On management: Prophets and loss

From supermarket competition to outsourcing, economists all too often get it wrong, writes Simon Caulkin

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Management has always been economics’ poor relation. And, as in many families, the ­relationship is a fraught one. Economics, it turns out, is a poor guide to management. Actually it’s often a poor guide to economies too – and for the same reason: the misguided attempt to apply the deterministic principles of the hard, physical sciences to irrational, contradictory, emotionally bendable human beings. As Emanuel Derman, an ex-Wall Street quantitative analyst, noted in New ­Scientist recently, “the worm at the heart of economics has been its dark love of inappropriate scientific elegance and scientism”.

One area where economics leads managers astray is the excessive faith it puts in mechanical notions of ­efficiency and economies of scale. Take outsourcing. For decades it has been taken as read that if firms can do part or all of their manufacturing or service production in lower-wage countries, they should. “Outsource everything but your soul!” exhorted guru Tom Peters. But the bargain was a Faustian one: it was difficult to tell where the body ended and the soul began.

Thus, when Dell first did an outsourcing deal with Asustek it was for the manufacture of simple circuit boards. Some years later, the Taiwanese company was designing and manufacturing the entire computer – and managing the supply chain too. Financially the deals were a success, improving Dell’s profits. The next time Asustek came calling, however, it was on the big computer retailers, offering them own-brand computers that were 20 per cent cheaper than Dell’s.

Chinese outsourcer Lenovo took the next logical step and swallowed customer IBM’s PC arm lock, stock and barrel in 2005. The other US personal computer giant, HP, is threatening to sell its PC business too. Inevitable? Well, no. Although Apple’s computers are made in China, no one could accuse it of surrendering body or soul.

By maintaining a tight grip on hardware and software design, it continues to build premium products rather than the cheap commodities with wafer-thin margins of its rivals.

But there is more. Now that the finance sector’s hard numbers have turned out to be softer than the melting snow, the economic doctrine that making things is no longer important looks deeply dubious. But “rebalancing the econ­omy” will be much harder, if not impossible, now that the “industrial commons” – the collective process, production and supply chain knowhow, along with the supporting research and development, that figures nowhere in the economic calculations – has been lost. The US now could probably not make a Kindle, or almost any part of it, if it wanted to. Economically rational outsourcing deals have turned out to be collective management folly, bequeathing the US a trade deficit in high-tech industries that reached $80bn in 2008.

Take another example: the economists’ version of competition. UK competition authorities have consistently ruled that fierce competition among the big supermarket chains is enough to safeguard the public interest, even though the “big four” (Tesco, J Sainsbury, Morrisons and Asda) account for an astonishing two-thirds of the British grocery trade. But this argument fails the common-sense test. If a company is ­determined to open a store, no town can prevent it. Industry after industry has been allowed to consolidate, not only at national but also at global level – retail, banks, insurance, computers, media, cars, the list goes on. Without noticing it, the point has been reached (most clearly with banks) where it becomes the purpose of the economy to support the functioning of big companies, rather than the other way round.

How have executives got themselves into a position where it is easy to tag them “predatory”, with results that ­became evident in protests in New York’s Zuccotti Park and beyond? The answer is that they have too unquestioningly adopted the economists’ reductive view of rationality, forgetting that, as the economist and FT columnist John Kay points out, “the economic world, far more than the physical world, is influenced by our beliefs about it”.

Adam Smith’s version of self-interest wasn’t crudely about looking after number one. It was that the self-interest of the one is naturally bound up with that of the many. The extreme self-interest institutionalised in today’s huge businesses, on the other hand, is learnt, not innate. “People learn it,” say business school professors Fabrizio Ferraro, Jeff Pfeffer and Bob Sutton, “by studying economics and business.”


Think again

In Thinking, Fast and Slow, psychologist (and economics Nobel laureate) Daniel Kahneman uses his own example to show how we reach flawed ­decisions. His research, say some economists, leaves the idea of econ­omic rationality in tatters.

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