Editor's Note: The following comes to us from Thomas Vass, owner and manager of The Private Capital Market, a fee-based subscription crowdfunding site. Vass writes in to discuss Wassily Leontief's economic theories and applies them to the crowdfunding ecosystem.?For more on The Private Capital Market, check out the company's website. You can read Vass' previous articles for Crowdsourcing.org by clicking here.
How Radical Innovations In One Sector Unexpectedly Affect Distant Markets
Prior to his death, Wassily Leontief, the father of input-output economics, had been working on a modification of his econometric model to make it more applicable as a tool for investigating the impact of capital investments made in one sector on the rest of the economy.
In his last published modification of his earlier celebrated article, The Economy as a Circular Flow, (Structural Change and Economic Dynamics, Volume 2, Issue 1, June 1991, Pages 181-212), Leontief was using the model to visualize market relationships between capital and the rest of the economy. His starting point for the new treatment was to ?close? his matrix of capital coefficients away from the rest of the model of the economy in order to investigate the effects of changing the magnitude of capital investments at any point in time.
Of particular relevance to crowdfunding, Leontief?s modification allowed the model to look back into time to analyze what would have happened to other sectors if a certain type of capital investment had been made in some other sector.
In other words, his modification would allow crowdfunding proponents the ability to answer the question: ?If we invest $10 million in a small biotech company, located in Raleigh, what other parts of the local RTP [Research Triangle Park] economy would have been stimulated??
In marketing theory, this idea of visualizing economic effects is often called the ?supply chain,? and is usually described in terms of a raw good or resource making its way down the production chain until it gets to the final consumer. The supply chain marketing analysis tends to be unidirectional in time, from raw resources extraction to final finished good.
All along the way to the final consumer, various firms add something of value to the product. The product leaves one firm as a semi-finished good, and goes on down the road to the next firm, to get an even bigger dose of value added. At the end of the supply chain, a transportation company delivers the finished good to the consumer, the consumer pays for the product, and finally, everyone in the supply chain gets paid.
The great intellectual value of the Leontief modification to the input-output method is that it tends to be multi-directional in time. An analyst can look back in time, using his model, to see what would have been the effect on the economy in the past of an investment made today, or to look forward in time, to assess what changes may occur to the regional economy, as a result of the investment made today.
As Leontief described it, ?The economic process, as it unrolls with the passage of time, can be visualized as a moving band of fabric woven of strands of many different materials and different lengths. Its pattern is controlled by sets of structured parameters, the composition of which varies from one stretch of time to the next.? But, unlike the emphasis on production and efficiency for almost all of current mainstream equilibrium economists, Leontief was working on the idea that the best starting place for understanding the inter-relationships in the economy was with capital investments.
The preliminary results of his model showed that, not only was capital the right place to start the investigation, but also that capital tended to be the most significant factor in terms of stimulating economic activity throughout the rest of the economy.
Leontief called market relationships ?interdependencies? because he believed that firms in one industrial sector ?depended? on other firms in other sectors for business and profits. He would often use the analogy of a cookbook recipe to describe the idea that if you wanted to bake a bigger cake, you had to use more eggs, because the cake ?depended? on the eggs.
His model?s outcomes were so detailed that other economists often professed great surprise and disbelief when they used his model to assess the economic impacts of monetary or fiscal policy changes. ?Leontief?s model,? they would murmur to each other in scholarly articles, ?simply can not be true.?
In other words, the mainstream economists were continually surprised by the unexpected outcomes that the Leontief model generated, and since most of the outcomes were not explained by their competing economic priority of production efficiency, the other economists tended to be very skeptical of the results generated by the Leontief model.
This treatment of Leontief by other economists is instructive for applying evolutionary economic theory to the impact of crowdfunding on the rest of the economy. According to evolutionary economic theory, most radical innovations that may result from crowdfunding capital investments will involve the crossover of technology between two seemingly unrelated sectors, generating outcomes that are completely unexpected.
The unexpected outcomes caused by two-parent technology crossover will change the trajectory of technology, irrevocably.
And, one of the biggest unexpected interdependencies stimulated by of crowdfunding is going to occur in the least expected place, the business professionals who act as intermediaries and advisors to private companies that are raising capital via equity crowdfunding. Their role in facilitating equity crowdfunding is mirrored by their importance in evolutionary theory as the economic honeybees who transmit and diffuse tacit knowledge.
In the case of understanding the impact of crowdfunding, using the conventional wisdom of mainstream economists applied to the angel, or venture capital model, will completely miss this unexpected outcome on business professionals.
It will also miss another important implication of crowdfunding. Once crowdfunding begins to affect the business professionals in a metro region, the older venture capital model of raising private capital will become obsolete, or, to use the evolutionary metaphor, extinct.
Applying Feser?s Model of Technological Affinities To Assess the Impact Of Crowdfunding On Business Professionals
Leontief described the source of capital for investing as a combination of ?entrepreneurial returns, monopolistic revenues and windfall profits resulting from appreciation of commodity stocks on hand.? In order to describe how the economy was a circular flow, his method of input-output analysis required that this static source of supply of capital be lumped together with the more dynamic source of capital derived from net revenues from operations, which is the traditional source of profits in neoclassical marginal analysis.
Leontief pointed out that the entire combination of capital, called ?undistributed surplus,? plays a double role in economic theory. ?On the one hand,? Leontief wrote, ?it represents the values of materials, additional pay rolls, and other cost elements, on which, it usually is spent in the process of new investment?? On the other hand, the capital represented a type of fuel that powered the economic growth engine that resulted from capital investments in technology innovation.
The importance of this distinction about the two sources of capital related to crowdfunding is that Leontief?s treatment of capital is primarily related to established operational companies that are generating top line revenues, not to entrepreneurial startups, that have no revenues or profits.
In other words, the implication of Leontief?s distinction about capital is that it primarily relates to capital that would be raised under the authority of Title II of the JOBS Act, as a Reg D Rule 506 offering, not capital raised under Title III of the JOBS Act.
Several years after Leontief died, an economist named Ed Feser started to revive a part of the Leontief method. Feser?s modification kept Leontief?s distinctions about capital, and continued to use the Leontief method of closing the input-output model with respect to capital in order to assess the effect capital investment would have on other members within certain types of ?technology industrial clusters.?
Feser?s (1997), modification added the step of factor analysis to the national input output tables in the technical coefficients matrix, commonly called the A matrix. (Feser, E. J., and Sweeney, S. H., 1997, ?Industrial Complexes Revisited: A Test For Coincident Economic and Spatial Clustering,? Working Paper, Department of City and Regional Planning, University of North Carolina, Chapel Hill.)
The additional step of factor analysis allowed for the discovery of underlying technological affinities in manufacturing and production technology that exist between different industrial sectors. Feser?s method resulted in the discovery of technological affinities that do not, on first glance, appear to be in obviously related industrial sectors.
This same idea of ?shared specific knowledge? between what first appear to be unrelated industrial sectors was described by Bryce and Winter, (2006), as the ?general inter-industry relatedness index.? Bryce and Winter provide the example of the shared knowledge relatedness between the Metal and Partitions Sector, (SIC 2542), and the Automatic Vending Machines Sector, (SIC 3581).
The starting point for investigating the trajectory of regional technology is the application of Feser?s technological affinities model that suggest different future technological scenarios, given a set of hypothetical private equity investments. All of the future economic scenarios generated by the Feser method are contingent outcomes.
Nothing about the creation of future markets is a naturally-occurring event, or is, in any way, preordained by the competitive forces in the free market that purportedly lead an economy to equilibrium. Borrowing from evolutionary science, what exists today in the way of the human species, for example, could have been something entirely different with a slight modification of past genetics.
The same is true for the regional technology evolution and economic growth caused by crowdfunding capital investments. What exists today in any metro region could have been something completely different, if different investments had been made in the past, and could be completely different in the future, if certain types of capital investments are made today.
Feser?s method tended to show that technology innovation occurs in nine high tech clusters, and that each cluster has its own unique set of industry partners who get stimulated if an investment occurs anywhere in the cluster, either in upstream suppliers, or downstream clients and customers.
Interestingly for crowdfunding, the Feser method kept coming up with economic impacts in a 10th industrial cluster that did not look like the rest of the clusters. And, oddly, the effects on this 10th cluster tended to be pretty big, relative to the impacts on other members in the other nine high tech clusters.
As Feser noted, the professional service and support sector cluster was so big and important that Feser assigned it to its own cluster. ?The largest technology-based clusters are technical and research services (4.3 million employees in IIQ 2004) and architectural and engineering services (3.5 million workers). There is, however, considerable overlap between those two clusters.?
Feser called this part of the nine clusters the ?enabling? industries cluster because the work the third party professionals do for innovation, enables innovation to occur. (Benchmark Value Chain Industry Clusters for Applied Regional Research, Edward Feser, October 2005, Department of Urban and Regional Planning & Regional Economics Applications Laboratory (REAL) University of Illinois at Urbana-Champaign).
All in all, Feser lists over 50 categories of professional service providers who form the small business support backbone of most regional economies.
In one of his economic development applications of his method, for the State of Kentucky, Feser called this 10th cluster the ?Knowledge Cluster of Engineering, Technical & Research Services.? The cluster was comprised of the following occupational titles:
- Architectural & engineering services
- Environmental & other technical consulting services
- Management consulting services
- Scientific research & development services
- Specialized design services
- Other ambulatory health care services
- Custom computer programming services
- Other communications equipment manufacturing
- Information services
- Custom computer programming services
The important implication for crowdfunding is that this professional service provider cluster plays an essential role (looking back at the circular flow) in enabling innovation to occur when a crowdfunding investment is made, and gets stimulated to grow, looking forward when investments are made today in small technology firms.
By calling it a knowledge cluster, Feser was highlighting the importance that the flow of tacit knowledge plays in stimulating regional innovation.
The economic and financial impacts on this cluster, given a rate of capital investment in small technology firms in a regional economy, tend to be very large. In other words, as a result of crowdfunding in each metro region, professional business advisors are about to surf a tsunami of new business.
The reason for the big future financial impacts of crowdfunding on business professionals is that professional work that used to be done in closed, proprietary venture capital networks will become open, outsourced work in the new business networks that are created as a result of the open crowdfunding platform.
Applying the Distinction About Capital To The Two Main Categories Of Crowdfunding Websites
In Thinking About Technology: Applying a Cognitive Lens to Technical Change, Sarah Kaplan and Mary Tripsas, (March 2008), describe how all the actors in the innovation process have a mental map of how innovation works:
?Producers invest in a particular technology or not. Users adopt the technology or not. Institutional actors support one technology or another. Each of these actions has an effect on the direction of a technology?s evolution by providing more effort, investment, legitimacy or scale economies for one particular variant over others. For instance, in the case of cochlear implants, researchers? beliefs about the technology, embodied in their evaluation routines, were shown to influence technical choices (Garud & Rappa, 1994). The technological frame that actors apply to the situation will thus shape these choices, and it is in this way that the frame influences outcomes.?
The same type of mental map is true for the for the professional business service and support firms in a metro region. When the professionals in a given region have a mental map of innovation, then can implement strategies to assist a radical new product innovation achieve commercial success.
Under the provisions of Title III of the JOBS Act, most of the mental maps for commercial success will be internalized by the older model of venture capital, just as they were in October of 2008, before the financial collapse. The reason for limited economic affects from this type of Title III websites are that the organizers and owners of these type of websites are ?internalizing? the business professional services of a capital market exchange, under the roof of a single website, which severely curtails the regional employment and income multipliers.
The older model of private capital also curtails the flow of tacit knowledge, which limits regional technological innovation, which reduces regional economic growth. The source of capital for Title III websites are not derived from operational revenues from the firm, but are legacy profits from past successful exits of the venture capital firms.
Applying the insights of Leontief, this source of capital does not work well in stimulating the circular flow of economic activity because those profits are not widely distributed in the regional economy.
The second category of crowdfunding website, under the provisions of Title II of the JOBS Act are likely to cause much more interdependent business in a capital market cluster because the firm raising capital is using the second type of crowdfunding website to directly issue, or self-underwrite, the securities, without the assistance of the closed proprietary network of advisors.
In the second type of Title II equity crowdfunding websites, following Leontief, net revenues of the firm (profits) are combined with other sources of crowdfunding capital, to provide the firm with the capital fuel it needs to innovate and grow.
Both the capital invested, and the returns to capital, are more widely distributed in the open business networks as a result of crowdfunding, and one of the major beneficiaries of this wider distribution of income and profits will be the network of business professionals who share a mental image of how technology innovation contributes to their metro region?s economic prosperity.
About Thomas Vass: Vass is the owner and manager of The Private Capital Market, Inc., a fee-based subscription crowdfunding website. Much of the analysis of this article is based upon his economic research and theory of technology, contained in Predicting Technology (2007). For more of his scholarly papers, click here.?
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