MBA Education and Economic Theory

From Orgtheory, there is “an all-out Texas cage match between the hards and the softs in business schools. The question motivating the tussle (in a Harvard Business Review forum) is whether business schools have any responsibility for the current economic crisis.” Here in the How To Fix Business Schools:

In my experience, most economists at top business schools are clueless about the nitty-gritty of management, which can’t be captured in elegant mathematical models. They treat any teaching remotely related to what leaders actually do on their jobs as a low status activity; at faculty meetings, I’ve seen economists and their followers dismiss and ridicule professors who teach “soft” skills

vs

Bob Sutton (and Joel Podolny) are also much too negative about the effects of teaching the economic point of view. As Steve Kerr also points out, the world economy is strikingly better off today than it was 20 or 30 years ago. World GDP per capital has grown substantially and in virtually every region of the world. Life expectancy and education have also increased similarly. And poverty has declined. These will remain true even after the current recession ends…In other words, there is a strong argument that society, both in the U.S. and the rest of the world, has benefited greatly from businesses, capitalism, and MBAs.

What? “My course materials have caused global literacy to increase; if you let my opponents set the syllabus, world hunger will result.” I’m not sure if the end of that series will just be a fancy academic pissing contest, and as I’ve thought about this from time to time, how the core knowledge of economics influences business schools, and I’d like to add a few points.

Pluses

1) There’s little point to the education if students can’t walk away using the micro ideas and language of marginal costs, decreasing returns, etc. One course in micro is necessary, though should be able to be gotten out of with some economics background.

2) A class that approaches Industrial Organization using game theory is usually one of the best, both in interest and application, classes that a MBA student can take. With returns to scale, globalized corporations, and brutal competition at the margins, the idea that markets consists of firms and workers simply taking prices as is, without any ability to effect them, is not relevant for what people do. Especially when one of the future questions of business is how to compete and thrive in a world of no marginal costs – the world of the perfect digital copy – this material will only grow in importance. However that basic model is necessary to understand the deviations from it, and why that is important.

I’m happy to see sociologists or non-economists teach this class. The formalism is distracting; speaking as someone who has gone through graduate game theory (Rubinstein/Osborne) in a math department, and read the MBA staple “Thinking Strategically” by Dixit/Nalebuff (both economists, but the book is targeted for business people), I found the second about 100 times more useful for applying the concepts.

Minuses

1) A lot of the complaint is centered around the idea that the problem with economics is that it assumes everyone is greedy. I think the real problem with economics is that it assumes that the most fulfilled person in the world is one who is alone in a bathtub strung out on heroin. The entrepreneurial spirit of capitalism is lost in economics. One day about 70 years ago someone couldn’t figure out a way to take the derivative of the Creative Destruction function, and that part about capitalism is lost to the modeling. Which is unfortunate, because what we really want from our business leaders is that entrepreneurial spirit – the drive to create new useful things while expanding knowledge, not how to minimize costs by chunking benefits overboard or whatever other alchemy comes out of the optimization mindset. To the extent that knowledge can be sharpened and tested in an MBA setting, it won’t happen through economics.

2) Economics doesn’t have anything interesting to say about two staples of an MBA education – marketing and accountancy. Why should you advertise? To signal quality by burning money? To create demand? What advertising even does, much less how to do it well, isn’t answered very well in economics, and economics isn’t the place to look for answers. Accountancy, as we are learning, is one of the key skill sets for the 21st century economy, and it doesn’t even exist in Micro or Macroeconomics. (I tend to believe that double-entry accounting is one of the better inventions of modernity, up there with the printing press.) Economics, which assumes that consumers wander around calculating their entire lifetime’s income in their head (talk about having a good accountant!), waves away the very concept.

3) Finance. They just wrote a post about MBA students being owned by their models. The general idea underneath this is that these models are too complicated to understand, and taught to be something that is true rather than something that approximates a lot of contingent data.

There’s a joke that goes around quant message boards. An MBA class at a highly ranked school has their esteemed teacher solve the Black-Scholes PDE, and they get the final answer:

at which point someone raises their hand and goes “can’t we cancel out the d’s?” Ha, right? “No, thats the symbol of the derivative, not a variable. Moving on….”

Now think about that for a second. What should we expect the student to walk away with in this situation? There’s too much emphasis on solving models rather than seeing models used. Often the final answer on the test is “write out the CAPM equation” rather than “discuss how you would use the CAPM in your work day.” Not the normal “list the X assumptions this model makes”, but actually thinking through the deployment in the field. I think shifting the focus from models as a kind of deep economic truth to just another tool you use in your day-to-day, like excel, would be very useful.

I could continue, and talk about how Economists, when pressed for specifics on how their models apply to the real world, do the half-dodge Friedman “Positive Economics” thing, and that their real obligations are to Theory not the mucky-muck of day-to-day business. In “A Camera, Not an Engine”, Modigliani is quoted as having said, after explaining his MM theorem to a classroom (a theorem which won a Nobel Prize, one of the few for business), “I don’t believe this is true.” Think about that. A theorem many people credit for causing a giant leap in leverage among corporations, and lead to many “why don’t businesses carry more debt?” hand-wringing, the professor can’t get behind. Going forward, I’d prefer to see more of the mucky-muck parts being taught.

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7 Responses to MBA Education and Economic Theory

  1. financeguy says:

    I think there may be an interesting meta-question that’s being ignored — if it’s not, pardon my ignorance, and just shove this comment under the carpet (I have no game theory classes, only a meager Harvard Ec 10 course :)). But here’s what I wonder: is there any model that attempts to integrate the models (or if not a model, does anyone who models ask themselves how might the prevailing models interact with each other to produce unintended cascading effects?) What’s partly interesting in this meltdown is that it’s made clear how these seven sigma (or whatever) events aren’t that at all, because there are huge pile-on effects. In essence, everyone runs for the exits simultaneously, and the more program trading (and more aligned thinking you have, because everyone’s learning the same theory, or the same strategies become known quickly and spread) the quicker and more disastrously that stampede occurs. (I feel like I’m on the brink of a Taleb thought here …) I mean look at CDS. In theory they sound great (and Felix Salmon will surely defend them till they heap dirt on his grave :)), but in actuality they suck hard on the liquidity hose when everything else is too … I’m kinda with Buffett about being wary of geeks bearing formulas, because I think the originator of these models often understands them well and their limitations, and then the kids run off and play with the dynamite. Hmm.

  2. Mike says:

    Great comment! This is all about the meta-questions, because those are the first assumption we need to figure out for ourselves, and for MBAs – the future of our executive class.

    For me the first approximate question is how well traditional economics can handle this. Andrew Lo is working overtime trying to figure out liquidity risks (which is ignored in most models, Black-Scholes-Merton, with its dynamic hedging, most among them), as well as the risks from everyone use the same model at once – which is your, correctly, big concern (as per Lo’s great work with hedge funds blowing up when they all do the same pairs trades). Probably next week, I’m going to talk a little bit more on sociological finance; I think they can perhaps bridge the gaps between models and firms that we need. Or at least they can try better than most that are currently cranking.

  3. financeguy says:

    Thanks for the reply, Mike. Interesting stuff, and I’ll definitely check back for your entry next week. You’ve got a much better understanding of this than I do and I’ll be eager to see what you have to say about the sociology angle. That sounds intriguing. One note about liquidity — I also flit into and out of the Michael Pettis blog on China finance (as that’s really my specialty) and he sees the financial system largely through a liquidity prism with Minskyite glass. In other words, he sees the forest when we’re arguing about the trees (regulatory lapses, Wall Street financial engineering, what Summers said when). Anyway this is a bit of a ramble — my point is I’d be curious how Lo is trying to deal with liquidity. It seems slippery (oops), especially in a modern derivative-heavy world and a shadow banking system. How do you measure? Pettis said he’d tried to figure that out working with a colleague, but I got the sense that they hadn’t got far. Here’s the point: if we agree that too much liquidity for too long is bad (and that seems safe to assert yes?), we need to both (1) be able to measure liquidity broadly and reliably and (2) be able to identify at a given point in time (with given economic conditions) what the appropriate level (or range) for liquidity is. Not sure to what degree Lo’s work touches on this (I’ve probably just attacked it more from a regulatory angle), but it sounds fascinating anyway… I look forward to reading more, cheers.

  4. Jacob says:

    This is a bit off-topic, but financeguy uses a terminology I’m on a quixotic quest to eliminate (mostly through anonymous comments on econ blogs, but alas Yves Smith won’t allow that any more).

    I would like to see an end to the use of the phrase “n-sigma” to describe extremely unlikely events. It suffers from the same ignorance of kurtosis that is to blame for a lot of the mess in finance. The thing is that while a 7-sigma, or 16-sigma, or “25-sigma 7 days in a row” (David Viniar, GS CFO) event would be ridiculously unlikely from a normal distribution, when you consider other possible distributions it’s really not all that unusual at all. So it’s not that a 7-sigma event “wasn’t that at all,” it’s that the underlying distribution had excess kurtosis.

    Specifically, we can use Chebyshev’s inequality to express the maximum probability of such an event occuring, P[|X-mu| >= k*sigma] <= 1/k^2. That is, there’s at most a 1 in 49 or roughly 2% chance of a 7-sigma event happening. Could be much less, of course, but it’s not such a meaningful statement by itself without a distribution being specified.

  5. Pat says:

    I think the MM point is a little unfair. The assumptions are made very clear and it’s very obvious that if financing does matter it’s because those assumptions are violated.

  6. Mike says:

    Pat,

    I love MM! I wanted to get a bit into how the general idea of “Positive Economics” and how it is meant to convey that Economists first job is to Economics, not to the regular real-world. Mankiw invoked it with proposing a gas tax to fight The Great Recession, and Miller invoked it to defend MM. I should have either developed it more or left it off. That’s fine with esoteric stuff, but with MBAs and finance they are fashioning the business minds that are about to enter the world, and as such there is going to be a line where the analysis goes from a model to “this is how it SHOULD be.”

    That said, in weak hands the theorem is Leverage Doesn’t Matter. I think it’s been used to provide for a lot of debt taking, and to this day we get a lot of “why don’t companies take on more debt?” assumptions in the corporate finance literature. Separately, the assumption that “bankruptcy and financial distress costs” hedge taking on too much debt – well, how much does that costs? How much should you hedge for the business cycle? Etc. The assumption can get quite complicated quickly – and the assumptions are where all the drama is.

  7. Pingback: Will Dearman Lifestream » Daily Digest for April 17th, 2009

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