John Kay - Economics and Business: 1990

Economics and Business: 1990

Economics has never been more relevant to business problems. The two key groups of question of interest to businessmen – the internal organization of the firm and its relationship between its suppliers and customers, and the nature of strategic interactions between small groups of firms – are clearly on the agenda of modern economics in a manner which has not been true for most of the last century.

If you ask most businessmen what they think economics is about, their answer will be economic forecasting. They do not think very much of economic forecasting – although they go on thinking they need it – and so they do not think very much of economists. Every day they are concerned to analyse their costs – which is done by their accountants. They determine their prices – this is the responsibility of their marketing department. They need to interpret the business environment they face – the task of their corporate planners and strategic advisers. The economic input into any of these functions is minimal.

Yet costs, prices, industries and markets are the very lifeblood of micro-economics, just as inflation, output and growth are the lifeblood of macroeconomics. Economics dominates public policy and every country’s chief executive regards his (or her) macroeconomic adviser as a vital aide. But economics has almost no influence on business policy, and in only a small minority of companies does the chief executive have an economic adviser at all. The evolution of microeconomics over the past century provides a partial answer. 1990 is not only the centenary of the Economic Journal; it is also the centenary of the first edition of Alfred Marshall’s Principles of Economics. It was Marshall who set the agenda for much of the economics that was to occupy the Journal for the subsequent 100 years. Marshall’s analysis, and his understanding of the commerce of his day, was sophisticated and wide ranging. Indeed Marshall probably knew more about the day-to-day functioning of business than any leading economist this century. Yet his approach barely scratched the surface of the firm. Marshall’s key tool of analysis is ‘the representative firm’. His famous metaphor of the trees in the forest is designed precisely to play down the role of individual agents and the importance of their distinctive characteristics. It is no accident that his second landmark work is entitled The Economics of Industry, not the economics of the firm. The imperfect competition revolution of Chamberlain and Joan Robinson changed this direction little. In the models they develop, firms do differ from each other, but the ways in which they do so are essentially trivial.

The Structure-Conduct-Performance Paradigm

Since the Second World War, the dominant tradition in industrial organisation has been based on the strongly empirical structure-conduct-performance paradigm. The focus of this work is clearly set out by Bain (1959: pp. vii-viii)

I am concerned with the environmental setting within which enterprises operate and in how they behave in these settings as producers, sellers and buyers. By contrast, I do not take an internal approach, more appropriate to the field of management science, such as could inquire how enterprises do and should behave in ordering their internal operations and would attempt to instruct them accordingly… my primary unit for analysis is the industry or competing groups of firms, rather than the individual firm or the economy wide aggregate of enterprises.

Fig. 1.1, drawn from Scherer’s (1970) definitive survey of that tradition, illustrates its essential features. All of the factors in it are external to the firm:

Fig. 1.1. A model of industrial organization analysis.

Source: simplified from Scherer (1980: fig. 1.1).

Nothing explains why one firm in an industry differs from another. True, Scherer’s work is also a rich encyclopaedia of information about American business, but it is precisely that which distinguishes it so clearly from other contributions in its genre. His unit of analysis is emphatically the industry, not the firm. For industrial economists in this tradition (and, indeed for those of the Chicago school which represented its principal alternative) the policy issues of interest were those of public policy, not business policy.

This inability, or unwillingness, to probe within the boundaries of the firm itself has serious weaknesses even in its own terms. If opportunities are equally available to all they are available to no one in particular. This problem, most clearly articulated by Richardson (1960), lies a little beneath the surface. But the failure to resolve it creates a theory of industrial organisation of limited value to practical businessmen. Reviewing the state of oligopoly theory in 1975 Joskow comments that ‘the ultimate test of the utility to the various models is whether they prove useful to people involved in analysing problems involving actual markets or groups of markets. I suggest that not only aren’t they particularly useful but also that they aren’t really used.’

The Development of Business Strategy

The vacuum that this leaves has been filled. Igor Ansoff is generally credited with founding the subject of corporate strategy. Although such a development is clearly foreshadowed by Chandler’s contributions to business history, Ansoff (1965) (p. 16) is explicit that his work is motivated by the deficiencies of contemporary microeconomics:

Study of the firm has been the long time concern of the economics profession. Unfortunately for our present purpose, the so-called microeconomic theory of the firm which occupies much of the economists’ thought and attention, sheds relatively little light on decision-making processes in a real world firm.

It cannot be said that the development of a distinct discipline of strategy has enjoyed such success. The tools of the strategist – the experience curve and the portfolio matrix – are jejeune at best, and much of what passes for strategy is platitude or pious exhortation. The most substantial body of empirical research to be found under the heading of strategy is based on the PIMS database (Buzzell and Gale 1987) and would fit comfortably into the structure-conduct-performance tradition.

The most widely read and influential management book of the 1980s is probably In Search of Excellence, a journalistic account of the characteristics of leading American corporations (Peters and Waterman 1982). The two most important contributors to the development of strategic thinking in the last decade are probably Porter and Moss Kanter, whose work has recognizable antecedents in economics and organizational sociology respectively. Strategy has even developed its own counter-culture, based largely around the engagingly eccentric Henry Mintzberg, who denies the possibility, or at least the relevance, of a rational strategy.

Michael Porter stands out from this field in having taken economics to business leaders and in having based strategy firmly in economics. Yet the economics he uses is economics with which Bain and Mason would have been comfortable and familiar. Porter’s ‘five forces’ – suppliers, substitution, entry, customers, rivalry – have an obvious affinity with Scherer’s S-C-P presentation in Fig. 1.1. And this should come as no surprise, since what Porter has done is to cross the Charles River, metaphorically and literally, and bring together the traditions of Harvard economics with those of its Business School. It is notable, but consequential, that the approach is decidedly less successful when applied to the firm (in Competitive Advantage (1985)) than when applied to the industry (in Competitive Strategy (1980)).

The absence of a well-ordered body of knowledge is most clearly reflected in the way in which the subject is taught. This is based largely on the case method – a kind of classroom learning by doing. No one teaches physics by cases and, interestingly, the technique is not much used in law either. But if economics might lay claim to providing that well ordered body of knowledge which strategy lacks, it is not a claim that has been widely recognised. While business education as a whole has been expanding, the role of formal economics within it has generally been contracting.

The New Industrial Economics

But while all this has been going on, and following directly on the pessimistic comments of Joskow cited above, the subject of industrial economics itself has undergone massive changes. Those that are relevant to the themes of this article fall into two broad areas. Each reflects the resurgence of formal methods in industrial economics: in reaction to, or perhaps in development of, the strongly empirical traditions of the structure-conduct-performance paradigm.

One of these areas is the development of models rooted in game theory. An economist who knew nothing of business strategy might well suppose that it would be centred around the theory of games. He would be quite mistaken. A recent volume (Oster 1990) is the only major text book on strategy I know even to mention the subject and even that apologizes for its novel content by beginning with the slightly shamefaced confession that ‘this is a book about competitive strategy by an economist’. Now it is perhaps true that game theory has never quite lived up to the potential which its initial development appeared to offer. One recent text on the subject (Rasmussen 1989) describes it as the Argentina of economics, in terms of the gap between potential and achievement. If game theory seemed to offer the key to analyzing oligopolistic interactions, the lock proved obdurately hard to turn. But from the mid 1970s it did begin to move, and modern textbook in industrial organizations such as Tirole (1988) are very largely based on game theory, at least in the broad sense.

The second important area of change is in that group of issues concerned with asymmetry of information, with principals and agents and with the nature of contracts and ownership. This area of study is currently developing in many different directions, and at present enjoys little coherence taken as a whole. This hardly matters. It is evidently a fertile area of study and has attracted many of the most fertile minds in the profession. It holds out the prospect of a theory of the internal organization of firms, and of the relationships which is both between firms more comprehensive and more powerful than anything that has existed until now.

The Future of Economics in Business

The firm is a collection of contracts. Its internal organization is a set of arrangement between principals and agents. Its relationships with its competitors are non-cooperative games and those with its suppliers and customers are cooperative games. All these are subjects which have been at the centre of research in economic theory in the past fifteen years. The key issue for the development of microeconomics in the next century is whether they can be expressed and developed in ways which gives them relevance to business policy. This requires change in the attitudes of both businessmen and economists.

It is, of course, easier to say what businessmen must do. Distinguish insight from cliché. Discover that learning comes not from hearing the felicitous reiteration of what one has oneself just said – the mainstay of most consultancy and business seminars – but from experiencing challenges to one’s pre-conceptions. Most of this will happen as the educational level of management rises.

Microeconomics has potentially the same role to play in relation to management issues that macroeconomics currently has for political issues. Because of the ways in which the subject has evolved over the past 100 years, it has conspicuously failed to play that role. Today businessmen’s expectations of what economics can offer are not related to microeconomics at all – they look to economists mainly for their forecasts (and are inclined to look at them less).

Yet the present state of knowledge in microeconomic theory is one which makes the time particularly apposite to assert that economics has a much wider range of practical uses. Economics is the natural integrative discipline for much of management science. But its past relative neglect of the firm as the unit of organization has severely limited the role which it has to play. That is now changing, and that can mean that economics in the next hundred years will have a quite different, and much wider, range of policy applications than those it has exercized in the century that has passed.

The two key groups of question of interest to businessmen – the internal organization of the firm and its relationship between its suppliers and customers, and the nature of strategic interactions between small groups of firms – are clearly on the agenda of modern economics in a manner which has not been true for most of the last century. First year students are still puzzled when they are faced with models of atomistic perfect competition and wonder which real world industries this actually describes. It is a safe bet that they will not be presented with the same material in the next century.

 

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