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Why Economics Doesn’t Understand Business

Iton is In the mid-1990s, economics professors at a leading business school were in a meeting. The gathered Downs was upset. Many are uncomfortable with the higher status enjoyed by business school fields such as marketing and organizational behavior despite their apparent lack of rigor. There is a strong sense that economics deserves more respect. A professor could barely hide his contempt.any good phd He declared that a PhD in economics could easily be taught in any other department of the school.

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It’s easy to dismiss this as a story about the hubris of economists. In a way, it is. The imperialism of the discipline—its tendency to appropriate fields adjacent to economics—is a vexing problem for social scientists. Yet the professor had a point. In the 1990s, economics could plausibly claim to be moving towards a unified business science. A realistic theory of the firm is on the horizon. Alas, three years on, and it’s not getting any closer. Economics is rich with models of competition and markets. But once inside a factory gate or an office building, its power still falters.

It’s worth asking why. Economics is — or at least should be — about the allocation of scarce resources. In neoclassical theory, the market is at the center. The supply and demand of factors of production (land, labor, and capital) and of goods and services change according to price signals exchanged in markets. Resources are used for the most profitable use.

That’s the theory. It has one glaring omission, as the economist Ronald Coase pointed out in a 1937 paper. Much of the allocation of resources in the economy takes place not in markets but within firms. The main enablers are employees. They are guided not by price signals but by executive orders. The theory that firms are profit maximizers is another clash with reality. Herbert Simon, a pioneer in artificial intelligence and decision science, points out that they operate in a fog of ignorance and error. No business can handle all the information it needs to maximize profits. Instead, companies operate under conditions of “bounded rationality,” making desirable rather than optimal decisions.

Over the years, economics has hardly moved along the lines drawn by Coase and Simon. As late as 1972, Coase complained that his paper on the nature of the firm was “cited many times but rarely used”. However, almost at the same time that Coase was bemoaning its absence, a flood of rigorous research on the company began to emerge. Over the next two decades, it began to flourish.

A key pillar of this research is the idea of ​​firms as coordinators of team production, with each team member’s contribution inseparable from the others. Team output requires a hierarchy to delegate tasks, monitor work and reward people accordingly. This in turn requires a different arrangement. In market transactions, the goods are exchanged for money, and the transaction is completed without much dispute. But due to bounded rationality, it is impossible in business to predetermine all the requirements of the parties in every possible situation. A company’s contract with its employees is necessarily “incomplete.” They are sustained by trust and, ultimately, by the threat of collapse, which is costly for all parties.

Where there is a mandate, there is an incentive issue—how to get employees to act on behalf of the company, to be team players, and not narrowly self-serving. This is known in economics as the principal-agent problem and was the source of many heuristic theories of the period. Incentives are important, of course, but often the best approach is to have the organization pay a fixed salary rather than tie the reward to any one task. For example, by tying teachers’ salaries to test scores, they are “teaching to the test” rather than encouraging students to think independently.

Oliver Williamson, Oliver Hart, and Bengt Holmstrom won the Nobel Prize in Economics for this research route. (Coase in 1991; Simon in 1978.) Their work partly explains why, by the mid-1990s, our business school professors were so confident that economics should rule business research. Economist-turned-business guru Michael Porter’s best-selling book fuels this optimism, as does excitement about the potential of game theory in corporate strategy.Yet today, if a company hires a chief economist, it is for accountability gross domestic product growth or Fed policy. It is not advice about corporate strategy.

Excluded companies

There is a reason for this. One is academic reputation. Economics likes to think of itself as a fundamental discipline, like physics, rather than a practical discipline, like engineering. But most of the factors that make a business thrive cannot be summed up in a rigorous theory of a few equations. Often it depends on how well ideas, information and decisions are disseminated throughout the company. Compensation is not the only motivator. Strong businesses are shaped by shared values ​​and a shared philosophy about the right way to do things—company culture. People take pride in their jobs and their workplaces. These are not natural themes for economists.

Economics is also incapable of adapting to the particularities of business problems. Solving these problems goes beyond creating the right economic incentives. It requires a detailed understanding of technologies, processes and competitors, as well as social psychology and political trends. The economy is never enough.Many implications for any hot business question – which tech company will win AI Race, for example – is outside its purview.

Some economic ideas are ignored by business people at their own peril. If a company’s strategy can be freely copied, it should expect its profits to be quickly contested. Sound businesses need an edge. But beyond these rules, economics has little practical use for what makes a successful company. Commercial studies remained an outpost of empire. It now seems unlikely that it will completely conquer the terrain.

Read more from our economics column Free Exchange:
China now unlikely to be a safe haven (March 30)
US banks lose hundreds of billions of dollars (March 21)
Fed kills capitalism to save it (March 16)

Plus: How the Free Exchange column got its name

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