Possible Insight

As I’ve written before, I am not entirely satisified with how microeconomic theory characterizes firms. So I’m going to take another tilt at the windmill and try to develop a model more suited to answering the questions I find puzzling. Note, the body of posts in this series will appear below the fold. They are as much for my own benefit as readers’, so probably interesting to a limited audience. And to any professional economists who may read this series, please be gentle. I realize it’s a rather presumptuous undertaking. But I’m more trying to work through my own thoughts rather than attempting to advance the field.

While my Production Function Space (PFS) hypothesis produced a few decent insights (see here, here, and here), it had some major flaws. First, it completely ignores the demand side of the equation, i.e., how what consumers might want affects what firms try to produce. Second, it doesn’t incorporate uncertainty to the degree I feel it should. Third, it doesn’t really tell me much about the particular kinds of products different firms will chose to make and the types of people they will choose to hire.

But that’s okay; I almost never succeed on the first attempt at anything. Developing PFS and realizing its weaknesses pointed me in a hopefully better direction.

Motivation

Before introducing the upgraded approach in the next post, I’d like to discuss my motivation. As far as I know, the traditional microeconomic treatment of firms is primarily concerned with three questions (other than why they exist at all):

1. How do they price their products under different competition regimes?
2. When do they vertically or horizontally integrate?
3. What kinds of contracting and incentive arrangements should they use?

These are all important question. And, of course, there is some work in many other areas. But I haven’t been able to find much that tackles the big questions that the CEO of a major firm would probably have.

Scenario

In thinking about what I’d want from a “grand unifying theory of the firm”, here’s the hypothetical scenario I envision… I’m in a hotel bar on a business trip circa Summer of 2013.  I realize that that Steve Ballmer, John Chambers, Marissa Mayer, and Meg Whitman are sitting together at the table behind me. I can’t help eavesdropping and hear them commiserating on the challenges of restoring their respective companies to their former glory. They notice my interest and, due to having put back a few, invite me over.

After needlessly introducing themselves, they ask me, “So what’s your story?” I give them the short version. Steve cuts to the chase, “So mister evidence-based model man, what should we do?” Marissa expands, “Yes, surely in analyzing all these innovative companies, you’ve developed some hypotheses that would illuminate our paths?” “But no generic BS about competitive advantage,” grumbles John. Meg chimes in with, “And none of the standard spiel about pricing, outsourcing, or compensation.”

Now, I don’t expect to just sit down, type in some data to my iPad and spit out a detailed course of action for Microsoft, Cisco, Yahoo, and HP. But it sure would be nice to give these CEOs (a) some framework for thinking systematically about their problems, (b) models within the framework that capture their key strategic questions, and (c) equations from the models whose parameters one could at least conceivably estimate.

Goals

Given this setup, here are some examples of the types of questions I think my model should be able to address:

• How can we formally characterize the tradeoffs in devoting R&D to line extensions versus completely new businesses?
• Can we identify groups within the firm that should assume more or less risk?
• What’s the best way to analyze the strategic value of a potential acquisition?
• How can we formally characterize the value-add of marketing and sales departments?
• If a company’s businesses experiences a downturn, what factors determine when to begin layoffs and whom to let go?

In future posts, I’ll present the model and how I think it could answer questions like these. For reference, here are the currently released posts in the series:

“Market Space” Approach to the Firm

“Market Space” as a Multi-Armed Bandit Problem

Hill Climbing in “Feature Subspace”

Startups in “Market Space”