Monday, November 18, 2013

Business Schools Need To Teach Economic Theory

In both articles, Types of Strategy: Which Fits Your Business? and Blue Ocean Strategy, production cost and product value are identified as key variables that need to be considered when developing a business strategy.[1]   The former specifically elucidates a Low-Cost Leadership strategy and incorporates both variables in some form or another into the remaining three strategies (Differentiation, Customer Relationship and Network Effect Strategy).  The later article expands on the notion of product value, arguing that businesses need to create uncontested market spaces where competition is irrelevant (blue oceans).  In each, the authors suffer from an apparent ignorance of basic economic theory and fail to grasp the interconnection between these two variables and their role in developing consumer demand.  Without explaining this interconnection, the reader is left trying to reduce costs and trying to create “blue oceans” with no understanding of the key mechanism that leads to comparative advantage.

Rather than focusing on a businesses perspective, imagine how consumers optimize their consumption.  Consumers have needs and based on their understanding of the products available to satisfy them they mentally create an ordinal ranking of goods based on their cost and the relative benefit they provide.  To this extent, a consumer chooses one good over another based on the ratio of cost to benefit.  This means that at the same cost an increase in value will increase a consumer’s willingness to purchase a good.  Similarly, a reduction in cost when values are identical will also change consumer behavior.  In this analysis, “Red oceans” reflect a market where value and cost are relatively stable.  Also, just because a business raises the value of its product does not mean anyone will demand the product.  If there exists a similar product that still is seen as providing more value relative to cost, consumers will still choose this product over an inferior, but improved alternative. 

This simple and obvious analysis is completely absent in the two articles.  The reason that any of the strategies discussed work at all is because “blue ocean” markets are created when products are created that more cost effectively satisfy the needs and desires of consumers.  Cirque du Soleil was successful because they created a form of entertainment that had a greater relative impact on the needs and desires of consumers relative to other options.  Starbucks was successful because it sold not only a higher value product but also satisfied their consumers desire for an upscale coffee experience, which was not available elsewhere.  Ford created an affordable transportation devise that was superior in price and value to walking and riding a horse.  Both factors (cost and value) must be taken into consideration and in relation to comparable products. 

With this understanding, a business could then ignore each of the myopic strategies discussed in the two articles and focus on what really matters: satisfying the needs and desires of the consumers.  If businesses did this, businesses could create “blue oceans” that would not only lead to success, but would also benefit consumers.  Just image an entire economy mobilized to discover and satisfy each consumer’s most superficial need.  This leads back to the real problem in these two articles and the problem with most businesses in general.  People go into business to satisfy their own needs, but those who are successful quickly realize that their success derives from focusing on satisfying other people’s needs.

[1] Kim, Chan and Renee Mauborgne.  Blue Ocean Strategy.  Boston: Harvard Business School. 2013. Print.
Types of Strategy: Which Fits Your Business?.  Boston: Harvard Business School. 2005. Print.

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