I have a macro economics mid-term tomorrow, so my head is filled with international trade, emerging market growth, labor markets and so on. Tonight I’ve gotten to thinking about the Cobb-Douglas production function, and how it applies to the things that I’m interested in: new technology.
The Cobb-Douglas production function says a lot more than I care to in this post, but the basic equation states the following:
GDP is a function of A (Total Factor Productivity or TFP), K (The Capital Stock), and H (Human Capital). The little alpha takes depreciation of the capital stock into account. So, economists start here and get into a lot more depth in analyzing how certain markets grow.
The letter “A” is the intriguing factor here. A is total factor productivity (TFP) and it basically represents two things:
- How easily markets can clear (generally a lack of government intervention), and
These two things makes labor more efficient and productive. Without technology, economies have a difficult time growing. This got me thinking about that VC world and investments in new technology. Total factor productivity measures how effective technology is at helping labor become more efficient. There have been a number of transformative technologies that have made our lives easier, that have made us more productive of transformed the way that we do one thing. These technologies are exciting to me. Google’s search technology is a big, obvious example. Microsoft Windows. The personal computer.
I read this post today from PE Hub about venture capital returns being below market returns, and got to thinking about “A” in the Cobb-Douglas function. Technologies that we invest in need to address a need and generate value for a large marketplace. My understanding is that there’s always a focus on market size when it comes to venture capital; the economics of the business model simply dictate that market potential be somewhere in the billion dollar plus range. My hope tis that, in the process of vetting new investments and sizing up market size, that investors are thinking about the value that these products provide to the end-user, in the long-term and applying their knowledge of fundamental economics in their decision-making process.
I’m sure a lot of projects look like Google before the rubber hits the road. I think that the venture capital industry provides important value to the marketplace and the global economy; I hope to see it investing and growing TFP-positive companies.