Business school, on a field trip.

Economics for Masters of the Universe

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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This year my university has me teaching managerial economics to MBA students. Managerial economics applies economic theory to problems that a business manager would be likely to face -- such as how much to produce and what kind of pricing strategy to use. Econ class does some good and useful things, such as forcing MBAs to write down ideas in terms of equations and quantities instead of thinking about them in fuzzy, indistinct terms. It also teaches them a bit about statistics, which is an underemphasized area of education. And many of the concepts -- downward-sloping demand curves, for instance -- really will be useful in their future careers as managers.

But I find myself thinking that a lot of the things MBAs learn in economics class are not of much practical use, and might even be harmful.

For example, take game theory. Game theory is fun and interesting, and provides students with a mental workout, which is all to the good. But as a tool for making real decisions in the business world, it is deeply flawed. Game theory, as taught in economics class, relies on the idea that all the participants in a competitive situation are completely rational. The theory predicts that interactions between participants will reach a Nash equilibrium, in which each person is responding optimally to everyone else. But if you're up against an irrational opponent -- or even a rational opponent who thinks you're irrational -- it wouldn't make sense to assume that a Nash equilibrium would be the result.

For example, suppose you're playing a market-entry game. You're deciding whether to build a hospital in a town where there's already a hospital. If you go ahead and build your hospital, it would then make sense for your rival to simply share the local consumer base with you. Or your rival could launch an expensive campaign to drive you out of business -- say, putting out ads that claimed your hospital had bad safety procedures -- but the cost of this war would be so great that it would be a Pyrrhic victory for your rival.

In this type of situation, if your rival threatens you -- "If you build a hospital, I'll drive you out of business, even if it dang near ruins me in the process!" -- you can safely ignore this threat. Just call his bluff. Once you've actually built the hospital, he won't be foolish enough to follow through on the threat of mutual destruction.

That is, if he's rational. But what if he's a little crazy? Then he might not be bluffing. He might kill himself just to take you down with him.

This is probably the reason why national leaders often try to act a little crazy. If Vladimir Putin acts like he's nuts enough to be willing to start a nuclear war over a limited conflict, then the U.S. will shy away from starting a limited conflict (which it would win), out of fear of massive inappropriate escalation. Maybe this is also why Ronald Reagan joked about bombing Russia back in 1984.

The logic of game theory says that no one would be crazy enough to start a nuclear war. But following that logic means betting everything on the assumption that you're not playing against a nutcase. The same is true in business -- if you always assume common knowledge of complete rationality, as your economics class told you, you might be setting yourself up for failure.

In other situations, economic analysis isn't dangerous, but it might just be useless. For example, MBAs are expected to learn how taxes affect markets. That is certainly an extremely important thing for managers to know. But part of the canon of economics is the idea of deadweight loss -- the idea that taxes cause a net loss of efficiency for society as a whole. This idea is certainly useful for policy makers, who actually set taxes. But is it useful for managers, who merely respond to taxes? No! And yet, economics textbooks always spend lots of time on calculating deadweight losses.

There are other examples, but the pattern should be clear. The discipline of economics has produced a number of smart insights and sometimes-useful models. But these aren't necessarily useful to everyone. Econ seems more interested in showing off its toolkit than in figuring out what tools to offer to which people. It offers up a bunch of hammers, and leaves it to the hapless students to decide if and when their problems qualify as nails.

I think the economics profession could use a little more connection with the real world, at least when it comes to teaching. Economists don't need to prove their intelligence to MBA students by showing off fancy models -- save that stuff for research seminars. In the classroom, they should come down off of the mountain and focus on practical application. In the long term, that, more than any cool model, will increase the amount of respect that non-economists have for economists.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net