Academic journal article The McKinsey Quarterly

Strategy at the Edge of Chaos

Academic journal article The McKinsey Quarterly

Strategy at the Edge of Chaos

Article excerpt

"Fishbowl" economics once provided the basis of corporate strategy. No more

New theories show markets are "complex adaptive systems"

Making your company an evolver

Are we more than blind players in an evolutionary business game?

The Economist Paul Krugman says that there are three types of economics. There are up-and-down economics ("stocks were up and unemployment was down today"), airport-bookstore economics (Ten Easy Steps to Avoid Global Depression), and Greek-letter economics. Greek-letter economics is the mathematical variety practised in universities and published in academic journals. And it is in serious trouble.

Historically, Greek-letter economics has rewarded mathematical pyrotechnics over fidelity to the real world. The core theories it has produced over the last few decades, such as rational expectations and general equilibrium, are mathematically elegant, but lacking in empirical validity. Joseph Stiglitz, chairman of the US President's Council of Economic Advisors, recently observed, "Anybody looking at these models would say they can't provide a good description of the modern world."

The dismal state of the dismal science matters to managers, CEOs, consultants, and business professors because much of modern thinking in management is built on a foundation of Greek-letter economics. The bad news is that this foundation is now in serious doubt; the good news is that a radically new one is starting to be put in place. Though the term paradigm shift is overused, the changes currently taking shape in economics justify the use of the phrase Thomas Kuhn coined to describe how scientific fields enter a state of crisis and then move to a completely new way of thinking, as with the shift from Newtonian to Einsteinian physics.

The new approach to economics has important implications for management, and in particular for strategy and organization. Although it is still in its infancy, we can begin to see how it might help us gain fresh insights into a host of difficult questions. Why do industries that look stable suddenly get turned upside down? How can companies develop strategies in the face of uncertainty? Why are big companies that seem to have it all so often vulnerable to attack by small upstarts?

Let's begin by considering where traditional thinking on management comes from, and how it is based on a central metaphor that originated in physics and was adopted by economics.

The roots of management thinking

Many of the most successful and widely used strategy tools today - the five forces framework, cost curves, the structure-conduct-performance (SCP) model, and the concept of sustainable competitive advantage, to name a few - owe their origins to ideas developed in the 1950s in a field known as the theory of industrial organization. IO theory, which is concerned with industry structure and firm performance, is in turn based on microeconomic theory.

Modern neoclassical microeconomics was founded in the 1870s by Leon Walras, William Stanley Jevons, and Carl Menger, and synthesized into a coherent theory by Alfred Marshall at the turn of the century. Seeking to make economics more scientific, Walras, Jevons, and Menger had borrowed ideas and mathematical apparatus from the leading science of their day, energy physics. Twenty years earlier, Julius Mayer, James Prescott Joule, Hermann von Helmholtz, and Ludwig August had achieved breakthroughs in energy physics that paved the way for thermodynamics. The early neoclassicists copied the mathematics of mid-nineteenth-century energy physics equation by equation, translating it metaphorically (and, according to many physicists, incorrectly) into economic concepts.

Another neoclassicist, Irving Fisher, showed in his 1892 doctoral thesis how the physicists' "particle" became the economists' "individual," "force" became "marginal utility," "kinetic energy" became "total expenditure," and so on. …

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