Strategy

by Lawrence Freedman

  John Rockefeller did not appear in the index to Porter’s Competitive Strategy. He might have found the language and concepts unfamiliar but as one ready to try every trick in the book to position Standard Oil, the broad thrust of the argument would have been well understood. The management strategists of the late twentieth century were operating in an environment shaped significantly by the great trusts of the nineteenth century and the progressive movement’s attempts to deal with them. The logic of any attempt to tame markets was to make life difficult for at least some competitors. While the first wave of management strategists ignored this issue, because they were dealing with firms that were in secure positions or close to the limits of their legal growth, this was not the case with the second wave, which—as exemplified by Porter—did not so much embrace competition as seek ways to subdue and circumvent it. The third wave embraced competition with enthusiasm.

  CHAPTER 33 Red Queens and Blue Oceans

  Here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast.

  —The Red Queen in Alice Through the Looking Glass

  AGAINST THE BACKDROP of intense competitive pressures, the role of the manager was increasingly thrown into relief. The rewards they could make at the top of major companies grew, but so did the risks of being fired. Their performance was being judged against ever more demanding standards, but short-term profitability of the sort that would impress investors increasingly became the most important objective by far. Investing for the long term appeared less attractive than selling off weaker units or taking aggressive action against all perceived inefficiencies.

  The challenge to the role of the managers was posed by agency theory, derived from transaction cost economics. It directly addressed the issue of cooperating parties that still had distinctive interests. In particular, it considered situations in which one party, the principal, delegated work to another, the agent. The principal could be in a quandary by not knowing exactly what the agent was up to, and whether their views of risk were truly aligned. This issue went to the heart of relationships between owners and managers. The rise of managerialism reflected the view that the agents were the key people. In business and politics, the notional principals—the stockholders/ board members and the electorate/politicians—were transitory and amateurish compared with the fixed, professional elite. The progressive separation of ownership and control had been charted by Berle and Means in the 1930s. The question posed now was whether and how the principals could reassert control over their agents.1 If the agents did not wish to be so controlled, they had to take the initiative in demonstrating their value to shareholders or else find ways of releasing themselves from this constraint by becoming the owners as well as the managers.

  Agency Theory

  Michael Jensen, a Chicago-trained economist at Rochester, was impressed by a 1970 article in the New York Times by Milton Friedman that announced his arrival as an outspoken advocate of free-market economics. Friedman’s target was activist Ralph Nader’s campaign to get three representatives of the “public interest” on the board of General Motors. Friedman countered that the only responsibility of the corporation was to make profits so long as it engaged in “open and free competition without deception or fraud.” His arguments challenged the managerialism of the past two decades directly: the leaders of the big corporations should neither expect to act as agents of the state nor expect the state to shield them from competition. This led Jensen and a colleague, William Meckling, to try to turn Friedman’s plain speaking into economic theory. They found little to work with. They then made a big leap, taking what had become a contentious hypothesis when applied to finance—that markets were sufficiently efficient to provide a better guide to value than individuals, notably fund managers—and applying it to management. In this way, Justin Fox remarked, “the rational market idea” moved from “theoretical economics into the empirical subdivision of finance.” There it “lost in nuance and gained in intensity.” It was now seeking to use the “stock market’s collective judgment to resolve conflicts of interest that had plagued scholars, executives, and shareholders for generations.”2 By assuming perfect labor markets, so that employees cost no more than what they were worth to the company and if necessary could move without cost to an alternative job, their analysis concluded that the most important risks were those carried by shareholders.3

  By 1983, because of the growing interest shown by economists, Jensen felt able to claim that a “revolution would take place” over the coming decades “in our knowledge about organizations.” Though organization science was in its infancy, the foundation for a powerful theory was in place. This involved departing from the economists’ view of the firm as “little more than a black box that behaves in a value- or profit-maximizing way” in an environment in which “all contracts are perfectly and costlessly enforced.” Instead he argued that firms could be understood in terms of systems geared to performance evaluation, rewards, and the assignment of decision rights. Relationships within an organization, including those between suppliers and customers, could be understood as contracts. Taken together they formed a complex system made up of maximizing agents with diverse objectives. This system would reach its own equilibrium. “In this sense, the behavior of the organization is like the equilibrium behavior of a market.” This insight, he argued, was relevant to all types of organizations. It led to cooperative behavior being viewed “as a contracting problem among self-interested individuals with divergent interests.”4

  The prescriptive implication of this approach was that the owners had every reason to worry that their managers were getting distracted. Getting the interests of owners and managers back into alignment through monitoring and incentives required challenging the claims of managerialism. Deregulated markets were favored because they put at risk the positions of managers who were not delivering value for shareholders. Contrary to the pejorative connotations of hostile takeovers, the argument of Jensen and his colleagues was that these could increase the efficiency of the market. Managers dare not get sidetracked by loose and fashionable talk of multiple “stakeholders” but must keep their focus on the needs of the “shareholders” for profit maximization. While managers might complain about takeovers, they were a way of increasing value, redeploying assets, and protecting companies from mismanagement. “Scientific evidence indicates that the market for corporate control almost uniformly increases efficiency and shareholders’ wealth.”5 Companies were viewed as a bundle of assets, formed and reformed according to the demands of the market. The market was all-knowing, while managers were inclined to myopia. By 1993 Fortune could declare: “The Imperial CEO has had his day—long live the shareholders.”6

  Adopting this view reduced the need for strategy and management. Once free-market determinism was adopted, then it was possible to “assume a management” as all other factors might also be assumed. It became just another “substitutable” commodity or, even worse, an opportunistic actor “in need of market discipline.”7 The manager’s obligations were not inward-looking but only outward-looking, toward the shareholders. This was despite the fact that shareholders might be transitory and incoherent as a group and short term in perspective, or that efficient organizations had to be formed and nurtured if the moves the market demanded were to be implemented. The implications for the standing and vocations of managers were profound. The theory suggested that an organization’s history and culture were irrelevant, staffed by people who might as well be strangers to each other. Managers being trained in this theory would offer no loyalty and expect none in return. Their task was to interpret the markets and respond to incentives. Little scope was left for the exercise of judgment and responsibility.

  Management: A Dangerous Profession

  In the early 1980s, warnings were first heard about the potential consequences of such logic for the running of businesses. The malaise was identified in 1980 by Robert
Hayes and William Abernathy, both professors at the Harvard Business School. American managers, they complained, had “abdicated their strategic responsibilities.” Increasingly from marketing, finance, and law rather than production, they sought short-term gains rather than long-term innovation. Particularly pointed, especially in the leading business school journal, was the assertion that the problem lay in an increasing managerial reliance on “principles that prize analytical detachment and methodological elegance over insight, based on experience, into the subtleties and complexities of strategic decisions.” Within both the business community and academia, a “false and shallow concept of the professional manager” had developed. Such people were “pseudoprofessionals” who had no special expertise in any particular industry or technology but were believed to be able to “step into an unfamiliar company and run it successfully through strict application of financial controls, portfolio concepts, and a market-driven strategy.” It had become a form of corporate religion, with its core doctrine that “neither industry experience nor hands-on technological expertise counts for very much,” which helped to salve the conscience of those that lacked these qualities but also led to decisions about technological matters being taken as if they were “adjuncts to finance or marketing decisions” and could therefore be expressed in simplified, quantified forms.8

  At the end of the decade, an unimpressed Franklin Fisher observed, “Bright young theorists tend to think of every problem in game-theoretic terms, including problems that are easier to think of in other forms.”9 Even in oligopoly theory, to which game theory seemed most suited, Fisher argued that it had not made a fundamental difference. It remained the case, after game theory as before, that a “great many outcomes were known to be possible. The context in which the theory was set was important, with outcomes dependent on what variables the oligopolists used and how they formed conjectures about each other.” The effects of market structure on conduct and performance, he argued, had to take account of context. It was true that game theory could model these contexts, but this would not be in a convenient language. In response, Carl Shapiro argued that game theory had much to show for its efforts. But the prospect he offered was explicitly close to Schelling, suggesting not so much a unified theory but tools to identify a range of situations, ideas of what to look for in particular cases, but still dependent on detailed information to work out the best strategy. He also suspected “diminishing returns in the use of game theory to develop simple models of business strategy.”10 The subtle and complex reasoning described in the models was rarely replicated by actual decision-makers, who were “far less analytic and perform far less comprehensive analyses than these models posit.”11 Saloner acknowledged the challenge, especially if the models were taken literally and supposed to mirror an actual managerial situation with the aim of coming up with a prescription for action. He argued that “the appropriate role for microeconomic-style modeling in strategic management generally, and for game-theoretical modeling in particular, is not literal but rather is metaphorical.”12 It was not a distinction that was regularly recognized. It was all very well producing elegant solutions, but they were of little value if they were to problems that practitioners did not recognize and expressed in forms that they could not comprehend, let alone implement.

  Although there were available academic theories that might assist in the design of organizations fit for particular purposes or at least explain why apparently rational designs produced dysfunctional results, nobody in business or government seemed to be taking much notice. Despite this growing divergence, the framework for research was difficult to change. Journals put a premium on established theories and methods. The apparently harder, quantitative work inspired by the economists assuming rational actors was dominant. Because modern software made large-scale number crunching possible, there was also a large database mentality. Research students were advised to avoid qualitative studies.13 The effects could be seen not only in the research but in the norms for behavior the standard models were suggesting. In 2005, Sumantra Ghoshal observed:

  Combine agency theory with transaction costs economics, add in standard versions of game theory and negotiations analysis, and the picture of the manager that emerges is one that is now very familiar in practice: the ruthlessly hard-driving, strictly top-down, command-and control focused, shareholder-value-obsessed, win-at-any-cost business leader.14

  During the 1990s, theories were developed for this new breed of manager, promising success that could be measured in profit margins, market share, and stock prices. They reinforced the challenge to the idea of manager as the secure and steady, but essentially gray, bureaucrat who knew his place in the large corporation, which in turn knew its place in the larger economy. They offered “a conception of management itself in virtuous, heroic, high status terms.”15 As James Champy, who was at the heart of the neo-Taylorist push in the 1990s, observed, “Management has joined the ranks of the dangerous professions.”16 The sense of danger reflected the greater demands being placed on managers, as they had to fear not only absolute but even relative failure. In the world as celebrated by Jensen, stockholders were demanding faster and larger returns, and predators had their eyes open for potential acquisitions. Survival and success required not only attention to customers and products but a readiness to be ruthless, to hack away at the least efficient parts of the business, to push away and overwhelm competitors, and to lobby hard for changes in government policy—especially deregulation—that would open up new markets.

  Attitudes toward finance had been transformed. The oil shocks and inflation of the 1970s extended a period of modest returns on equities, combined with a traditional reluctance to carry excessive debt. By the end of that decade, new and imaginative ways of raising capital were found. Companies could grow ambitiously and quickly by issuing bonds. Those investors prepared to take a greater risk could anticipate higher yields. With capital plentiful, many companies grew through mergers and acquisitions rather than by developing new products and processes. Attitudes became increasingly aggressive, with the focus on extracting value from corporate assets that had been missed by others or which current owners were unable to exploit. The logical next step was for the senior executives of companies to challenge the ownership model which saw others get the greatest benefit from their achievements. Management buyouts liberated them from their boards, providing greater scope for initiatives while incidentally generating a lot of money. This surge of activity eventually ran its course as the deals became more expensive and the returns disappointed. The debt still had to be serviced, and if it was too large, bankruptcy followed.

  Businesses were now judged by their market value. This should reflect their intrinsic quality and the longer-term prospects for their goods and services, but that was not always easy to assess and all the incentives were for those who held the stock, including managers, to talk up its current value. This made success tangible and measurable compared with the longer-term development of a business which might require patience and low returns before the rewards became evident. But assessments of market value were vulnerable to sentiment and hype, as well as downright fraud. The energy company Enron was the prize exhibit of the latter possibility. This risk was greatest in areas that were hard to grasp, whether because of the sophistication of the financial instruments or the potential of the new technologies. Within companies, any activities that might be holding down the price, not providing the value that was being extracted elsewhere, came to be targeted. Thus they encouraged remorseless cost cutting.

  Business Process Re-engineering

  The Japanese success over the postwar decades could be taken as a triumph of a focused, patient, coherent, and consensual culture, a reflection of dedicated operational efficiency or else a combination of the two. Either way, the pacesetter was the car manufacturer, Toyota. Having spent the Second World War building military vehicles, the company struggled after the war to get back into the commercial market. Hampered by a lack
of capital and technical capacity and by a strike-prone, radicalized work force, Toyota would probably have gone bankrupt were it not for the Korean War and large orders to supply the American military with vehicles. It then began to put together what became known as the Toyota Production System. The starting point was a solution to labor unrest by a unique deal which promised employees lifetime employment in return for loyalty and commitment. Together they would work to establish a system which would reduce waste. Ideas for improving productivity could be raised and explored in “quality circles.” As this was a country where everything was still in short supply, a visit to a Ford plant in Michigan in 1950 left an abiding impression of the wastefulness of American production methods. Toyota aimed to keep down inventories and avoid idle equipment and workers. With excess inventory identified as both a cause of waste and a symptom of waste elsewhere in the system, methods were developed to process material and then move it on “just in time” for the next operation. Within Japan, Toyota’s methods were emulated and further developed by other companies. In one industry after another, including motorcycles, shipping, steel, cameras, and electronic goods, Western companies found themselves losing market share to the Japanese. Government policy, the need to start from scratch after the war, and a cheap currency all helped.