Business In A Highly Specialized Economy

Our economy is highly specialized, with trade enabling us to consume many products that we do not make. Business leaders should understand the extreme specialization of the modern economy, a point made by Arnold Kling in his new book, Specialization and Trade: A Re-Introduction to Economics, which I reviewed recently. In this article I describe some implications of Kling’s analysis that will be useful for people in the for-profit world, both corporate and small business.

The continuing evolution of the economy seems like a pain to many people in business. Just when you get processes optimized, something changes. Maybe it’s customer tastes, maybe input costs, maybe a new competitor. I hear some “change management” experts talk about preparing for a change and then implementing a change, as if it’s something that happens every decade or two. The truth is, at this very moment, one of your competitors is trying to better satisfy your customers. Another competitor is trying to cut his costs. And some of your customers are shopping for an alternative way to satisfy their needs and wants. It’s not something that happens occasionally, it’s continuous.

Diversity of customers is a critical point in a highly specialized economy. We tend to make great generalizations, when in fact people are quite varied. A recent example is a Wall Street Journal article “Millennial Luxury Customers Are Scarce” based on a survey of 563 people. The article concludes “… investors probably shouldn’t be counting too heavily on U.S. millennials to boost the bottom lines of luxury brands. They carry a median student-loan balance of $19,978, and 48% say they are living from paycheck to paycheck ….” It’s probably true that many Millennials are not good candidates for luxury products, but some certainly are. Stop by the parking lots of Google, Facebook and other tech companies with many Millennial employees and you’ll see plenty of BMWs, Mercedes, and Teslas. In a highly diverse economy, generalizations are dangerous.

Kling has a nice discussion (derived from the work of Armen Alchian and Harold Demsetz) about when to do things within your company versus buy from another company:

“… when the value of different tasks can be isolated, specialization will tend to take place between firms, coordinated by the price system. When the value of a particular task is difficult to measure, because its value varies a great deal depending on how it is combined with other tasks, specialization will tend to take place within a firm….”

Bulk printing, for example, is easily valued as many printers can do good work and are happy to quote a job. As a result, most companies have now outsourced it. Major retailers, however, tend not to outsource sales clerks. The value of the clerks interacts with their knowledge of the company’s merchandise and with the effectiveness of the company’s marketing efforts.

Innovation continues in our highly specialized economy. Kling describes three steps: experimentation, evaluation, and evolution. Try different things. Carefully figure out what worked and what didn’t. Then change your company’s practices according—and start over with the next experiment.

Trust is vital in a specialized economy, because we use goods and services provided by strangers. Kling asks, “How do I know that the biking gloves I order really have the padding that I want? How do I know that the retailer will send me the gloves that I order? How do I know that the gloves will not be stolen before I receive them?” These issues apply within the corporations. Can we trust the expense summary that the finance department produced for us at month-end?. All known methods for rewarding trustworthy behavior and punishing non-trustworthy behavior have flaws. “Gaming the system” is a common corporate behavior. Given the difficulty, Kling argues for flexible evolution. That is, instead of imposing a set of rules for reward and punishment, society—and I think the corporation—needs a system that will adjust over time. Given the recent revelations about Wells Fargo’s employee trust issues, this problem merits attention.

Economics is not just a tool for looking at GDP and inflation. Understanding economic processes can help business leaders be more successful, and Arnold Kling’s Specialization and Trade is a valuable tool.