Economists and Economics in Business

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Most businessmen think that the role of economists is to produce macroeconomic forecasts. Since modern business strategy is, however, increasingly based on economic foundations – largely through resourced based theories – it might be time they reconsidered.

University of Westminster: 4th June 1999

My subject this afternoon is the role of economics and economists in business. Most business people think that economics about macroeconomic forecasting. They do not have a very high opinion of macroeconomic forecasting, although they go on thinking they need it, and therefore they do not have a very high opinion of economists. I keep surprising people when I say that I am not that kind of economist.

Some people in business do know there are other types of economist. They know economists are concerned with issues of public policy. They are the people who undertake utility regulation, and administer competition policy. When business hires economists, other than to do forecasts, it is very often because they have received a letter written by someone who is an economist, or is advised by someone who is an economist. Typically, that person works in a government agency. They then employ an economist to write back, rather as you would hire a Dutchman to respond to a letter written in Dutch.

But if economists have things to say about regulation and anti-trust, and I think they do, it is because economics provides the best framework for analysing a wide range of business issues. A friend of mine did some work in the 1980s on market definition in the computer industry. He showed that the old distinctions between the markets for mainframe computers and the market for other types of machine were rapidly disappearing. His client was delighted, because this argument was of considerable assistance to them in the anti-trust proceedings they were then engaged in.

His client was of course IBM, and the notion that this analysis had any relevance to their business was not something that had occurred to them. Economists have tools for analysing market structures and their evolution. If that is their role, it ought not to be confined to dealing with regulatory agencies. I want this afternoon to explain how this pigeonholing of economists came about, and why I hope it is changing.

The formal study of strategy dates back to the 1960s. At that time, industrial economics was centred round what was called the structure conduct performance paradigm. It is well summarised in a diagram at the beginning of what remains the definitive textbook in that genre, F.M. Scherer’s Industrial Market Structure and Economic Performance. If you look carefully at that diagram you see two important features. One is that the framework of structure – conduct – performance, which argues for a chain of causation from market structure through industry behaviour to firm performance, fails to explain why different firms in the same industry or market perform differently. But of course this is the key issue of business strategy.

And a second important characteristic can be seen if we look to the bottom of the slide and ask what Scherer means by performance. Not profit, or market share, or growth. His measures of performance are employment and allocative efficiency – objectives of public policy, not of business policy. For these reasons, when consultants and business school professors sought to develop the subject of business strategy they found little in the microeconomics of the time which was directly relevant to them.

Eventually the transition was made. If you look at Porter’s famous ‘five forces’ diagram, you immediately see the affinity between it and Scherer’s structure-conduct-performance framework. What Porter did was to translate the industrial organisation theory of the Harvard Economics Department of the time into material that could be assimilated in the business school.

But the reasons that made the structure-conduct-performance paradigm of questionable relevance for those developing concepts of business strategy remain true today. The five forces framework may be a basis for analysing industry and markets, but it is not a tool for understanding what differentiates the performance of firms. And it is ironic that Porter’s more recent work has reverted to issues of public policy rather than those of business.

What I hope to do this afternoon is to argue that modern economics has much more relevance to business strategy and, conversely, that modern business strategy is being developed with a much more substantial economic base. The link between the two is in large measure provided by what has become known as the resource based theory of strategy.

For me, the fundamental technique of assessing the analysis of firms, industries and markets is to pose the question: where are the rents? The object of business is to search for economic rents. The structure of industries is typically defined by the acquisition of rents and their distribution. And changes in the structure of markets or industries are dominated by the distribution of rents and changes in these rents.

One of the reasons why the concept of rents has not made the impact on business thinking which it should have is the unfortunate term we economists use to describe it. The reason paradoxically, is the very age of the analysis. We owe the analysis of the determination of rents to David Ricardo, and to an era when agriculture was still the most important form of economic activity. Diagram three is the encapsulation of the Ricardian theory of rent.

All the land in England is ordered from the best in the upper left part of the diagram to the worst at the bottom right. On the vertical axis is measured the yield which the land provides at any level of crop prices. The cost of production, assumed to be independent of the quality of the land is marked on the same axis. All the land to the left of Z will grow crops – Z is what Ricardo called the margin of cultivation.

Let’s think for a moment about an industry in the same way. We list the firms in it.

The essence of the Ricardian analysis of course is that rents arise because land is fixed in supply and in quality. That land earns rent because of the difficult of creating any more of it. In a similar way, firms can only earn rents from scarce factors – features of their organisation or history that cannot be reproduced or imitated. These can originate in various ways. They can be the product of legal protection monopoly or other strategic assets. Most often, however, distinctive capabilities of firms arise because of their behaviour or their relationships with their customers or with their suppliers which are (blurred) – they cannot be imitated because they cannot readily be written down and defined – or they are the product of the company’s history – a feature of it which is most difficult to replicate.

This is the essence of the resource based theory of the firm. The success of firms is based on access to distinctive resources which cannot be readily replicated by competitive firms operating in the same market. This emphasis on distinctive capabilities takes one far away from many of the sources of competitive advantage which are discussed at length in the literature on business strategy, size and scale, getting the market right.

Instead, our attention is forced on scarce (?) factors,

· on telecommunications licences.

· on the structure of relationships which Marks and Spencer has established with its suppliers.

· on Microsoft’s monopoly of is MS-DOS operating system.

· on the advantages which London derives from having the thickest market in marine insurance and Hollywood from having the thickest market in most of the components which go to make up a film.

In these ways, the modern analysis of competitive advantage is bound up with the economic analysis of rents and quasi-rents.

I would like to turn now to a second group of concepts which integrate economic theory and business strategy. The relationship between markets firms industries and activities. Markets are defined by reference to consumer needs, which may be served in different ways. So laundries and washing machines serve the same market, even though they do so from very different industries. Industries are defined on the supply side, so that ferries that ply between Dover and Calais and between Piraeus and Heraklion are part of the same industry, although the markets they serve are wholly different. It is useful also to think of competition in terms of strategic groups. Here we look to see the strategic battlefield and observe Coke and Pepsi fighting with each other in many different markets in which they face front competition. A good deal of confused strategic thinking comes from the failure to distinguish these concepts. Once there was the famous diversification of oil companies into the energy business. The mistake here is to think that because oil and coal serve similar consumer needs, their management requires similar distinctive capabilities. It doesn’t. The same mistake was made by Bass, for example, persuading itself that it was in the leisure business and should add betting shops and package holidays to its brewing activities.

An activity broadly speaking corresponds to what an economist identifies as a production function. Take the insurance industry, for example. The structures is conventionally one that distinguishes between brokers, insurers and reinsurers. The activities which make up the industry are better looked at in different ways. There is retailing – dealing with small final customers which requires similar skills to other types of financial services retailing. Risk bearing requires both the capital and the professional knowledge needed to assess and take on board financial risks. And there is a group of advisory and consultancy services which now form the major part of the activities of traditional insurance brokers. This is a reflection of the general way in which the industry is becoming organised round activities. Firms whose market positions are not based on activities but on history and established market share are losing out to those who have distinctive capabilities relevant to particular activities. It is evident that the skills required for each of these activities are very distinct.

We can apply the same type of analysis, for example, to media industries. The majority of media industries are organised on what I call a tripartite structure. In books, for example, we distinguish authorship, the originating talent, publishing – the business of coordinating, marketing and financing – and distribution – the services provided by booksellers and printers.

Other media industries are organised on similar lines. The film business, for example, has originating talent – the number of different kinds – distribution through cinemas and indeed through video stores and publishing activity by what are misnamed studios. In both these industries, the distribution of returns is governed by the distribution of rents. There are substantial rents to originating talent. There are some rents and by those who have distinctive capabilities in publishing. And delivery and distribution, although large businesses, are ones that offer little in the way of rents even to the more successful players in these fields.

This framework is helpful in thinking about the evolution of electronic media. Historically, the organisation of electronic media has differed from these other industries because there has been scarcity at the point of distribution. So long as the only means of getting signals into people’s homes was terrestrial broadcasting, terrestrial broadcasters earned substantial rents. Many of these were handed back to customers, at prices much lower than the market could bear – and others were used to take control of the whole of the value chain, so that broadcasters integrated back into publishing and maintained tight control of originating talent. What has happened in the last decade has been that the scarcity of distribution capability has rapidly disappeared.

The result is that the industry is restructured around the new distribution of rents. The increased earnings of movie stars, and the explosion of revenues from sports rights are examples of how rents have been pushed back the value chain by change in the distribution of scarcity.

My focus this afternoon has been on issues of corporate strategy – those concerned with the scope of business and the structure of industries. I shall leave for another day the ways in which modern industrial organisation theory contributes to the analysis of competitive behaviour among firms within a market. I began by describing the industrial organisation theory of the 1960s based around the structure-conduct-performance paradigm. Economic theory that has been developed since then, with its emphasis on games contracts, asymmetric information and small number interactions is much more directly relevant to the key issue of why different firms in different industries perform differently. At the same time, the resource based theory of strategy draws the work of business strategists closer to that of economists. And that is why I believe that the recent dichotomy between economic thinking and strategic thinking is likely to narrow rapidly.

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