Modular Innovation

Seth Roberts says economists neglect innovation:

How to avoid or recover from stagnation … is the central question of economic life, with no clear answer. Yet it is roundly ignored. In the Berkeley Public Library a few years ago, I picked up an introductory economics textbook for junior colleges, 700 pages long. It had one page – fact-free, poorly-written – about where new goods and services come from. This is typical of the introductory economics textbooks I’ve seen. It reflects the profession as a whole: I estimate about 1% of mainstream economic research is about innovation. It should be half the field.

He’s right; innovation is neglected, at least using a standard of what has impact or relevance. But academics don’t study topics because they are important; they study topics to gain prestige, by being certified as mastering impressive techniques. Sure, all else equal it can help to write about an important topic.  (At least if you avoid taking on a topic too big for your status – big grand overviews and contrarian jabs tend to be reserved for senior folk.) But academics usually aren’t rewarded enough for the added effort to figure out what topics are actually important. So they might as well just do what others say is important. And since it is hard to use standard impressive tools to study how to promote innovation, that topic gets neglected.

Enough excuses; here’s a positive contribution. It seems to me that one of the major factors limiting innovation is this: would be innovators must now combine two risky decisions:

  1. What innovative ideas or projects are ripe and promising to purse now?
  2. Who is best placed or skilled to attempt the realization of each idea?

People who pitch project ideas to venture capitalists often focus on convincing them of #1, idea quality, not realizing that if you convince them of that but not #2, your team quality, they will just steal your idea and give it to another better team. Usually they hear from several teams pitching pretty similar concepts, so they are judging mainly on team quality.

Knowing this, sophisticated innovators tend to neglect idea quality, and focus on team quality. Naive innovators address both issues, but being naive they don’t know enough about what other folks think about the quality of their ideas. The net result is too little aggregation of info about idea quality. Could we do better?

Prediction markets, to the rescue! Imagine prediction markets on which innovative ideas will succeed soon, possibly conditional on approach or team style. Such prediction markets could offer a valuable modularity to aid innovation. Some people could focus on idea quality, and profit from their insights by trading in markets on which ideas will succeed when. Other folks could focus on team quality, by creating high quality teams which pursue the ideas that prediction markets have endorsed. Such teams could hedge some of their idea risk in prediction markets, and that hedging would add market liquidity, enabling idea specialists to better profit from their insights.

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  • Doug

    How does this materially differ from buying equity in a basket of companies that pursue the idea. If firms X, Y, and Z are doing idea A I buy shares in firms X, Y and Z aren’t I basically taking a position in idea A while staying neutral about firms X, Y and Z. (Or short firms X, Y, and Z if I’m bearing on idea A).

    The only negatives of this compared to direct prediction markets on ideas is 1) markets many companies that are at the forefront of ideas often aren’t liquid (many being small, privately held companies), and 2) this gives no exposure to as of yet uncreated firms, holding implicit long positions in presently created teams and short positions in uncreated teams.

    Both of these problems seemed like they could be at least by partially solved by opening up liquid widely investable funds that target specific ideas with liquid secondary markets. This could be accomplished by drastically loosening investment regulation, especially in regards to Private Equity/Venture Capital.

  • anon

    One obvious problem with prediction markets or idea creation is that prediction markets need to be adjudicated in a reasonably consistent way, lest they devolve into popularity contests. Judging the relevance or success of a new innovative idea could be much harder than verifying more factually based predictions.

    I agree in principle with Doug that much of this could be done with idea-specific funds, but “liquid markets” for startups are practically infeasible due to private info problems.

  • http://www.uncrediblehallq.net/ Chris Hallquist

    Big question for Robin (though not on the main topic of this post):

    Aside from excessive focus on status signaling, what do you think the big flaws in the way the academic world operates are? For example, my impression is that you think one of them is you think academics aren’t Bayesian enough. (If I understand correctly, you also think the latter is a consequence of the former, but focusing so much on the cause and not the bad consequences gives a me an incomplete picture of your views, making it harder to assess them.)

    • http://www.uncrediblehallq.net/ Chris Hallquist

      Follow up: it might be worth explaining that I ask in part because I’m trying to figure out how serious the problems you allege are in the fields I’m currently most interested in.

  • http://entitledtoanopinion.wordpress.com TGGP

    It’s unusual for an economist to propose a new idea for how business should be done. If something is a good idea, they tend to assume someone is already trying it (hard to find $100 bills on sidewalks).

    What do you think of the purported decline of the stock market?

  • Robert Koslover

    Re: “…they will just steal your idea and give it to another better team.”
    Robin, I don’t think that is a fair characterization of most venture capitalists. Any professional venture capitalist (VC) will tell you that a key part of your pitch to a VC is demonstrating that you have legally secured your intellectual property (IP) rights to the technology, process, etc, that is the basis of the business idea. Many times, this is in the form of patent(s), which you have already obtained (or at least have officially filed and have acquired “patent pending” status) prior to your meeting with the VC. And those people who have neither secured, nor appear able to secure, their essential IP rights are generally dismissed promptly (along with their business ideas) by VCs.

  • http://hanson.gmu.edu Robin Hanson

    Doug, yes, many new ventures don’t have liquid, or public, stock, and aren’t created yet.
    anon, the idea here is to just judge if the idea was fielded to some scale.
    Chris, the biggest problem is that academia isn’t trying to answer important questions.
    TGGP, I’m an economist with many proposals I think worth considering.
    Robert, yes VCs like you to have some IP, but they usually don’t believe it protects you.

    • richard silliker

      I lack the formal training of an economist. Taking this into account, would you please give me a couple of questions you feel economists should be trying to answer. I am trying to come to an understanding of where you are going. Thank you.

  • http://www.uncrediblehallq.net/ Chris Hallquist

    I would say that “not trying to answer interesting questions” isn’t necessarily a bad thing.

    In the physiology and neuroscience classes I’m taking right now, I’m not sure much of what I’m learning would count as “answers to interesting questions.” The stuff I’m learning is like a collection of some of the low hanging fruit we’ve gathered so far. My reaction to learning about it is “this is really cool, imagine what the world will be like when we’ve gathered even more of this stuff.”

    But I’m not sure I know what you mean by “interesting questions” – maybe your understanding of the term somehow encompasses biological minutiae.

  • http://zatavu.blogspot.com Troy Camplin

    Isn’t innovation, by definition, unpredictable?

    • Michael Turner

      Specific innovations might be hard to predict, but an overall pattern can become so established as to become a virtual requirement of the employees engaged in innovation. Moore’s Law has been the starkest example. Admittedly, there aren’t many others, at least not yet.

      • http://zatavu.blogspot.com Troy Camplin

        Even if one can predict that a certain kind of innovation will take place (Moore’s law being an example), you cannot predict who will do it, or where. Or even when — Moore’s law is a statistical average.

        More than that, who could predict the iPod, iPhone, or iPad, though those all came from the same company? There are always innovations that are truly unpredictable. That is almost the definition and nature of innovation.

        Innovations can come out of either familiar or unfamiliar territory. Sometimes it requires someone coming in and looking at even familiar territory with new eyes. Who would have predicted 20 years ago the revolution in phones? How long was phone technology essentially the same?

  • http://www.sethroberts.net Seth Roberts

    Isn’t innovation unpredictable? No. If you study something that has been studied to death or use a method that’s been used thousands of times, you are less likely to discover something new and interesting than if you study something that hasn’t been studied much or use an entirely new method. I agree with Robin’s explanation/description of how professors choose research topics. In psychology, most of what innovation there is comes about when a prestige-generating (e.g., expensive, technical) new method comes along. E.g., MRI. Then researchers happily migrate to it. As Robin says, this migration has nothing to do with importance — a new method does not make what it touches more important.

  • prospective economist

    I don’t think innovation is neglected; economists focus a lot of their attention on “innovation.” They just call it by a different name sometimes, like “technological change.” Attempting to explain cross-country differences in total factor productivity is basically an exercise in trying to determine why some countries innovate more and adopt new technology faster than others. And many economists also feel that this question — the same question that motivated Adam Smith to write “The Wealth of Nations” — is the most important unanswered question in economics.

    • Michael Turner

      Nobody has yet invoked Schumpeter, nor for that matter Marxist economists who have looked closely at innovation.

      • http://freemarketalternative.blogspot.com/ Cyril Morong

        Schumpeter used the term “creative destruction.” See the link below to my paper on entreprneurs as heroes. The mythologist Joseph Campbell himself said that entreprneurs were heroes and he used “creation and destruction” to describe the action of the hero in his book “The Hero With A Thousand Faces.”

      • richard silliker

        @ Cyril

        Nice to have you on board as to J.C.

      • Cyril Morong

        Thanks!

  • http://freemarketalternative.blogspot.com/ Cyril Morong

    Innovation relates to entrepreneur.

    Candace Allen Smith has written about how entrepreneurs are like heroes. She gave a talk on this at the Dallas Fed in 1997. Here is the link:

    http://www.dallasfed.org/research/ei/ei9701.html

    I think that got reprinted in the Freeman. She also had a similar, award winning article in the Journal of Private Enterprise in 1996.

    Walter Williams also wrote about entrepreneurs as heroes

    http://www.hillsdale.edu/news/imprimis/archive/issue.asp?year=2005&month=03

    So did Johan Norberg

    http://www.cato.org/pubs/catosletter/catosletterv5n1.pdf

    I have also written a couple of articles on the subject

    The Calling of the Entrepreneur
    http://cyrilmorong.com/ENTREPRENEUR.htm

    The Creative-Destroyers: Are Entrepreneurs Mythological Heroes? (Presented at the annual meetings of the Western Economic Association, July 1992)
    http://cyrilmorong.com/ENTREPRENEUR.doc

    In one of his books, Israel Kirzner said something like “entreprneurs discover opportunities for economic proft by leading a life of purposeful action.”

    Lawrence Summers explained his vision for an entrepreneurial future last year at the White House blog.

    http://www.whitehouse.gov/blog/A-Vision-for-Innovation-Growth-and-Quality-Jobs/

    “An important aspect of any economic expansion is the role innovation plays as an engine of economic growth. In this regard, the most important economist of the twenty-first century might actually turn out to be not Smith or Keynes, but Joseph Schumpeter.”

  • cournot

    Robin said:

    “Imagine prediction markets on which innovative ideas will succeed soon, possibly conditional on approach or team style.”

    This is a non trivial task. Correctly framing the issue so that you’ve identified the relevant alternatives and the relevant conditionals is a demanding and difficult job — arguably an important component of investment research. Who is going to do that for a prediction market without direct payoff?

    For the most part, that’s why we have look to high status experts to serve as filters. The prediction markets you actually come up with may be biased or incomplete in lots of ways and many leaders don’t want to work on these a) partly for fear it will erode their authority as Robin tends to assert, but also for b) it (creating the actual vs ideal prediction market) potentially being a waste of time, misleading, or involving effort that they expend in other forms with better compensation and no spillovers to competitors.

    • Jeffrey Soreff

      Setting aside the liquidity problems in markets for startups, is it possible
      to approach the problem from the other direction, exploiting the highly
      liquid market for stocks in established companies? In particular, is it
      legal to have a contingent futures option on a stock, contingent on
      e.g. the company bringing a product with stated characteristics to
      market by a stated time?

  • RJB

    Economists have trouble dealing with innovation for a very basic reason: statistics and game theory require specifying a known “state space” of possible outcomes to which they can assign probabilities. True innovation arises when someone identifies new possible outcomes. Economists are largely at a loss on how to model a setting in which someone can uncover new possibilities.

    I am not sure how the same problem won’t plague prediction markets. To the extent the market simply determines prices for known possibilities it won’t shed much light on innovation. And I don’t know how you construct securities whose payoffs are contingent on outcomes that haven’t yet been described by anyone at the time the securities are designed.

    The market you have actually described just sounds like a more public sort of venture capital market. But there is a reason venture capitalists keep matters close to the vest. Do you believe there are positive externalities that keep VCs from opening markets like this?

  • Chris T

    One impediment is a general lack of understanding of how science and technology work among economists. Innovation is a process rather than a discrete event or new technology.

    Too often I see non-scientists refer think of innovation in terms of new nouns and then doing a comparison between how many nouns were created in a period of time. What we call an object is irrelevant, the important part is how well it performs its intended function.

  • Douglas Knight

    I reiterate TGGP’s second comment. The stock market it isn’t a great prediction market (in particular, it fails at the modularity of this post), but it’s the biggest one we’ve got and we should pay attention to how it is used. Companies used to go public when much smaller, when they were young and innovative. Why did they stop? SarbOx plays a role, but it doesn’t match the timing.

  • http://hanson.gmu.edu Robin Hanson

    cournot, it isn’t a trivial task, but must of this task is already done by people who propose various innovation projects.
    RJB, that just isn’t remotely true.

  • http://zatavu.blogspot.com Troy Camplin

    There are models of creativity/innovation. There is Hector Sabelli’s Bios Theory and Stuart Kauffman’s adjacent possible. Both are such models — but note, that they are also necessarily highly abstract.

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