Strategy Land

When I studied economics in the early 1970s, the totally dominant point of view in academic circles was that differences in profit rates were industry effects. High profits were due, it was argued, to muted competition taking place behind high barriers to entry. Economic studies compared industry profitability to overall industry concentration and found a relationship. A done deal.

This dominant view had serious consequences. It shaped the Federal Trade Commission’s guidelines on concentration and mergers and served as the background to many antitrust battles in the courts. At this time, the strategy field was just beginning to find its legs as a legitimate discipline and I began to realize that our basic proposition was that this “industry” view was terribly incomplete. Case studies of a number of industries had revealed that competing businesses did not all approach the market in the same way, and often achieved sharply different levels of performance. We called these differences in approach strategies. Our field data indicated that many industries were far from homogeneous—within each industry, firms differed greatly in their approaches and their results. Full entry→

In 1982, Steven Lippman and I offered a very general logical answer to the puzzle of sustained differences in efficiency or effectiveness. Our theory—uncertain imitability¹—argued that the inability to understand and explain the sources of efficiency differences is precisely what allows them to persist. The act of trying to build or replicate a business is fraught with uncertainty and error. Therefore, imitative attempts will not produce identical outcomes. In competition, after attempts to adopt “best” practices, some firms will still be more efficient than others. Full entry→

1. Lippman, Steven A. and Richard P. Rumelt, “Uncertain Imitability: an Analysis of Interfirm Differences in Efficiency Under Competition.” Bell Journal of Economics. 13 (1982): 418-438. [↩]

The strategy field’s first systematic theory about these sustained differences in performance attributed them to learning and market-share. Indeed, during the late 1970s, almost every book, paper, and address on business strategy put learning and market-share on center stage. Today we know that this early focus on learning and market-share grossly overstated their importance. That understanding was the hard-won result of a number of complex research efforts. Full entry→

For me, there is a special excitement in fundamental questions—their childlike simplicity covers deep mysteries. A student once asked physicist John Wheeler: “What is time?” Wheeler replied, “Time is what prevents everything from happening at once.” Just as time is a fundamental mystery in physics, the world of business strategy also has its fundamental questions. One that I helped define and which has guided a great deal of my own research is “Why are firms different?”

At first glance this might seem to be a trivial concern. Each tree or mountain is different from other trees or mountains—so why are differences among firms puzzling? The puzzle arises because firms compete. If one firm has a design which works better, either by accident or cleverness, then other firms will work to incorporate those superior elements into their own designs. Yet, we know, that despite all this continual striving, striking differences in effectiveness remain among competing businesses. The challenge is to discover what allows these differences in effectiveness to persist despite competition.

As a simple example, Dell succeeded greatly during 1988-2002, besting competitors IBM, Hewlett-Packard, Compaq, and Gateway. Because of this high performance, books were written, MBA students studied cases about Dell, key managers left Dell for employment elsewhere, and a host of other mechanisms spread the word about Dell’s strategy and methods. After over a decade, what can possibly remain proprietary about Dell that that its rivals could not have duplicated or even improved?¹ Just as time is that which separates events, there is something that sustains the distinctiveness of firms. That “something” is the substance out of which sustained advantage is constructed. Figuring out the nature of that “substance” energizes a substantial stream of research in the field of business strategy.

In this series (What Keeps High Profits High?) I trace key steps in the evolution of thinking about this “something.” It is largely a personal narrative, centered on my own research and my own changes in thinking. It is also unabashedly academic in content and tone. Indeed, part of my intent in writing this series has been to communicate some of what it feels like to do scholarly research.

Being a Foot Soldier

Everyone knows that university professors teach, an activity we have all experienced if only on the receiving end. But, what is it to be a scholar in a practical field like business? Being a scholar is not normally a road to riches or popular fame. Instead, scholars are interested in finding out how things work. Their external rewards, if any, are recognition, honor and remembrance by their fellows. The University of California, where I work, has nine campuses, and employs about 8,800 professors. According to the internal promotion documents, each professor is at the forefront of their field. But most know the truth—almost all of us are only foot soldiers in the battle for understanding. Only one of us in fifty will be read after their passing. Only one in five hundred will be remembered half a century beyond. And, perhaps one in a generation will write words that whisper down the centuries.

The academic community has a long memory. Within it, research in business is a new activity and research in business strategy is in its infancy. We boast no Nobel Laureates nor is there any “Council of Strategy Advisors” to the President. Why would anyone choose such a field over well-established strongholds like, economics, political science, and psychology? I chose it because it is small, new, and undeveloped. I thought that in this new developing field one foot soldier just might make a difference.

1. HP and Compaq merged in 2002. IBM sold its PC business to Levano in 2004. [↩]

Mao and Khrushchev in Beijing 1958

In 1956 Chairman Mao declared a new openness in the Chinese Communist Party. He echoed the Soviet Party’s criticisms of Stalin and declared “Let a hundred flowers bloom.” It wasn’t long before criticism arrived. Wall-posters and speakers began to complain of the Party’s monopoly on power and compared life in China to being in prison. After five months of “openness,” the trap closed. Mao ordered that criticism was forbidden. People who had spoken out were labeled “Rightists.” Denunciations began and he set an official quota of 10% of all intellectuals to be identified as Rightists. Many of those denounced became suicides, their families outcasts. Some were executed. Full entry→

Extortioners coerce payments by threatening loss or violence. When I was in high-school in Queens, New York, the younger students were shaken down each day by Gino and his two friends. We had to cough up lunch money or be beaten. My friend, Robert, complained to his home-room teacher who confronted the small gang. Gino broke the teacher’s arm. After that, the school administration put a system of hall monitors in place. The hall monitors got to skip a class in return for their work. Gino and his gang were the monitors.

Extortion and protection are always closely related because the physical or political power to protect is, at the same time, the power to coerce, and vice versa. As people have learned over and over again through the millennia, the governments, armies, and police that are created to protect also have the power to extract payments and force behavior. Full entry→

Richard Helms CIA Director

In 1973 I was living in Iran, on leave from my faculty  position at Harvard Business School, helping to start a new business school in Tehran—the Iran Center for Management Studies (ICMS). While there I spent an afternoon with Richard Helms. He had been one of the founders of the CIA and had been its chief since 1966.

When I met Helms, he had just been pushed out by President Nixon because he refused to help cover up the Watergate affair. He was in Iran for a week, mulling what would soon be his new position in the hinterlands—ambassador to Iran. Helms was concerned with how the U.S. embassy staff tended to live apart from ordinary Iranians and wanted to talk about how we avoided that kind of insularity at my school. Full entry→

When you buy a hamburger from McDonald’s you know the product and you know that you value it more than the money paid for it. Combine this sort of voluntary transaction with Darwin’s principle of “survival of the fittest,” and you have the doctrine that “in economic competition the firms that survive are the most efficient available ones in providing economic benefits to society.”¹ According to this point of view, successful firms are those which are capable of providing the most value to buyers at the least cost. This perspective informs most modern discussions of business strategy.

If people and firms only competed by offering superior value in voluntary fully-informed transactions, the world would certainly be a better place. Unfortunately, only Dr. Pangloss could overlook the amount of parasitism, coercion, rancid character, and exploitation of human weakness in the world.

Competition is not limited to rivals trying to offer more value at lower costs. Many firms will routinely exploit the natural human weaknesses of their buyers, earning profits that are disconnected from any social benefit. Once a company establishes a competitive advantage, parasites will attempt to skim payments without providing any value in return. More seriously, some agents will try to extort payments from any successful enterprise. Politicians will enact general rules and then reserve special exemptions for those who have curried favor. And, competitors will misrepresent products and exploit the ignorance of naiveté of buyers. As a strategist, you must be prepared for the dark side.

1. Clem Tisdell, “Economics, Ecology, and the Environment,” University of Queensland Working Paper No. 62, 2001, p. 7. [↩]

Risk Assessment Model (www.mathworks.co.kr)

Since the vivid failure of financial risk models in 2007-2008, regulators, auditors, IT professionals, and others have begun pressuring for estimates of “model risk.” Looking back, it is clear that financial engineers underestimated the risk of a crash in housing prices and, more importantly, did not model the fragility of the interconnections among leveraged banks and the shadow finance system. Put simply, “model risk” is the risk that a risk model is wrong.

The whole idea of “model risk” comes from financial engineering’s quasi-religious belief that their models can be made to match reality by sufficiently vigorous tweaking of assumptions and parameters. By contrast, real engineers know that models are always wrong—that is why they are called “models.” Full entry→

Franklin Delano Raines

In 2002 Fannie Mae gave CEO Franklin Raines a salary of just under $1 million, a bonus of $3.3 million, stock options worth $6.7 million, and a “long-term” incentive payment of $7.2 million. These non-salary payments were each geared to meeting various annual goals for earnings and earnings per share. This very typical way of compensating top executives dramatically increases the riskiness of the strategies they choose.

One way to increase your income under such a plan is to cheat. That is what Clinton-appointee and Rhodes Scholar  Franklin Raines did. In 2004, the SEC determined that his administration had overstated the corporation’s income by at least $10 billion. He resigned, keeping his past bonuses and retiring on a pension of $114,000 per month. Full entry→