John Mauldin: Knowledge and Power

business, this payback will be surprising, disruptive, and disequilibriating to the existing order. If established companies can manipulate the channel to protect their own products and businesses and margins, a new product cannot pass through.

The unexpected financial profit is surprisal or entropy—what Peter Drucker termed an “upside surprise.” Drucker pointed out that most measured financial “profits” are not real in this sense. They merely cover the cost of capital—the return of interest. Innovation is the source of real profit, entropic profit, which derives from the upside surprises of entrepreneurial creativity.

In order for the entrepreneur to succeed, he must know that if his creation generates an upside surprise, the related profits will not be confiscated or taxed away. If they may be confiscated, his entire project will not be able to command the necessary resources to bring it to market in volume. Thwarted are the crucial processes of learning and knowledge-creation that constitute economic growth and progress.

Linking innovation, surprise, and profit, learning and growth, Shannon entropy stands at the heart of the economics of information theory. Signaling the arrival of an invention or disruptive innovation is first its surprisal, then its yield beyond the interest rate—its profit, a further form of Shannon entropy. As a new item is absorbed by the market, however, its entropy declines until its margins converge with prevailing risk-adjusted interest rates. The entrepreneur must move on to new surprises.

The economics of entropy depict the process by which the entrepreneur translates his idea into a practical form from the realms of imaginative creation. In those visionary realms, entropy is essentially infinite and unconstrained, and thus irrelevant to economic models.  But to make the imagined practical, the entrepreneur must make specific choices among existing resources and strategic possibilities. Entropy here signifies his freedom of choice.

As Shannon understood, the creation process itself escapes every logical and mathematical system. It springs not from secure knowledge but from falsifiable tests of commercial hypotheses. It is not an expression of past knowledge but of the fertility of consciousness, will, discipline, imagination, and art.

Like all logical systems founded on mathematical reasoning, information theory is dependent on axioms that it cannot prove. These comprise the content flowing through the conduits of the economy and they come from the minds of creators, endowed with freedom of choice. Once the entrepreneur reifies his plans in the world, projecting them into the channel of the economy as falsifiable experiments, they fall into the Shannon scheme. Measured by their entropy—their content and surprisal—new products face the test of the market that they create. They converge learning, knowledge and power in an experimental economy of freedom.