Arnold Kling on EconTalk talks innovation in bureaucracies

In this EconTalk appearance, Kling explains why he thinks it’s rational for bureaucracies of large companies to poo-poo new ideas:

“…if you’re in middle management and you propose some very potentially spectacular project for your company, you’re going to have to sit in meetings. And, they are going to be 10 people in the room, and if one of them says, ‘This won’t fly,’ that’s it. You’re done. And, that’s actually rational from the corporation’s point of view, because as a middle manager, you have very little skin in the game. Suppose your project is going to cost $20 million; the upside is $500 million or a billion dollars worth of value. You’re not going to get very much of that upside.

On the other hand, if the corporation loses the $20 million, you’re going to lose zero of the downside.

So, you don’t have much skin in the game when you’re playing with the corporation’s money. And so, a corporation that doesn’t set up a bureaucracy that’s skeptical of ideas that come from middle management is just going to end up throwing money at lots of projects that it can’t–that don’t turn out well, and it just squanders its money.”

I’ve worked in large companies for some decades, in a variety of innovation cultures and I don’t find this explanation compelling.

In my view, Kling makes the same mistake as companies with large bureaucracies, he thinks too big. In his example, he assumes the only way to try an idea is with a big investment.

Bureaucratic cultures make this mistake because they presume success based on how an idea sounds to leadership, build to scale and optimize, before they even know if it is something customers want.

I’ve also worked in more productive innovation cultures. They use a simple way to avoid blowing $20 million on a new idea: They spend much less to try out ideas on small scales to see if there’s something to it, like how start-ups do. They call these proof of concepts and pilots. They creatively find ways to try new ideas for sometimes as little as a few hundred dollars to get an initial read on whether the idea has merit.

Kling makes a fair point about skin-in-the-game, but I think there is room for creativity there, too. I once accidentally improved an innovation productivity around promotions by asking field managers if they would want to prove out their promotion ideas on their own budgets.

I say “accidentally,” because that was not my intention. My intention was to slow down an overflow of ideas from them that our bureaucratic culture couldn’t handle and were mostly ideas that had already been tried and failed.

I figured when I asked managers to prove their ideas on their own budget, that might make them put their money where their mouth was. It worked and cut that idea flow by 90%, because they now had the incentive to do the breakeven math to see how much more business their idea would need to bring in to cover the costs of the promotion. Most could see right away that they would be lucky to recoup a fraction of the cost.

But, it also had the unintended consequence of giving them a path around the organization’s red tape and try some new ideas at low costs. So, while fewer ideas were flowing, more ideas were being tried on small scales and some turned out to be big winners that were scaled to the full business. Those ideas would have never been tried if it were up to the bureaucracy to approve and sadly, after I left, it was never understood how and where those ideas came from and the culture went back to the way it was before.

In this case, managers still didn’t have much direct financial skin in the game, but it put enough reputational and job risk in their court to change the way they viewed this activity.

Rather than believing bureaucracies serve a purpose to prevent the organization from taking big risks, I just see bureaucracies as what will likely cause the demise of the business when they do not allow innovation to occur at a rate to keep up with competitors and substitutes.

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