(FORTUNE Magazine) – CAN ECONOMISTS teach business people anything useful about the day-to-day running of companies? About such meat-and-potatoes problems of managerial life as how to restructure your company, how to motivate and compensate employees, how to outfox your competitors, whether to compete in a new market? For much of its 200-plus-year history, the dismal science has had little to say about such questions, but that's changing fast. A generation of young economists has been applying new theories and powerful tools to the real world of business, and a river of research has begun to flow from their efforts. Some of their thinking is percolating into the world of consulting and into executive management seminars at leading business schools. And as companies hire young university graduates exposed to the new ideas, the concepts will increasingly become part of corporate decision-making. Call it business-oriented economics, and it is very much a two-way street. Says Daniel Spulber, who teaches the subject at Northwestern University's Kellogg School: ''Economists have a lot to contribute to management and a lot to learn from talking to managers and finding out about their concerns.'' Spulber edits the quarterly Journal of Economics & Management Strategy, a two- year-old showcase for the new research. Adds Judy Lewent, chief financial officer of Merck: ''Some of the academic work is running parallel to what a lot of us in industry are trying to do -- analyze a competitive environment that gets tougher and tougher, where every problem has more than one variable.'' What defines business-oriented economics is its focus on what economists call ''the firm'' -- and the rest of us call ''the company'' -- as the unit of analysis. Traditional microeconomics, by contrast, is concerned with markets and prices. It looks at the economy or at an industry, but rarely peeks inside the individual enterprise. Indeed, anyone who wandered into the usual course in microeconomics would discover only that the firm sells everything it produces at a market price that it does not control. Says Yale economist Bengt Holmstrom: ''There was nothing there for a manager to learn.'' A SERIES of conceptual breakthroughs in microeconomics and game theory over the past dozen years has set the stage for today's work. Microeconomics begins by applying the standard methodology of science -- the formulation of mathematical equations -- to model the problems of prices and markets. Game theory uses equations to model the behavior of decision-makers whose choices affect one another. The new ideas tend to be commonsensical notions with forbidding-sounding names like ''bounded rationality,'' ''asymmetric information,'' and ''incomplete contracts.'' Bounded rationality merely adds to game theory the obvious fact that decision-makers cannot know all -- or maybe even most -- of the possible outcomes of the negotiations and transactions they are involved in. Asymmetric information is the blinding insight that one party to a deal usually knows more about it than the other, while incomplete contracts describes the real-world truth that contracts between two parties are not a straightforward you-pay-me-and-I-work, the standard economic assumption. Instead, they are often vague and unclear about what the parties must do if conditions change. Once these concepts are rigorously thought through, turned into equations, and plugged into economic models, they make theory sit up and work. Says Stanford economist John Roberts: ''The ability to begin representing in a detailed, formal way the rules for various kinds of decisions has made it possible for economists to analyze questions that basically escaped them when all they knew how to study were prices and markets.'' For a practical example of how mathematical models and the arcana of game theory are being used today to assist managers, check out Merck and the work that Judy Lewent is doing. She sits on the seven-person chairman's staff, and her 500-strong finance team not only handles the basics of corporate finance such as bond issuance and bank borrowing but also helps evaluate, analyze, and quantify Merck's major business decisions. Last year the finance department built a supersophisticated computerized economic model to analyze Merck's proposed $6.6 billion acquisition of Medco, the mail-order pharmacy company. The question the model sought to evaluate was how Merck would fare in the future with Medco -- and without it. Into the equations went a vast number of variables, representing information about the U.S. health care system, about profit margins, about possible future changes in the mix of generic and brand-name drugs, and about Merck and its competitors -- along with game theory guesses about how the competitors would react to the merger. Perhaps the biggest variable was what kind of health care reform there would be in the U.S. The model gradually swelled to include thousands of formulas. Lewent subjected the complex model to a statistical technique known as Monte Carlo analysis, often used in modern economics, which simulates the haphazard events of real life. A computer changed the variables at random and then tested the model to see how the proposed merger would work out under different economic and business scenarios. Says she: ''Monte Carlo techniques are a very, very powerful tool to get a more intelligent look at a range of outcomes. It's almost never useful in this kind of environment to build a single-bullet forecast.'' The model helped Merck management decide that the Medco acquisition made sense -- whether or not health care reform materializes. Some of the recent work in business-oriented economics is more akin to basic research. It helps managers organize their experiences and insights and provides them with a framework for thinking about actual business problems. Stanford's John Roberts and Paul Milgrom are pioneers in the field and authors of Economics, Organization & Management, a textbook used in many MBA programs. Among the subjects they investigate is the importance -- and difficulty -- of coordinating decision-making within a company. In one example, they look at the typical tension between a company's marketing and manufacturing divisions, and show how that tension can distort profitability in the absence of explicit strategic planning. For example, the marketer decides how many products to offer and in what variety, while the manufacturing manager determines how large the batch size will be. Greater variety will permit the firm to tailor its products more closely to customer needs and either charge more for them or sell more units. But there are offsetting costs, such as higher inventories. When Milgrom and Roberts model this relationship, with each manager's possible choices reduced to a mathematical formula, they arrive at a key insight. There will be several possible ''solutions'' -- combinations of product mix and batch size -- that will appear to each manager to produce optimal profits for the firm, based on what each expects the other to do. The professors call them ''coherent combinations.'' BUT ONLY ONE of the combinations will produce the highest absolute profits for the firm, and the managers, on their own, may not have enough information to make the best decision. That's when the senior manager with access to all the information must look at all the combinations and decide. Translating the business problem into the austere structure of a mathematical model can help a manager concentrate on its essence. But if he or she fails to understand the breadth of the required changes and implements only some of them, a disaster can still result. Consider one of the great tactical blunders of modern manufacturing, General Motors' multibillion-dollar investment in robots in the 1980s. GM installed sophisticated, flexible machines that could have turned out different models and innovative designs by the car lot. But GM failed to reengineer its factories to realize the full potential of the robots, and thus wound up using them simply as an inflexible substitute for labor. This was an ''incoherent combination,'' as Milgrom and Roberts would call it. Had GM's top managers thought through their plans for robotics in a microeconomic framework, boiling down the essential elements into a mathematical model, the exercise might have helped them recognize the problems ahead and saved GM's stockholders a bunch of money in the process.

Business-oriented economics can also be applied to management problems that are usually considered purely subjective. Imagine, for instance, that it's your job to find a new CEO. You can hire Mr. Nice, who will empathize with and empower his subordinates, or you can opt for bottom-line-driven Ms. Barracuda, who cares only about her stock options and secretly yearns to be on the cover of FORTUNE's Toughest Bosses issue. The central question is, What effect does management style have on profits? That's an inquiry older than Machiavelli and as subjective, seemingly, as a sunset. Julio Rotemberg and Garth Saloner, who teach economics at MIT and Stanford, respectively, took up this question in a recent research paper. While their work is full of the kind of math beloved by the plastic-pocket-protector set, one element gives an idea of what they're up to. The key variable in all their calculations is the boss's personality type. For Barracuda, the value plugged into the computations is zero. The variable increases as the CEO becomes more empathic and less profit-oriented until we arrive at a value of one for Nice, who cares only about his team. Then Rotemberg and Saloner incorporate the insights derived from the stylized mathematics of game theory: that is, the subtle ways that incentives affect real-world behavior. Suppose you want the CEO's subordinates to generate proposals for profitable new projects. People reporting to Mr. Nice believe he wants them and their projects to succeed, so they will suggest more ideas. Nice will also try hard to make their schemes work out, staying with them even when they begin to look dubious. By contrast, Ms. Barracuda's subordinates know anything that looks iffy will get the quick chop, so they will generate fewer ideas to begin with. Finally, Rotemberg and Saloner calculate the profitability of a range of new ventures for their imaginary firm, given the different values for the variable that represents managerial style. The main conclusion of the exercise is the not surprising insight that what kind of leader you want depends on what kind of business environment you're in. You will anoint Barracuda if new ventures aren't likely to pay off, but if one hits it will be big. On balance she will do a better job for your shareholders because she will bet only on a sure thing. If the likelihood of new ventures' succeeding is high, however, Nice is your guy. Not only will he make his subordinates happy as he lets a thousand projects bloom, he will also maximize shareholder value because enough of the ideas will be profitable to offset the losers. In the extreme case where the environment is so attractive that all projects will pay off, it doesn't matter whom you hire. HUNDREDS OF economists are now studying business subjects as varied as labor relations, mergers and acquisitions, marketing, and new-product development. The body of knowledge they are generating will grow in the slow fashion of scholarship as they observe the business world, construct formal theories and models of its ways, and then test the results of their research. Says Michael Porter, the Harvard business school management professor who was one of the first modern business strategy experts with a background in formal economics: ''The explosion of this literature has been enormously positive, and we've learned a lot.'' The day will never come when an economist with a game theory model on a computer disk can give you a five-year plan for turning your market-lagging mutt of a company into a sleekly profitable greyhound. But what the modern business economist is just beginning to do -- by submitting ideas and data to the discipline of mathematics and models -- is help you understand the nature of your managerial problems, explain how certain ways of thinking about them may be better than others, and show you how actions taken now might affect outcomes in the future.