John Kay - In out of the cold

In out of the cold

Economists have walked out into the cold as far as business strategy is concerned. Slowly, they are starting to return.

Most business people think economics is about macroeconomic forecasting. Economists tell you whether interest rates will go up or down, what is going to happen to exchange rates, and have comments to offer on every new batch of economic statistics. Most business people also think that economists do not really know whether interest rates will go up or down, or what is going to happen to exchange rates, and there are as many contradictory opinions about the interpretation of economic statistics as there are economists. Therefore business people have a low opinion of economists although, for some reason, they go on thinking they need them.

But what most economists do has little to do with inflation and exchange rates. Much of economics is concerned with costs and prices, markets and industries. People in business are equally concerned with costs and prices, markets and industries. But when these issues arise, they do not turn to economists. Indeed they rarely have economists, and if they do they employ them to say whether interest rates will go up or down. Costs and prices, markets and industries, are matters for accountants, marketing experts, and strategy consultants. Economists are left out in the cold.

Or rather they walked out into the cold, rather like Captain Oates. For most of the last century, economists have focused on the industry, rather than the firm, as their unit of analysis. The great Cambridge economist Alfred Marshall, who pioneered the economic analysis of markets and industries, once likened individual businesses to the trees in a forest. And there is an important point there: much casual theorising about economics does fail to see the wood for the trees. But that is not the right perspective if you are trying to sell your services to the trees.

And so for many years the dominant tradition in the economics of industry was what came to be known as the structure – conduct – performance paradigm. That explained how industry structure depended on basic conditions of supply and demand, and that structure in turn determined the behaviour of firms. It led to economists traditional concern about the malign effects of monopoly and the exercise of market power.

But there was one group of issues this framework of analysis entirely failed to address. If two firms face the same basic conditions of supply and demand, and operate within the same market structure, why does one firm do better than another?

This is by far the most important question for anyone running a business, and that kind of economics had almost nothing to say about it. Economists of the structure – conduct – performance school were regularly hired by anti trust agencies and government departments, but not by business. The spiritual home of these economists was Harvard, but the Harvard economics department, not the Harvard Business School.

That is why a subject of business strategy grew up in the 1960’s, quite independent of economics and economists. People like Igor Ansoff, one of the founders of the subject of strategy, were quite explicit about this. “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 process in a real world firm”. (HI Ansoff, Corporate Strategy, McGraw Hill, 1965, P16).

It cannot be said that the attempt to develop a theory of strategy independently of economics enjoyed much success. Some of the strategist’s tools, like the experience curve, were rather confused expositions of issues which economists had analysed more carefully. Others, like the portfolio matrix, which purported to categorise businesses as dogs, cows, or stars, fell into the same category of knowledge as the attempt to describe human behaviour by reference to the humours or the elements. Fads and fashions came in rapid succession, and trite slogans – go global, stick to the knitting – too often substituted for thought.

One of the most successful attempts to apply more rigour to the subject came from Michael Porter, a Harvard economist trained in the structure – conduct – performance tradition. What Porter did was to translate the main findings of his mentors into terms that business people could understand. Porter’s famous five forces diagram is the structure – conduct – performance argument in a flow chart. And like the structure – conduct – performance paradigm, it fails to explain why different firms in the same environment, facing the same five forces, perform differently.

That is why Porter’s analysis is more successful in its application to the industry (in his first book, Competitive Strategy) than in his second (Competitive Advantage). And, it is more successful still in describing issues of public policy (as in his third book, The Competitive Advantage of Nations) than determining those of business policy.

But in the same period, there have been great changes in the subject matter of economics Not so much in macroeconomic policy, where some people continued to think interest rates would go up and other that they would go down. But economists interested in firms and in markets developed game theory, began to interpret the variety and complexity of contractual relationships, and replaced assumptions of perfect market by the analysis of markets with imperfect information. These tools bore directly on the key question of why some companies did better than others.

Mostly, these ideas were expressed in rather abstruse mathematics, even further removed from the day to day concerns of practical people running a business. What needs to be done now is the job of translating these insights into everyday business language. It is starting to happen. And as it does we will have a serious subject of business strategy, firmly rooted in the economic analysis of costs and prices, markets and industries.

 

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