The changing nature of business (pt 2): Economics remodelled
Oct 9, 2012 4:20:00 AM
Economic models use a sequence of assumptions and simplifications to describe how the world works - or more specifically to explain human behaviour. Recently, economic models have received a bashing for their inability to accurately offer clarity around major global economic events. Putting another nail into modern economics seems a slightly vindictive task, as there are so many nails in there already it is hard to know where to put another .. But I'm going to have a go anyway.
A major reason that many macro-economic models fail is that they are too detached from today's 'real' business world (see John Kay's essay on the state of economics). And so it is true with respect to micro-economic models, which heavily rely on labor and capital as being the key resources for any business. Up to a point this is, in absolute macro terms, true - there is only so much labor and capital inside a business or an economy. However, these models are an overhang from times gone by when businesses generally manufactured things themselves. That's changed.
Our recent research found that the growth of global trade and explosion of specialization has resulted in the externalization of the cost base. Today's average large corporate spends two thirds of their revenues on non-labor items (such as third-party suppliers). In contrast, labor costs account for only 12% of annual revenues. And this trend is increasing.
Whilst it starts to make the mathematics more complex, introducing a third key variable - the supply base, would be a better way of modelling the decision-making choices open to businesses. It certainly puts some boundaries on the costs of labor and capital, and their inter-changeability. It also opens up a broader discussion about the nature of a firm and how to manage it.
Today's business leaders choose how to deploy people, capital and their suppliers, redefining the boundary of the business. Economics needs to catch up.