Challenging a traditional view of markets with Professor Ramesh Rao

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Many business school professors dream of their research challenging convention, finding something against the norm or totally new. We spoke with Ramesh K.S. Rao, the McDermott Centennial Professor of Banking and Finance at the McCombs School of Business at the University of Texas at Austin, to find out more about how his research could challenge conventional theory. 

Rao’s research interests include corporate finance and the interface between finance, economics, and related business disciplines. In addition to his academic background, he has consulted in the areas of bankruptcy, corporate restructuring, valuation, corporate litigation, and executive education. He has even testified as an expert in, among others, American Express vs. Visa et al., The State of Alaska v. Veco Corporation, and Boone v. CIGNA.  

Can you tell me the key findings of your research? 

Traditional market models overlook uninsurable risks that hinder innovation. My research shows firms can act as ‘risk-internalisers‘ to make ‘average-quality innovations’ viable, creating a ‘dual engines’ approach to wealth generation.

For many years, economic theory has painted a rather simplistic picture of innovation, solely crediting the open market as its driving force. This perspective, while offering a starting point, neglects the inherent complexities that exist within the innovation landscape. Traditional models often fail to consider the value implications of uninsurable risks and incomplete contracts, factors that can significantly impede the progress of groundbreaking ideas.

A more nuanced understanding emerges through the ‘dual engines of innovation’ framework. This framework proposes a collaborative approach, recognising the critical interplay between markets and firms in fostering innovation and economic growth. While markets excel at efficiently allocating resources for some innovations, firms act as risk-internalizing institutions.

By assuming uninsurable risks associated with innovation, such as production failures or entrepreneur credibility concerns, firms enable ‘average-quality innovations’ to become economically viable. These innovations, which might struggle to gain traction in the market due to uninsurable risks, can flourish within the relatively sheltered environment provided by firms.

A key finding is that the research challenges the traditional view about the primacy of markets in maximising the aggregate (social) welfare. I show that both markets and firms can maximise welfare, depending on the ‘quality’ of the innovation. This brings to centre stage the role of economic institutions in creating new wealth for entrepreneurs. Firms provide property rights protections that, in the mainstream economic theory, exist only as ‘a datum’ with no effect on economic outcomes.

Can you elaborate on the ways in which firms’ ability to innovate contributes to wealth creation for society as a whole?

Not all innovations are economically viable when production is organised through the markets. This is because the suppliers of factors of production will demand market prices that reflect the innovation’s potential for economic default and for the propensity of entrepreneurs to act opportunistically. Firms with adequate cash that is collateralised can mitigate these uninsurable risks. Suppliers will now demand a lower price for their inputs and this can make marginally viable innovations economically attractive.

The theory implies that wealth creation is maximised, depending on innovation quality, either through the markets or through firms. In both cases, the outcome is Pareto optimal (meaning that the social welfare cannot be improved further without making someone worse off). Moreover, innovations of average quality that are infeasible through the markets can be brought to consumers if production is through firms. 

Your research mentions that firms can generate more wealth than markets because they navigate uncertainties better. How and why do firms do this more effectively? 

Not always. Whether markets or firms generate more wealth depends on the innovation’s quality. If an entrepreneur has low trustworthiness or if the innovation is very risky, the innovation has lower quality, and the entrepreneur can generate more wealth by transacting as a firm. This is because firms can ‘internalise’ the uninsurable risks faced by suppliers and thereby procure inputs at lower prices. By minimising input costs, firms can generate more wealth when the uninsurable risks are large.

In what ways does your research challenge conventional market-based models of wealth generation and allocation? Are there any notable implications for economic theory or policy?

The research suggests a more nuanced view of innovation, acknowledging the interplay between markets and firms. Policymakers should consider a ‘dual engine’ approach, fostering both markets and firms through:
  • Strengthening property rights infrastructure.
  • Facilitating firm creation (streamlining registration, reducing regulatory burdens).
  • Promoting financial inclusion for entrepreneurs (access to credit).
  • Investing in education and skills development for a vibrant entrepreneurial ecosystem.
  • Cash infusions in developing economies (as done by the World Bank) to establish property rights and empower entrepreneurs.

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