How Things Fit – Microeconomics and the OODA Loop

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

decision-making.

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

unmistakable.

1. Observation and description of a phenomenon.
2. Formulation of a hypothesis to explain the observed phenomenon.
3. Use of the hypothesis to predict the existence of similar phenomena

   (generalization), or to predict the outcome of future observations

   (prediction from causation).

4. Performance and re-performance of experimental tests of the

   predictions.

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

  action’s effects.

• 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

OODA Loop:

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

action.
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.

Observation

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

company with a great deal of growth ahead of it. The minority opinion was to the contrary. The short-sellers were

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

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

others.

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

larger:

   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

transactions organized.

   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

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

homo economicus, was described as bounded rationality by Herbert A. Simon. Without perfect knowledge and

perfect understanding, we cannot expect to make perfect decisions.

Action

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

public view.

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
The Man

to Thank: John Boyd and the OODA Loop in Iraq
Col. Boyd’s description of the OODA Loop as derived from his

original briefing slides
Biography
More…

Ronald Coase
Profile
The

Nature of the Firm

Friedrich A. von Hayek
Profile

Herbert A. Simon
Profile
Decision Making and

Problem Solving

Joseph Schumpeter

Schumpeter’s Challenge: Market Dynamism
Profile