The Gap Between Business Practice and Economic Theory

As a student, Steven Levitt, Alvin Baum Professor of Economics and the College and director of the Becker Center on Chicago Price Theory, struggled with advanced mathematics and had to develop an “intuition” to score higher. “In a very roundabout way, that intuition relates back to the Chicago style of economics,” Levitt said during the lunch address at the 2007 Conference on Chicago Economics at the Charles M. Harper Center November 10.

“You obviously have to be good at math, but you don’t necessarily have to be more than good at math,” Levitt said. “You need to have a working knowledge of the economy. You need to be thinking about questions from all sorts of perspectives. Ultimately, the reason I came back to get a PhD was that my years in business had frustrated me and made me wonder why I did not find the rules and lessons I had learned as an undergrad in economics in the internal workings of businesses.”

After some 10 years in academics, Levitt has finally started to fulfill his promise to himself to apply economic tools to how businesses work, he said. “Some might disagree, but I would argue that economics has shed very little light on the particulars of economic decision making,” Levitt said. “The contrast between how businesses actually make decisions and how economists think shows a big disconnect.”

Even former economist Paul Feldman, who left academics to sell bagels on the honor system in parks around Washington DC illustrated most businesses’ inability to incorporate feedback about less defined processes in their day-to-day practices, Levitt said. Incorporating supply principles, pricing formulas, and daily sales data, Feldman’s quantity calculations provided an “incredible demonstration of the ability in simple settings for people to do what economic models predict,” Levitt said.

However, Feldman raised his prices only four times in 15 years despite dramatic increases in revenue and profits each time, Levitt said. Even after acknowledging Levitt’s projection that Feldman lost 25 to 30 percent in revenue as a result of pricing errors, Feldman said it was too risky to raise prices even in random tests, Levitt said.

“When it came to quantities, he had tremendous feedback everyday,” he said. “On prices, he got no feedback. He just had a price and the price seemed right, so he kept it. He had no way of knowing if he changed his price, would he do better? That is a general point about business. Many businesses have not been set up to maximize feedback on decisions. Often they have just the opposite - aversion to feedback. It’s not that they haven’t thought about it; in some cases they work hard not to get feedback.”

Levitt prompted first-year student Raul Mara to weigh the potential gains of real business experiments with the risks, Mara said. “He really emphasized the importance of feedback for the purpose of determining the best strategy for your business,” he said. “He echoed what had been said in previous panels at the conference in terms of human behavior. He emphasized the importance of economic experiments.”

- Phil Rockrohr