Posted by Mitch Townsend on May 26th, 2005 (All posts by Mitch Townsend)
It occurred to me that we tend to see the same economic thinkers
associated with each other. Sometimes it is because of membership in a
particular school of thought (Chicago, Austrian, Neo-Classical), sometimes
due to the political implications of their economics, other times as a
result of direct citation and elaboration of each other’s work. Often the
connection is unclear but the association is strong. In these cases, it
might be that the writers were describing different aspects or phases of
related economic processes. As a practical man of business, I was
interested in seeing what long-dead economist actually owned me, and I was
pretty sure it wasn’t Keynes. It turned out that I am in thrall to more
congenial proprietors, and some of what they say is of immediate interest in
understanding what is going on around me and what I’m doing about it. These
thinkers can be arranged in a sequential format to help describe economic
Col. John R. Boyd (USAF) developed a model of the decision cycle in war.
It is called the Boyd Cycle or the OODA Loop, for Observation,
Orientation, Decision, and Action.
The resemblance to the four steps of the scientific method is
- Observation and description of a phenomenon.
- Formulation of a hypothesis to explain the observed phenomenon.
- Use of the hypothesis to predict the existence of similar phenomena
(generalization), or to predict the outcome of future observations
(prediction from causation).
- Performance and re-performance of experimental tests of the
While the elements of both processes are similar, the OODA Loop differs in
two essential respects:
- The OODA Loop is explicitly recursive. After the action has been
taken, the observation phase begins again with the assessment of the
- The OODA Loop is measured in time. The object is not just the accuracy
of the result, but the speed with which the cycle is completed.
Col. Boyd formulated his theory to explain his experiences as a fighter
pilot in the Korean War. The MiG-15 flown by the North Korean, Soviet, and
Chinese forces had a better climb rate, faster acceleration, and a smaller
turn radius than his F-86 Sabre Jet. Nevertheless, the F-86 tended to win
more dogfights – about a 10 to 1 ratio. The F-86′s advantages lay in
its hydraulic controls and its cockpit design. The F-86 could change
direction, speed, and altitude more quickly, making it more difficult to hit
and allowing the pilot to counter his adversary’s moves more quickly. The
F-86 also gave the pilot a wider view of the sky and a better look at his
opponent’s actions. A series of rapidly-executed maneuvers, each performed
a little faster than the adversary could respond, would leave the MiG
vulnerable and unable to recover.
Col. Boyd explained the implications of aircraft design (he was also
involved in the F-15 and F-16 projects) and pilot behavior in terms of the
Observation: The pilot who sees the other first has the
initiative. As the situation changes, the first to perceive the new
situation can be the first to respond to it.
Orientation: Based on the situation and his knowledge, he assesses
his own and his adversary’s strengths and weaknesses. He can then predict
the likely outcomes and the opponent’s reactions for each possible course of
Decision: He picks the most favorable action, bearing in mind the
opponent’s ability to predict his actions.
Action: The pilot begins his maneuver. This changes the situation,
and the cycle starts again.
The pilot who executes this sequence faster is “inside the OODA Loop” of
the other. His actions have outpaced the ability of the other to respond to
the situation as it develops. The adversary’s actions are no longer suited
to the changed situation, and he loses. This has naturally been applied to
business management. If you struggle to suppress your gag reflex, as I do,
when you hear another military analogy applied to corporate life, you can
relax. All this post will use is Col. Boyd’s method, not the narrative, in
a microeconomic context. Using the OODA Loop as a framework, it is clear
that some of the Chicago Boyz’ icons have ideas that support each and
reinforce each other.
The process of observation is the receipt and recognition of raw
information from the environment. A sentence spoken in English over the
radio would mean nothing to someone who did not speak the language. Someone
without a radio would not hear it at all. In economic terms, Hayek compares
the information contained in market prices and their changes to
telecommunications: “We must look at the price system as such a mechanism
for communicating information if we want to understand its real function.”
(Economics and the Use of Knowledge) Hayek gives the example of a discovery
of a new use for tin, or a new supply of ore. Either would induce the
consumer of tin to either conserve it, if it became more expensive, or to
use more, if cheaper. Similar to a radio transmission, the sender and the
receiver need never meet, yet the information is passed regardless.
What Could Go Wrong?
Delay in receiving information
Information decays quickly. Someone who trades based on newspaper articles
will be behind someone who listens to earnings announcements and follows the
news online in real time. Insider trading based on information not yet
public is prized (and regulated) only because it is early, and those who can
trade on it have a great advantage over the other market participants. A
day later, the advantage disappears.
Information is incorrect not useful
The clarity of a broadcast transmission is measured by the ratio of signal
to noise. Periodically, a wave of panic selling will wash through the stock
market in response to a rumor, only to be reversed when the rumor proves
baseless. Earlier this month, there was a rumor in the stock market that a
large hedge fund had been crippled by declines in GM’s stock and debt. The
sell-off took about 4% off the broad market indices, despite low inflation
numbers and falling oil prices. At times, the panic selling comes without
any identifiable cause. The only useful information in this situation is
the knowledge of what the other market participants are doing.
Information is not easily available or easy to analyze
Before Enron collapsed, there was a near consensus that this was a valuable
basing their analysis on numbers that were readily available, but presented
in different places and different contexts, and combining them in ways not
noticed by other investors.
Information does not reach the decision-maker
One financial services company had a corporate culture that was hierarchical
and unforgiving. Questioning a superior was dangerous, abusing subordinates
was encouraged, and many of the notorious head cases and screamers in the
industry found happy homes there. When their compliance department found
some unethical trading activity and brought it to top management’s
attention, they were told, in effect, “Thanks, we’ll handle it.” When the
behavior continued, the compliance department took the hint and kept quiet.
The ensuing regulatory disaster took out the chairman, the CEO, the CFO, the
general counsel, and others. Some of them protested that they had not known
that the unethical practices had continued. It never occurred to them that
suppressing bad news and punishing those who report it only ensures that the
news will not be delivered, not that there will be no news. In any
dysfunctional organization, there are many ways of making sure that the
person with the necessary information and the person who will make the
decision are always two different people.
Orientation by Context
If the separation of information and decision authority is something to
avoid, it is probably easier to move the decision to the right person than
to transfer the knowledge.
[T]here is beyond question a body of very important but
unorganized knowledge which cannot possibly be called scientific in the
sense of knowledge of general rules: the knowledge of the particular
circumstances of time and place. It is with respect to this that practically
every individual has some advantage over all others because he possesses
unique information of which beneficial use might be made, but of which use
can be made only if the decisions depending on it are left to him or are
made with his active co-operation… The shipper who earns his living from
using otherwise empty or half-filled journeys of tramp-steamers, or the
estate agent whose whole knowledge is almost exclusively one of temporary
opportunities, or the arbitrageur who gains from local differences of
commodity prices – are all performing eminently useful functions based
on special knowledge of circumstances of the fleeting moment not known to
Hayek; The Use of Knowledge in Society
Part of the necessary information, imposed by the cyclical nature of the
OODA loop, is how reality has changed since you last acted:
[S]ince equilibrium relations exist between the successive
actions of a person only in so far as they are part of the execution of the
same plan, any change in the relevant knowledge of the person, that is, any
change which leads him to alter his plan, disrupts the equilibrium relation
between his actions taken before and those taken after the change in his
knowledge. In other words, the equilibrium relationship comprises only his
actions during the period in which his anticipations prove correct.
Hayek; Economics and Knowledge
This includes the changes in the situation that your own previous actions
have caused. You must assess the results of your efforts as you go.
Orientation by Purpose
Some critics of Hayek have taken his argument to mean that only individuals
are legitimate economic actors. This is exaggeration to the point of
parody. Hayek wrote at a time when central planning along rational lines
was considered a great advance in human society. It seemed obvious that if
we could do so well by accident with uncoordinated activity (capitalism), we
could do much better with purposeful planning (socialism). Hayek did not
exclude any middle ground. Individual liberty includes the right to
voluntary association with other individuals. Also, some have mistaken the
organic but unplanned operation of free markets for random activity, often
by pushing the analogy to Darwinian evolution to a place where it does not
belong. Economic activity is only purposeful: everyone engaging in
it is doing so with the intention of bettering his position.
A voluntary, purposeful economic association is what Ronald Coase calls a
“firm” in “The Nature of the Firm” (1937, Economica). A firm is put
together to overcome the frictional effect of transaction costs by buying
and producing in bulk (it would not be hard to tie marginal utility to this
idea) and acting under the direction of an entrepreneur. Transaction costs
include the cost of information: “The main reason why it is profitable to
establish a firm would seem to be that there is a cost of using the price
mechanism. The most obvious cost of ‘organizing’ production through the
price mechanism is that of discovering what the relevant prices are.”
Orientation by Analysis
A new bit of information, such as a price movement, is best evaluated when
it forms part of a pattern of knowledge. When it is transferred to another
decision-maker, the context does not travel with it. In Col. Boyd’s
original formulation, this context might include not only the performance
capabilities of each aircraft, but the current altitude, speed, and
direction of each. The pilot will want to see the current situation clearly
and quickly. Only then can he extrapolate to the possible outcomes. The
purpose of analysis is to make predictions of the expected results when
evaluating potential courses of action.
What could go wrong?
In Coase’s analysis, the costs of gathering and using information also tend
to limit the size of a firm:
Other things being equal, therefore, a firm will tend to be
a. the less the costs of organizing and the slower these
costs rise with an increase in the transactions organized.
b. the less likely the entrepreneur is to make mistakes
and the smaller the increase in mistakes with an increase in the
c. the greater the lowering (or the less the rise) in the
supply price of factors of production to firms of larger size.
The when the cost of obtaining and processing information meets or exceeds
the savings in transaction costs, the firm cannot grow any further. In
other words, a firm must stop growing when its nerves and blood vessels can
no longer support its bulk.
As the Coase quote indicates, mistakes are a cost of doing business.
Mistakes arising at the orientation stage commonly include faulty
predictions of supplies or of customers’ future demands (think Microsoft
Bob). They can also result from trying to fit new information into an
obsolete context. In fact, businesses devote considerable effort to
rendering their competitors and their business models obsolete. As
explained by Joseph Schumpeter, entrepreneurs
seek to create temporary monopolies by introducing new technologies, new
methods of production and distribution, or product differentiation. This
upsets the existing context of price competition by disrupting the
equilibrium that pure price competition would otherwise achieve, as in a
market for fungible commodity goods. Naturally, competing businesses also
seek to break the temporary monopolies of their competitors. The repeated
deliberate disruption is what drives an evolutionary economy.
Decision theory is an entire discipline in itself. In classical economics,
decisions were believed to be entirely rational. We know, though, that the
distinction Jonathan Swift drew between animal rationale (a
rational animal) and animal rationis capax (an animal capable of
reasoning) is a valid one. The quality of our decisions is limited by the
information available to us, and by the limitations of our analysis in the
orientation phase of the cycle. This insight, in effect the obituary of
perfect understanding, we cannot expect to make perfect decisions.
Action is the physical realization of the first three steps. Strictly
speaking, there are few mistakes in this phase, but mistakes earlier in the
OODA Loop meet reality here, and this is where those errors lie exposed to
What could go wrong?
Delays in execution are the chief danger in the action phase. Physical
breakdowns, supplier failures, labor problems, even poor weather can disrupt
the execution of an economic plan. These are changes in the available
information, but they occur after the action has begun. In Hayek’s terms,
action and anticipation are no longer in equilibrium. The OODA Loop has
taken too long to complete. The longer it takes to complete a cycle of the
OODA Loop, the greater the chance that reality has changed without you.
More on these topics:
Col. John Boyd
to Thank: John Boyd and the OODA Loop in Iraq
Col. Boyd’s description of the OODA Loop as derived from his
Nature of the Firm
Friedrich A. von Hayek