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Two Laws for Creating Wealth
I have just returned from the snow-covered town of Davos, Switzerland where I spent a week attending the Annual Meeting of the World Economic Forum . This is truly an extraordinary event, both stimulating and exhausting. It draws together 1,000 CEO’s from leading corporations around the world to mingle with government leaders, rising young corporate leaders, heads of major non-governmental organizations and a variety of intellectual and cultural luminaries, including more than a few Nobel Prize winners. These people are crowded together in a remote Alpine town for a week of meetings that begin at 6 AM breakfasts and end with "nightcap" meetings that start at 10pm and often go on to the wee hours of the morning.
It is an unparalleled opportunity to get the pulse of the world’s elite and spot emerging issues that will shape the agendas of corporations and governments around the world. This year, I was overwhelmed by the pessimism that pervaded the formal sessions, the informal meetings and the conversations in the hallways. Invariably, discussions focused on threats, risks and challenges. An overwhelming chorus of skepticism quickly drowned out those few who tried to discuss opportunities and new sources of growth. A siege mentality ruled in Davos.
Given the eminent positions of the participants, one might be tempted to say that this pervasive sense of malaise is a bad sign for the world – if they are worried, perhaps we all should be worried. God knows, there is enough to be worried about. The U.S. is stumbling into something that only vaguely resembles a recovery, key European countries like Germany are sliding into recession, Japan remains stuck in a decade-long downturn with no sign of recovery. The imminent U.S. invasion of Iraq increasingly looks like only the beginning of a long series of destabilizing unilateral initiatives by the U.S. government to "liberate" the rest of the world. AIDS ravages broad sections of the developing world, the Arab/Israeli conflict seems more intractable than ever and terrorist movements show little sign of retreat.
Yet, I have been attending the Annual Meetings of the World Economic Forum long enough to know that the participants, as august as they are, remain prone to the same kinds of fads and fashions as the rest of us. During the tech bubble, all you could hear about was the opportunity to change the world through rapid adoption of technology. Now that the bubble has burst, the pendulum has swung in the opposite direction and all we can talk about are the threats and challenges that prevent us from moving forward.
In challenging times like this, uncertainty becomes very corrosive. All the old rules seem no longer to apply. New rules are hard to identify.
In an effort to combat the pessimism and uncertainty, and perhaps in the process move the pendulum a little more towards center, let me focus on two laws of business (and other human activity) that continue to apply. Business executives who understand these laws and who exploit these laws will continue to create economic value, even in the most challenging of times. The two laws I want to discuss are the Pareto Law and the Power Law.
The Pareto Law has a venerable tradition. It was first developed in 1897, over one hundred years ago, by the economist Vilfredo Pareto. In studying wealth and income distribution in nineteenth century England, Pareto noticed an interesting pattern: 80% of the wealth was held by 20% of the population. As Pareto looked at a broader range of economic activity, he realized that this pattern was not confined to that one period or one country. It seemed to broadly apply to many forms of economic activity. Unfortunately for Pareto, he never distilled the law to a simple formulation that could be broadly understood. Instead, he developed complex mathematical formulas demonstrating the logarithmic patterns that pervaded economic activity. If he had been more adept at popularization, he might have framed his law as the "80/20 rule" and secured himself a much more prominent position in economic history.
Today, all experienced business executives are familiar with the 80/20 rule, although few systematically apply it in their day to day business activities. One of the best books to explore this law is The 80/20 Principle: The Secret to Success by Achieving More with Less by Richard Koch. It sounds like one of those dreadful self-help books that dominate the business best-seller lists, but it is actually a very insightful development of the implications of the Pareto Law.
Bottom line, the Pareto Law can be useful to business executives at two levels. First, it is enormously helpful as a guide to cost-cutting and near-term performance improvement. My friend, Scott Cook, the founder of Intuit, is fond of saying that the best way to make money is to stop losing money. Sounds obvious, but few executives follow this basic insight. The Pareto Law provides a quick way to identify where a business is losing money. How many executives can quickly identify the 20% of customers, products, facilities and business units that generate 80% of the profits in their company? This basic question can focus company initiatives on the other 80% of the company – what can be done either to improve profitability of these parts of the business or to scale back activities in these under-performing segments?
This is a promising way to improve near-term profitability. But the Pareto Law can also be a powerful tool for enhancing business leverage: generating more value with fewer resources. Look at the 20% of the business that is generating 80% of the profits. These are precisely the business activities that generate the most value today with the least effort and investment. What can be done to expand those parts of the business? Chances are, there are hidden opportunities to accelerate growth and further improve profitability by investing modest amounts in high leverage areas of the business.
So far, we have been talking about the Pareto Law as an opportunity to improve performance within the enterprise. Let’s turn now to the Power Law. Earlier, I framed the Pareto Law and the Power Law as two separate laws. In fact, these are actually both the same law, although you wouldn’t know it by listening to analysts of either law. I mentioned earlier that Pareto never got very far with the formulation of his insight because he framed it in complex mathematical terms (something like log N = log A + m log x – is it any wonder that it didn’t catch on?). Someone later came across Pareto’s work and realized he was describing a simple 80/20 relationship (to my knowledge, Pareto never himself reduced it to this simple formulation) and helped immensely in popularizing his mathematical analysis.
The complex mathematical formulation of his law survives today among analysts of the Power Law – largely academics who have focused on understanding the behavior of networks and complex adaptive systems. Networks refer broadly to any collection of objects and a set of relationships among the objects. Economic networks include markets, individual supply chains or even collections of people who work together within enterprises. Social networks include relationships that might be shaped by schools, ethnic backgrounds or religious affiliations. Networks also include electronic networks like the Internet or biochemical networks like neurological networks or metabolic systems within the human body. The real focus in network analysis is on how relationships form among the objects and, in turn, how these relationships affect the performance of the objects.
Essentially, the Power Law describes a common pattern existing in networks of many types. It suggests that the size of certain events within the network is logarithmically related to the frequency or distribution of those events. For those of you whose eyes glaze over at the mention of logarithmic relationships, a simple example will illustrate what this means. Look at the distribution of cities around the world – there are a few very large cities and a lot of very small cities. In fact, as the size of a city increases by a certain percentage, the frequency of cities of that size will diminish by a corresponding percentage. It is exactly this relationship that leads to the 80/20 pattern popularized as the Pareto Law – 20% of the cities account for 80% of all city dwellers. The prevalence of this pattern is quite impressive – it is very good news for the 20% that account for most of the activity but it is very challenging for the 80% that have to share the remaining activity.
OK, we’re getting pretty conceptual here – what does all this have to do with business? The Power Law is actually central to new forms of strategy. Through an accident of history, business literature has tended to apply the 80/20 rule of the Pareto Law to activities within the enterprise – 20% of effort tends to account for 80% of the value. The Power Law has been largely absent from business literature, but it takes the same general phenomenon and focuses on its appearance in networks extending beyond a single enterprise. Boiled down to its basics, the Power Law suggests that certain positions within certain kinds of networks are strategically advantaged. Not only do they possess more of the resources at any point in time, but the dynamics behind the Power Law suggest that they will accumulate resources at a faster rate than other positions throughout the network. These positions will tend to generate more value over time relative to other positions in the network. Put colloquially, the rich will get richer. By understanding and occupying these privileged positions within a network, the firm can generate far more value for a given amount of investment. This is the external equivalent of the leverage within the enterprise that the 80/20 formulation of the Pareto Law focuses on.
The goal of strategy therefore is to understand the dynamics of networks and, wherever possible, to shape these dynamics so that the firm can find and occupy the strategically advantaged positions. (Although they have made enormous contributions to our understanding of complex adaptive systems, complexity theorists and network theorists tend to view these systems as evolving in ways that cannot be affected by the participants. While these systems cannot be designed in a top-down fashion, they certainly can be, and are, shaped by actions taken by participants.)
We are only beginning to understand the implications of network dynamics for business strategy. I have written about this (although I use the term economic webs) in my article "Spider versus Spider" and in chapters 6 and 7of Net Worth: Shaping Markets When Customers Make the Rules. In an earlier blog entitled "Coping With Margin Squeeze," I referenced some of the interesting recent literature on network theory that is certain to redefine how we think about strategy (although, I should warn you, none of these books really deals with business strategy issues directly – that is left to the reader to intuit). Since that blog, another great book, perhaps the best of the recent crop, has appeared – Six Degrees: The Science of a Connected Age by Duncan J. Watts, one of the pioneering researchers in network theory.
I will use my forthcoming newsletter to discuss in more detail how these insights regarding network dynamics might be used to shape new forms of business strategies. For those of you who can’t wait, let me give you three key questions to ask about your business strategy, driven from the insights of network theory:
In essence, these questions all focus on how you can start to shape a network or economic web by focusing more explicitly on incentive structures. The key to harnessing the Power Law is to define appropriate incentives for third parties to affiliate with you rather than any other competitors and, in the process, enhance the value you can offer to customers. By driving growth and strengthening preferential affiliation (a term of art used by network theorists), companies can create more value with fewer of their own resources – the essence of leverage. Of course, a lot more needs to come together, including stronger capabilities to manage third party relationships and greater focus on creating feedback loops to enhance performance of the network participants.
Bottom line, I hope all business executives will resist the temptation to sink into a siege mentality. Now, more than ever, they need to be driven by an opportunity mentality. By studying the dynamics behind the Pareto/Power Law and systematically applying the lessons learned, business leaders will discover new forms of leverage that will unleash significant value creation.
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The Next Wave of Open Innovation
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- Creation Nets: Harnessing the Potential of Open Innovation (co-authored with John Seely Brown) April, 2006
- Connecting Globalization & Innovation: Some Contrarian Perspectives (Prepared for the Annual Meeting of the World Economic Forum in Davos, Switzerland January 25 – 30, 2006; co-authored with John Seely Brown)
- "The Benefits of a Long Distance Relationship" (co-authored with John Seely Brown), August 9, 2005
- "Feed R&D - Or Farm It Out?" (HBR Case Study with Commentary co-authored with John Seely Brown), July 2005
- "Productive Friction: How Difficult Business Partnerships Can Accelerate Innovation" (co-authored with John Seely Brown), February 2005
- "From Push to Pull: The Next Frontier of Innovation" (co-authored with John Seely Brown), 2005, No.3
- "Innovation Blowback: Disruptive Management Practices from Asia" (co-authored with John Seely Brown), 2005, No.1