An Innovation-Based Model of the Economy

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Taking our understanding beyond the levels of individual, phenomenon, and organization, the set of theories presented [in the book Spointra and the Secret of Business Success (The Aged Edition)] also provides a new economic worldview or a new perspective on how economies work. And that is important because the economy constitutes the broader context for an organization’s activity. Furthermore, "over the previous two and a half centuries, three different economic worldviews, in succession, reigned" (DeLong, 2007).

Adam Smith's view, which focused on matters such as trade and the power of the market, dominated the economic landscape of the late 18th and early 19th centuries. The second era was that of David Ricardo and Karl Marx, who were mainly preoccupied by the laws of the market and their general impact on the quality of life. Their view dominated the late 19th and early 20th centuries. Then, spanning the middle and late 20th century, the third reign was that of John Maynard Keynes, who argued that government can supplement the market forces to achieve stable and full employment. Nonetheless, throughout the end of the 20th century and beginning of the 21st century, the general economic views that guided most Western societies gradually shifted toward a Smithian perspective, which was more aligned with the prevalent ideas of free market and deregulation.

In practical terms, the last several decades could be characterized as a continuous "tug of war" between those favoring a "small government" and those advocating for more government participation in the business and economic affairs. Although evidence suggests that a more realistic perspective lies somewhere in the middle, as many governments have successfully used approaches that blend elements associated with both opposing views, our general understanding of how economies work provides little guidance here. And this is where the new economic worldview brings more clarity, getting us closer to a more realistic representation.

Reaching at the very core of what constitutes commercial activity, the new model is rather simple, being built around transactions and the associated customer value. As already illustrated in the book, any economy can now be seen as a continuously-evolving collection of commoditizing tofmos (virtual business spaces defined by an offering and a set customers with the same associated need-addressing behavior). And it is the dynamics described by the tofmos, particularly their size and distribution along the continuum of need-addressing behaviors, that provide valuable insights into the state of the economy.

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The commoditization of a tofmos is generally characterized by a gradual increase in the number of associated customers and revenue, followed by a sharp decline at the end of its life span. Some tofmos are rendered obsolete by new offerings, ending their lives even more abruptly. Others persist for extended periods of time in highly-commoditized states, as their defining offerings evolve into various types of commodities (i.e., electricity, gasoline). As for the associated profit, the curve typically peaks earlier and declines slower than the revenue. Now, although these dynamics bear a strong resemblance to those associated with the concept of product life cycle, with its stages of introduction, growth, maturity, and decline (Day, 1981), the concept of tofmos differs fundamentally from the conventional product-centric view.

By definition, a tofmos is tied to the perceptions associated with an offering in a relatively stable environment. If the "outside" conditions change significantly, for example, causing the perceptions relative to the offering to change as well, then a new tofmos is created. Consequently, the life span of a tofmos has a rather predictable evolution. As knowledge associated with the defining offering accumulates, the tofmos commoditizes, generating a revenue stream that will roughly describe an S-shaped curve. In contrast, the conventional product-centric view does not account for changes in perceptions, severely limiting the concept's prescriptive power.

In a frictionless or little-regulated environment, the collection of tofmos that defines an economy tends to naturally bunch up at the "commoditized" end of the continuum of need-addressing behaviors. And it is not just because all tofmos commoditize over time, but it is also because the participants in the marketplace exacerbate this tendency. While customers are the main force behind the process of commoditization, vendors strive to make the most of the given circumstances through incremental innovation that would slow down commoditization and by creating new ofmos, whether that means creating new tofmos or entering existing ones. Unfortunately, from the vendor's perspective, it tends to be easier and, thus, more lucrative to enter exiting tofmos or to create new ones that could be quickly commoditized, than to create new high-level tofmos that would also prevent the "bunch up" tendency.

In other words, economies tend to naturally evolve toward a state where most of the revenue, which is generated through the entire commercial activity (i.e., Gross Domestic Product), comes from highly commoditized offerings. And that has significant implications because more "commoditized" revenue means more automation, less workers, less high-skill, more low-skill, more volume, and lower profit margins. But it also means that, in the process, the overall wealth tends to grow concentrated in an increasingly smaller segment of the population — a trend that would eventually threaten the existing social order and democracy.

At this point, it is important to note that the role of an organized society (i.e., a nation state) and its economy is to continuously provide the average individual with freedom (within the limits that preserve the society) and a decent quality of life (relative to the entire population). Translating that into our theory, the society's primary goal becomes one of maintaining a more balanced distribution of its total revenue along the continuum of need-addressing behaviors. But, realistically, can it be done? As I explained earlier, taking a "small government" approach does not work, as the economy's natural tendency is to destroy the fabric of society.

The new set of theories also provide an explanation for why a "planned economy" approach does not work either. The collapse of such society would be caused not only by the totalitarian government and its effect on individual liberty, but also by the economic system that inherently gives rise to underground economies and corruption, as emerging unmet needs are creating significant business opportunities. Furthermore, even a larger government presence within the business and economic affairs, as informed by the Keynesian view, does not help. Most of the associated policies tend to maintain the status quo, simply delaying the "bunching up" of the economy.

The new model, however, suggests that a more balanced distribution of an economy's revenue across the three basic types of offerings and the associate business approaches can be achieved by creating a continuous flow of tofmos. With the right enabling conditions, new high-level tofmos (i.e., type III offerings) can continuously emerge, while low-level tofmos (i.e., type I offerings) are smoothly disappearing. Coincidentally, these findings are highly consistent with Joseph Schumpeter's economic worldview, which revolves around the process of creative destruction that

"incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one" (Schumpeter, 2008).

The alignment between his view and our theory is even more apparent, as he further indicates that

"in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance) — competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives."

[A transcript of this video presentation is available on Cristian's blog.]

REFERENCES

Day, George S. (1981), The Product Life Cycle: Analysis and Applications Issues, Journal of Marketing

DeLong, J. Bradford (2007), Creative Destruction’s Reconstruction: Joseph Schumpeter Revisited, The Chronicle of Higher Education

Schumpeter, Joseph A. (2008), Capitalism, Socialism and Democracy, Third Edition, Harper Perennial Modern Thought

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This is an excerpt (page 42) from the first, unedited draft manuscript of a "letter to the reader" that was intended to complement Cristian's 2013 book Spointra and the Secret of Business Success (The Aged Edition) — a picture book for grown-ups aiming to capture the smallest amount of knowledge that explains the largest amount of phenomena in the business world.

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Image 1: Illustration "Adam Smith, Karl Marx, Joseph Schumpeter, and John Maynard Keynes" by Ingram Pinn, via Financial Times (2009).

Image 2: A screenshot from Cristian Mitreanu's book Spointra on the iPhone 4.

Image 3: Video A New Economic Worldview by Cristian Mitreanu (2008, 2010).

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This article was first published here.

Cristian Mitreanu