No.

3

2014
The Economics of Effective Leadership
Roberto Weber

What can economic science tell us on effective leadership?

Economists have typically assumed that the only way, as a leader, to get people to do things is to use carrots (e.g., pay raises) or sticks (e.g., threats of firing) to incentivize the behavior. One of the important contributions of recent research on leadership is to test the extent to which this really is true. Can leaders also motivate and inspire workers with their statements and speeches? Or, is the creation of hard incentives the only way to get followers to do something?

A growing number of economists engage in the search for answers to these questions. A rapidly growing set of economic studies view leadership as a fundamental issue that economists must better understand. The economic approach – including carefully designed experiments that let us really identify whether leaders actually cause outcomes – has produced a better understanding of leadership, where it matters, and which characteristics make some leaders more effective than others.

In this Public Paper, Prof. Roberto Weber (University of Zurich) overviews the recent development in economic science on this subject. His research confirms some commonly held beliefs about leadership. Effective leaders actively influence their followers’ behavior in many ways. It is not surprising that setting a good example can be an important function of leadership. Furthermore, leaders can play a critical role in maintaining ethical conduct in organizations. While ethical leaders tend to produce groups with more ethical behavior, unethical leaders produce less ethical groups.

Other findings turn many commonly held beliefs about leadership on their head. For example, the extent to which mere words have a similar – or, sometimes even stronger – effect than financial incentives.

Leaders exert profound influence on their followers’ behavior through what they say. Moreover, it is not just what a leader says, but how the leaders says it. A second example is that when things go well or poorly, we naturally attribute part of it to good or bad leadership. These judgments can be wildly mistaken. We often credit or blame leaders for things that are beyond their control. Another illustration of how commonly held beliefs about leadership turn out to be wrong is the fact that we assume the selection of people for critical leadership positions – such as powerful roles in government – is a serious process. But, as it turns out, children staring at photographs for a few seconds seem to identify much of what goes into these judgements. Putting this all together, a leader’s success or failure is often a haphazard process – full of biases and luck – and frequently detached from the noble traits we assume to be characteristic of good leadership.

An effective leader will take this into account, recognizing that there are many strategies that make leaders successful or unsuccessful, but that he or she often has little control over many other important factors. This new evidence will greatly affect the insights economists can disperse to practitioners about how to lead organizations and societies more effectively.

Economists have typically assumed that the only way, as a leader, to get people to do things is to use carrots (e.g., pay raises) or sticks (e.g., threats of firing) to incentivize the behavior. One of the important contributions of recent research on leadership is to test the extent to which this really is true. Can leaders also motivate and inspire workers with their statements and speeches? Or, is the creation of hard incentives the only way to get followers to do something?

A growing number of economists engage in the search for answers to these questions. A rapidly growing set of economic studies view leadership as a fundamental issue that economists must better understand. The economic approach – including carefully designed experiments that let us really identify whether leaders actually cause outcomes – has produced a better understanding of leadership, where it matters, and which characteristics make some leaders more effective than others.

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Key implication

Effective leaders recognize the power of words. The words a leader uses, and how they are delivered, can greatly affect the extent to which workers exert effort in pursuit of a common goal. In many instances, words may have a stronger effect than financial incentives.

Introduction

There is a widespread conventional wisdom that leadership is important for the functioning of firms and societies. The actions and words of political leaders command great attention, as with the annual “State of the Union” speech delivered by United States’ presidents and other similar addresses by national leaders. The business press and shareholders emphasize the importance of CEO turnover and the valuable role of a strong leader − such as Walt Disney, Jack Welch, or Steve Jobs − for defining corporate culture, establishing vision and priorities, and influencing a firm’s profitability. Financial markets closely attend to and scrutinize the credibility of central bankers’ public statements about economic conditions and future policy directions. Even local school boards and amateur sports teams concern themselves greatly with who is leading them and with what these people say and do. Moreover, history and the arts are full of prominent examples of influential leaders inspiring bold action merely by their statements to followers − from Mark Anthony’s, “Friends, Romans, countrymen …” speech in Shakespeare’s Julius Caesar, to Winston Churchill’s famous radio address to Great Britain (“we shall fight on the beaches … we shall never surrender”) at the onset of World War II. We all agree, it seems, that leaders matter. However, one group of people for whom leadership seems to matter little is economists. If you took economics courses while studying at university, think back to them. You almost certainly learned about firms, perhaps something about how they operate and what makes them profitable. But it is also very likely that there was virtually no role for leadership in these firms. In discussions of governments and policy, there was also very likely little discussion of leadership as an important factor. To the extent that there was something like leadership in these courses, it was probably exclusively focused on a “leader” as someone in a firm who sets pay contracts in order to motivate workers to exert effort. To date, the study of “leadership” in economics still focuses primarily on corporate leaders as managers who obtain worker effort and influence profitability mainly by structuring contracts and incentives in conjunction with performance monitoring. Similarly, in the case of political leaders − even though economists have cleverly shown that such leaders matter − the economic perspective focuses primarily on political leaders’ ability to impact outcomes through their influence on economic policies (see box “Do leaders matter for economic growth?” and figure 1 on page 5 and 6).

But, is this really all that leaders do? I suspect most of us would disagree. In the typical person’s view of the role of a CEO, there is more to this professional function than making strategic decisions and establishing compensation policies. As John Kotter noted in an influential 1990 Harvard Business Review article,2 effective corporate leaders create a vision for the future of a company and inspire and motivate employees to pursue this vision, often voluntarily. Similarly, strong political leaders do more than manipulate policy levers, they also reassure citizens and markets in times of crisis, and convince them of an obligation to prioritize the common good over their narrow selfinterest. Think of John F. Kennedy’s declaration, “My fellow Americans, ask not what your country can do for you, ask what you can do for your country,” which had no immediate impact on policy, but is the type of bold and influential statement we associate with strong and effective leadership.

But, this notion of leadership − even though widely recognized by most people as important for understanding what makes some firms successful and others fail − is largely absent from economic theories and research. Part of this is the result of skepticism among many economists that such leadership really matters. After all, in a science rooted in the power of “hard” incentives, what room is there for the “softer” forms of inspiration and persuasion exerted by corporate and political leaders? Fortunately, this is changing, as more economic research directly studies the inspirational and motivational functions of leadership, and how these aspects of leaders can influence firm productivity. This is fortunate on two fronts. First, it fills an important hole in economic research − the study of how leaders shape the behavior of followers. Second, it brings the rigorous methods of economic research to the study of leadership. This is important, as economists are often very careful and critical in establishing whether a specific factor − such as a particular type of leader − really causes particular outcomes. In the case of leader-ship, where there is a great deal of conventional wisdom about the powerful effects of leaders, this rigorous scrutiny is valuable for identifying what exactly leaders do and do not do. That is, economists contribute to our understanding of leadership both by asking how much of what leaders do can really be shown to matter? And, relatedly, where do leaders matter less than people think?

There is a widespread conventional wisdom that leadership is important for the functioning of firms and societies. The actions and words of political leaders command great attention, as with the annual “State of the Union” speech delivered by United States’ presidents and other similar addresses by national leaders. The business press and shareholders emphasize the importance of CEO turnover and the valuable role of a strong leader − such as Walt Disney, Jack Welch, or Steve Jobs − for defining corporate culture, establishing vision and priorities, and influencing a firm’s profitability. Financial markets closely attend to and scrutinize the credibility of central bankers’ public statements about economic conditions and future policy directions. Even local school boards and amateur sports teams concern themselves greatly with who is leading them and with what these people say and do. Moreover, history and the arts are full of prominent examples of influential leaders inspiring bold action merely by their statements to followers − from Mark Anthony’s, “Friends, Romans, countrymen …” speech in Shakespeare’s Julius Caesar, to Winston Churchill’s famous radio address to Great Britain (“we shall fight on the beaches … we shall never surrender”) at the onset of World War II. We all agree, it seems, that leaders matter. However, one group of people for whom leadership seems to matter little is economists. If you took economics courses while studying at university, think back to them. You almost certainly learned about firms, perhaps something about how they operate and what makes them profitable. But it is also very likely that there was virtually no role for leadership in these firms. In discussions of governments and policy, there was also very likely little discussion of leadership as an important factor. To the extent that there was something like leadership in these courses, it was probably exclusively focused on a “leader” as someone in a firm who sets pay contracts in order to motivate workers to exert effort. To date, the study of “leadership” in economics still focuses primarily on corporate leaders as managers who obtain worker effort and influence profitability mainly by structuring contracts and incentives in conjunction with performance monitoring. Similarly, in the case of political leaders − even though economists have cleverly shown that such leaders matter − the economic perspective focuses primarily on political leaders’ ability to impact outcomes through their influence on economic policies (see box “Do leaders matter for economic growth?” and figure 1 on page 5 and 6).

But, is this really all that leaders do? I suspect most of us would disagree. In the typical person’s view of the role of a CEO, there is more to this professional function than making strategic decisions and establishing compensation policies. As John Kotter noted in an influential 1990 Harvard Business Review article,2 effective corporate leaders create a vision for the future of a company and inspire and motivate employees to pursue this vision, often voluntarily. Similarly, strong political leaders do more than manipulate policy levers, they also reassure citizens and markets in times of crisis, and convince them of an obligation to prioritize the common good over their narrow selfinterest. Think of John F. Kennedy’s declaration, “My fellow Americans, ask not what your country can do for you, ask what you can do for your country,” which had no immediate impact on policy, but is the type of bold and influential statement we associate with strong and effective leadership.

Conclusions

Economists have generally ignored leadership in their research, theoretical models, and teaching. However, as this Public Paper notes, this is changing. There is a rapidly growing body of economic studies that view leadership as a fundamental issue necessary for economists to understand better. The economic approach − including carefully designed experiments that let us really identify whether leaders actually cause outcomes − has produced a better understanding of leadership, where it matters, and what characteristics make some leaders more effective than others.

For example, this work has demonstrated that we should often be careful in ascribing too much importance to leaders, the things they do, and their control over out- comes. When things go well or poorly, we naturally attribute part of it to good or bad leadership. But, these judgments can be wildly mistaken; we often credit or blame leaders for things that are beyond their control. In addition, we think that the selection of people for critical leadership positions − such as powerful roles in government − is a serious process with great attention paid to the qualities that make some people better leaders than others. But, as it turns out, children staring at photographs for a few seconds seem to identify much of what goes into these judgments.

Putting this all together, the success or failure of a leader is often a haphazard process − full of biases and luck − and frequently detached from the noble traits that we assume are characteristic of good leadership. An effective leader will take this into account, recognizing that there are many things that make leaders successful or unsuccessful, but over which he or she has no control. On the other hand, there are also many ways in which effective leaders do influence the behavior of followers. Setting a good example can be an important function of leadership; but economic theory and experiments demonstrate that this is most effective when the leader has access to information that followers do not have. In such situations, leading by example can be particularly effective as a way of convincing followers of the value of collective effort. In fact, leaders may sometimes want to withhold information from followers, and let their actions do the talking, thus making both leaders and followers better off.

It is not surprising that leaders also influence the behavior of followers through the use of “hard” incentives; that is, the use of carrots and sticks as means to induce desirable behavior. This is consistent with the primary role of leaders in much of economic theory. What is more surprising is the extent to which mere words have a similar − or, sometimes, even stronger − effect as financial incentives. Several studies show that leaders exert profound influence on their followers’ behavior through what they say, even when they do not provide followers with any new information. Moreover, it is not just what a leader says, but how the leader says it. Charismatic rhetorical techniques like metaphors and analogies, rhetorical questions and three-part lists can enhance the degree to which a leader’s words resonate with, and ultimately motivate, followers. While conventional wisdom has held for centuries that powerful orators are effective leaders and motivators, this had not been rigorously tested as a mechanism for eliciting harder work, until very recently. Ultimately, words matter a great deal, and may often be a more cost-effective means of motivating effort than monetary incentives. These findings turn a lot of what students of economics typically learn about leadership − that it is about contract design and incentives − on its head.

Very recent research has finally established a clear causal link between unethical leaders and the unethical behavior of those they lead. Despite its widespread intuitive appeal and much anecdotal evidence, no one had shown that unethical leaders actually produce unethical groups. Recent studies in economics − relying on experiments and careful ways of measuring individuals’ propensities to act unethically − have established a clear relationship: unethical leaders produce groups with more widespread unethical conduct. Therefore, in selecting a leader, issues of morality and character should play a prominent role.

Finally, a very exciting aspect of writing this Public Paper is that the research described here is just the tip of the iceberg. With a growing number of economists studying how, precisely, leaders affect followers and shape the groups and organizations they lead, much more stimulating and informative new evidence will arise. This evidence will not only make leadership a much more important part of economics training and research, but it will also ultimately greatly impact what economists can tell practitioners about how to lead organizations and societies more effectively.

Economists have generally ignored leadership in their research, theoretical models, and teaching. However, as this Public Paper notes, this is changing. There is a rapidly growing body of economic studies that view leadership as a fundamental issue necessary for economists to understand better. The economic approach − including carefully designed experiments that let us really identify whether leaders actually cause outcomes − has produced a better understanding of leadership, where it matters, and what characteristics make some leaders more effective than others.

For example, this work has demonstrated that we should often be careful in ascribing too much importance to leaders, the things they do, and their control over out- comes. When things go well or poorly, we naturally attribute part of it to good or bad leadership. But, these judgments can be wildly mistaken; we often credit or blame leaders for things that are beyond their control. In addition, we think that the selection of people for critical leadership positions − such as powerful roles in government − is a serious process with great attention paid to the qualities that make some people better leaders than others. But, as it turns out, children staring at photographs for a few seconds seem to identify much of what goes into these judgments.

Authors

Professor of Economics, University of Zurich
Prof. Roberto Weber

Roberto Weber is a Professor in the Department of Economics at the University of Zürich. His research and teaching falls primarily within the areas of behavioral and experimental economics, decision making, and the study of organizations and institutions.

Professor of Economics, University of Zurich
Prof. Roberto Weber

Roberto Weber is a Professor in the Department of Economics at the University of Zürich. His research and teaching falls primarily within the areas of behavioral and experimental economics, decision making, and the study of organizations and institutions.