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Why companies fail: Don’t look to economic textbooks to master dynamic capitalism

Why companies fail: Don’t look to economic textbooks to master dynamic capitalism

Is setting up a micro brewery a licence to print money? This month, a private equity company acquired 22 per cent of BrewDog for just over £200 million, netting a neat £100 million for the founders. Last year, the owners of Budweiser, AB InBev, bought Camden Town Brewery for a reported £85 million. This follows the sale of Meantime Brewery in 2015 to the global giant SAB Miller for an undisclosed amount.

There has been an explosion in the number of craft beer start ups. The number of micro breweries in the UK has grown from 1026 to around 1700.

But far from replicating the BrewDogs of this world, most of these will fail.

The same thing happens in every innovative market where new products are developed. Between 1900 and 1920 there were almost 2000 firms involved in automobile production in the US. Over 99 per cent of them disappeared. Before the First World War, the European film industry operated on a global scale, supplying half the American market. By 1920, European films had virtually disappeared from the US and had become marginal in Europe itself. Hollywood had taken over.

Being big offers no guarantee against failure. Only this month for example, we have seen the reputation of United Airlines seriously damaged, and Toshiba has projected that is losses this year could be as much as $9 billion. Between 2005 and 2009, MySpace was the largest social networking site in the world. NewsCorp bought it for $580 million in 2005, but sold it in 2011 for just $35 million.

These firms, including MySpace, remain in business for the moment, but many giant companies go under eventually. The failure rate of small businesses is high in the first 2 or 3 years of life, because of elementary mistakes such as, for example, not making provision to pay the tax authorities. But, after that, the probabilities of failure in any given year of small and large firms become very similar.

The basic reason is that there is an inherent level of uncertainty about the future, which no amount of cleverness can reduce. In 1914 Briansk Rail and Engineering in Russia was one of the largest industrial companies in the world. But it disappeared in 1917 after the seizure of power by the then tiny Bolshevik Party. This itself became the giant Communist Party of the Soviet Union until it, too, eventually collapsed.

In the economics textbooks, running a business is easy. One of the basic things which students learn is how to maximise the profits of a firm. Even the more advanced material is set in an essentially static world.

The distinguishing features of capitalism are innovation and evolution, but economics has very little to say about these. Things do not just stand still. Last year, for example, Ford had a global income of $151 billion and Tesla had $7 billion. Yet this month, Tesla’s market capitalisation has overtaken Ford’s.

By all means take early retirement to brew the beer you have always wanted. But don’t expect to get rich.

As published in City AM Wednesday 20th April 2017

Image: Micro Brewery by Bernt Rostad is licensed under CC by 2.0
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What climate warrior Twisleton-Wykeham-Fiennes teaches us about punishment

What climate warrior Twisleton-Wykeham-Fiennes teaches us about punishment

Natalie Twisleton-Wykeham-Fiennes: don’t you just love her? One of the Black Lives Matter campaigners, our Nat caused chaos by occupying the runway at London City Airport, on the grounds that climate change is racist.

She and eight others, including a former member of the Oxford University Croquet Club, were sentenced by the courts last week. For many, their punishments were derisory: token fines and suspended prison sentences.

Would harsher treatment deter future protests like this and the one which disrupted Heathrow last month? Anecdotal evidence suggests it would.

In the town where I grew up, nestling in the foothills of the Pennines, the police would often drive miscreant youths late at night to remote hamlets up on the moors and make them walk home. It helped if it was raining, which it usually was. The more recalcitrant were likely to discover that the damp made the steps of the local police station unusually slippery. Compared to today, crime was low.

But this is mere causal empiricism, and there is a vast academic literature on whether or not harsher punishments deter crime. As a broad approximation, criminologists themselves tend to be sceptical about the impact of punishment as a deterrent.

A few years ago, I was at a seminar on the topic in which a criminology professor at Middlesex University asserted, without a trace of irony, that crime was caused by capitalism. In contrast, economists, who believe that agents respond to incentives, often claim that deterrence works.

Economists base their conclusions not just on theory, but on statistical analysis of detailed databases. Even so, the results might not be straightforward to interpret. For example, if prison sentences are increased and we see a fall in crime, is this because potential criminals are deterred, or because prolific criminals are in jail and can’t commit crimes?

Francesco Drago and colleagues published an influential paper in the Journal of Political Economy in 2009. They exploited the natural experiment provided by the Collective Clemency Bill passed by the Italian Parliament in July 2006. This provided for an immediate reduction of three years in the sentences of existing inmates, and as a result 22,000 of them were released. But if they re-offended, they had to serve all the suspended time, plus whatever extra they were given.

The study showed decisively that an additional month in expected sentence reduced the propensity to re-commit a crime by 1.24 per cent. Steve Levitt, in his bestseller Freakonomics, described similar results obtained by smart analysis of American data.

Perhaps the way forward is to experiment with another fundamental concept in economics, that of externalities. Twisleton-Wykeham-Fiennes believes that flying, while convenient for the individual, imposes costs on others through its negative impact on the climate. Other people bear these costs, which are external to the benefits to the person flying.

The airport protests inconvenienced many others. So the fines should be in proportion to the external costs created by the crime. The assets of the well-heeled protestors would vanish in a trice. Anyone for this natural experiment? Future Twisleton-Wykeham-Fienneses might prefer croquet instead.

Paul Ormerod

As Published in CITY AM on Wednesday 21st September 2016

Image: Croquet by Aren’tYouAlex-Spencer? as licensed under CC BY 2.0

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There’s a smart case for diversity – but it’s not the one you think.

There’s a smart case for diversity – but it’s not the one you think.

Andy Haldane, chief economist at the Bank of England, hit the headlines last week with his confession that even he could not understand much of the material which pension providers give to customers. Less noticed, however, was a speech he gave the previous week at a dinner organised in aid of Children in Need on the fashionable theme of diversity.

The concept is dear to the heart of the liberal elite. Company boards, public institutions, all must embrace it without question. Each must have its “appropriate” quota of under-represented groups – every group, in fact, except white working class men. Mass immigration and open borders should be welcomed on the grounds that this makes society more diverse, which is unequivocally a Good Thing.

Haldane, one of the most original economists around, puts forward an altogether smarter set of arguments for diversity. A very deep seated human instinct is to be very wary of anything which is different. For much of our history, we have lived in small hunter-gatherer communities of 100 people or less. Groups of this size were very vulnerable to events which could make them extinct. The principal threats were conflict and disease, and the principal bearers of these were strangers. So it can be very sensible to prefer people who are similar to you and to distrust the unknown. As Haldane points out, this is “ecologically rational” behaviour.

But decisions which are rational for the individual can have consequences which are, collectively, bad. It is perfectly rational for everyone to head to the exits if the fire alarm sounds in the theatre. But the collective consequences are potentially catastrophic.

Haldane notes that economists call this an externality problem. He argues that a certain amount of diversity can generate positive externalities for society and the economy as a whole. Taking a very broad sweep of history, he cites Ancient Greece, medieval Italian cities and the London of Elizabeth I as examples of cosmopolitan, diverse cultures in which creativity flourished. Shakespeare was very much the product of that latter era, when England was opening up the world. And diversity, Haldane argues, in addition offers protection against the dangers of “group think”.

Some of his other examples are less convincing. He cites the results of the Harvard economist Alberto Alesina that a 1 per cent increase in the population arising from skilled immigrants raises long-run output by 2 per cent.  But the point here is surely that they are skilled rather than that they are immigrants. And, incredibly, Haldane gives the Monetary Policy Committee as an example of successful diversity.

Cultivating creativity requires what Haldane calls cognitive diversity, which may not be related at all to ethnic or gender diversity. Cambridge in the middle of last century consisted almost entirely of white, upper class men. Yet Keynes in economics, Wittgenstein in philosophy and, most important of all, Crick in biology generated world-changing ideas.

Haldane’s speech is a powerful counterweight to the tick-box mentality which currently dominates the thinking on diversity in policy circles.

Paul Ormerod

As published in City AM on Wednesday 24th May 

Image: All the colours by Garry Knight licensed under CC by 2.0

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