The Observer, 2 October 2005
Who cares about management theory? Well, you'd better. Even if you've never read or even heard of transaction cost economics or agency theory, these ideas are re-engineering your world as surely as religious fundamentalism, if a lot more insidiously.
That sounds hard to credit. After all, managers proudly ignore theoretical concerns. Even academics lament that the journals they get brownie points writing for are read by audiences numbering a few thousand - if they're lucky.
Yet invisible though they are, theories matter. 'The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood,' wrote Keynes in The General Theory. 'Indeed, the world is run by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slave of some defunct economist ... Soon or late, it is ideas, not vested interests, which are dangerous for good or evil.'
Keynes was right, even if he greatly underestimated the phenomenon. This is because of something called 'the double hermeneutic': where human behaviour is concerned, if enough people believe a theory, even a 'false' one, it becomes self-fulfilling and therefore 'true'.
Crudely, if managers believe that individuals will only work under a regime of sticks and carrots - controlled by hierarchy and incentivised by money - and design companies accordingly, that is what people become.
The converse is also true. Just as distrust breeds cheating and self-interested behaviour that attracts still tighter surveillance (the 'supervisor's dilemma'), research shows that assumptions that individuals are hard-working and trustworthy produce workplaces where people are less interested in money and co-operate more.
'The conventional view is that theories win because they are better at explaining behaviour,' notes Jeffrey Pfeffer, professor of organisational behaviour at Stanford Graduate Business School. 'This stands it on its head: theories win because they better affect behaviour, becoming true as a result of their own influence irrespective of their empirical validity.'
Pfeffer, a respected senior researcher, is one of a small but vocal chorus of academics who are increasingly concerned by the damage, as they see it, that theoretical assumptions are doing to the practice of management. Just before his death last year, London Business School's lamented Sumantra Ghoshal wrote a much-noticed piece for a US journal entitled Bad Management Theories are Destroying Good Management Practices, in which he independently reached some related conclusions. It was no good business schools being pious about Enron and WorldCom, he argued, when 'it is our theories and ideas that have done much to strengthen the management practices that we are all now so loudly condemning'.
In this view, the damage occurs because the assumptions about human nature underlying all conventional management are overwhelmingly negative. In a paper in the American Management Review, and in a series of punchy presentations sponsored by the Advanced Institute for Management Research (AIM), Stanford's Pfeffer traces the root of the dynamic to the core principle of economics: that every agent is actuated only by self-interest.
From this, everything else follows. If people are self-interested, they have to be motivated by incentives. Different self-interests lead to endemic conflicts, hence agency problems.
To resolve conflicting interests efficiently, markets are best. Self-interest and markets favour competition rather than co-operation, and mandate hierarchy to keep people in line. They also empty management of all moral or ethical concern. And, indeed, the typical firm has come to be structured around these principles, from governance based on agency theory and shareholder value, to internal markets and performance-related pay, sharp incentives and performance management lower down.
Yet there is little empirical evidence that the assumption of exclusive self-interest is valid. Self-interest exists, of course, but to assume that nothing else does defies common sense as well as well as research findings. Conversely, 'There is growing evidence that self-interested behaviour is learned behaviour - and people learn it by studying business and economics,' says Pfeffer.
In an 'incredibly depressing' range of studies, business and economics students have been found to be more prone to cheat, free-ride, and violate codes than those of other disciplines. What's more, unlike contemporaries, they undergo negative moral development during their courses. In other words, they more and more resemble the rational utility maximiser - rational economic man - that is the starting assumption of their disciplines. Economics and business courses, sums up Pfeffer, are 'hazards to your moral health'.
As both Pfeffer and Ghoshal show, the effects carry over into business itself, irrespective of whether managers have been to business school or studied the individual theories.
Institutional mechanisms such as governance arrangements, social norms - so that people assume that others are self-interested although they aren't - and language all carry the virus around the world.
The evidence is everywhere. Downsizing (ie firing people), once a last resort, is now done pre-emptively. Incentives are ubiquitous despite zero evidence that pay for performance works. Outsourcing is going through the roof. One study found that, in larger companies, the more MBAs there were among top managers, the more likely the company was to behave illegally.
So now we can see why theory matters - not just for academics, but for everyone who works in organisations. As the psychologist Robert Frank wrote: 'Our beliefs about human nature help shape human nature itself' - and, as embodied in current management theory and practice, they are in danger of turning us into travesties of human beings: narrow economic actors who are expected to leave moral, ethical and even generous impulses at the door. This is not inevitable, since just as 'bad' theory is doubly bad, 'good' theory has the potential to be doubly good. But it does mean that theory is all our concern; too important, in fact, to be left to theoreticians.
... Unless it's a bad theory
Transaction cost economics arose from attempts to understand why, and under what conditions companies exist. In essence, companies exist only as a result of market failure, when situations are too complex for market contracts to be drawn up to cover all eventualities. As individuals are opportunistic, managers must exercise authority or 'fiat' to ensure they do as they are told to maximise profits, and create strong individual incentives. Implications: hierarchy, incentivisation, markets are best.
Agency theory teaches that self-interest leads to a conflict between 'principals' (shareholders) and 'agents' (managers). Managers, being opportunists, cannot be trusted to maximise shareholder interests rather than their own. The resulting 'agency problems' must be overcome by aligning managers' and shareholders' interests, typically through incentives. This was a major justification for the 1990s stock option bonanza. Agency theory is a powerful influence on corporate governance.
The 'five forces' strategy model asserts that companies create strategic position by developing power over customers and suppliers (and implicitly employees), increasing barriers to entry and by managing interactions with competitors. That is, profits come from restricting and distorting markets.