Topics discussed in this blog like extrinsic factors, signalling, and social capital naturally lead to the topic of consultancies. I am just partially kidding. This blog post will try to explain the transaction of services, money, and prestige among CEOs, firms, consultancies, consultants, and Universities. First, I will give the benefit of the doubt: explaining how consultancies can add value, fair money being paid for exceptional services. This view of the transaction creates some puzzles. These include the strange oligopoly of the big three, or why consultants are the best-looking kids from the best schools in the US and UK? Lastly, I will present a different view on what is being traded when consultancy firms are hired. Rather than strategic services, it is prestige. Graduates buy it from universities, Consultancies buy it from students, and CEOs lastly buy it from consultancies. This theory best explains the economics of consultancies.
The value-add theory of consulting focuses on the benefits of 3rd party advisers with strong track records. Here consulting companies can create value by coming into a firm, optimizing and restructuring. This is what they focus on and what they do best. Relocate offices, cut costs, pivot existing operations, and if necessary, fire people. The company being consulted might be good at what they are doing but less so in running an efficient company. I get it. My personal consultant is my dad: While I am good at writing uni essays or burying my head in work, I get stressed out and tend to get frustrated pretty fast. My dad gets me back on track. He comes up with strategies to best cope with current problems, having the bigger picture in mind. This is definitely a value-add.
Since optimizing is not an easy thing to do, consultancies get paid a lot of money, that they spend on smart employees. Smart people come from good schools and have a good work ethic. The value-add theory predicts that profit making firms should optimize their operation by bringing in strategic consultants. These consultants should be unbiased (thus inexperienced), young and educated, motivated and ready to work 100h. This will leave everyone better off: The firm maximizes profit, the consultancy gets money, and young consultants get a good salary and experience.
Since I am not expecting to get hired from the big 3 any time soon, here are some problems with the value-add theory: If consultancy is such a value-add, why don’t we see it in every size and sector of the private enterprise? Why do only big corps spend big money on the big 3? Why hire 20-year olds straight out of uni to advice on huge strategic decisions? Wouldn’t it be way cheaper for a firm to ask their young employees, probably with the same educational background, to advise on these huge strategic decisions? Why spent millions to get advised by the people you could easily hire for just a fraction of that money? And why are consultants so damn good looking?
The answer is prestige. Rather than trading knowledge and optimization-services for money, it is prestige that is traded on every level. It all starts with a CEO of a big corp needing validation for a decision. This either entails an unpopular decision with his/her board, his employees, or the public. The CEO needs extra validation to push something that someone will not happy about. He/she has to buy a strong ally. This ally comes in the form of a prestigious consulting firm. He/she can now fall back on the Power Point slides of a consultancy to hedge his/her unpopular decision. If it goes wrong, he/she can blame the consultancy. The more he/she spends the stronger the ally. Giving someone ten bucks to consult on a decision won’t convince your enemies. Giving a prestigious consulting firm 10 million will for strategic advice will hold up much better. This leads to positive feedback that can explain the oligopoly of the big 3. They managed to turn the demand curve upside down – creating higher demand for higher prices, thus abnormal profits. The more CEOs pay the more prestige they will get. If this system works then only a few selected consultancies can profit from this. The CEO now has a partner that represents prestige, respected in the business community, payed with a lot of money.
But how does the strategy consultancy get prestige? Well they need to buy it from somewhere else. The cheapest place to buy prestige is from young college graduates from the best schools. Even better, the consultancy does not care if you majored in Queer Musicology or Golf Management, as long as you graduated from Ivy of Oxbridge. Consultancies build up expensive stands at uni job fairs, fund college challenges, even giving out scholarships, for no other reason than to buy prestige from prestigious universities.
Unis get prestige through famous Alma Maters, low acceptance rates, and est.s dating back to the early part of the High Middle Ages. Their students give prestige to the uni by their excellent SAT scores and get extra prestige out once they graduate. A fairly new and pretty crude method is attempted by “international management schools”: Charging 3x student fees and spending half of it just for “advertisement”. I suspect some of that money is wired straight to ranking agencies (that requires a blog post of itself).
Looking at it upside down: Prestige is created from good students, going to good schools, being hired by good consultancies. This prestige is being sold to CEOs facing unpopular decisions.
People defending the value-add theory must explain the abnormal profits of the big 3 oligopoly, the efficacy of young Musicology Ivy graduates, and the “need” for strategy consulting in only the biggest corporations. Prestige explains all these factors. One last question is still unanswered: Why are consultants so good looking? I’ll let you answer this one…
To read more on this, read Robin Hanson’s Overcoming Bias, or listen to an enlightening discussion on Freakonomics Radio about this topic.
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