Do Economists Understand Business?

Economic models miss a lot

You can learn a few things about business by taking economics courses. But if you then work for a business or start a business, you will find that what you learned is far from adequate, and some of what you were taught in economics class you would be better off unlearning.

The Complexity of Business Strategy

In the economics class, the emphasis is on two extreme types of markets. There is no strategy involved in either type. The firm just mechanically decides how much to produce.

One market type is called “perfect competition,” in which every firm must charge the market price. Charge a penny more and you lose all your customers. Charge a penny less and you get plenty of sales, but you lose money on each one. Given the market price, the right amount to produce turns out to be the amount that minimizes average cost (I don’t want to waste time here explaining this—consult an economics textbook if you care).

The other market is a monopoly. The monopolist faces no competition. It has the entire market to itself. It picks the single price that maximizes profits. It produces the amount that will match demand at that price. (Again, consult a textbook if you need more explanation.) Economic textbooks assume that the monopolist knows its demand curve, meaning that it knows how much it can sell at various prices. In the real world, you will never meet a firm, monopolist or otherwise, that knows its demand curve.

In the real world, the most common types of markets are imperfect competition and oligopoly. Even if the market demand curve were known, each firm would face uncertainty, because one firm’s demand depends on what other firms choose to do.

Imperfect competition and oligopoly give rise to problems of strategy. Textbooks mention them, but they do not like to dwell on these cases. The complex, multidimensional nature of strategic choices seems to turn off most economists.

In an oligopoly, there are a few firms in the market, and they watch each other. They try to jockey for advantage. But they also try to be careful not to compete too aggressively.

For example, in the late 1980s and early 1990s I was with Freddie Mac, which bought mortgages from orginators and sold securities backed by those mortgages. Our lone competitor was Fannie Mae, which made the two firms an oligopoly. We could compete on many dimensions in order to induce sellers to choose Freddie over Fannie. We could offer lower fees for guaranteeing mortgages. We could alter our fees based on perceived risk of the loans, trying to “skim the cream” away from Fannie. We could choose to accept or refuse mortgages with weaker risk. We could require more or less documentation from lenders. We could be lenient or stringent when mortgages defaulted early (being stringent required the lender to repurchase the mortgage and take the loss). We could propose alternative ways to share losses on risky mortgages.

But we also needed to “manage the duopoly.” If we aggressively lowered fees, Fannie could match, and the result would be low profits for each firm. Or if we tolerated riskier mortgages, we ran the risk of suffering losses later. While I was at Freddie, our CEO, Leland Brendsel, put a stop to a competition to offer “low-doc” loans, in which borrowers were not required to prove that they had the income and job stability needed to be able to repay a mortgage. About 15 years later, Brendsel was gone (so was I), and another “low-doc” competition broke out. This time, nobody stopped it, and the country experienced the Great Financial Crisis of 2008 mostly caused by the proliferation of NINJA (“no verification of Income, Job, or Assets”) loans.

With imperfect competition, there are many firms offering products that are similar, but not identical. Think of all of the restaurants in your area. They have multidimensional strategic choices. They can compete on price. They can change their menu selections. They can compete on the basis of location. They can compete on decor and atmosphere. They can offer daily specials. They can offer senior discounts. They can use different methods of advertising. They can provide entertainment. They can offer customer convenience, by allowing online orders. And so on. All of that is ignored in the textbook model that focuses solely on the decision of how much to produce.

Price Discrimination Strategy

Economists also under-rate the significance of fixed costs. See The Marginal Revolution is Dead.

In the twenty-first century, marginalism does not apply to pricing or to wage-setting. To understand the contemporary economy, we have to think in terms of overhead. Real-world business is often dominated by overhead.

I have a catch-phrase Price Discrimination Explains Everything. Why do groceries offer coupons? Price discrimination. Why do airlines offer discounts for advance purchases and for stand-by passengers? Price discrimination. Why do cell phone providers offer different plans? Price discrimination.

The goal of all these tactics is to bring in more revenue in order to help cover overhead. Price discrimination means finding a way to charge more to customers who would rather just pay a higher price than go to a lot of effort to get something cheaper. Meanwhile, the business looks for a way to sneak in discounts to customers who are more discretionary about when and where they buy.

Corporate Soap Opera

Economists treat “the firm” as if it were a single, cohesive unit. In 2016, Bengt Holmstrom and Oliver Hart won a Nobel Prize for undertaking analysis of just one internal conflict—that between a manager wanting performance and a worker preferring to shirk. But in the real world, a business is a cauldron of conflicts.

Even the best economists assume that there is a stable relationship between incentives and outcomes, so that there is a single optimal “incentive compatible” compensation system. But in fact employees learn over time how to hack compensation systems. As a result, compensation systems always degrade over time. No system is ever optimal to begin with, and every system weakens as employees discover how to game it. The important thing about compensation systems is to change them with the right frequency. Change them too often and the expenses of training and implementation are excessive. Keep them in place too long and the incentives degrade too much.

More important, if you look inside a real-world business, especially a large organization, what you see are all sorts of personality conflicts, inter-group rivalries, strange embedded behaviors, and so on. I call this Corporate Soap Opera.

One day, a senior VP at Freddie Mac had me in his office and asked me if there were any shortcuts to implementing my pet idea, which was to use statistical pattern-matching to underwrite mortgage loans more accurately at less cost. I thought for a moment, went to his whiteboard, and drew a matrix of down payments and credit scores. Thus was Freddie Mac’s automated underwriting system born.

Shortly afterward, I was quitting Freddie. My supervisor (not the senior VP) had demoted me without even informing me. Corporate Soap Opera.

The key innovation that made Large Language Models like ChatGPT possible was invented at Google. But the engineers who developed this technique, which they called the Transformer, left the firm. That smells to me like Corporate Soap Opera. Obviously, the conflict a few months ago between Sam Altman and his Board was Corporate Soap Opera.

If you interview anyone who works in a large organization, I will bet you will find that the person has people he considers enemies. In his view, they cause harm to him and to the firm overall. Corporate Soap Opera.

I sometimes think that workers in organizations reproduce family dysfunction at work. Their competitions for pay and status are like sibling rivalries. They resent bosses the way children resent parents. Their pursuit of positions in other parts of the organization can feel like marital infidelity. Corporate Soap Opera.

Recently, Robin Hanson wrote,

A firm’s tangible assets include buildings, machines, contracts, and inventory. But for firms in the S&P 500, only 10 percent of firm value, on average, is accounted for by such assets. …

firms are complex social systems. They have many parts that are hard to see, understand, or control. Parts that add up to “the way we do things around here.” Some of those parts are stable, shared across the firm, and hard to vary within the firm, such as status markers and behavior norms. These add up to a firm’s “corporate culture,” which seems to account for most firm value; firms with good cultures are worth far more than those without.

…firm managers try to steer their cultures as best they can. This can take five years or more, and even then, two in three attempts to change firm culture fail. The usual life history of a firm’s culture is that, after some initial improvement, it will tend to drift, accumulating dysfunction, until the firm ceases to be worth saving and dies.

Good cultures minimize the cost of corporate soap opera. For example, Freddie Mac tried to inculcate the principle “assume positive motivation.” That is, rather than assume that the person from finance is trying to undermine the sales rep, assume that the finance person has a positive motivation to do cost accounting correctly.

Another example of corporate culture is Amazon’s “two pizza teams” approach to projects. A project team is kept small and integrates with the rest of the company via software interfaces rather than using the meetings and discussions favored by bureaucratic organizations.

When I had a web business that I ran myself and merged with another small firm, their culture included something that they called “the integrity agreement.” This meant that if another partner did something that bothered you, rather than letting your resentment fester you would schedule a meeting with that partner, with another partner present to act as neutral. Then you and the partner who had bothered you would hash out the problem.

Whether these cultural elements work or not, their intent is to minimize the damage that otherwise might come from Corporate Soap Opera. As Hanson points out, cultural norms contribute significantly to the overall value of a modern firms.

But all corporate cultures are flawed in some way. I like to say that anyone who is afraid of competing with a big corporation has never been inside one.

Conclusion

Many people see businesses as inherently rich and all-powerful. Taking an economics class can help you to see past this naive view. But the only way to really understand real-world firms is to work for them.