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How Modern Economics Is Built On 'The World's Dumbest Idea'

Posted on 06-Sep-2013
Topics: Economic Debates  

From Forbes:

I reported earlier this month that the Financial Times published a pair of important articles asking why the goal of a firm is to maximize short-term shareholder value is still being taught in business schools.

“While there is growing consensus that focusing on short-term shareholder value is not only bad for society but also leads to poor business results, much MBA teaching remains shaped by the shareholder primacy model.”

The challenge is massive because shareholder value is now deeply embedded in the basic economics that is taught in business schools and economics faculties around the world. Moving on from the shareholder value theory, which even its foremost exemplar, Jack Welch, has called “the dumbest idea in the world”, will entail re-thinking and re-writing much of the basics of modern economics.

Two prime textbooks on managerial economics

To understand the depth of the problem, let’s look at a couple of the best-selling textbooks on managerial economics. One is Managerial Economics and Business Strategy, by Professor Michael Baye, the Bert Elwert Professor of Business Economics in the Kelley School of Business at Indiana University and Jeffrey T. Prince, Associate Professor of Business Economics & Public Policy also at the Kelley School of Business.

The other is Managerial Economics, by William Samuelson, Professor of Economics and Finance at Boston University School of Management and Stephen G. Marks, Associate Professor of Law, Boston University.

Their learning doesn’t come cheap. The latest edition of the Baye/Prince book (8th edition in 2013) will set you back $173.99 on Amazon. The latest edition of the Samuelson/Marks book (7th edition in 2012) is cheaper–a mere $161.12. Fortunately for the authors, sales of their books are not determined by the kind of free markets that they advocate in their books, which are required reading in myriad college courses around the world.

One might have expected that books at such prices would come with the very latest in cutting-edge thinking. Sadly, both books are, like most mainstream economics textbooks when you look at them closely, imbued with, and indeed built on, the obsolete shareholder value theory and the idea that the whole job of the manager is to maximize profit for the company and its shareholders.

How managerial economics is built on shareholder value

Let’s start with the best-selling book from the distinguished professors, Baye and Prince. Here, we learn at the outset that the very foundation of managerial economics is, guess what: maximizing shareholder value. As the book amiably confesses at the outset, “much of this book assumes the manager’s task is to maximize the profits of the firm that employs the manager.”

“Assumes”?

The goal of maximizing profits is thus apparently not something to be justified or proved or demonstrated or even supported by any evidence as the appropriate goal. It is simply assumed to be a truth of the universe. That’s the way the world is. QED. Moreover, the underlying principles that follow from the assumption are said to be “valid for virtually any decision process.” (p. 3) According to the authors, “if you learn a few basic principles from managerial economics you will be poised to drive the inept managers out of their jobs!” (p.2)

Astonishingly, almost everything in the following 550 pages flows from this basic assumption. Almost all of the complex examples and problems, the dazzling mathematics, the esoteric charts and the apparently precise analyses, which millions of economics students and managers have been forced for decades to master, rest on this flawed assumption. The “right answer” to almost every problem is to apply “the dumbest idea in the world.”

...

It is evident from what follows that one doesn’t need to worry too much about the long-term because of another convenient, but equally dubious, assumption that pops out of nowhere, without justification or proof or argument in its support: increasing short-term profits will increase long-term value. Thus, the goal of maximizing the value “often is achieved by trying to hit intermediate targets, such as minimizing costs, improving the production process, decreasing the time it takes to make decisions, and improving product quality.” (p.7)

...

Sources:

[1] "How Modern Economics Is Built On 'The World's Dumbest Idea'", Steve Denning, Forbes, 22-July-2013

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