Tuesday, May 19, 2015

An Invisible Handshake for The Digital Wealth of Nations

It is time to replace the venerable "invisible hand" of Adam Smith with something new and more suited to the strange and challenging nature of digital products. Think instead of an "invisible handshake," that draws producers and consumers into a more cooperative, balanced, and productive relationship. It takes a handshake, because digital is a post-scarcity economics. What matters here is not a balance of demand and finite supply over a population of producers and consumers in a single market -- but a compatible understanding of value between individual pairs of producers and consumers who can act without that producer constraint.

Let's indulge in some armchair economics to explore some big-picture ideas derived from previous posts.  This draws especially on the prior post -- about my thought experiment of an all-knowing economic demon, that leads to the idea of an invisible handshake, as replacing the invisible hand.

(This sequel is best understood after reading that.)

I suggest a kinder, gentler kind of scarcity. Some scarcity is unavoidable, so our solution is not the extreme peer-to-peer "economics of abundance" that some now advocate -- with its limited ability to motivate and sustain serious production of value.  The solution is to re-imagine the socio-economic contract between consumers and the producers that create value for them, to ensure a business model for producers. To maximize the value produced, and the entrepreneurial creativity, we need to motivate organizations that are selfishly driven by a desire for profit. I suggest a new kind of market that rewards the production of intangible stuff, based on a this new socio-economic contract -- neither the limited motivational power of pure altruism, nor the deadweight loss of artificial scarcity. And I suggest that this new economy can evolve from where we are, starting now, with the FairPay architecture outlined in this blog.

Allocating scarce resources with the invisible hand

The beauty of the Smith's invisible hand is that it set prices in a way that worked not only at a micro level, but also as a basis for an allocation of resources for society at large. The whole edifice of market economics has been based upon this.

But now the digital world creates strange new rules, at least in that special portion of our markets.  So then, for the digital domain, what now?
  • We now have freemium and other new models, but do they have any real economic rationale? Do they tell us how to allocate resources in a way that is good and efficient for individual producers and consumers, and across society? 
  • Many producers rely on some form of artificial scarcity as a way to sustain revenues, but put the accent on artificial -- this has no fundamental basis, and creates no balance or fairness in resource allocation,  "The inefficiency associated with artificial scarcity is formally known as a deadweight loss" (Wikipedia article on artificial scarcity),  This may help keep producers solvent, but is fundamentally very hit or miss.
  • We also have the sharing economy, that recognizes digital abundance with its emphasis on collaboration and open-source, but with questions of efficiency, effectiveness, and sustainability at scale. 
Can we do better?
The core challenge of the economics of real goods and services is the allocation of limited resources: physical resources, labor, and capital. As Adam Smith said in 1776 in The Wealth of Nations, "...price...is regulated by the proportion between the quantity...brought to market, and the demand of those...willing to pay...." Smith went on to describe how "...he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. ...By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it."  So in the face of scarcity across a market, prices are set by the invisible hand to allocate the supply where it is most wanted. Hayek expanded on Smith to argue that an economy needs prices as the only effective way to signal how resources should be allocated. Debate on how well this works for society continues, but it is widely recognized that it works to build wealth. Is there something to replace that in the digital world?

An invisible handshake -- allocating share of wallet in a post-scarcity digital economy

I propose doing allocation in digital markets with an invisible handshake, because the game changes without scarcity of supply. What matters is no longer a dance of a market as a whole at a given point in timebut a dance of each consumer with each producer over time. So what should determine price?
  • Each producer can provide as much as is desired by each consumer. There is no inherent supply constraint -- all that matters is whether the compensation from that consumer satisfies that producer. 
  • Prices for different consumers need not bear any relationship. What does it matter if some pay more and some pay less? Maybe that depends on how much they want to use, what value they get, and how able they are to pay. We are conditioned to think price discrimination is unfair (and sometimes illegal), but that is true only when unilaterally enforced by excess producer power, not if done for reasons acceptable to consumers. 
The new allocation is not one of supply, but of share of wallet. If each consumer deals with a market full of suppliers for all of their digital products and services, the relevant scarcity is of their wallet -- how much can I spend on all of my digital desires, and how do I split that among my providers?
  • If I negotiate over time, in "dialogs about value," to share the economic surplus of my digital purchases, I am forced to allocate my spending within some digital budget, across all of my suppliers. I can do that any way I wish (to the extent that each supplier agrees to permit).
  • If all consumers do that, then all suppliers get their fair share of all of the wallets for all of their consumers.  They sell as much as their aggregate market population desires, at a sum of prices that is the maximum each market particpant is comfortable allocating.  
  • Given a scarcity of nothing but wallet, what works for each individual pair in the market leads to a result for all pairs that approximates a market-wide optimum.* 
So, like the invisible hand, the invisible handshakes between each of the individual pairs leads indirectly to a socially beneficial allocation. Like the invisible hand, it refers to an emergent process that by seeking local solutions, leads to globally optimal solutions.
  • The invisible hand applies external market-wide forces (supply vs. demand) to producers and consumers at a given point in time (actually a short interval), It pushes them together to a market price. That pricing process indirectly leads to an approximately optimal distribution of scarce supply resources.
  • The invisible handshake is driven by an agreement between individual consumers and producers to seek a mutually beneficial relationship. That binds them in an emergent process that generates prices over the course of the relationship, and indirectly allocates the wallet share of each participating consumer to demand as much digital wealth as each is willing to pay for -- at prices that work for each of them individually -- to compensate producers for producing as much as each one -- and thus the total population -- values. 
Thus the handshake is essentially a moral contract between the individual parties. That may sound utopian, but as outlined in the prior post and elsewhere in this blog, it is a moral contract with teeth. There are strong practical incentives to adhere -- and data that can be applied to help verify adherence. (This is the process I call FairPay, as described throughout this blog -- see sidebar.)
  • Digital products and services can be instrumented to generate detailed usage data that correlates to the actual value received.
  • Both parties participate in ongoing dialogs about value, which add subjective insight, but still can be partially validated by the usage data.
  • Based on these dialogs, the producer extends pricing "credit" to the consumer. If the consumer abuses this credit, they get less credit, and lose some or all of the ongoing privileges of the handshake.
  • This process generates consumer reputation ratings for fairness with each producer.  Since a good reputation rating has benefits (much like a credit rating), consumers will seek to maintain it.
It is this balance of forces -- the subject of the handshake -- that governs the allocation of wallet (in an approximation of the wisdom of the pricing demon).** Different producers can manage their own policies to make their handshakes very strict and demanding, or more loose and forgiving. Different segments of the population may play the game more or less fairly and honestly. But the process will adapt, and find workable relationships for most segments of the market. (And conventional pricing can be applied for those segments that fail the handshake.)

This provides the basis for a post-scarcity economy, at least for digital -- and perhaps more broadly. The digital goods and services are not scarce, but the willingness of consumers to sustain producers is scarce. The invisible handshake governs an allocation of that willingness to sustain. To/from each consumer according to his willingness and ability to pay. To/from each producer according to their ability to create realized and recognized value.

As noted in the prior post, this handshake enables a kind of first degree price discrimination. Conventional economics views first degree price discrimination as economically efficient, but not feasible. But what emerges from the handshake is a new kind of first degree price discrimination that is feasible and agreed to by each consumer.

A kinder, gentler -- and more sustainable -- market

This enables a broader sense of economic value than is generally addressable in conventional markets.
  • The invisible hand allocates supply and demand for particular items at particular times, thus narrowing consideration, in ways that ignore sustainability and other aspects of social value ("externalities"). Many have sought to broaden the focus of producers with notions of "Creating Shared Value" (CSV) and triple or quadruple bottom lines, that factor in financial, environmental, and social (and other) dimensions.
  • The invisible handshake creates prices that reflect not just financial value, but whatever dimensions of social value the producer-consumer pair want to reflect in the dialogs about value. There is no need for added bottom lines, or separate CSV objectives -- CSV is integral to the handshake
This handshake is not on a transaction price, but on a continuing relationship. As a result, it fundamentally changes the our economics from working across markets without regard to past or future, to taking a longer term view:
  • It is the lack of past and future that create many of the problems in conventional market economics. We balance supply and demand in the short term, with no direct way to factor in long-term consequences for the individual parties, or society as a whole. Addressing those "externalities" by bolting on special measures (taxes, subsidies, etc.) is artificial and very problematic.
  • With the invisible handshake, the whole focus is on a relationship over time.  Value shares may fluctuate in the short term, but move toward a desirable sharing over the life of the relationship. Sustainability can factor in directly.
Instead of trying to find a price, we need to find a broader kind of agreement. Instead of agreeing on price. we price out of agreement.  That agreement will naturally vary from person to person and from time to time. The effect of this "invisible handshake" is to draw producers and consumers into a more cooperative, balanced, and productive relationship.

Now that our digital market has been shattered to bits...

Moving from here to there will take learning and adjustment by all market participants. But digital has already shattered the market for content to bits -- shouldn't we take advantage of this opportunity?

Ah, Love! could you and I with Him conspire
To grasp this sorry Scheme of Things Entire!
Would not we shatter it to bits--and then
Re-mold it nearer to the Heart's Desire!

-- Rubaiyat of Omar Khayyam, Edward FitzGerald translation


*There is of course the important case of ad-supported digital services that take no share of wallet. It seems clear that this is not sufficient to support all digital services but it will remain an important contributor. The handshake process can factor in the value of ad viewing as one part of the compensation that offsets any monetary price, and thus takes less share of wallet. In fact, any aspect of value (attention paid to ads, personal information made available for sale, referrals, etc.) can be factored in as credits into these dialogs about value.

**Of course conventional set prices (or any pricing scheme at all) will also effect some kind of allocation of wallet. But is there any economically sound rationale? -- it is arbitrary, crude, and not personalized (as the pricing demon would suggest), and thus results in significant deadweight losses (notably the value not provided to those who would benefit from and pay fairly for it).

Monday, May 4, 2015

Harnessing the Demons of The Digital Economy

The dynamics of networked commerce combined with the essentially free replication of digital offerings has created devilish problems that our current economics has yet to tame.  Sellers have no clear rationale for setting prices and consumers feel they should not have to pay anything at all.

One way to step back and re-think this is to do a "thought experiment," as has proven valuable in the development of science. Some notable thought experiments involve imagining benevolent "demons" with special powers and/or knowledge: Laplace's demon, with its perfect knowledge of the state of the universe and all its natural laws, and Maxwell's Demon, with its ability to individually sort hot from cold molecules.* Maybe we cannot build such demons, but thinking about them can clarify concepts and possibly point to approximations that can be built, or can suggest directions for looking outside the box.

The demon I propose is one that can power a system of commerce.  Imagine a demon that has perfect ability to read the minds of buyers and sellers to determine individualized "value-in-use" -- the actual value perceived and realized by each buyer, at each stage of using a product or service -- such as songs or articles or e-books, either in a subscription or item-by-item context.
  • This "value demon" knows how each buyer uses the service, how much they like it, what value it provides them, and how that relates to their larger objectives and willingness/ability to pay. It understands the ever-changing attributes of current context, where the value of a given item can depend on when and how it is experienced.
  • Furthermore, this demon can determine the economic value surplus of the offering -- how much value it generates beyond the cost to produce and deliver it.
  • The demon can go even farther, to act as an arbiter of how the economic surplus can be shared fairly between the producer and the consumer. How much of the surplus should go to the consumer, as a value gain over the price paid, and how much of the surplus should go the producer, as a profit over the cost of production and delivery.
This commerce demon could thus serve as the brains of a system that sets prices that are adaptive and personalized -- to set a price for each person, at each time, that is fair to both the producer and the consumer.

Imagine we could build an e-commerce system, with advanced programming and data that worked as an artificial intelligence version of this demon. We could build services like Amazon, iTunes, Netflix, or a newspaper subscription that were priced by the demon. Prices would not be pre-set by the seller, but would be set dynamically by the demon at levels that would be fair and acceptable to both the buyer and seller.

(This takes us in a direction very different from the ideas from the early days of e-commerce of "bots" that would negotiate prices for us. The demon is in some ways analogous to a bot, but instead of negotiating a single transaction, it works at a higher level that centers on value, not just negotiating power.)

With such a demon setting prices, we could reap the cornucopia of goods and services that the infinite replication of digital offerings promise ("information wants to be free") while still providing fair profits to the producers ("information wants to be expensive"). Every consumer who is willing to pay more than the marginal cost of production would be able to buy, while those who get and can pay for significant value would pay appropriately higher prices.

This may sound pointlessly fanciful, but thinking about it can suggest new approaches that are practical.**

One such approach, the FairPay architecture I have been describing in this blog, works very much like an approximation of this demon. Not perfect, but still workable as an emergent process that uses simple procedures and dialogs to approach what this demon knows. Details are in other posts and the sidebar, but some basic points:
  • FairPay shifts our perspective from individual transactions to a series of transactions over time in a relationship.
  • Instead of the invisible hand of supply and demand pushing from outside, it brings an invisible handshake in which the buyer and seller agree to cooperate to find a fair basis to exchange value.  This can inform a new balance of powers, based on "dialogs about value." 
  • The buyer's power is to set prices for a current transaction -- "fair pay what you want" -- with the understanding that he agrees to be fair, and that this is a temporary privilege that the seller will continue only as long as he agrees the prices set by that buyer are usually fair.
  • The seller's power is to decide whether to continue these attractive offers, or not. That gives the buyer full buy-in on all prices, but motivates him to keep up his end of the bargain.
  • Additional data feeds in to the process, including the seller's suggested price to each buyer, the buyer's reasons for pricing higher or lower, and all of the increasingly rich individual details that digital system instrumentation can make available about usage levels, patterns, and contexts, to inform and validate these dialogs.
  • Based on all of that, the seller tracks each buyer's fairness rating, much like a credit rating. Consumers will warm to the idea of this pricing privilege, and will seek to protect their fairness rating just as they do for credit ratings.
The result is an emergent process that seeks to discover the price, just as the demon understands it. The approximation may start out being quite crude, but digital sellers can afford some unprofitable cycles in the early stages of each relationship, if that soon leads toward convergence on fair prices. As experience is gained, this will become a science of Big Data and predictive analytics -- one that works to serve both the buyer and the seller.

So this FairPay process acts as an engine that approximates what the demon knows. It draws out the knowledge of the buyer, encourages truth-telling, nudges that with the views of the seller, and provides a context for the dialogs about value that lead to a fair split between the producer and consumer surplus. Such a process can totally change the game of selling digital stuff, for more profit, and more value to society.

[Update 5/18/15]
To consider the broader implications of this new approach, see this sequel: An Invisible Handshake for The Digital Wealth of Nations.

**[Update 8/3/15] 
I should have added that there is a proven way to approximate my value demon -- but one that has been restricted to high-end, sophisticated industrial markets, and generally ignored in most other markets. As described in a 2014 HBR article, companies like GE are increasingly realizing that set prices are not best for either the supplier or the customer --and for large industrial products or services, it is better to develop custom prices very much along the lines of what the demon knows. These "value-based" pricing or "outcomes-based" models work well for such industrial equipment where a cooperative team of both producer and customer can negotiate not a specific price, but a method of analyzing value as actually achieved by the customer in use, and then basing the price on that after the data is known. Just as the Internet of Things is making that more widely applicable, FairPay points to how a lightweight, heuristic variation on that theme can work for computer-mediated mass consumer markets..

*Expanding on these demons, and the two well-known examples...
  • Laplace's Demon, has been influential in philosophy and physics, as one who has perfect knowledge of both the current state of the entire universe, and all the laws of nature. Thus Laplace's demon can look forward or backward to derive the exact state of the world at any past or future time. This is relevant to questions of free will versus determinism, and to quantum uncertainty.
  • Maxwell's Demon, has been influential in thermodynamics, as a gatekeeper in a box with two chambers separated by a small hole with a door. The demon can control the door to allow high speed molecules to go from left to right only and low speed molecules to go from right to left only, thus making the left side get colder while the right side gets hotter. This would violate the second law of thermodynamics.
(There are reasons why both are infeasible, but thinking about them sheds light on why that is.)

Adam Smith's invisible hand can be thought of as a similar demon that helps balance supply and demand in a market at a given point in time. As we know, Smith's demon actually works fairly well for many markets.

Economics has generally ignored my demon, but it has been lurking in the background. First degree price discrimination was defined by Pigot as applying this kind of information in idealized monopoly situations -- but has been viewed as not realistic for reasons such as arbitrage (those who bought cheaply could resell to others so they did not have to pay the full amount they would be willing to pay).**

I propose that the workings of FairPay enable something much like first degree price discrimination, but instead of all the surplus going to the monopoly, my demon shares it fairly between producer and consumer.  And since resale of digital services can often be made impractical, the arbitrage problem generally does not apply.

[Update 1/1/16]
A nice bit on how Einstein's thought experiments changed the world is Walter Isaacson's "Light Beam Rider" piece in the NY Times (10/30/15).