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

Cost Analysis

With respect to cost reduction, several participants mentioned their company's on-going concern with reducing costs, and three noted the contribution of outsourcing (or the reduction of worker benefits) to cost reduction. However, with a single exception, it did not appear that the economists themselves were actively engaged in establishing enterprise criteria for reducing costs.

RECOMMENDATION 6. Business economists should become more active in developing criteria for cost reduction and on-going productivity improvement.

Risk Management

The other of the initial questions to which few responses were received was that concerning risk management. Half of those interviewed indicated that their enterprise achieved a measure of risk management through product or geographic diversification, and economists in several less diversified companies mentioned the role of the finance department in dealing with international currency hedging. However, none of the twelve economists seemed to be involved in their company's analyses dealing with risk management. The economists seemed to conclude that those determining corporate policy were behaving as if they were following economic principles and acting quite reasonably in this sphere.

RECOMMENDATION 7. Even in companies with small economics units, someone from those units should participate in the development of criteria for corporate risk management.

The Use of Rules of Thumb and Other Heuristics

While several economists emphasized their efforts to get enterprise decision makers to use more analytic approaches in dealing with decisions, it was acknowledged that mental short cuts--routines and heuristics--often were used in the firm. This was true not only in decision-making regarding the company's competitive moves, but also in their hiring policies, in forecasting, and even in assessing productivity. Respondents acknowledged that their own analyses also combined rules of thumb with the more precise calculations of optimization techniques. They observed that they were obliged to do so by considerations of time, inadequate data, and cost, as well as by the need for alternative frameworks in "turning point" situations. In one case, the economist was obliged to come up with an analysis of a truly complex situation in less than an hour. One reflected that the advice he offered sometimes was at variance with economic theory, or at least that the imperfectly competitive situation his firm faced was not dealt with adequately by available economic models of which he was aware. On the other hand, one economist/financial analyst maintained that he had prepared investment frameworks that catered to the low risk or higher risk tolerance of his clients; and he believed that the models he and his colleagues prepared came close to optimizing, given the respective risk preferences. Note, though, that some of what respondents initially characterized as standard economic analysis, was revealed to employ elements of judgment that were important in determining the outcome. A case in point: one firm's long-term estimate of GDP included an estimate for the annual change in total factor productivity, and that critical determinant was estimated by adjusting from the productivity increase registered in an earlier time period that was judged to be a reasonable proxy for the next five-to-ten years.