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| Why Most Things Fail Summary |
The Fact of Failure
Most businesses fail. Even large, successful, monopolistic corporations are not secure. Pioneering economist Alfred Marshall thought early in his career that, like trees, massive corporations would eventually die. Later, he changed his mind, writing around 1910 that such companies “often stagnate, but do not readily die.” He was right the first time. Most of 1910’s big companies no longer exist. They failed. Yet economists have nearly ignored this fact of business life. Instead, they treat failure like the exception to the rule. Conventional economics depends on equilibrium, a precise balance of supply and demand. Equilibrium is static. However, the people and circumstances in a social system, and an economic system, are not static. They are in perpetual motion and change. Thus, the kind of data about demand, cost, pricing and competitive response a traditional economist might use to plot a strategy are often inadequate. Conventional economic analysis offers simplistic approaches to the complex matter of managing a business. Failure is not unique to business. It exists in many dimensions. For example, government policies devised to reduce social inequality have not achieved their goals. In the Western world, social inequality has grown, not decreased, over the past several decades. Social mobility has declined. Global wealth is more equally distributed among countries, but inequality within countries is often stark. Additional data or laws cannot change this fact.Small Causes, Big Effects
Economic systems are almost random. An economic phenomenon, such as GDP, is a result of millions of small decisions combined. It is impossible to know how any individual decision might affect the big picture. People - and scientists are no exception - seem to prefer to imagine that big effects must result from big causes. However, this is not true. Consider segregated neighborhoods. Friedrich Engels, Marx’s collaborator, described the sharp class segregation in Manchester, England, in 1844. Little changed over time. Despite 150 years of social reform, class segregation in Manchester was almost as severe in 2004 as in 1844. In the U.S., segregation is based more on race than class. Despite laws, court rulings, affirmative action, the civil rights movement and government programs, segregation persists. One more or less conventional school of economic thought postulates that segregation is the result of people making rational analyses of their own best interests and deciding they prefer to live in segregated neighborhoods. But, people don’t need a strong desire to live among their own kind, or to avoid the other, for neighborhoods to be segregated. Even a very mild preference for living among people of the same class or race can result in very segregated neighborhoods. Even if people only decided to move when they became the minority in a neighborhood, the collective result could be homogenous neighborhoods separated by class or race. No one has to want to live on a segregated street or intensely dislike another kind of person for this to happen. A small preference can lead to an outcome that seems to mirror the result of massive racial or class-based hostility.
What’s in a Game?
Economics has a lot of uncertainty, yet Marshall outlined a theory that more or less ignored uncertainty. His graphs of supply and demand interaction seemed to leave no room for the indeterminate or the uncertain. Yet, any auction demonstrates that Marshall ignored a key fact of market life, and provides an interesting insight into uncertainty and indeterminacy. Game theory seems to shed some light on such situations because it offers a methodology for analyzing strategies and payoffs. The famous “prisoner’s dilemma” game describes two prisoners facing a choice. If neither one confesses or accuses the other, both will go free. If both confess and accuse each other, both will have a moderate sentence. If one confesses and accuses the other, the confessor will go free, but the accused will get a long jail term. Mathematically, confession is the best individual option for either prisoner, but the best collective option is to remain silent. For the group, cooperating and saying nothing is the best chance for freedom, yet for the individual, confession and accusation is the guaranteed way to get released. This dilemma gets more interesting when rounds are repeated. John Nash, the 1994 Nobel economics laureate depicted in the film A Beautiful Mind, devised the “Nash equilibrium.” It presents a rational, static situation in which neither player has any reason to change his or her approach. In tic-tac-toe, arriving at Nash equilibrium is easy. In poker, it’s harder. Also, although the Nash equilibrium in any game is eminently rational, even some very rational players refuse to take the most rational strategy. Merrill Flood, an inventor of game theory, gave up the field when he realized that people don’t do what they “rationally” should. In one experiment, he offered a secretary a choice between getting, let’s say, $10, immediately or $15 if she could agree with another secretary on dividing the prize. Rationally, the first secretary should accept the $10 or to split the remaining $5 with the second secretary. Rationally, it would make sense for the second secretary to accept any amount, even a penny, because she would be better off. The secretaries, however, did not behave rationally. Unfamiliar with economic logic, they persistently divided the cash irrationally but “fairly,” at $7.50 apiece. Flood arranged a prisoner’s dilemma contest between an eminent mathematician and a renowned economist. They played 100 rounds. Although betrayal was the Nash equilibrium strategy, they chose instead to cooperate. When Nash was informed, he said, “It is really striking how inefficient the players were in obtaining rewards. One would have thought them more rational.” Notwithstanding its rationality and theoretical strength, game theory has very evident limitations in real-world applications. However, companies and government policies operate in the real world, which is not a place of pristine theoretical conditions. It is messy and unpredictable. Great art and literature are meaningful because they reflect the real circumstances of human life. Macbeth kills the king because he expects certain outcomes. At first, his theory - so to speak - seems sound, but other people have unexpected reactions and interfere, causing results Macbeth never imagined. Logic and reason do not equip us to predict how people will act or react. Surprises happen even in games that people have played for thousands of years. Few games have been more exhaustively studied than chess, yet discerning the “best” move at any point in the game is nearly impossible. Even the great chess masters do not insist on finding the best move. They make moves that, overall, seem reasonable and unlikely to cause big losses. Businesses operate in an environment even less subject to analysis and understanding than the game of chess. Microsoft seems to have established its computer market dominance through a combination of almost supernatural sagacity and ruthlessness. Yet in his book, Barbarians Led by Bill Gates, lead graphics developer Marlin Eller emphasizes accidents, serendipity and spontaneous, almost reflexive reactions to threats and opportunities. As recently as the late 1980s, even Bill Gates thought Windows had no future and that OS/2 would become the standard operating system. The fact is, even reasonable, well-informed economic models have little relevance to businesses. They rarely allow for the uncertain, unexpected, incomplete or unclear. In fact, evolutionary biology offers insights into the phenomenon of failure, insights that may prove instructive for business management and government policy.
Extinction and Economics
Some economists borrow badly from biology when they infer that evolution is a matter of survival of the fittest. It is not. The relationships among species are so complex that absolute fitness doesn’t exist. Fitness is relative to a particular moment, a certain alignment of all relationships. Evolution is random; it is not an orderly process leading to the emergence of the most fit. Species emerge and go extinct as a result of unpredictable, uncertain events and connections too complex to analyze or describe in detail. Many minute subtle connections link species. Predator and prey, for example, may seem antagonistic. Yet they cannot survive without each other. When lynx are scarce, rabbits multiply beyond the land’s carrying capacity. With prey abundant, the lynx multiply so fruitfully that they severely reduce the rabbit population. Then, the lynx population lacks enough food to sustain itself, and falls in turn. The cycle repeats and repeats, with predator and prey mutually dependent, mutually interacting. Change is constant, but on the whole, balance is maintained. Evolutionary biologists have tracked extinction events over the past 600 million years or so. Of course, the data on such events is much less comprehensive and agreed upon than the data on economic history. However, even in the nineteenth century, scientists identified five massive extinction events. Biologists used them to mark the evolutionary calendar. Some suggest that extinction events are numerous and rather regular, occurring roughly every 26 million years. Clearly, extinction seems to obey a power law, that is, a law that is magnified by some power - squared, cubed, to the tenth power or the like. Small extinction events - when a lower proportion of species become extinct - happen more often than relatively infrequent large events. The question that is most germane to economics is: Why do they happen? Some external events, such as meteor showers, may account for some extinctions, but the connections among species are so tight and complex that a small change can have massive effects throughout the system of life. To relate this to economic life, consider the 1987 stock market crash, which was so severe that it cut a third of the value of the Dow Jones average in a week. Yet, no apparent cause drove it - no important data, no catastrophic event, no big news. It just happened. Economic historians still wonder why. About 10 years later, the collapse of a single hedge fund, Long-Term Capital Management, almost caused the collapse of the entire world financial system. Causes seem out of proportion to effects, which is what happens with power laws. Extinction is common in business. About a tenth of U.S. firms go extinct annually. Yet, some years see almost no extinctions and, in other years, more than half of U.S. firms go extinct. Firms can become extinct without a massive external shock, such as war. Extinction and failures seem to be built into the system. Of course, economic failure can result from external shocks, but it doesn’t have to. The relationships among people, institutions, government policies, weather, companies and other factors are so complex and subtle that they are impossible to enumerate. A small change plus a power law can result in massive failure. Failure is not necessarily the result of a company making a bad decision. Indeed, companies can make remarkably good decisions and fail. They may get more and more “fit” and yet fail.
Government Beware
This has major implications for government economic system regulations. Often guided by conventional economic theory, government regulators propose to set rules and penalties for various business circumstances and events. For example, antitrust regulators seek to prevent the emergence of monopolies and to encourage competition. This is probably misguided. The histories of evolution and of economics indicate that the occasional remarkably successful species or enterprise characterizes evolution. However, just as dinosaurs went extinct, so also do remarkably successful enterprises. The fact that so many big, good companies fail ought to tell regulators that even an apparently impregnable monopoly is, in fact, vulnerable. Therefore, hobbling a giant to encourage the multiplication of gnomes might not be prudent. Government regulation postulates logic and order. It depends upon a level of understanding that is almost completely illusory. Economics is random, so it can’t be governed. Regulators who aim to encourage internal competition in a system may reduce the system’s overall health. The failure of the U.S.S.R.’s experiment in central planning demonstrated that the state should intervene as little as possible in economic life. Reality is far too complicated for society’s regulations. Indeed, great regulatory experiments, like promoting social mobility and reducing social inequality, have failed. Given so much uncertainty, and probable failure, governments should encourage innovation and experimentation by stepping back.
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