Economists wake up: it’s the 21st Century

Akerselva was the cradle of Norway’s industrialisation in the second half of the 19th century. Back then the river gave power to saw mills, textile factories and mechanical workshops.

Today Akerselva plays a valuable role as a “green lung”; a popular recreational area with green parks and luxuriant nature. Many of the old factory buildings along the river have been refurbished and now house cafés, galleries, offices and schools.

— VisitOslo.com

Along the Akerselva River in Oslo Norway, the buildings of the industrial era have been re-purposed or replaced. The same is true in Pittsburgh, Pennsylvania or Birmingham, England. But economists still inhabit the world of the 19th century, in which hordes of interchangeable workers in stark factories toil in the service of the owners of capital.

Wake up! We’re not in the 19th century any more. It’s time for economists to stop trying to look at today’s economy through 200-year old glasses. In particular, economists need to update their thinking to take into account the complex evolution of business strategy.

Mental-cultural factors: Business Strategy

John Perry Barlow, the founder of the Electronic Frontier Foundation who recently died, wrote an article in 1994 called The Economy of Ideas. He warned,

If our property can be infinitely reproduced and instantaneously distributed all over the planet without cost, without our knowledge, without its even leaving our possession, how can we protect it? How are we going to get paid for the work we do with our minds? And, if we can’t get paid, what will assure the continued creation and distribution of such work?

It used to be that creative works, such as this essay, were provided in a format that was rivalrous and excludable. If this essay were in a print magazine, then a copy of that magazine can be held either by you or by me, but not by both of us at the same time. We are rivals for the ability to own that copy of the magazine. We have to bid against each other for it, or each of us must buy our own copy.

The essay in the print magazine is also excludable. If you do not obtain a copy of the magazine, then you are excluded from reading the essay.

What John Perry Barlow recognized is that when essays and other idea-based commodities migrate to the Internet, they are no longer rivalrous or excludable. You can read this essay online without interfering with anyone else’s ability to read it. In contrast with a print magazine, in which the default state is excludability (you cannot read it without paying for it), on the Internet the default state is non-excludability. Letting you or anyone else read my essay is not costly for this web site. What is costly is setting up the capability to stop non-subscribers from accessing their content.

In terms of traditional economics, the offerings that are available via the Internet, because they are not rivalrous or excludable, are public goods. Yet for the most part they are being provided by private companies. To answer the question posed by John Perry Barlow — how are we going to get paid? — 21st-century firms have had to develop and implement various strategies, often along the lines suggested in response to Barlow by Carl Shapiro and Hal Varian in their book Information Rules.

Our outdated economic textbooks still treat business strategy as nothing more than deciding the mix of capital and labor along with the quantity of output. 21st-century economists should instead be aware of the way that the Internet has made business strategy much more complex and important. For example, John Van Reenen and colleagues have found that differences in management techniques account for large differences across firms and regions in their effectiveness.

Research Directions (1): Firm Interaction

What determines which activities are done inside a firm, under the direction of management, and which activities are handled externally to the firm, by the decentralized market? In business, this is known as the “make or buy decision.” In economics, it is know as the “boundaries of the firm question.”

The most promising theories of the boundaries of the firm stress intangible factors, such as information processing by management and the challenge of providing motivation and compensation in a setting where output is the joint product of teamwork. But because economists are more comfortable working with tangible, measurable goods, there has not been much effort devoted to applying these theories to the real world. In the 21st century, there is an opportunity to rectify this.

The entire business ecosystem is complex in ways that no economist imagined a hundred years ago. My essay on the value of economic classification systems pointed to examples of economists who have explored this complexity. We need more work like theirs, which involves staring at the real world instead of at a mathematical model.

Research Directions (2): Determinants of Economic Success

• Neoclassical economics says that factors of production are paid their marginal product. But mental-cultural factors and rapid evolution make “marginal product” unobservable.
• In short, neoclassical economics treats the creation of value as technologically determined by the characteristics of the factors of production. It sees the capture of value as proportional to the creation of value.
• In reality, value capture and value creation are much more contingent. Value creation depends on how business and engineering ideas are combined and on how competitive strategies are employed. Value capture depends on how various strategies interact with one another.
• Research by John Van Reenen and colleagues points to management skill as a major factor in differences in economic success across firms and across regions. As they point out, this raises the puzzle of why best practices are not adopted swiftly everywhere. The slow rate at which successful business models and management techniques diffuse represents a puzzle. Why do some firms consistently outperform others? Why do some regions consistently outperform others?

Research Directions (3): The Functions of Financial Intermediation

The 2008 financial crisis revealed major gaps in economists’ understanding of financial intermediation. Mainstream economists have a very simple, stylized model of banking that ignores most of the vast array of financial instruments and strategies that have developed over the past 50 years. They claim to be able to answer questions about financial regulation, such as how to set capital requirements for banks, without having a clear understanding of what financial intermediaries do to create value in the first place.

Mainstream economics is materialistically oriented. Economists view the firm as an entity that transforms tangible inputs into tangible outputs. Because they insist on focusing on what is tangible, their analysis of finance frequently degenerates into “irrelevance theorems” that supposedly prove that finance does not matter.

But banks and other financial intermediaries operate entirely in the realm of the intangible. They change the way that risk and duration are perceived. The risky, long-term assets in a bank’s portfolio are perceived as short-term and riskless by bank depositors.

All forms of business debt, whether issued by banks or by non-bank firms, serve to alter perceptions of investors. People are willing to hold debt instruments who would never be willing to delve into the risks of the underlying assets.

Because this effect on perceptions is intangible, economists have been reluctant to explore it. As a results, many obvious questions about financial intermediation have not been addressed. These include:

• Can we view perceptions of financial instruments as deterministic or are is there a random component?
• Are there multiple equilibria of self-fulfilling beliefs?
• How do the beliefs of different groups of investors become reconciled?
• Do beliefs change slowly, or do cascades sometimes occur?
• How does the capital structure of banks and other financial intermediaries matter?
• How does the structure of government guarantees matter?
• How is the emergence of new forms of financial intermediation affected by new technology, new developments in the nonfinancial sector, exploitation of government guarantees, attempts to get around regulation, and other factors?

Research Directions (4): Measuring Overall Economic Performance

• Measures of productivity trends are not reliable. The numerator, output, is less and less well approximated by GDP. Hard-to-value services are an increasing share of the economy. Un-priced information goods are increasingly important. And the value of increased variety is difficult to measure. The denominator, labor input, is becoming less meaningful as well. Workers are not manning an assembly line, governed by a time clock. Many are engaged in leisure in the workplace and engaged in work while at home. Worker are not interchangeable in terms of their skill level. Instead, they are highly specialized. Summing up the hours worked by this heterogeneous labor force to calculate “labor input” is a dubious exercise.
• We may need a variety of indicators of economic well-being. They might include subjective measures of occupational satisfaction and consumer satisfaction. They might include objective measures that currently do not receive much attention, such as workplace injury rates for people in the labor force or rates of chronic health problems among the elderly.

Over the last two hundred years, the economy has evolved to become more complex, with intangible factors playing a much bigger role than when most economic activity consisted of agriculture and manufacturing. If they would adapt their approach to modern reality, economists could better contribute to understanding today’s world.