Innovation — legal and otherwise

13/07/2012 Comments Off on Innovation — legal and otherwise

The Libor scandal has been making me think about different sources of innovation.

Innovators produce extra profits for themselves because they do things differently. The theory is that when technologies are well known and widely used, all excess profits are competed away. People and firms using common technologies don’t make much money. You can see this in the real economy: there is a huge number of small firms barely making an average wage. Often, when people buy a business they are really just buying a job.

But what is ‘differently’? And here, I have a theory.

There are the types of innovation we usually think about: new products, like smartphones, or new processes, like continuous fermentation or precision agriculture. The new products are better than old ones so we are happy to pay more for them. The new processes are more efficient, so they produce more with less. Either way, a gap opens up between production costs and consumer willingness-to-pay. For a time, innovators are able to keep some of that gap for themselves.

Another type of innovation is based on social innovation. Sometimes, it is about creating new social norms. Other times, it is about iconoclasts or sociopaths refusing to go along with social norms. These innovators are able to do things that are perfectly legal but that others don’t think to do or that are considered unexceptable. The first cafe in a neighbourhood to put a few tables out on the footpath is an example. Footpaths are, after all, public space, but such cafes appropriate the public space for private use. As another example, some of the extra value from fashion is about flouting social norms for fun and profit.

A third type is illegal innovation. Innovators are doing things that are possible but not legal. They make extra profit because of the gap between what most people do (what is legally allowed) and what they themselves are willing to do. They have a complex problem to solve — weighing up the potential gain from illegal innovation against the risk and cost of legal action. If they can make it work, they profit. Rolling back odometers on used cars is a good example.

Although I set these up as three types, it’s more a three-dimensional space. There is an interplay amongst technology, social relationships, and the law. A new technology can affect social conventions, and may also provoke a rethink of the law. The issues around Facebook and privacy are one example. The ongoing dispute about Easter trading laws — also discussed over at Offsetting Behaviour — is another case in point. Stores opening on Easter Sunday has become somewhat socially acceptable but remains illegal. Some stores are trading and then paying the fine, making a profit along the way.

The Libor scandal is an odd hybrid, too. It is an innovation. The standard procedure is for banks to report their rates and then deal with whatever the Libor ends up being. A few banks figured out an innovation: game the Libor and push it where they want it to be. They could then make profits on the gap between what does happen and what would have happened. I’m not sure what the legalities are, though. Did the banks do anything that was actually illegal? Sure, they appear to have violated expectations about conventional behaviour. But have they just found a gap between social conventions and legal requirements, and exploited it for profit?

There was an article a while back, which is now swamped on the search engines by recent news, that explained the process for setting the rate. The central message was that it was set by a couple of guys making a few phone calls and then guesstimating a number. That’s it. Given that the rate-setting was a social process, it could also be hacked by a social process.

So there’s a broad definition of innovators. It includes the creative and iconoclastic, as well as the sociopathic and criminal.


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