The Panda Principle

Previously, I talked about how markets tend to grow stale as they end up in a state of low creativity as they reach a Nash Equilibrium. An equilibrium is in general a stable point in a dynamical system where small disturbancies will die out, leaving the system still resting at the equilibrium. This type of point is also called an optimum. So does that make a market at a Nash Equilibrium optimal? Hardly. In fact, one could argue that it most certainly must be sub-optimal from one prespective or the other. A market is as said a very complex beast, and as such probably has many stable optima (or equilibriums), and the fact the a particular stale market has landed where it is, is more on the happenstance side than by smart design. The likelyhood that the equilibrium reached is the globally ”best” for all involved parties is probably quite low. But, and this is the crucial point, when a Nash point is reached, there is no simple way to get out to a new, greener spot somewhere else.

In eveolutionary biology this is known as the Panda Principle, which is derived from the fact that a species such as the Panda is actually not very optimal, having quite small and silly thumbs not very suited for climbing bamboo stalks. The panda is good enough though, and since it is here it blocks new species from evolving into its niche. On the other hand, if a fully evolved and globally more optimal species in the panda niche were to be introduced into the same habitat, the panda would be in for a tough match indeed.

In the words of Stephen Jay Gould, the famous american biologist that coined the Panda Principle term

”Evolution leads to the occupation of niches by locally optimal creatures, not by globally optimal ones”

Markets are also subject for evolution, with companies being the species that compete for resources in the form of money. The panda principle is actually very adept in explaining many peculiarities in world economy;

Credit Cards

Why is there no good, secure way to make electronic payments? The omnipresent credit cards have been around for decades, without changing appreciately since their conception. When they were introduced, card fraud was not much of an issue and so security was not a big consideration. In the connected world of today, the situation is quite different with credit card fraud increasing rapidly (PDF).

Yet, the credit card is still by far the most common mode of electronic payment system, despite the fact that numerous of other schemes have been introduced in pursue of a more secure system. But it is really very difficult to replace the current system, since the installed base of card readers, software, bank systems and so on is so large and represents such a huge combined value. A replacement will have to wait until a system arrives wich is much more secure, has both online and offline precence, and at the same time comes with low installment costs when scaling to a global size. Not a very easy task, indeed.

Windows

I can’t resist using the panda principle metaphor on everybodys favourite love/hate affair Microsoft Windows. With so many people constantly nagging about the different installments of the worlds leading OS, regarding security, stability and just about every other aspect of the product, why is this still the most popular OS by a large margin? When it arrived in the 80’s as MS-DOS, Microsoft were blessed by one of history’s biggest business oversights when IBM licensed an outsider to deliver the OS for their new PC platform.

Since then Windows has become so entrenched in the everyday business and lives of so many people and companies that replacing it seems virtually impossible. All while people using some flavour of Unix or Mac OS scoff at the unfortunate rest of us. I will not elaborate any further about if they are right or not, and which is really the best OS, but the fact remains – Windows can hardly be seen by anyone as anything but a small approximation to the best (globally optimal) solution to the need for computer operating systems. Maybe something like this can come in and break Windows dominance in the future, your guess is as good as mine.

Don’t Let the Panda Sit On You

The lesson to take away from my ramblings here should be that even though you think you have a superior solution to some problem, that is not enough. If there is a 800 lbs panda solution to your problem out on the marketplace already, think again before you go at it. Maybe the time is right and your solution is so much better, easier and competitively priced that you can replace the panda, but the odds are against you. But do distinguish the panda from the gorilla, which is a big, dominant player in a marketplace, but that does not neccessarily have any entrenched panda principle to its solutions. Not saying that gorillas are any eaier task, just different. The worst beast of theam all would be the Panrilla (or is it Gonda?), the fearsome cross breeding of the two. Anybody thinking Microsoft again?

Nashisism

These days, a hot water-cooler topic is the doings and should-be doings of the record labels and their peers in the movie studios. How should they act to address the threat posed by file sharing and other low cost alternatives to their traditional CD and DVD sales channels? The debate goes back and forth, without reaching some generally accepted consensus, except on the basic fact that something has to be done. What can hardly be debated is the loss of goodwill the industry people get from their current solution to the problem, which boils down to the unimaginative act of suing teenagers for illegal file sharing. Illegal or not, this solution tastes quite bitter to most people, and raises questions like ”why don’t they come up with something smart to solve this?” I will try to answer this by using (very little) mathematics and (even less) cinematography.

”A Beautiful Mind” is a very good movie about a mathematician and economist called John Nash, who work in a mathematical field called Game Theory. This field is widely used to analyze and forecast the behaviours of players in a market, and thus of big importance to modern economics. Nash, who was schizofrenic and believed that he was part of a big spy plot, later recieved the Nobel Prize for his theories. Anyway, the movie naturally concentrates on the more catching personal fate of John Nash, rather than his theories, but that doesn’t mean that they are any less interesting.

The more scientific Nash story states (and this is simplified almost to the same level as the movie)

In any competitive game with a bounded number of players and a set of applicable rules there exists an equilibrium where any change of strategy by any of the players, will put that player in a disadvantage towards the other players.

In other words; in due time all markets (the games we are interested in here) will in some sense turn stale when the players by happenstance, luck and smart reach their respective strategy mix that puts the whole system into equilibrium. After that point, any change by any of the competitors will only be to their own detriment, and so will quickly be cancelled. This point is called a Nash Equilibrium, after its now famous inventor.

A game like a real-world market is naturally very complex and don’t lend itself to clean analytical analysis, but in general terms it is none the less applicable and you don’t need to be a genious on par with John Nash to see the pattern in the world around us. One thing that can seem to invalidate the whole notion of using Nash’s theory on a larger ecnomic scale is that it starts by assuming that all players behave rationally. Anyone that thinks that the market is purely rational ought to think back a few years to the state of affairs around the shift of the millenia! This is not so alarming as it first sounds though, since we must consider that the games plays out over a large time scale. The resoning behind the validity of game theory to general economics goes as follows (adopted from wikipedia entry on Nash Equilibrium)

1. The payoff in economics is money, which are the fundamental bottom line of survival (agents ignoring this will not appear in the long run).
2. The assumption of rationality among all participants is based on the long-run time scale arguments.
3. ‘The market’ is ascribed the ability to test all or a large subset of all available strategies.
4. Over time an irrational agent is presumed to disappear due to poor performance

So, saved by these broadly applicable observations, we can try to map out how a Nash equilibrium is eventually reached after the creation of a new market.

1. A new market forms by the introduction of a new technology or idea by some player
2. The player recieves a lot of initial success which attracts a host of competitors
3. A wide variety of strategies are tested against eachother and new players pop-up at a staggering pace, while others are disappearing equally fast.
4. Some strategies are found to work better than others and are thus adopted by more and more players.
5. Finally a Nash equilibrium is reached with some optimal mix of strategies. The rules of the game are well understood and agreed upon. Profits are stable and new, significant entrants few.

I guess you feel very familiar with this process, it is a fact of life we have become acustomed to. In fact, this process is so common that it has a name; the Innovation S-curve. The reasoning behind this name is that if you look at a market develop from a small niche to a big industry, you can plot market growth as a function of time and the resulting graph resembles a stretched S. I like to call it the Yawn-function since it shows how a market develops towards a steady state where innovation and new ideas are no more.

So, all in all, old news really. But the begging question here is – why is it like this? Why do a market (and the companies operating in it) grow stale, why do the market stop develop at a certain point and not somewhere else, why is it so hard to break out and start on a new path? The reasons are of course plenty and varying depending on the particular market, but in a pure mathematical sense the answer is; because the market reached a Nash equilibrium. The steps taken by the players in the early market led the system on a path that rapidly converged towards a particular Nash-point, and when reached, no further development is possible. Remember that when a market is at a Nash equilibrium, any changes in strategy by any of the players will only be to their own detriment.

This will also explain why it is so difficult for large companies to be innovative – they will actually not benefit from any innovations they might create! From the graph it is possible to derive when the industry is at it’s most innovative phase. Just take the derivate of the Yawn function (i.e the measure of its slope) and you get something like this

Somewhere mid-term the rate of innovation is at its highest and the market is in a ‘buzz’. Everybody is talking about it, and the excitement is high. Who will win, which will the prevailing strategies be? Over time these issues are resolved and the buzz fades away. The market settles at an equilibrium and what was exciting becomes old news. If we break this down even further to look at second derivative of the Yawn function, we get a graph that describes the flow of innovation in the industry, i.e how much innovation is flowing in or out of the industry at different times. It looks something like this

All positive values represent an influx of innovation into the industry, innovation on the whole is increasing. The negative values shows diminishing innovation. But what does it mean to have an increasing or descreasing rate of innovation in a market? In my book, the only carrier of innovation is people, so when innovation is drying up in an industry this must mean that the creative people working there are either leaving or taken out of creative work (i.e being ‘promoted’). Creativity is being replaced by something else, which by necessity is its antithesis. Lacking of a better term I will call it Accounting Smog, the brain smothering process of turning businesses into numbers and spreadsheets. When the suits come in through the main entrance and start to run the business as an Excel exercise, you can be sure that the creative people are on their way out through the back door.

The creative among us balk at this and say that the old spirit of inventivness and entrepreneurship is gone – the business has become boring. But don’t blame the suits for this, they are actually doing exactly what is needed at this point – fine tuning the companies’ processes around the Nash equilibrium. You and I are really not needed anymore, the only things we can bring in are moneylosing disturbances!

At last we arrive at an answer to our question in the epigraph:

Q: Why don’t the record industry come up with something smart to solve the problem with file sharing?

A: Because the can’t. Whatever they do will put their businesses in a less favourable position, i.e earn them less money. How to present such a solution to the suits in the corner office? Better to hide out and wait for something to budge. Besides, the innovative people they need for the solution are long since gone, perhaps creating a new file sharing application…