Circuits Assembly Online Magazine - Imperfect Information

News

The business opportunities that business and economics schools don't discuss.

Years ago on Saturday Night Live a comedian impersonating a senior clergyman from the Vatican offered up his sound bite rendition of an MBA. He would say things like, "Buy low, sell high." Another sound bite from economists and business schools is, "Assume perfect information." But what about the hidden opportunities that occur in the presence of imperfect information?

By throwing out this fundamental assumption that is a foundation of business and economics graduate programs, one opens the door to many opportunities for profit and competitive advantage. The assumption of perfect information should not be completely ignored, but often one can find great opportunities by overlooking it from time-to-time.

Perfect information suggests that everyone knows all the same things at the same time. In other words, if one person has information on something, that information is also available to everyone else. If everyone has access to the same information, any decisions needed are made on a level playing field - no one has an advantage or a disadvantage. The concept of perfect information is critical to stock markets, where no one has an unfair advantage (or disadvantage) in deciding whether a stock should be purchased, sold or held in a portfolio of investments. Attempts to gain from imperfect information, insider trading for example, are illegal. This ensures that perfect information governs the trades of shares and that the stock market is perceived by everyone to be fair.

There is an old joke regarding the concept of perfect information involving an economics professor. In the story, the professor and a student are talking as they walk across the campus. The student sees a $20 bill lying on the ground. "Look!" the student says. "There is a twenty dollar bill on the ground." The professor responds, "Ignore it. If the money were real someone else would have already picked it up." The important point is that opportunities do come about through imperfect information - in this case clearly every person in the world does not simultaneously learn about the location of the dropped money. Consequently, a temporary opportunity exists to pick up the money.

Harvesting Information

The most obvious example of imperfect information opportunity in business is trade secrets. Businesses maintain secrets - like the recipe for Coca-Cola syrup - to offer a temporary advantage over competitors. In some cases, as with Coca-Cola, these secrets and the temporary advantage are long term. While secrets such as the Coca-Cola recipe offer obvious value and are worthy of protection, a typical manufacturing environment has many opportunities to add value through imperfect information. While these opportunities may not be the foundation of an entire business such as the recipe for a popular soft drink, they add value nevertheless.

Opportunities for value through imperfect information can be offered by products or the processes that are used to make the products. In most cases firms are constantly subconsciously obtaining value from imperfect information. By recognizing these opportunities and actively trying to harvest them, a firm:

Is more likely to identify opportunities to profit from imperfect information.
Is more likely to obtain the value for a longer period of time.
Is less likely to experience trauma when one of those temporary sources of profit ceases to be profitable.

By knowing something exists and looking for it, you are more likely to find it. With many scientific advances, once it is understood that the discovery is possible it becomes much easier for people to duplicate the discovery.¹

If one is obtaining value from a temporary source based on other people lacking the information, it is less likely that employees of the firm will absentmindedly give away the valuable information that is critical to retaining the advantage.² At the same time, it is not healthy for employees to feel that they cannot discuss anything with anybody. Past research has found that one of the most important sources of information for solving problems is from discussion with colleagues at competing firms.³ Companies that prevent employees from speaking to outsiders risk losing the benefits that occur when people at other firms help each other and share experiences, but if employees understand what not to talk about the firm can obtain the benefits of both openness and secrecy.

Firms sometimes depend too much on a source of profit. Management does not acknowledge that the novelty of a product or process will decline over time. Admitting that profits may be transient permits a firm to better structure itself for business renewal and the associated long-term profit. A textbook example of a large firm that has renewed its competitive advantage for decades is 3M. This company continuously introduces high margin products, shielding themselves from the decline in profit that occurs as older products become relatively unprofitable due to commoditization or obsolescence. Whirlpool for many years could not understand why its continuously improving products were not creating continuously improving profits. The realization that the improvements they were making were being quickly integrated into competing products made it clear to management that they could not depend on imperfect information as much as they had been for future profitability. This resulted in changes to the firm that has positioned them for a more profitable and desirable future.⁴

The Sources of Value

Having considered why it is important to move from the subconscious harvesting of value from imperfect information to exploitation and management of opportunities resulting from imperfect information, the two sources of value are considered - product and process.

A well-known example of a product offering value from imperfect information is the Coca-Cola recipe. Trade secrets can offer great value, but this and other forms of intellectual property protection are not the only ways to obtain product profits through imperfect information.⁵ The replacement of existing products with better versions of the product based on increases in market and production knowledge is another. The active participant in a product market may be able to gain further insights into market needs and production possibilities; by continuously improving, one can take advantage of that information. If a firm does not pursue continuous improvement, they will lose this information advantage. Even if firms do not purse continuous improvement aggressively, knowledge tends to drift out⁶ and over time products tend to become commodities if they are not renewed or replaced. Similar arguments can be made on the customer side of product improvement. The imperfect information advantage can be harvested from the customer, by seeking access from and listening to the voice of the customer.⁷

Consider the opportunities that a firm's current products and expertise offers. These advantages result from knowledge of distribution channels or as a result of the product technology.⁸ Further opportunities may result from products that are related to current products. Such possibilities can be offered by goods - such as spare or remanufactured parts⁹ or by value-added services - such as warranties or training. Product opportunities based on imperfect information do exist.

In addition, profit opportunities from imperfect information can come from business and production processes. Improvements to processes tend to offer a large number of small or incremental advantages that disappear over time as competitors discover improvement opportunities independently or through benchmarking, reverse-engineering of product or movement of employees between firms. The advantages from process-based imperfect information are typically short-lived. The profits offered by imperfect information can be very large depending on how imperfect the information is. The early history of automotive radios is an excellent example. Originally, radios were purchased by automotive firms, since electronics manufacturing is a different skill set than assembling automobiles. It was not until some radio suppliers went public and disclosed their financial performance that the management of automotive firms realized how profitable the manufacturing of radios can be. Once automotive firms recognized the margins on the radios, they started making their own. The less your customers and competitors understand your processes and the cost of making products, the better your firm is positioned to keep profits arising from process benefits based on imperfect information.

In the real world imperfect information offers opportunities for profit. By managing these opportunities a business can harvest the value, lengthen the duration that imperfect information exists and be prepared for the eventual leaking of the information without the associated dissipation of profit. This management lesson is much more likely to be learned from successful entrepreneurs and managers than in universities.

References

There is a difference between trying to do something that may not be possible and trying to do something that you know is possible.
During World War II reminders of the importance of secrecy were common in slogans and posters such as Loose lips sink ships. If people realize they are doing well because of something they know that their competitors do not, they are less likely to give away the critical information.
See, e.g., E. Von Hippel, "Cooperation Between Rivals: Informal Know-How Trading," Research Policy 16, pp. 291-302, 1987, and J.D. Linton, "The Role of Relationships and Reciprocity in the Implementation of Process Innovation," Engineering Management Journal, March 2000.
M. Arndt, "Creativity Overflowing," BusinessWeek, May 8, 2006.
IP laws are an unusual way to make profits from imperfect information, since one typically discloses information in a form such as a patent or industrial design. Consequently, everyone has access to the information (perfect information), but in exchange for registering full disclosure of the information people are limited in their right to directly use the information.
E. Mansfield, The Economics of Technological Change, W. W. Norton, New York, 1968.
For interesting insights on VOC, see J.R. Hauser and D. Clausing, "The House of Quality," Harvard Business Review 3, pp. 63-73, 1988.
Different types of innovation associated with differences in distribution and product technology are considered in W.J. Abernathy and K.B. Clark, "Innovation: Mapping the Winds of Creative Destruction," Research Policy 14, pp. 3-22, 1985.
M. Knight and J.D. Linton, "The Remanufacturing Equation," Circuits Assembly, October 2004.

Acknowledgments

Thanks to Professor Joel Goldhar of the Illinois Institute of Technology for his thoughts on imperfect information and disequilibrium, as shared in conversation at the Production Operations Management Society Annual Meeting in Boston.

Jonathan Linton is the Paul Desmarais Professor of the Management of Technological Enterprises at the School of Management at the University of Ottawa and editor of Technovation: the International Journal of Technological Innovation, Entrepreneurship, and Technology Management; linton@management.uottawa.ca.