Economists as gurus
Most managers do not think economics has much to offer them. They should take a closer look
|Is it any wonder that businessmen cannot stand economists?
The typical manager never seems to face the same problem twice, always
says exactly what he means, expletives included, and is certain that the
people he deals with are not even remotely rational. He could not
have less in common with the typical economist, who is always searching
for universal solutions, cannot articulate them even when he finds them,
and bases his entire view of the world on the principle that people
are rational to a fault.
When economists are called upon by businessmen, therefore, it is rarely to provide any kind of legitimate advice about strategy. Instead, firms tend to look to economists either as fortune-tellers, predicting whether demand for their products will rise or fall, or as hired guns in the courts, helping to fend off product-liability suits or antitrust rulings.
In the most recent edition of the McKinsey Quarterly*, one of the firm’s consultants, Eric Beinhocker, takes a potshot at what he refers to as “fishbowl economics”—the economist’s tendency to treat every industry as though it were heading towards a tidy equilibrium, just as a ball rolling in a fishbowl must eventually settle at the bottom. This assumption, he argues, is squarely at odds with the real world, which is always changing, leaving the economists and their pet theories behind. He calls for a new economics that recognises how much technology and markets change.
Mr Beinhocker’s ideas are typical of the complaints that consultants and other “practitioners” levy against economists. But is he right? Arguably consultancies, with their glib (albeit popular) maxims, are often much worse advisers for this increasingly complex, contradictory world than economists. Unlike consultants, who tend to dream up a theory and then search for a few examples which “prove” it, a trained economist can hardly even think up a new theory without musing, in almost the very next breath, about where one would look for evidence that contradicts it. That does not always make economists easy to follow; but, in a world where unforeseen obstacles abound, this rigour can be useful.
The opportunities for using economics wisely begin on the shop floor. For example, driven by the advice of consultants and the demands of customers, most firms are anxious to squeeze ever faster response times out of their factories. But this does not always make sense.
Phillip Lederer, a professor of operations management at the University of Rochester’s Simon business school, has developed several economic models that help to gauge the effect of responsiveness on prices, consumer demand and costs*. Although responsiveness does pay in some cases, it often makes sense for firms to use their rapid production abilities to operate at higher volumes instead, lowering unit costs while making customers wait. Few management gurus would dispute this. But Mr Lederer’s models allow managers to determine more accurately when the low-cost, slow-response strategy makes sense; and they can help a firm to segment its market judiciously, offering different combinations of price and responsiveness to different customers.
Mr Lederer also thinks that firms focus too much on costs when deciding where to put their plants. Location decisions, he says, also affect the prices that firms can charge for their products, and that in turn affects demand in different regions. Accounting for this can be complicated. But Mr Lederer has collected systematic data on how firms themselves decide to price their products, after they have put factories in place and seen how competitors respond. As a result, he has developed models that allow them to look ahead, integrating their factory-location and pricing decisions in a way that anticipates rivals’ responses, and leaves fewer profit opportunities wasted.
Another strong area for economists is incentive management. They may not be able to say what motivates a particular kind of employee, whether he is a research scientist or a financial trader. But if a firm can tell them what its employees care about, economists are well equipped to craft a compensation system that encourages the right kinds of behaviour.
The wealth of firms
Economics can be just as effective in the executive suite as it is on the factory floor or in the personnel department. Michael Porter dominated much of the writing on strategy in the 1980s. Now two other economists at the Harvard Business School, David Collis and Cynthia Montgomery, have produced a book*** that argues that firms need to do three things: make products that people want at profitable margins; develop special skills that competitors find hard to replicate; and build a system in which they can do both these things without becoming too dependent on those highly skilled employees, lest the latter leave.
As a conclusion, this is not particularly original. What is more notable about the book is the systematic way in which the two economists show how firms can integrate these three objectives into their business strategy, and then link that strategy to their organisational structure. For instance, they praise Michael Eisner of Disney not only for spotting lucrative entertainment niches, but also for structuring Disney around “staff” who cannot run away: in the words of Warren Buffett, “the Mouse doesn’t have an agent.”
Despite these many advantages, however, the dismal science’s pessimistic nature can also be a severe handicap. Most successful firms become that way because at some point in their troubled evolution they simply refuse to quit, and press on against the odds. Unfortunately, many unsuccessful firms share this very trait. One of the hardest tasks facing managers, therefore, is rating their chances accurately. And most economists, if left to their own devices, would be far too prone to give up (or, in their parlance, “make tradeoffs”). Fortunately, however, nobody has yet suggested that economists actually be allowed to manage anything.
*Strategy at the Edge of Chaos, McKinsey Quarterly, Number 1, 1997.
**Perspectives on Operations Strategy and Economics, Working Paper Number OP-96-03, University of Rochester, 1996.
*** Corporate Strategy: Resources and the Scope of the Firm, Irwin,, 1997