Saturday 8 October 2011

The art of business and the science of economics

Business and economics are tied up together in lots of people's minds. After all, they're both about money, aren't they? An awful lot of people seem to believe that economics is Big Business and business is small economics. (Even the generally reliable Economist magazine seems to use this definition in deciding what should go in its business or economics sections.) The failure to keep the two apart leads to some bizarre misconceptions in the popular understanding. For example the idea  that countries are businesses in competition with each other, or that business is about self-serving greed and economics is the soulless science of large scale greed. 

Business is the art of commerce. Economics is the study of the production, distribution and consumption of goods and services. Just from the definitions we can immediately see one clear difference. Economics concerns systems and general principles and is therefore a theoretical subject eminently suitable for academic study in a university, while business is a practical craft that does not belong there. 

Sure there are skills that are important for successful business life - like managing people well, knowing how to make a spreadsheet, giving great powerpoint - but there’s nothing academic about them. Business schools also make much of their case-studies, analysing a famous or infamous company or manager, usually with a particular theme in mind. This may properly be called biography (or creative writing), and seems as useless to practical business life as the obligatory single course on moral theory. Of course there are real theoretical economics issues associated with business that can be the subject of rigorous academic research, such as the economics of imperfect competition (industrial organisation), the theory of the firm, and logistics. But these can just as well be studied in economics departments.

So why does business studies exist as an independent academic subject? Two main reasons spring to mind: demand from students, and demand from business professionals. First, teaching business studies at universities allows young people who want to pursue a career in commerce to attain a certificate of academic prestige, which is fashionable these days [previously]. They also seem to have the mistaken idea that university is a good place to learn useful skills (when in fact students of business studies, and other vocational subjects, seem to learn the least from their college experience). In order to meet this lucrative demand, simulacra of academic departments were created, which then, in order to support their legitimacy, had to invent some new field of scientific research or recharacterise an existing area of study as 'business economics'.

Secondly, business professionals want a useable economics and are willing to pay for it. That gives business economics its form. Academic economics is imbued with arcane theory and severely disinterested in the kind of problems important to business: 'What do I have to do to make money in this market?' Business economics promises to give you answers to those questions in keeping with your own common-sense views of the world (though obviously with the technical jargon that adds the necessary gravitas). It is not its subject matter but its orientation to economic issues that makes business economics quite different from economics. To put it bluntly, while one set of academics is advising farmers on proper hen house construction, the other is advising foxes on how to take best advantage of weaknesses in the walls. 

Economics is scientific in the sense that its positive goal is the disinterested study of economic phenomena. But it also has a normative goal, as part of the 'science of the legislator' (as Adam Smith put it), to increase the prosperity (efficiency) of the whole economic system. That means economists are concerned with understanding what a perfectly efficient economy would look like, and then mapping how the real economy deviates from that and suggesting how to fix it. For example economists have an ideal of perfect competition in which profits decline to the costs of production: in this perspective sustained excess profits for any economic agent are seen as the result of market imperfections that should be removed. 

In contrast, the aim of business is to make excess profits. Business economics is therefore concerned positively with understanding the determinants of profits (rather than efficiency), and normatively with advising economic agents on how to generate sustained excess profits (rents) by creating or exploiting market imperfections. That is, business economists make use of some of the same scientific analysis of market imperfections as economists, but they have diametrically opposed purposes. They study industrial organisation in order to analyse what companies can do to establish localised control or market dominance over some part of the economy, i.e. to create islands of security from the full force of competition that will benefit themselves at the expense of the efficiency of the system in general (and hence at the cost of consumers). While economists strive to induce real competition, businesses strive to escape it. 

Two kinds of utilitarianism

Both economics and business have utilitarian moral foundations i.e. the maximisation of material prosperity. However, the difference in the level at which they operate (economic systems and business agents) means that they have very different perspectives. In particular, the utilitarianism of economics is systemic and indirect, while the utilitarianism of business economics is strategic and opportunistic. Pernicious misconceptions arise when the agent-level perspective of business is transposed to the system level of economics, and vice versa. 

1. Business thinking is bad for the economy

Economics is about evaluating whole systems; business is about strategic positioning with respect to local competition. In a closed system every action has further consequences that also matter. Economies are like this and these systemic effects are what economists study (using abstract models to explore counterfactual worlds). Increased employment for example can create damaging inflation; unemployment can create depressions. Economics' claims to be a science rests on its expertise in tracing the unintended but foreseeable effects of the interaction of causally significant mechanisms through a closed system. 

In contrast, businesses are open systems. If a company doubles its workforce (or fires 50%)  that company, or even that industrial sector, will not generally feel any systemic consequences. Businesses, even very large ones, operate at the wrong scale to have to worry about the systemic impacts of their choices, and hence business economists aren't used to thinking in those terms.

One of the benefits of whole system thinking is that one can see and evaluate non-obvious relationships, such as how people in one place benefit from people elsewhere doing well (as in foreign trade). Economists have long argued (since Adam Smith and David Ricardo) that since both parties gain from a trade, it is not something it makes sense to try to 'win', even if one party is.... (ugh!) ...French. In fact, the more prosperous the people of France become, the more opportunities for mutually beneficial trade would appear for the people of Britain. 

That perspective conflicts directly with the common sense of business agents who see their daily reality as an unending zero-sum competition with others for the same market. When one company loses market share, the others benefit ('win'). When that attitude is dressed up as business economics and reproduced at the systemic, i.e. economy, level it results in strange ideas indeed. For example, Paul Krugman points out in his excellent article A Country is not a Company that many successful business professionals believe that free trade is good because it increases the number of jobs and that countries then compete for where this set of jobs is to be located, with the countries who export most 'winning' more jobs, at the expense of importers. 

Such common sense business logic makes basic errors in arithmetic because it doesn't understand the basic difference between closed and open systems. It thinks of GDP as a company balance sheet! Nevertheless, the self-confidence and apparent common sense of business economists has ensured that, despite 200 years of economics orthodoxy, the idea that countries compete with each other in the same way that companies do is extraordinarily entrenched across the political spectrum from right (support our businesses) to left (support our workers). All sides are united in seeing the rising prosperity of other countries as a threat to our own, and in urging the government to do 'something'  to stop us losing the race.

2. Good business can be bad economics

Business economics gives advice to economic agents on how to make the most of the opportunities that come their way, while economics gives advice to governments about which rules will best lead to maximising general prosperity. That is, economists note that unless properly directed by the right rules, individual profit seeking may not generate and can even undermine system-wide economic growth (the invisible hand only operates in certain circumstances). 

(I acknowledge that the examples of slavery and empire are not exactly representative of contemporary business practices and may seem a bit dated. Nevertheless they were promoted by the business economics of their time ('mercantilism') and the calumny has somehow stuck to economics proper. You may substitute Credit Default Swaps and the tobacco industry if it helps you feel more topical.)

The business of buying and selling slaves was presumably profitable to those who engaged in it (apart from the slaves themselves, of course). And common sense suggests that since slave labour doesn't require wages it must be more efficient than free labour. But common sense is wrong. As economists like Adam Smith have long pointed out slave labour is actually more expensive (because slaves still have subsistence costs but, because they are not rewarded for their productivity, they have little incentive to work very hard or efficiently compared to free labour). So economists like Adam Smith modelled slave owning as a form of consumption rather than investment (and excoriated the baseness of the desire to dominate others on which it is built). Economists argued that the economic system as a whole would be much more prosperous if it incorporated the rule that all actors are equal and free in labour markets, rather than the short-term opportunism of treating some like property. 

Similarly, the economics of empire is the business of stealing from poor people (taxes on salt!). Profitable to those in the right place perhaps, but much less economically productive than when the equality and freedom of all parties is guaranteed and free markets can direct capital and labour to where they can be most productively employed. The general lesson from economic theory: successful capitalism is all about institutionalising the correct constraints on economic agents, not a free for all.

In addition, there are some parts of the economy that the invisible hand can't reach. Economists have identified many activities that are beneficial to the economic system as a whole but offer insufficient opportunities for immediate profit for business to be interested in supplying them. These public goods - like universal education, transport infrastructure, and pollution control - need to be organised (if not directly funded) by the government.

3. Homo economicus is bad for business

The damage of conflating business and economics is not only one-way. Most notably, certain idealising assumptions in micro-economics have been taken as giving a licence for amorality to business. Micro-economists make the reasonable seeming assumption that rational agents act to advance their perceived best interest. Under certain circumstances the interactions of many such rational economic actors generates a productive economic order (this is Adam Smith's invisible hand of the market, and, on a grand scale, society). Unfortunately economists have allowed two distortions of this mechanism to become entrenched in popular opinion, and thus business economics. First, that the definition of self-interest be understood narrowly as selfishness. This gives the impression that the invisible hand is actually Mandevillian (not Smithian). That is, markets magically transform the private vices of individuals into public benefits. Second, that selfishness is a normative requirement, i.e. that the invisible hand only works if agents focus entirely on furthering their selfish interests.  

People naturally understand economists to be saying that greed is rational, greed is profitable, greed is right. And they think the 'Dismal Science' is well-named. The consequences of this awful misunderstanding of economic theory have at least been somewhat confined to the realm of market activity, though that touches all of us to some extent. But it has led to a strange division of ethical life into that part one lives in the market (where one should be ruthlessly selfish and opportunistic), and the rest of one's life, where more normal ethical conduct is required (such as towards one's colleagues at the company you work for). Not surprisingly those involved directly in commerce are most affected. Much of business ethics can be understood as wrestling with the conundrums produced by this misunderstanding: when is it right to be selfish and what moral rules still apply? (It's a lot like the ethics of war: when is it right to kill people because someone told you to, and what moral rules still apply?)

Because business is a practical art and overly self-conscious about its lack of intellectual credentials, it is peculiarly vulnerable (even gullible) to people toting theories, however bad. In this case, and against their own common sense, business people and academics seem to have bought into the idea that success in business is a matter of trying to resemble a distorted picture of homo economicus, which is itself a simplified caricature of actual economic actors that economists use to make modelling easier. In doing so they have thrown out the real virtue of business, which Adam Smith talked so much about, prudence: the proper understanding, discipline, and security of one's self-interest. Real prudence requires requires taking a metaphorical step back from one's immediate circumstances and concerns to adopt a critical perspective on one's options and goals. Prudence is a difficult but vital disposition and set of skills that requires deliberate self-cultivation, and external support in the form of learning opportunities and role-models.

Selfishness gets in the way of achieving prudence because it short-circuits the learning mechanism in various ways. First it gives the misleading impression that your own immediate selfish inclinations are your best guide as to what is good for you, when in fact you often need to think hard about what it is that you really want to achieve and exercise self-discipline in keeping your immediate impulses in check.

Second it undermines the necessary reflection on the appropriate means to achieving your goals, which are often indirect. Maximising profits may be a reasonable goal, but it is not a reasonable strategy. That would be to skip ahead to the making money part without paying attention to the rather more important work of producing high quality products that people want to pay you for. Business success also depends largely on the voluntary co-operation of others, from employees to collaborators to suppliers to customers. Those whose business strategy is based on straightforward selfishness will not be able to co-operate with others - for example they won't be able to understand how reciprocal relationships work, or how to woo customers by catering to their needs. They will also find that few people are interested in co-operating with them.

Finally, the selfish actor approach outsources responsibility for prudence to the market. This is a mistake because, although markets are quite good at schooling people in the virtue of prudence, the idea that they can substitute for it is a mistaken interpretation of the invisible hand (Smith's arguments were addressed to the legislator, recall, and included lots of advice for systemic regulation to prevent imprudent agents endangering the system - previously).

In conclusion

The present easy conflation of business and economics is bad for both. Business economics transposes the shallow zero-sum strategic orientation of business competition onto complex closed-system economic issues. That has little influence on academic economics, of course, but its seductive basis in common sense intuitions gives it a central role in how most people, and most politicians, understand the way the economy works. 

Business economics also too easily conflates success at the level of individual economic actors with the success of the whole system. Hence such self-serving arguments as 'What's good for Wall Street is good for America'  can be sincerely held, though that doesn't make them any less wrong. 

The idealisations and simplifications of economic models are not intended as a description of the real world, but the authority of theory is so great and its claims so little scrutinised that perfectly sensible and virtuous business professionals have become convinced that homo economicus is a better description of business reality than their own experience and common sense tells them. As a result, the true and practical virtue of prudence has been sacrificed in favour of the convenient moral 'duty' of selfishness.

Update: I recommend srp's well-informed critical comment (below) that cracks open several generalisations and assumptions implicit to my argument. Check out his blog: strategy profs.

Update 2: I just came across an excellent blog - Mr Money Moustache - that illustrates the virtue of prudence very well.