The economic analysis underlying corporate decision making: what economists do when confronted with business realities—and how they might improve

Business Economics, July, 2004 by Hugh Schwartz

The number of economists employed by industrial corporations appears to have declined sharply since 1990, an incentive for those remaining to redouble efforts to contribute to the profitability of their enterprises and hold onto their positions. This report is based on in-depth interviews with a dozen economists over the course of a year and is aimed at understanding the reasoning processes that underlie their analyses and advice. It considers the extent to which the analyses of economists in industrial, construction, and financial enterprises are based on optimizing techniques. It also considers, where analyses are based on less formal heuristics and other rules of thumb, the degree to which those rules are clearly specified and--if necessary--adjusted so as to contribute to rational and cost-efficient decision making. Suggestions are offered to improve economic analysis undertaken in business firms, with particular attention to the use of rules of thumb.

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The number of economists employed by the corporations whose economists were interviewed for this study declined precipitously in the 1990s, particularly in manufacturing and construction, and has increased relatively little since then. However, only a small portion of in-house economic analysis has been taken over by outside economic consultants. This paper is based on periodic interviews with a dozen corporate economists from October 2002 through November 2003. (1) It is the first study that employs multiple-session, in-depth interviews with profit-oriented enterprises in an effort to detect the extent and circumstances of application of formal economic theory and the extent to which the reasoning is based on heuristics (mental shortcuts such as "rules of thumb"). (2) It notes the conditions under which the use of heuristics may be quite consistent with a rational process of decision making. One objective of the study is to present findings that can be tested in experimental economics laboratories and by other empirical analyses that use data from actual business transactions. The principal objective, however, is to contribute to the analysis of economic factors undertaken in business enterprises both directly and indirectly.

Design and Conduct of the Study

All but two of those interviewed belong to the National Association for Business Economics (NABE). None characterized themselves as behavioral economists, but all revealed practices that have been identified primarily with that group. In particular, when they generalize, most endorse the traditional position on economic rationality and efficient markets but all employ heuristics for some links in the chain of their reasoning. With one exception, they believe that their analyses contribute to corporate goals of higher profits. Indeed, given that the decline in the number of economists in the enterprises represented in this study declined by more than 60 percent since 1990 (and the downgrading of the rank and relative pay of several of the lead economist positions), there is considerable incentive for them to attempt to help increase enterprise profits.

Recent exposures of accounting irregularities have underscored the differences between economic and accounting concepts. The latter, long an impediment to sound economic analysis, is one of the reasons why business economists seek proxies for certain readily available financial data and helps explain why many companies make decisions on basis of data that differ from FASB accounting standards. What these economists have been doing is very much in line with the position that the use of heuristics in decision making can be a rational manner of proceeding, even though not optimal (Gigerenzer and Selten, 2002). Note that the emphasis is on the process of decision making--what Herbert Simon referred to as procedural rather than substantive rationality, the latter being what traditional neoclassical economics assumes will prevail in the marketplace. (See Simon, 1982, particularly Chapters 8.3 and 8.4.)

Interviews were undertaken approximately once every four weeks. Half of the respondents were Ph.D.s in economics and most of the rest had MA degrees in economics or MBA degrees emphasizing economics or finance. All had worked for Fortune 1000 companies. Eight were currently employed with the enterprises in question and one, recently retired from a major enterprise, was employed as a consultant in the same industry. Another, also a consultant, worked many years for a leading corporation. One respondent served as an economist and financial analyst in a development bank and then as the supervisor of portfolio managers for several leading private banks. Yet another worked for many years with a consulting firm, advising many leading institutions, most of which were financial. Much of the information obtained is confidential.

At the outset, I sought to focus on four areas--the analysis underlying decisions about cost reduction, quantity of output (and pricing, if possible), investment, and risk management. I broke with this approach for two reasons. To begin with, those interviewed differed in the degree to which they dealt with these topics and the importance they assigned to them. For example, while several respondents spoke of the criteria for cost reduction in their enterprises, one assured me that it required extreme pressure to give much attention to that. Another maintained that cost reduction could not contribute much to competitiveness in his industry and added that those who focused on costs did not rise to prominent positions in the company. In addition, individual respondents were not uniformly informative on the same subjects. This led to interviews that were broader in orientation than I had planned, though, from the outset, the intent was to have particularly open-ended sessions in order to try to capture the nature of reasoning processes wherever respondents were willing to reveal it.