Edge Perspectives with John Hagel

Mastering New Marketing Practices

Last month, I had the pleasure of addressing a CMO Summit held in New York.  I was given 15 minutes to set up a discussion on the future of marketing. It forced me to be even more concise than usual, but I was  able to pull together a number of themes from my client work that I will eventually develop in a more systematic form.  In the meantime, I thought it would be useful to write up my speaking notes to share a high level view of where marketing is going.

Shifts in business economics

We are in the early stages of a profound shift in the economics of business that will transform marketing (along with many other things). Three shifts in economics are occurring in parallel.

First, we are moving from a world of relatively scarce shelf-space to relatively scarce attention.  Second, costs of production and physical distribution are significantly declining on a global scale and customer acquisition and retention costs are rising.  At the risk of over-simplification, value creation is shifting from businesses driven by economies of scale in production to businesses driven by economies of scope in customer relationships. Layer in a third factor at work – the systematic and significant decline in interaction costs that make it easier for customers to identify vendors,  find information about them, negotiate with them, monitor their performance and switch from one vendor to another if they are not satisfied with performance.

These three forces reinforce each other and help to explain the growing power of customers in markets around the world.

Redefine marketing strategy

These shifts have broad implications in terms of marketing strategy, branding and marketing performance metrics.  To start with marketing strategy and again at the risk of over-simplification, conventional marketing is built upon the three “I’s”:

• Intercept – target and expose customers to your message wherever you can find them.
• Inhibit – make it as difficult as possible for the customer to compare your product or service with any other options.
• Isolate – enter into a direct relationship with the customer and, wherever possible, remove all third parties from the relationship.

Nirvana is the walled garden of direct marketing.  It is captured in the mantra of “one to one marketing” – one vendor dealing individually with each customer.

A different approach will be required to succeed in a business landscape defined by the economic shifts described earlier. I describe this marketing approach “collaboration marketing” and define it in terms of three “A’s”:

• Attract – create incentives for people to seek you out.
• Assist – the most powerful way to attract people is to be as helpful and engaging with them as possible – this requires a deep understanding of the various contexts in which people might use your products and a willingness to “co-create” products with customers.
• Affiliate – mobilize third parties, including other customers, to become even more helpful to the people you interact with.

In contrast to the “one to one marketing” mindset of conventional marketing, collaboration marketing requires a “many to one” mindset.  The winners in this new world will be orchestrators who can mobilize rich networks of resources to serve customer needs.

Move to a different brand promise

I have written about this before here, here and here. Conventional brands are built upon product or vendor-centric promises: “Buy from me because I have great products or because I am a great vendor.”  These brands are generally eroding in value.

Brands will become even more important and valuable in this new marketing world, but they will be based on a very different customer-centric promise: “Buy from me because I know you as an individual customer better than anyone else and you can trust me to use that knowledge to configure the right bundle of products and services to meet your individual needs.”  Note that this is different from customer segment brands like Nike or Disney – customer-centric brands require a deep understanding of the needs of individual customers. Not all companies can or should make the transition to this new kind of brand promise, but those who do will be richly rewarded.

Adopt new performance metrics

Given the shift in business economics defined earlier, companies need to move from measures of performance based on product or facility economics to measures based on customer economics.  Two key questions will increasingly shape business performance. First, what is the average life time value of customers – how much does it cost to acquire a customer, what is the average length of a relationship with a customer, and how much profit is generated over the lifetime of the customer? Second, what is the 80/20 segmentation of customers – which 20% of customers generate 80% of the profitability and why? Few companies today can systematically answer these questions.

We will also move to a new form of ROA measure – this time, it means Return On Attention, both from a customer perspective and from a vendor perspective. From the customer point of view, the question that customers will increasingly ask is: “Of the total attention I allocate to a particular source, what is the productivity of that attention in terms of  value received for effort and time invested?”

We’ll also see a new form of ROI measure – Return On Information, again from both a customer and vendor perspective.  From a vendor point of view, the key question will be: “How much effort and cost did I invest in acquiring information about individual customers and how much value have I been able to generate in return, both for the customer and for me?” In this context, lead-times matter; the more quickly a vendor can turn around and deliver tangible value in return for information from a customer, the more quickly and effectively the vendor will be able to build trust and willingness to provide even more information.

Vendor response disappointing so far

Sorry to say, vendors are responding as vendors – old habits and old instincts die hard. While there is a broad recognition among marketers that attention scarcity is becoming a big issue, the response has been increasing desperation to get some of that scarce attention.  Intrusive ads are appearing in more and more places – projected in lights on the sides of buildings at night, plastered on the sides of farm animals in fields and running on video displays above urinals. Rather than just focusing on how to get attention, vendors might also want to consider how they can help their customers receive attention that is important to them and not just from the vendor, but from others that matter to the customers.

Vendors also tend to commoditize attention, viewing attention as a fungible good that can be bought and sold.  Successfully attracting attention requires an understanding that attention is highly context sensitive – it is both deeply personal and social at the same time.  Attention is deeply embedded in, and shaped by, relationships.  These relationships are not static, but increasingly dynamic.  The key challenge and opportunity for vendors is how to participate in, and enrich, these relationships in order to construct more value for their customers and to amplify the value of attention.

Vendors also narrow the focus very quickly from attention to intention, asking “how can we more effectively intercept people who have already formed an intent to buy?”  The missed opportunity is how to engage the attention of customers at a more fundamental level in ways that create more value for the customers and for the vendor.

Finally, vendors tend to develop a narrow focus on new, network-enabled marketing tools like blogs, wikis, virtual communities and social networks, treating them like a checklist to be deployed like  artillery in a military campaign – “yes, we’ve set up some blogs.”    Few of them systematically ask how these tools might be used to increase return on attention for customers.  Even fewer ask who else already has deployed these tools and how they might help their customers find and connect to these resources and perhaps where they might participate in existing environments in ways that provide more return on attention.

Actions to take

To navigate through this fundamental shift in marketing, CMOs will need to recognize that this is an organizational change challenge, something that most CMOs are not very comfortable in confronting.  They would much rather design and deploy a clever marketing program than figure out how to change the hearts and minds of people throughout the organization.

At its most basic level, adopting these new marketing approaches will require a shift in mindset.  Rather than viewing markets as places where vendors seek out customers and try to sell them as much stuff as possible, successful players will recognize that we are increasingly participating in “reverse markets” where customers seek out vendors when it is relevant and then negotiate to get as much value as possible from the vendors they deal with.

To support this shift in mindset, CMOs will need to focus on three things in particular.  First, find some ways to demonstrate impact through focused initiatives designed to demonstrate the power of new marketing approaches.  Identify specific opportunities to be more helpful to some of the company’s most profitable customers.  Find partners who can help to leverage the value of the firm’s resources and then define a set of near-term value exchanges with customers that can help build trust and earn the right to more attention from these customers.  Measure and celebrate the results.

Second, and more broadly, change organizational roles where necessary so there are executives that have clear accountability for specific customer segments – and sufficient influence to mobilize the resources required to serve those customer segments effectively.  Third, adopt performance metrics throughout the organization that recognize and reward initiatives designed to increase the life time value of customers and deepen relationships with the most profitable customers (while working to improve the profitability of the rest of the customer base).

Customers are rapidly gaining more power in dealing with vendors.  Marketing practices have only modestly changed to reflect that new reality.  There is still enormous opportunity to master the new marketing practices required to compete successfully in reverse markets.  The change in mindsets and practices is significant, but there is a pragmatic migration path that companies can pursue. 

Innovation and the Competition for Talent in China and India

The Financial Times ran an article on July 20, 2006 headlined “Up to the job? How India and China risk being stifled by a skills squeeze” (registration required) looking at the growing competition for talent in these countries.

It’s interesting on a number of levels, but primarily because it underscores the danger of continuing to view India and China as offshoring locations offering simple wage rate arbitrage – a view that too many Western companies still hold. In the more developed cities like Bangalore and New Delhi and Shanghai and Shenzhen, competition for talent is intensifying, with predictable consequences for wage rates and employee turnover.

In the IT services industry in India for example, the article quotes Nasscom, an Indian trade association, as reporting that annual employee turnover rates are approaching 40 percent and pay inflation reaching 20 percent this year. As a result, according to the article, some Western companies like Apple and Powergen (a UK utility) have announced closure of support centers based in India.

Now, there are two ways to view this intensifying competition for talent.  Looked at through the narrow lens of wage arbitrage, this may be viewed as easing the pressure for Western companies to offshore their own operations and to compete with Chinese and Indian companies benefiting from lower wage rates in their home countries. So, perhaps this is good news for Western companies.  Maybe all this talk about the rise of China and India is just like the scare talk about Japan decades ago – remembers how the Japanese were going to buy up all our companies?

But wage arbitrage has always been much too narrow a lens for viewing offshoring and the changing shape of global competition. As JSB and I suggested in an oped piece in the Financial Times almost one year ago, a much more productive way to view these developments involves focusing on skill building arbitrage – the opportunity to participate in relationships and environments that can build capabilities more rapidly than would be possible elsewhere. This broader perspective begins to bring into sharper focus the significant management innovations that certain Chinese and Indian companies are pursuing to build capability more rapidly. In an earlier blog posting, I outlined three forms of management innovation that these companies are pioneering.

In this context, the intensifying competition for talent will only accelerate the management innovations that are already under way in these countries, making the companies even more formidable competitors or providers, depending on where you stand in the global value chain. In fact, from their earliest days, these companies have understood that their success depends upon attracting and retaining talent.  More importantly, they have discovered that if they develop their talent more rapidly than anyone else, they will also have an advantage in attracting and retaining talent, so that has been the focus of many of their management innovations.

They have also understood that not all talent needs to reside within their enterprise if they can collaborate effectively with a broad range of specialized companies, so another dimension of innovation has been the development of scalable process networks that bring together hundreds, and often thousands, of specialized business partners.

By the way, skill shortages and employee turnover are often signs of healthy local business ecosystems.  Here in Silicon Valley executives routinely complain about the limited supply of qualified engineers, escalating compensation packages and high turnover rates.  The 40% employee turnover rates reported by Nasscom are admittedly high, but those are averages and skewed by the large number of smaller offshoring service providers that have been most active in playing the wage arbitrage game.  These companies are losing talented or experienced employees to competitors willing to pay more while their clients suffer the consequences in terms of deteriorating performance. Leading firms like Infosys report turnover rates in the range of 10 – 15%, much more equivalent to what we experience in Silicon Valley.  In fact, as Annalee Saxenian reminded us in her insightful book, Regional Advantage, that kind of employee turnover is a key driver of innovation activity as companies routinely acquire new talent with a differ
ent set of experiences and perspectives.

While I’m at it, note the irony that the FT article is appropriately critical of the education systems in both China and India while at the same time many in the US focus on the deficiencies in our education system as a key factor in undermining our competitiveness in the global economy.  Without in any way diminishing the severe flaws that plague our public education system, too many people spend too much time focused on the deficiencies of education systems in shaping global competitiveness.

The economic growth of China and India only marginally depends on their formal education system – much more important has been the emergence of a set of innovative companies that have figured out how to access and develop talent much more rapidly than most Western companies. Both countries have also benefited from a flourishing (and admittedly very uneven) ecosystem of private training institutes and services that help to bridge the gap between what the public schools produce and what businesses require in terms of technical, language and management skills. Once again, a sense of urgency regarding talent development seems to matter much more than any objective measures of public education system performance. Young employees in entrepreneurial Chinese and Indian companies appear to have a much greater sense of urgency about their advancement than comparable employees in most US companies have.

The FT article quotes a McKinsey Global Institute study that has received a lot of attention regarding supply constraints on skilled labor in China and India. In fact, the FT gave this study a front page story under the headline “Foreign threat to service jobs overblown’” (registration required). The study is very useful in pointing out some of the challenges in these countries but, as I pointed out in a blog posting a while ago, the study is weak in terms of its methodology for projecting future skilled labor supply.  This is a rapidly changing environment where demand pull for talent already is leading to innovative approaches that have the potential to significantly reshape supply dynamics. 

Bottom line: the intensifying competition for talent in China and India will only increase the sense of urgency already felt by the leading companies in these countries in terms of the need to pursue management innovations that can accelerate talent development. In this context, the FT article quotes N. R. Naryana Murthy, one of the founders and the “chief mentor” at Infosys, warning about the growing competition from China’s IT industry: “China is running very fast to catch up with India. Chinese are much more determined than we are.” At the same time, Western companies reading the stats on rising wage rates and average employee turnover rates in China and India are likely to become more complacent about competition from companies in these countries.

The Long Tail and the Structure of the Media Industry

Almost two years after his initial article on “The Long Tail” first appeared in Wired, Chris Anderson’s long-awaited book The Long Tail was officially released last week.  As a tribute to the power of the meme which he has diligently discussed and refined in his blog, Chris’s book has shot up to #1 at Amazon. The book about the long tail has made it up into the short head, big time.

Even for those who have been following The Long Tail blog, the book is a welcome contribution to our understanding of a fundamental force reshaping the media industry. At this point, virtually everyone has heard of the long tail but, just in case, here’s the capsule summary.  While more and more media businesses have become blockbuster-driven over the past century, three forces are working to increase the economic and cultural importance of the “long tail” – the growing abundance of products that individually sell in small numbers but that, in aggregate, account for substantial consumption.  These three forces are:

• Democratizing of the tools of production – especially affordable digital technology that makes it economically feasible to make products, even in small quantities.  In Chris’s words, this results in “more stuff, which lengthens the Tail”.

• Democratizing distribution – here Chris places particular emphasis on the role of a variety of Internet aggregators in creating “infinite shelf space” businesses where virtually every product in a category can be economically accessed.  Again, to quote Chris, this creates “more access to niches, which fattens the Tail”.

• Connecting supply and demand – Chris focuses here on the emergence of businesses and taste makers  that act as filters, helping to cost-effectively and flexibly connect people with available goods, no matter how narrow the interest or specialized the product. These filters can take a variety of forms, including search algorithms, sorting algorithms, editorial recommendations and customer reviews. Chris suggests that more efficient tools to connect supply and demand “drives business from hits to niches”.

Chris does a great job of exploring these three forces and their role in enhancing the economic attractiveness of long tail markets.  While he clearly believes that these forces are playing out in a growing range of product and service businesses, Chris spends the bulk of the book discussing examples from the media business, ranging from video to music to books.

Given the importance that he attaches to the long tail, it is a bit surprising that Chris does not pursue in more detail the implications for the structure of the media industry.  His perspective is certainly suggestive in terms of direction, but he never really steps back and spells out how the long tail might re-shape media businesses, with particular attention to the most basic question of all: who is going to create economic value and who will destroy economic value?  Perhaps it is prudent for Chris to avoid such speculation given all the uncertainties in how this might play out, but this is the question that all media executives are confronting.

At one point in his book, Chris appears to suggest that there really may not be profound changes to the existing power structure, that perhaps this is all additive:

This shift from the generic to the specific doesn’t mean the end of the existing power structure or a wholesale shift to an all-amateur, lap-top culture.  Instead, it’s simply a rebalancing of the equation, an evolution from an “Or” era of hits or niches (mainstream culture vs. sub-cultures) to an “And” era.  Today, our culture is increasingly a mix of head and tail, hits and niches, institutions and individuals, professionals and amateurs.  Mass culture will not fall, it will simply get less mass.  And niche culture will get less obscure.

But, is that all there is – a simple and smooth “rebalancing of the equation”? Let’s take a look at some of the questions raised by Chris’s perspective.  Chris spends a lot of time profiling the rise and role of aggregators like Amazon, Netflix, Rhapsody and iTunes.  Within specific media categories like books, videos and music, these aggregators have played an increasingly prominent role and have become quite concentrated in a short period of time.

In the early days of the Internet, “disintermediation” was the buzzword – all intermediaries were going to disappear and customers would connect directly with content creators.  The long tail perspective, with its emphasis on the economic role of aggregators, suggests just the opposite – intermediaries rule, albeit a different set of intermediaries than have prevailed in the traditional media business. From the early days of Net Gain and Net Worth I have advanced a similar view, highlighting the growing importance of intermediaries as options proliferate.

But let’s go one level deeper.  What kind of aggregators will prevail?  Today, we have an interesting phenomenon – highly specialized aggregators focusing on one media type: Netflix for DVDs,YouTube for videos, Rhapsody and iTunes for music, Flickr for photos, etc. In many respects, this is a perverse replication of traditional media boundaries in what was once conceived to be a multimedia business. Amazon stands out as the major exception, although its real depth is in the book category. MySpace is another interesting exception, even though it retains a deep spike in music, perhaps because it, more than most aggregators, represents a deeper blend of community and content.

Will these media ghettos persist?  Will new generations of aggregators emerge that more creatively mix and match media types?  What about the efforts of major portals and search engines like Google, Yahoo and MSN to carve out major long tail aggregation plays of their own, not to mention the budding efforts of wireless network portals to aggregate wireless content?

My own view is that the current generation of aggregator businesses represents an unstable transitional form that will unbundle into two very different kinds of businesses: infrastructure management businesses and customer relationship businesses. As I have argued elsewhere, these businesses require different skill sets and cultures and they have different economics, yet most aggregators keep these tightly bundled.  I don’t think that will last.  Both of these businesses can be very profitable and can lead to high levels of concentration and consolidation but, to sustain world-class performance, they need to be managed as focused businesses, not bundled together.

Where does that leave traditional media businesses?  Well, by and large, they represent a third kind of business today – product innovation and commercialization businesses. Here’s the problem – in the long tail world, this kind of business tends to fragment as creative talent tends to seek out smaller and more hospitable organizational homes.

So, what are the large media conglomerates to do? As I have suggested here and here, they can either unbundle or rapidly evolve into something else.  Because of their broad reach to high quality audiences, they have an opportunity to make the transition to customer relationship businesses, potentially even preempting today’s generation of online aggregators if they move smart enough and fast enough. The problem is that this is a huge transition for most media companies today – the product mindset dies hard.

Here are two tests.  Most media companies today are driven by product centric economics – they track in great detail what it costs to make a media product, how many units are sold or distributed and the revenue generated by product. How many of them effectively track the life time value of their audience members or customers – what it costs to acquire an audience member or customer, how long their relationship endures and how much revenue and profit is generated by audience member or customer?  These customer centric economics drive customer relationship businesses.

Second test – how ready are most media companies to point their audience members or customers to media products offered by their competitors? From my experience, very few. A customer relationship business acts as an agent on behalf of the customer, helping to connect them with whatever resources are most valuable or relevant to them, regardless of source.

Why is this transition from product business to customer relationship business so important?  I’ve mentioned one reason – scalability, which in a long tail world becomes harder and harder for product businesses and more and more feasible for customer relationship businesses.  But there’s another reason – brand.

Chris and I have debated this before – here, here, here and here.  Chris appears to believe that in a long tail world brand fractures and fragments as customers themselves, or at least the tastemakers and celebrities among us, develop reputations as trusted advisors to help others navigate through the long tail. I hold that, in a long tail world, customer relationship businesses have an opportunity to create very powerful and scalable brands based on the proposition that they know individual audience members or customers better than anyone else and can be trusted to use that knowledge to become ever more helpful to the audience member or customer.

I am also a bit more skeptical than Chris appears to be about advertising as a sustainable business model for many media companies over the longer term. It’s a topic for another blog posting, but the very efficiency of advertising aggregators like Google in making it possible to sell “tens of millions of unique ads” will over time just contribute to the growing clutter as more and more options compete for our limited attention. The increasing current focus on intention and transactions in online advertising, while understandable, distracts from the real opportunity: to build deep and sustaining relationships.

Bottom line, the dynamics of the long tail (combined with other factors) will lead to a profound restructuring of the media industry.  In contrast with many others who believe that the long tail will lead to fragmentation, I see the potential for concentration and consolidation of focused infrastructure management and customer relationship businesses. I also see an opportunity to build much more powerful brands in the media business.  While there are early leaders in this effort, we are still very much in the early innings with lots of opportunities for new players to emerge and create significant economic value.  Current leaders risk significant value destruction if they don't rapidly adapt to the changing rules of the game.

All of this is not meant to detract from Chris Anderson’s accomplishment.  He has crafted a compelling meme to capture a fundamental shift occurring in the media business and his book explores many of the dimensions of this shift with great insight.  It is a tribute to his book that it prompts an even broader and richer set of questions that media executives and, ultimately, all of us will need to wrestle with as we navigate through the long tail. Perhaps these questions will be the focus of his next book.

Unbundling and Rebundling

What’s going on here?  It seems that each day brings another announcement of a major new merger or acquisition.  A few days ago, the newspapers reported a potential global alliance taking shape in the automobile industry, bringing together GM, Nissan and Renault.  In the past few weeks, we have seen Mittal Steel’s acquisition bid for Arcelor, Phelps Dodge’s acquisition of both Inco Ltd. And Falconbridge Ltd in the mining industry, and Johnson & Johnson’s acquisition of the consumer brands division of Pfizer, Inc.

I wrote a widely quoted article in Harvard Business Review back in 1999 entitled “Unbundling the Corporation” (purchase required) – how do I reconcile that perspective with the recent wave of merger and acquisition activity on a global scale? In fact, if we probe beneath the headlines, we see an interesting paradox: mergers and acquisitions are accelerating at the same time that a systematic unbundling of the corporation plays out.

The current wave of M&A is a direct response to intensifying global competition at two levels – in both product and financial markets.  In product markets, product life cycles are compressing, margins are eroding and market fragmentation makes it more and more difficult to make this all up on volume.  In financial markets, investors are becoming increasingly demanding, seeking not only near-term profitability but attractive growth prospects as well.

What’s a CEO to do?  Well, judging by the recent pattern of M&A activity, CEOs are increasingly looking for mergers and acquisitions within the same industry, often across national boundaries.  This is a marked improvement over previous waves of M&A activity that were more purely growth focused and often led companies into diversification strategies that destroyed value rather than creating it.

These consolidation strategies seem to have two primary drivers.  First, executives pursue opportunities to squeeze additional cost savings by leveraging economies of scale.  Second, they seek to expand their product brand portfolio as a way to pump up revenue growth.  There’s a third factor in play as M&A activity increases – CEOs face a choice of either embarking on an aggressive acquisition strategy of their own or risk becoming an acquisition target of someone else.

In the face of growing competitive and financial pressure, these are reasonable motivations.  The question is whether they go far enough.  Like the stock buybacks that I discussed in an earlier posting, these initiatives may reflect a more serious shortcoming: an institutional inability to internally generate profitable sources of growth.  In fact, these initiatives may significantly distract executive (and investor) attention from the pressing need to restructure enterprises to create sustainable growth platforms. The turmoil at Kraft Foods, where the CEO was recently replaced, illustrates this risk.  After embarking on an aggressive acquisition program to add new brands to its portfolio, Kraft has underperformed in terms of creating new brands of its own or generating more value from its existing brand portfolio.

The core message of my article on “Unbundling the Corporation” was ultimately a growth message – unbundling is a pre-requisite to sustainable and profitable growth. Unbundling does not lead to smaller enterprises, but instead creates powerful growth platforms.  In a nutshell, the article argued that most enterprises today are an unnatural bundle of three very different kinds of businesses – infrastructure management businesses, product innovation and commercialization businesses and customer relationship businesses.  By trying to manage the inherently conflicting demands of these three businesses within a single enterprise, executives undermine the potential for profitable growth.

In fact, this unbundling is already taking place across many industries around the world.  Over the past several decades, we have seen the rapid growth of many forms of outsourcing – including logistics, contract manufacturing and call center operations.  In effect, these outsourcing operations have grown as enterprises systematically make choices to strip out their infrastructure management businesses – high volume, routine processing operations – and turn them over to more focused companies.  And the leaders within the outsourcing business, whether we are talking about Federal Express and UPS in logistics or leading companies in contract manufacturing and call center operation, are enjoying significant growth as they leverage the scale economies that shape most infrastructure management businesses.

This first wave of unbundling is already well under way.  We are only in the earliest stages of the next wave of unbundling – separating product innovation and commercialization businesses from customer relationship businesses. This next wave is beginning to play out in some industries like pharmaceuticals where biotech companies focused on product innovation and commercialization are developing complementary relationships with established pharma companies that have deep relationships with “customers” (in this case, doctors and health care institutions).  As I have suggested in another posting, this next wave of unbundling will also shape the future evolution of the media industry as it grapples with the challenges and opportunity of digital networks.

So what are the implications of all of this for CEOs?  First, be wary of aggressive M&A campaigns until your management team has engaged with, and aligned around, the most basic question of all: what business are we really in?  Every management team faces difficult choices in terms of which of the three businesses to focus on, yet few companies have explicitly engaged on this question.  Until these choices have been made, M&A programs run the risk of complicating business operations – this is one reason why anticipated synergies rarely surface and why M&A transactions more often than not destroy economic value, rather than creating it. 

Second, once these choices have been made, pursue aggressive growth strategies consistent with the economics of the business chosen.  Each of the three business types has very different growth opportunities and sustainable growth will depend on pursuing consistent growth strategies.  M&A will certainly play a role in these growth strategies, but the real opportunity will lie in harnessing the internal growth potential that is made possible by operating a focused business. The paradox is that unbundling is a pre-requisite for profitable and sustainable rebundling.

The Challenge of Growth

Economics as a discipline would seem to be closely related to management studies. Yet the edge between these two areas of inquiry has often seemed more like a chasm than a fertile field for insight. Economists wedded to mathematical models of equilibrium look down on the “unscientific” musings of management theorists.  Management writers, on the other hand, look upon economics as a theoretical inquiry that offers little insight into the real world challenges of business executives.  As just one example of the latter, look at what Peter Drucker had to say about economics:  "There are no slower learners than economists. There is no greater obstacle to learning than to be the prisoner of totally invalid but dogmatic theories."

Two recently published books shed light on the potential to redefine economic inquiry in ways that could help to cross this chasm. The first book, Knowledge and the Wealth of Nations, by Peter Warsh focuses on the impact of one journal article – “Endogenous Technological Change” by Paul Romer - in re-shaping the focus of economic inquiry. The second book, The Origin of Wealth by Eric Beinhocker, does a remarkable job of describing the ways in which complexity theory provides new insight into economic issues.

A warning to executives – if you are looking for easy to digest management prescriptions or parables like “Who Moved My Cheese?”, stay away from these books.  They are both extremely well written, but they are much more concerned with describing new lenses for understanding the economic landscape than with offering quick tips for profitability and growth.  There is enormous insight to be gained from both books, but the reader needs to be patient and willing to think carefully about the material covered.

It is certainly not the place for a blog to try to summarize the complex and nuanced perspectives offered by these books.  Instead, I'll just briefly point out a few of the interesting elements in each book to try to prompt those interested to dive into the books themselves.

Both books begin by outlining some of the key limitations of 20th century mainstream economics: a deep focus on static equilibrium models and a tendency until fairly recently to view such critical factors as the extent of knowledge or tastes and preferences as “exogenous factors” that are not within the scope of economic analysis. As Warsh indicates, these exogenous factors “lay outside the model, treated as a ‘black box’ whose detailed internal workings were to be willfully ignored.”

While both books describe efforts to overcome these limitations, it is striking that these books have such little overlap.  In fact, Paul Romer, who plays a central role in Warsh’s book, merits only two brief mentions in Beinhocker’s book.  In contrast, the Santa Fe Institute and complexity theory, both key players in Beinhocker’s book don’t even surface in Warsh’s book.

Warsh’s book focuses on the “conceptual rearrangement in economics” precipitated by Paul Romer in his article on "Endogenous Technological Change" in the Journal of Political Economy in 1990.  Paul Romer’s key insight was to describe knowledge as a “non-rival, partially excludable good” that played a central role in driving both technological change and economic growth.  For the layman, this means that knowledge can be “shared equally by many persons at the same time practically without limit” but also that “access . . . can in some degree be controlled.”  Among other things, this provides a foundation for increasing returns, a concept that mainstream equilibrium economics found deeply problematic.

Warsh sums up the impact of Romer’s article in the following way:

The fundamental categories of economic analysis ceased to be, as they had been for two hundred years, land, labor and material.  This most elementary classification was supplanted by people, ideas and things. . . . Technical change and the growth of knowledge had become endogenous – within the vocabulary and province of economics to explain.

In the end, I fear that Warsh overstates the impact of Romer’s article, implying that it led to a fundamental shift in the economics profession, away from static, equilibrium models and towards more dynamic, growth models.  While the article was certainly influential and opened up a new set of issues for economic inquiry, too much of the mainstream economics profession remains mired in the mathematical marshes that simplify away all the interesting variables of economic life.

In particular, Warsh is much too optimistic about Romer’s role in resurrecting “that long-neglected figure (at least in economics classrooms), the entrepreneur.”  To really gain insight into the economic role of the entrepreneur, one still has to venture far beyond mainstream economics into the realm of Austrian economic perspectives, starting with Joseph Schumpeter and most recently developed by Israel Kirzner.

Beinhocker’s book takes on a more ambitious task.  As he indicates in his preface,

. . . the field of economics is going through its most profound change in over a hundred years.  I believe that this change represents a major shift in the intellectual currents of the world that will have a substantial impact on our lives and the lives of generations to come.  I also believe that just as biology became a true science in the twentieth century, so too will economics come into its own as a science in the twenty-first century. . . . .

Despite the importance of economic thinking, few people outside the hushed halls of academia are aware of the fundamental changes under way in the field today.  This book is the story of what I will call the Complexity Economics revolution: what it is, what it tells us about the deepest mysteries in economics, and what it means for business and for society as a whole.

This is a remarkable book (full disclosure: Eric acknowledges me as one of the people who played a substantial role in shaping the thinking in this book, so I am a bit biased).  It is a wide-ranging critique of the limitations of mainstream economics, succinctly summarized by Eric in the following way:

. . . economics has historically been concerned with two great questions: how wealth is created and how wealth is allocated.  Between the Classical Era of Adam Smith and the mid-twentieth century era of Samuelson and Arrow, the first question was largely overshadowed by the second.  The models of Walras, Jevons and Pareto began with the assumptions that an economy already exists, producers have resources, and consumers own various commodities.  . . . An important reason for this focus on allocation of finite resources was that the mathematical equations of equilibrium imported from physics were ideal for answering the allocation question, but it was more difficult to apply them to growth.  Equilibrium systems by definition are in a state of rest, while growth implies change and dynamism.

But this is only a launching pad, Eric’s primary focus is on providing a rich and powerful view of the drivers of wealth creation:

This book will argue that wealth creation is the product of a simple, but profoundly powerful, three-step formula – differentiate, select, and amplify – the formula of evolution.

Eric develops this perspective and traces out its implications in a broad range of domains in language that is simple and compelling while illustrating complex concepts with examples that are accessible and entertaining. Rather than trying to summarize his arguments and inevitably doing an injustice to the richness of his book, let me instead just briefly highlight two areas that I wish he had developed more, even though his book, with a wealth of footnotes, already breaks the 500 page barrier.

First, like most of the complexity theorists that influenced him, Eric puts great emphasis on the need for adaptability.  This is certainly appropriate, but it under-estimates the potential for shaping strategies.  In environments undergoing rapid change and a high degree of uncertainty, players have more degrees of freedom to alter outcomes than they would have in more static environments.  Shaping is of course different from dictating – we are talking about the ability to alter probabilities on the margin rather than designing and imposing outcomes.  This is an enormous opportunity for companies of all sizes, yet very little is understood about what is required to be a successful shaper.  This is a topic for another blog posting, but shapers have very different mindsets and practices relative to adapters, even though both types of players in the end have to be highly adaptable in the strategies they pursue.

Second, and related to the first, Eric’s rich discussion of business strategy towards the end of his book suffers from a tendency to focus solely on individual enterprises without exploring significant opportunities to pursue strategies that mobilize large networks or webs of participants. His discussion of strategy tends to assume a dichotomy of firm and market, without acknowledging the rich spectrum of relationships that exist between these two extremes. This is particularly surprising since, earlier in his book, Eric explores with great insight the role of networks in complex adaptive systems.

In the end, both books are deeply concerned with bringing the growth of knowledge and its role in wealth creation back into center of economic inquiry. This is a profound, and long overdue, development.  It may finally help to close the chasm that has separated economics and management studies.

But to do more than close the chasm and generate even greater insight, it will be necessary to add another key ingredient to the mix – exploring more systematically the role of relationships in shaping opportunities for learning and the growth of knowledge. In fact, these two topics are inextricably linked in terms of understanding the potential for wealth creation and it will be difficult to generate much insight for business strategy without understanding these connections more fully.