turning them into profit.
This illustration of the constrained flexibility which characterises the firms of Penrose’s theory is counterpointed by a later episode in which the Company President directed the Central Research Department to look for major new product lines that were unrelated to the company’s business. He called this a search for ‘new nylons’; but since he failed to understand the strategy that had produced nylon his directive ensured that the research capabilities were not linked to capabilities in development, production and marketing. It is not therefore surprising that this commitment of distinctive resources, though generating much first-class science, yielded almost nothing in options of value to the company.
As economists correctly recognise, decisions require closure, of both the set of actions and the set of outcomes to be considered. Incomplete contracts preserve a choice of closure, but restrict that choice. These restrictions may be thought of as decision premises, which, as Simon (1957, p. xii) suggested many years ago, provide appropriate units of analysis for the study of decisions, especially a sequence of decisions within an organisation. Decision premises are necessary in order to guide decision-makers in completing their models; since closures are always artificial, but may be decisive in choice, it is obviously desirable to close models in ways that turn out to be appropriate, and though there is no way to ensure this, decision premises which are based on accumulated experience often provide good guidance to sense-making. They also help to ensure shared sense-making, which is an obvious requirement for organisational success, though it certainly cannot guarantee it. Compatability of interpretations takes priority over compatability of incentives, and may also contribute to compatability of incentives, for our bounded rationality often makes us grateful for guidance on how to decide what to do.
The growth of knowledge, within any firm as in any academic discipline, requires a substantial degree of closure, or agreement on a set of decision premises, which we might even call a paradigm. But different closures, decision premises or paradigms are appropriate for different kinds of knowledge. The overall growth of knowledge, in an economy, in academia, or in society, therefore requires the kind of variety which is necessarily a property of a system, and not of the units within it. That it requires a system which is tolerant of variety ought not to require mention, but the apparent attractions of imposing uniform ‘best practice’ suggest that frequent reminders may be necessary. It was the foundation of Adam Smith’s theory of development that the division of labour was the source of continuing developments of productive knowledge - of better ways, in Menger’s terms, of meeting human needs. What Alfred Marshall added to Adam Smith was a Darwinian recognition of the importance of variation within each industry. As Herbert Simon (1992, p. 21) remarked, any
particular direction that is taken is likely to be wrong, and so it is better if people take different directions. That, we should note, is hardly possible within any economy in which resources are concentrated on a ‘national champion’.
It is here, above all, where the attractions of perfect competition have led economists astray. From a detached perspective it is astonishing as well as unhelpful that active competition is relatively little discussed, and when discussed is almost invariably condemned. This would hardly be possible if more economists took seriously the pervasiveness of uncertainty, and its implications. “Surely it is the essence of competition that the participants hold uncertain and divergent beliefs about their chances of success” (Richardson, 1975, p. 359); to which one should add divergent imaginations of what is possible. A competitive economy, in the normal instead of the economists’ sense, is a system for generating variety, and then selecting from the variety that has been generated. Competition is an evolutionary process. To enquire whether either generation or selection within a particular system is optimal is meaningless; but that does not mean that either process does not deserve examination, or is not subject to improvement by human intervention - provided that any intervention is recognised to be based on a fallible conjecture, as is any competitive action.
It is not my intention to conduct such an examination in this paper. But it is important to draw attention to the relationship between firms and markets in this evolutionary perspective. To say that markets provide the environment in which firms provide options from which customers select is not wrong, but it is incomplete, even when we note that in many markets the customers are other firms. As Menger recognised, markets are goods which may be used for meeting both present and future wants; the prospect of continuing markets supplies options for making contracts in the future. These options are a necessary complement to money as a means of postponing decisions, for without markets, money is of little value; they are also a necessary complement to any firm’s capabilities in developing productive opportunities, and if the relevant market options are not already available then the firm will have to deploy resources in order to create them. That entrepreneurial firms may have to make markets has been a theme of Mark Casson’s work since 1982 (Casson 1982, 1997).
Inter-firm trade is of particular interest. It has become the focus of (non-Coasean) transaction cost theory, which is a particular application of the effects of incentives on allocative efficiency; but Marshall recognised that it could also provide each firm with an ‘external organisation’ which connected distinctive frameworks in a way that facilitated the transfer of knowledge and the creation of new capabilities and new options. As Richardson (1972) pointed out, some of the most valuable options can be created only by the development of close working relationships; for some activities which are sufficiently different to be assigned to distinct businesses may nevertheless need to be carefully integrated in order to meet particular needs. These relationships may extend through a network which may sometimes merit the label of a competence block.
Two features of such relationships should be noted. First, handling cognitive transactions which are neither those of internal organisation, both formal and informal, nor those of arm’s-length market transactions, requires a distinctive kind of capability, which may be special to each relationship. The creation of such
capabilities may involve substantial investment of time and skill, but it may create valuable options within the relationship. The kind of options portfolio that Merton and Scholes believed sufficient to co-ordinate separate businesses will not suffice, just as information technology is insufficient to ensure relevant knowledge. (‘Insufficient’ does not imply ‘irrelevant’.) The second feature is the need to create trust. “Closely complementary” activities, as Richardson (1972) called them, are likely to exhibit precisely those characteristics which, in transaction cost theory, seem to mandate internal governance; but internal governance is of no value without an understanding of what is to be governed, and the division of labour is also a division of knowledge. The co-ordination, and above all the interactive development of divided knowledge, depends on willingness to rely on both the skills and goodwill of one’s collaborators. Trust is a means to the creation of options, sometimes of great value, because it is a means to distinctive new combinations of capabilities. Relational proximity is often an important basis for ensuring that the cognitive distance which is large enough to sustain the development of differentiated knowledge is nevertheless small enough to support shared understanding. Even ‘new economy’ techniques must be embodied in relationships, such as networking, which are of ancient lineage.
“The question at the end is how we look at the world” (Kay, 1997, p. 282). This is a question for managers, and also (as Kay intended it) for the members of any discipline; for the way that we look at the world controls the options that we can generate. The prize-winning (and loss-making) theory of option value appeared as a viable and attractive option within neoclassical economics; a substantially different theory of option value is inherent in Menger’s conception of the principles of economics. Not much attention is paid by most economists to such broad theoretical options, though there are some notable exceptions. Much of the apparent confusion that later commentators claim to have observed in Marshall’s Principles (1920) may be attributed to his prolonged effort to keep open the very different options of ‘mechanical’ equilibrium theorising and ‘biological’ evolutionary theory. His successors lost no time in abandoning the evolutionary option (in what we might regard as a classic example of ‘short-termism’) and have recently been struggling to produce a theory of development within the inappropriate option set to which their predecessors - and, in most cases, it appears, their own predilections - have restricted them. Economists, like GEC, and many other organisations, have lost options, and all are faced with substantial switching costs if something of value is to be created to replace them. But whereas biological processes can never recover an extinct species, it is possible to recover once-rejected ideas, although we can never know whether we have recovered the original interpretations. n any event, we must construct the cognitive options which we judge to be of value in our present situation.
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