WHAT ECONOMISTS KNOW THAT MANAGERS DON’T (AND VICE VERSA) ~ HARVARD BUSINESS REVIEW


Why did Jean Tirole win the Nobel Prize in Economics? Not for the highly-regarded work on competition between small numbers of firms with which his career began more than thirty years ago but for more recent work on how carefully structured regulation can improve performance relative to unbridled market forces. This is a reminder that serious students of market performance take market failures seriously.

But what many economists generally gloss over is a notion that I will argue is highly complementary to market failures: management failures. For policy-making purposes economists assume that all businesses act rationally in the pursuit of profits. The possibility that that might not be the case is generally ignored, or even when mentioned, quickly finessed.

Even Tirole betrays this bias. The section on the profit maximization hypothesis at the end of the introductory chapter of his classic 1988 textbook on industrial organization concludes by saying that even if a firm doesn’t maximize profits, it can be treated, for the purposes of many of its interactions with the outside world, as if it does. Partly because profit maximization is a bedrock assumption and partly because maximization is a basic mathematical tool, economists have trouble dealing with firms that are not maximizing profits.

In this worldview, disasters only happen because the rules of the game in which the businesses operate must be flawed. Economists disagree about the actual incidence of these market failures and the cost-effectiveness of governmental efforts to tackle them, but they broadly agree that the only factors that prejudice performance are external to businesses.

Businesses and management experts, in contrast, tend take the opposite position. Thus, Dominic Barton, among many others, traces capitalism’s current problems to capitalists who work with time horizons that are shorter than they ought to be. And Michael Porter and Mark Kramer point to a big pot of gold for businesses that properly internalize the social consequences of their decisions instead of incorrectly externalizing them. In this view, poor performance is (mostly) caused by management failures — specifically, miscalculations of various sorts — rather than inherent flaws in the workings of the marketplace. And specific prescriptions for practitioners are served up that are supposed to improve both private profits and public welfare.

Neither school of thought, though, has it quite right. In their efforts to characterize important failures as being (for one group) always market failures and (for the other group) management failures, the two groups end up missing out on each other’s insights.
For an example, reconsider the financial crisis. Some, arguably including the Fed Chairman who presided over its eruption, Alan Greenspan, were utopians who thought nothing could go wrong on either front: the rules of the game or managerial responses to them. But the financial sector was clearly subject to a number of the market failures that were well known to most economists.

To begin with, quite a few parts of it are heavily concentrated at a global level (the credit ratings business, for example, or global investment banking), and many more at the national level (just six financial institutions account for 46% of all U.S. banking assets and as such are “too big to fail”). This small-numbers problem invalidates Adam Smith’s “invisible hand” mechanism in which good performance is supposed to be ensured by large numbers of competitors, none controlling more than a sliver of the market and none, therefore, with the power to jack up prices.

Other aspects of the financial sector highlight some of the problems with markets that economists have added to their list since the time of Adam Smith. Because of informational imperfections (think subprime mortgages), segments within financial services have a history of provoking manias, panics, and crashes — volatility exacerbated by recent innovations such as exotic derivatives and high frequency trading. Since capital is like air to other markets, problems with the financial sector can have important effects on the rest of the economy, a version of the market failure referred to under the rubric of externalities.

But having run through those economic problems with financial market attributes, the meltdown probably shouldn’t be chalked up just to them: missteps on the part of key managers also contributed. Consider Lehman Brothers, whose collapse was the trigger for broader sectorial travails. In the aftermath of Dick Fuld’s refusal to agree with the terms proposed by the government to help bail it out, his net worth was estimated to have collapsed from close to $1 billion to about $100 million. Similar points could be made about Jimmy Cayne at Bear Stearns and many others.

Nor was the government — beyond Greenspan and the Fed — blameless in the run-up to the crisis. The push to expand home ownership swelled the subprime mortgages that ended up sinking large chunks of the financial sector. Bailouts — not just the ones after the crisis but also prior ones, such as that of Long Term Capital in 1998 — aggravated the problem of “moral hazard” that informational imperfections can engender. And the complexity of some of the post-crisis regulations seems, in a world of human rather than superhuman managers, to have slowed down recovery from it.

Given such realities — which could also be illustrated with other key sectors such as health care and education — the right response is to pay attention to both market and management failures. Doing so expands one’s sense of both the room to improve performance and the levers that might be pulled to do so. It also helps enhance credibility — another important consideration since recent surveys suggest that Americans, at least, are similarly dissatisfied with their government and with large corporations.

Finally and most importantly, considering both management failures and market failures helps spotlight the most serious problems because of an interaction effect: market failures expand the scope for management failures to matter a lot. For instance, the pay packages financial executives awarded themselves for “performance,” a contributing factor in aggravating the income and wealth inequality seen in some major economies. Are those market failures, or management ones? But to see these complementarities you have to take both market failures and management failures seriously — and not enough people are doing that as yet.

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