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  • How Things Fit – Microeconomics and the OODA Loop

    Posted by Mitch Townsend on May 26th, 2005 (All posts by )

    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.

    Boyd cycle illustration


    Boyd cycle illustration

    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

     

    2 Responses to “How Things Fit – Microeconomics and the OODA Loop”

    1. Michael S. Sargent Says:

      Mitch,

      Thank you for elaborating on Col. Boyd’s ideas in this particular forum. My own graduate work has been in some small way aimed at applying the OODA model in Communications and Management and I had long wished that someone might introduce the concept here. Despite a background in the Social Sciences, my grasp of the study of Economics has largely been obtained here and at other, similar, sites so I didn’t feel sufficiently qualified to be the one to raise the topic.

      One particularly fruitful avenue of investigation arising from the application of Boyd’s thinking in the economic realm, at least as I understand it, would be in the area of ‘operational tempo’. Having obtained (and while maintaining) superior speed in one’s OODA loop (i.e. ‘getting inside’ the competition’s loops) one may begin to influence the actions of the competition and anticipate their (rational) responses.

      That said, however, Boyd’s model was formulated in and applied to an environment in which the actors are particularly motivated to respond in rational and somewhat predictable ways. (Fighter pilots are usually assumed to be chiefly motivated by survival and constrained by similar objectives and common physics. These, in turn, lead to a relatively limited scope of rational action.) As the stakes are lowered and the objectives diversify the number of possible Actions increases and the predictability required for Orientation tends to break down.

      Also, Boyd’s model does not (in its simple formulation, at least) address communication as a source of information (both useful and otherwise) and so tends to oversimplify all but the most simply adversarial human interactions.

    2. decorabilia Says:

      smarter than I #5: Deep Throat edition

      Your posting has been included in the most recent “Smarter than I” carnival.