Usually the failure of a firm is attributed to mismanagement. The implicit argument being that firms (should) normally survive, grow and be profitable. This impression is based on successful business stories, but these stories are very rare and due to serendipity and luck. “Our current knowledge of survivors dominates our impression of the typical experience, and their triumphs are lionized, while the history of the failures is forgotten or considered untypical.” (Hannah, 1999). Failure is one of the great unmentionables in the world of business. This process of business turnover is the essence of capitalism, failure at the individual level is the key to success of the system as a whole.
The collapse of a firm is an emotional event. Somebody is to blame of course. However the causes of failure are not always clear; is it due to internal (mismanagement) or (non-controllable) external circumstances. In the business failure literature these views are called voluntarism and determinism (or population ecology). I sympathise with the population ecology view, but for different reasons.
Alchian (1950) already pointed towards the impossibility of identifying the causes of success (and failure): “the survivors, may appear to be those having adapted themselves to the environment, whereas the truth may well be that the environment has adopted them.” Ormerod (2005) illustrates this problem with different examples: Suppose business is like a tossing game. Does winning a game mean that a fully rational, maximizing strategy has been chosen? Suppose there are numerous players and the game is played a 100 times. There will still be winners: of course it is misleading to conclude that they have found the optimal strategy and that they behaved as if they were full-information maximizers. In fact we are not able to identify good and bad strategies. However we could reason - as most economists do - that managers behaved “as if” they fully maximized. A more realistic case is the stock market. Are investors able to outperform this market due to their superior strategy? The answer is no: this famous principle is known as the efficient market hypothesis. All information is embodied in the share prices. Share prices only react to new information, but it is not possible to predict new information, because the future is unknown. In this context the most simple hypothesis is to assume that the outcomes we observe are purely random. Are (managers of) firms different than investors, can they beat the market?
Hypotheses to qualify organizational behaviour range from unbounded rationality to a total lack of cognitive ability. According to Ormerod there is strong empirical support for this last hypothesis in the context of firm extinctions. The pattern of firm extinctions appears to be exactly the same as the extinctions of species. It makes no difference that firms/managers are rational conscious beings. It is like firms acted at random. Intent is not the same as outcome. These irregular but patterned extinction waves can be modelled and simulated using different models. These models break down when it is assumed that firms have only slight knowledge about the impact of their strategies. “The implication is that firms have very limited capacities to acquire knowledge about the true impact of their strategies.”(Ormerod, 2004). “Long term survival might be better regarded as a purely random result of complex interaction among competing organizations.” (Stubbart and Knight, 2006). Adam Smith - the first complexity theorist - already pointed towards the unintended consequences of human actions. Why has economics not incorporated and embraced this famous insight? If the cognitive capacities of managers are severely limited, how can we assert that the cause of failure is mismanagement?
Firms are not able to continuously outperform the market and competitors. In the end markets win because evolution is “cleverer” than firms. From the population ecology view it is assumed that firms resist change, are inert. But of course firms do change and reinvent themselves, but the problem is the fact that a business never contains the diversity of business plans as contained in the market as a whole. Taking account of all the future possibilities and opportunities in the economy, market, segment or industry, would paralyse the firm. True strategic decisions require investments that are irreversible. Firms need to specialise and focus and stick to their business, which means that they will certainly not recognise all (relevant) developments. They need to balance exploitation and exploration; this is called ambidexterity. There are no simple rules – no holy grail - for these decisions. In spite of this, most micro economics and management textbooks give the impression that running a business is easy and that maximizing and success are simple. Business failure textbooks contain simple “frameworks” for classifying failure and curing firms in decline. There is a difference however; micro-economic textbooks contain one universal rule: equate price with marginal costs. Curing and classifying business failure textbooks contain (too) many rather simple different frameworks and step-by-step procedures.
The assertion that mismanagement causes business failure has to take into account that most firms fail, that markets have an advantage concerning future developments and that there are serious limits when it comes to knowledge. In judging (mis)management we should recognise that the world of entrepreneurs and managers of enterprises is not as simple as in the dogmas of micro-economic scholars and management gurus. It is not easy to determine the causes of failure and how to restructure an insolvent firm (and to assess the viability of a firm). The rhetorical question is why most people who are involved in creating simple successful business formulas have not become rich from running an enterprise themselves?